How the Economy Works: Confidence, Crashes and Self-Fulfilling Prophecies

How the Economy Works: Confidence, Crashes and Self-Fulfilling Prophecies Summary:

By Roger E. A. Farmer

Publisher: University , USA

Number Of Pages: 208

Publication Date: 2010-04-08

ISBN-10 / ASIN: 0195397916

ISBN-13 / EAN: 9780195397918

Product Description:

"Of all the economic bubbles that have been pricked," the editors of The Economist recently observed, "few have burst more spectacularly than the reputation of economics itself." Indeed, the financial crisis that crested in 2008 destroyed the credibility of the economic thinking that had guided policymakers for a generation. But what will take its place? In How the Economy Works, one of our leading economists pres a jargon-free exploration of the current crisis, offering a powerful argument for how economics must change to get us out of it. Roger E. A. Farmer traces the swings between classical and Keynesian economics since the early twentieth century, gracefully explaining the elements of both theories. During the Great Deion, Keynes challenged the longstanding idea that an economy was a self-correcting mechanism; but his school gave way to a resurgence of classical economics in the 1970s-a rise that ended with the current crisis. Rather than simply allowing the pendulum to swing back, Farmer writes, we must synthesize the two. From classical economics, he takes the idea that a sound theory must explain how individuals behave-how our collective choices shape the economy. From Keynesian economics, he adopts the principle that markets do not always work well, that capitalism needs some guidance. The goal, he writes, is to correct the excesses of a free-market economy without stifling entrepreneurship and instituting central planning. Recent events have shown that we cannot afford to treat economics as an ivory-tower abstraction. It has a direct impact on our lives by guiding regulators and policymakers as they make decisions with far-reaching practical consequences. Written in clear, accessible language, How the Economy Works makes an argument that no one should ignore.

Amazon.com Review:

Amazon Exclusive: A Q&A with Author and Professor Roger E.A. Farmer

Q: Why does the stock market matter to every American?

Farmer: In the 1930s, stock market wealth was much more concentrated than it is today. Middle and low income Americans held their savings in banks and it is for that reason that the collapse of the banking system in the 1930s was so devastating. In the 21st century, most middle class Americans own pension plans that invest in the stock market.

US wealth is roughly two-fifths houses and three-fifths factories and machines that are indirectly owned by households through their ownership of financial intermediaries such as bank accounts and pension rights. When the stock market plummets but recovers quickly, as it did in 1987, the effect on private households is minimal. When the stock market falls, as it did in 2000, but house prices keep rising, the effect is again small since households can borrow against housing wealth to maintain consumption. When houses and stocks fall together as they did in 1929 and again in 2008, the effect can be devastating.

Q: From an early age, the American student learns the basics of math and science, but the fundamentals of economics are often not part of his or her core curriculum until college. Do you think economics should be a core component of a student’s primary education?

Farmer: Economic literacy is as important to citizenship as literacy in mathematics and the physical sciences. It has two components--an understanding of economic history and an evaluation of historical events using the tools of economic logic. How the Economy Works is accessible to high school students and it combines the elements of economic history and economic science in a way that should make it attractive as supplementary reading in high school classes in history, civics and economics as well as in introductory college courses.

Q: What are you hoping readers will take away from this "jargon-free" exploration of the current economic crisis?

Farmer: I hope that the reader will understand three things. First, that the current crisis is just the latest in a series of crises that have plagued market economies since the inception of capitalism. Second, that politics and economics are irrevocably entwined and that government responses to financial crises have a symbiotic relationship with the evolution of the history of economic thought. Third, that the correct response to the crisis is to learn from it, and to develop new tools. In the words of Francis Bacon, “He that will not apply new remedies must expect new evils; for time is the greatest innovator.” (Francis Bacon, Essays, 11. 1884 Of Great Place).

Q: What is the difference between the Classical and Keynesian approach to macroeconomics?

Farmer: Classical economics sees the economy as self-correcting. Keynes thought that the stabilizing mechanisms in the private market system are nonexistent or, at best, very slow. In How the Economy Works, I put it like this:

The classical Norwegian economist Ragnar Frisch likened the economy to a child’s rocking horse. The horse is regularly buffeted by shocks. Think of a child hitting the horse with a stick. According to Frisch, these blows are like major economic events. A war in the Middle East. A hurricane in the Midwest. An airline pilots’ strike. After each shock, unemployment might rise temporarily as the economy readjusted to the blow but it would quickly return to its equilibrium level just as the rocking horse will come to rest if left alone. This is a good physical analogy to the classical idea of a self-correcting economic system.

Keynes had much less faith in the free market. In Keynesian economics the economy is like a boat on the ocean with a broken rudder. Gusts of wind represent major economic events. A war in the Middle East. A hurricane in the Midwest. An airline pilots’ strike. After each shock, unemployment rises or falls permanently and there is no self-correcting mechanism to return it to a unique equilibrium: Just as a sailboat will be becalmed wherever it comes to rest, the unemployment rate can end up anywhere. The classical economists saw the economy as a stable self-correcting system. Keynes did not.

Q: The Great Deion occurred on the heels of the Roaring Twenties. Did the crisis of 2007/2008, after nearly a decade of prosperity, mirror what happened so many decades before?

Farmer: The 2007/2008 recession was preceded by a decade of prosperity, as was the crash of 1929, but so were many other recessions. What makes the current crisis like the Great Deion is that in 2008, as in the Great Deion, the Fed ran out of ammunition. The interest rate reached a fraction of a percentage point in 1934 and could not be lowered further. The same was true in most western economies by 2008/2009.

Q: What changes in Fed regulation do you think are needed to ensure that we don’t repeat the economic mistakes of the recent past?

Farmer: Many contemporary commentators have argued for greater bank regulation as a second tool of policy to help prevent financial crises. This follows from misdiagnosing the problem.

The current crisis was triggered by a self-fulfilling drop in confidence that caused housing and stock market wealth to fall simultaneously. The fall in wealth caused households and firms to cut back on demand and firms to lay off workers. The crisis was alleviated by two government actions. Central banks throughout the world bought long-term bonds and mortgage backed securities in an effort to lower their yields. National treasuries engaged in large expansions in government expenditures based on Keynesian theory.

The central bank purchases of long bonds was a good idea and was responsible, I believe, for boosting the value of the stock market and preventing a further collapse in the housing market. The expansion of government expenditure, financed by borrowing, was not a good idea and will leave our children and our grandchildren with a huge debt to foreigners.

Going forward, we need to institutionalize the policy of quantitative easing as a substitute to fiscal policy. The Fed should manage the short rate to target inflation. The Fed, in conjunction with the treasury, should manage a second asset price to target unemployment. Ideally, that second price would be the growth rate of a stock market index but the price of long bonds is a good substitute.

(Photo by Magnus Pettersson)

Summary: Clear and Concise History of Macroeconomic Thought

Rating: 5

This book pres a comprehensive description of the history of macroeconomic thought in the twentieth century. It explains in great depth, though in very simple language, what we know about the way the economy works. Prof. Farmer describes the different views that the best thinkers held about it and how our understanding developed over the course of the century. From the book it becomes crystal clear, which ideas and points of view shape the debate on what to do about the current situation, and what logical inconsistencies each of them has. At the end of the book Prof. Farmer presents his own views of how the economy works, which incorporate ideas of both Keynes and Hayek, but weed out the inconsistencies. This simple yet coherent framework leads him to some quite striking policy proposals, which are definitely worth careful consideration. Great reading and Great thinking!

Summary: Not Quite Successful

Rating: 3

I agree with many of the other reviewers. This book starts out as an outline summary of economic history over the last century (except for Adam Smith, of course.) Then, the author talks a bit about his own recommendations for the 2008 crisis, having to do with index funds. I have to say that the book reads a bit dryly to this non-economist. The author does seem to repeat himself a lot, and the book lacked "flow" for me, for lack of a better word. It was not easy reading, and a lot of books about the crisis have been published by now, so there is a lot of competition. I should point out that I read an uncorrected advance copy; maybe the final version is cleaner. It's also possible that an actual economist would get more out of this than I did.

Summary: Good introduction to economics

Rating: 4

Roger Farmer writes a good book for those who are "new" to economics. It's a good starter book for those who do not have advance understanding of markets and who just want to get a general idea. However, as we all know in life, hindsight is always 20/20. Even with a "full understanding" of the economy and how it "should" work, things just never seem to. There will always be some form of disruption which will throw everything into chaos and wreck havoc. We just experienced this because of the sub prime mortgage crisis and the scandals investment banks have been running. However, this book is an interesting read and is recommended to those who just want to get a general idea of economics.

Summary: Recessions, Unemployment, and Investor Confidence

Rating: 3

Professor Farmer has written a brief and relatively easy to follow account of the economy with the recent economic crisis as his focus. He gives a summation of each relevant branch of economic thought, and then makes his own suggestions that further the current synthesis. At the heart of the book is the fact that unemployment can remain high for periods that are unjustified by mathematical models, and the fact that investor confidence in the market plays a major factor in determining the strength of the economy. Professor Farmer successfully defends Keynesian economics by adding a few modern touches to the framework and proposes a type of central banking investment strategy in the stock market that I am unqualified to judge, but appears to be well considered. Farmer is skeptical of many of the current bailout programs, but he also shows a healthy disregard for the decisions that brought about the economic crisis in the first place, so that he shows no undue bias toward the left or the right, or the Republican or Democratic agenda. As a brief overview 'How the Economy Works' is recommended, but for greater detail weightier tombs must be sought. The introductory quotations to each chapter have been particularly well chosen.

Summary: Easy Read

Rating: 3

Yet another watered-down book on Economics and the Economy. The first half is simply a review of mainstream economists and their academic work. While the second half offered some analysis, unfortunately I found the material lacking rigor. 

The author constantly referred to his more rigorous book for the details. It was hard to see the real academic grounding when the author repeatedly reminded the reader that this was a simplification of the more complex theory. Perhaps I simply had higher expectation because of my academic training. At some very high level this could be an entreating and to some extend enlightening to those that don't have a formal training or understanding of the subject matter. If you are like me with some formal graduate level training in Mathematics and/or Economics then this is not the right book for you. On the other hand if you are looking for a high level qualitative review of popular Economic theories then this could be a good read.

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