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John Cochrane on Russ Roberts on What Economics Is and Isn’t Good For

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John Cochrane’s reflections [2] on Russ’s recent Medium essay [3] are excellent.  I encourage you to read it all – both Russ’s fine essay and the post by Cochrane that Russ’s essay inspired.  Here’s a slice from Cochrane’s post:

As you see, I think [we economists are] pretty good at identifying causal channels that most analysts ignore, even if we are not always great at quantifying their relative significance. But “not zero” is usually an eye opener in public policy.

In sum, I think economics provides an excellent set of bullshit detectors. This is my stock answer about my own professional expertise. I may not know what makes the economy grow, or how monetary policy works. But I know with great detail exactly why the ten stories in front of us are all wrong, and typically logically incoherent. That is useful knowledge.

And here’s Cochrane’s conclusion:

So let’s call it Hayekian humility. This is the hardest one for so many economists to admit, as we all like to play central planner.

Economics and economic history also teach us humility: No economist in 1900 could have figured out what farmers, horse-shoers, ice deliverers, street-sweepers, and so forth would do when those jobs disappeared. The people involved did. Knowledge of our own ignorance is useful. Contemplating the railroad in 1830, no economist could have anticipated the whole new industries and patterns of economic activity that it would bring — that cows would be shipped from Kansas to Chicago, and give rise to its fabled meat-packing industry. So, in a dynamic economy, all the horse-drivers, stagecoach manufacturers, canal boat drivers, canal diggers, and so forth put out of work by the railroad, and their children, were not, in the end, immiserized.

So, economics should be much better at being the lifeboat for simple lessons of economic history and experience. Alas our current professional training makes us pretty terrible at this.

My personally favorite way of sounding the above theme is to note that good economists are intrepid questioners.  We ask questions that most people seldom think to ask.  And the very asking of such questions leads any questioner to ‘see’ the unseen features of reality that economists do not literally see but know are real.  We know these unseen features of reality exist because we know that scarcity and (hence) tradeoffs are real, and understand that single-entry bookkeeping is not double-entry bookkeeping.

For example….

The politician says that he’ll improve the lot of low-paid workers by imposing a minimum wage.  As Cochrane says, the non-economist sees only an income transfer: employees are made richer and employers (and sometimes also consumers) are made poorer.  End of non-economists’ story.  The economist is skeptical and her skepticism prompts questions.  Here’s an imaginary, but not fanciful, conversation.

Economist: Because the minimum wage will cause the costs borne by employers of low-skilled workers to rise relative to these employers’ revenues, won’t the minimum wage lead such businesses to economize further on the now-more-costly input (labor)?  And won’t such economizing often mean employing fewer low-skilled workers?

Non-economist: No.  Employers are rich.  They can afford to pay higher wages.

Economist: What does being rich have to do with the matter?  Are rich people less eager than are poor people to adjust their actions so that they get the most satisfaction from at the least expense?  If rich employers are less sensitive to costs and benefits than are poor people, then what makes you think that rich employers generally pay their low-skilled workers too little?  Why, on your assumption, do not at least half of these ‘rich’ employers over-pay their low-skilled workers?  And do you, you non-economist, not understand that most business owners, even those who are truly rich, oversee or run businesses that are in competitive markets, where the rates of return are at, or only temporarily above, the minimum rate that is sufficient to keep in place all the capital currently in those firms?  When that rate of return falls, those firms and industries shrink.  Because the minimum wage causes rates of return in competitive industries that employ disproportionately large numbers of low-skilled workers to fall relative to rates of return in industries that employ relatively few low-skilled workers, unless owners in industries that are disproportionately affected by minimum-wage legislation successfully change their methods of production (say, by switching out of low-skilled workers and into more labor-saving technologies), capital will leave these industries in search of higher returns elsewhere.  Either way, jobs for some low-skilled workers will be destroyed or, at the very least, transformed into less-pleasant jobs for these workers.

Non-economist: No!  What you economists don’t see is the extra spending generated by minimum wages.  This extra spending raises sales revenues for employers, causing the minimum wage to pay for itself!

Economist (sighing): What extra spending?  If employers pay minimum-wage workers more, employers now have less to spend.  Employers’ consumer spending falls, as does employers’ investment spending.  And this reduction in employer spending is furthered by the business climate being made, by minimum-wage legislation, more hostile to enterprise.  It’s true that employers spend differently than do low-skilled workers, but what makes you so sure that all, or enough, of the higher incomes earned by minimum-wage workers will be spent on the outputs of those firms that employ disproportionately large amounts of low-skilled workers?  If your higher-spending-pays-for-the-minimum-wage argument is correct, then there would truly be no reason not to raise the minimum wage up to, say, $150 per hour, or even $1,500 per hour.

Non-economist (changing his tack): I read in the New York Times and in The Nation that studies show that workers who are paid higher wages are happier and, hence, work harder and more efficiently.  A minimum wage pays for itself by increasing worker output!

Economist: Then why do firms need to be prompted by government to raise wages?  If raising wages increases the hourly value of employee output by at least the hourly value of the wage hike, employers on their own will raise wages.  And they’ll do so until it’s no longer the case that a further hike in wages pays for itself.  Therefore, any government-dictated wage hike, even if it does increase the value of worker output, will increase the value of this output by less than the amount of the wage hike.  Employers will lose money and, therefore, will take steps, such as employing fewer low-skilled workers, to escape the costs of the mandated minimum wage.

Non-economist: But why wouldn’t…. [A PhD economist, but one whose true talent lies in data manipulation rather than in reasoning like an economist, enters the room, puts his hand on the non-economist’s shoulder, and says to him “Your support for minimum wages is justified, but your reasoning is weak.  Let me handle this.”  We’ll call this person “Econometrician.”]

Econometrician (speaking now directly, and with not a little bit of contempt, to the economist): You’re dogmatic and unscientific.  All the best empirical studies show no negative employment effects from minimum-wage hikes.

Economist: Look, many other empirical studies do show negative employment effects from minimum wages.  But let’s not debate the relative merits of these or those econometric studies.  I have a deeper question for you: if I’m to buy the results of the econometric studies that you point to, I’ll need to be able to tell myself a plausible theory for why those counterintuitive results prevail in reality.  So what’s your theory for why raising employers’ costs of using the input ‘low-skilled labor’ generally does not cause employers to use less of this input?  And, by the way, do you also believe that the same non-effect holds for inputs other than low-skilled labor?  That is, if government forces up the prices that firms must pay for printer paper, for office furniture, for office and factory space, for gasoline and electricity and other fuels, for materials such as rolled steel or shipping crates, or for government’s permission to emit carbon into the air, that these forced price-hikes also will not cause firms to further economize on the use of these other inputs?

Econometrician: Unlike you, I’m data-driven.  I appreciate the role of economic theory, but I have no theoretical priors, for they would bias my efforts to learn about, and to report, the facts.  The data tell me – the data, that is, from the best studies (rather than from the flawed studies that find that higher minimum wages reduce employment) – that minimum-wage hikes of the sizes that are typical in the United States do not reduce low-skilled workers’ employment prospects.  From this fact I infer that the market for low-skilled labor in the U.S. must be filled with monopsony power.  You know, of course, that in theory monopsony power creates a situation where appropriately set minimum wages actually raise employers’ willingness to higher workers.

Economist: So that’s your theory?  Monopsony power is rampant in the U.S. market for low-skilled labor!?  [The economist pauses, shakes his head at the farfetchedness of the econometrician’s tale, and draws a deep breath before asking….]  Why is monopsony power so rampant?  Have you a theory for that?  Industries that employ lots of low-skilled workers are retail, retail food service, cleaning services, lawn-care services, and light construction and handyman services.  While ‘frictions’ are present always, in any market, everywhere, are these industries ones in which entry by new firms, and expansion by existing firms, especially difficult?  Surely not.  Yet if the likes opening up a new restaurant, or starting a new maid service, or expanding a home-repair business is easily done, why does not this rampant monopsony power – and the excess returns to employers that it implies (if it is used to justify minimum wages) – prompt entrepreneurs to enter into, and to expand in, those markets currently characterized by such power?  Why should anyone believe you that monopsony power is so rampant as to justify government intervention, in the form of minimum-wage legislation, rather than believe the real-world entrepreneurs and businesses that are now not pouring with greater frequency into the industries that you allege are infected with monopsony power?

Indeed, why don’t you – an econometrician who claims to be very confident in his conclusion that monopsony power is rampant – put  your own money and time where your mouth is before asking the state to put low-skilled workers’ livelihoods at risk?  Why don’t you start a business to compete with the monopsonists?  You assert that you already possess what, I’m sure, most real-world business people will identify as the single most difficult and valuable piece of knowledge to get about the market – namely, knowledge that an actual profit opportunity exists in reality.  You, the econometrician, claim to know with great confidence that monopsony power is rampant in reality and that it is the existence of this power that accounts for the failure of minimum-wage hikes to reduce the employment of low-skilled workers.  Why don’t you act on this knowledge?  You yourself don’t have to quit your professorial job to act on this knowledge.  You can take your knowledge to business people and offer it to them.  Surely they’ll be delighted to be informed that the equivalent of bundles of $100 bills lie still on the nation’s sidewalks simply waiting for people with their skills at picking up $100 bills to actually pick them up.

So have you taken action to seize the profit opportunity that you insist is real?  If not, why should we believe you about the widespread existence of monopsony power?

Econometrician: Don’t be so absurd.  I have no business skills.  [The economist here nods his head in vigorous agreement with that confession.]  And you know as well as I know – from theory, I’ll admit – that it would be very difficult for me to capture the value of my special knowledge by offering to share it with someone who will then act on that knowledge.

Economist: You are not now profiting from your special knowledge of the widespread existence of monopsony power, and you show no signs of wishing to profit from this knowledge in the future.  So why worry about appropriating for yourself adequate compensation from a business person with whom you share this knowledge?  Hell, you’ve already shared this knowledge publicly – in academic journals and books, in op-eds, in blog posts, and in testimony before government.  (It’s rather stunning that business people haven’t yet taken notice of this information!)  So do a good deed for poor workers: offer your knowledge free to business people.  Visit some business people, or telephone, or e-mail them with the results of your econometric findings and your accompanying explanation that these findings are, as you claim, strong evidence of excess profits that exist because of rampant and widespread monopsony power in the market for low-skilled labor.  Do a good deed!  Once they are so informed, these business people – because they have more practical abilities than you possess – will actually seize these profit opportunities and, in doing so, raise the wages of low-skilled workers.

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