The Economics Profession Doesn’t Understand How The Economy Works

In the 1980s, a couple of ambitious young economists thought ski lift operators weren’t very smart. The economists assumed that if the business owners charged more on busy days, they could make more money. As recounted in “Knowledge and the Wealth of Nations” by David Warsh, the economists saw long lines on busy days as “prima facie evidence of market failure.”


After study, Robert Barro and Paul Romer concluded that they were wrong and that the people running the business were right. On crowded days, skiers waited longer in line and enjoyed fewer runs. As economists put it, the customers were paying more per ride even though the daily fee was the same. The business owners probably didn’t think of it that way, but they knew how much to charge.

Barro and Romer deserve credit for eventually acknowledging that fact. However, many economists today believe they know how businesses work better than those who run them. The problem is that no economist can account for all the variables so they simplify problems, make assumptions and often miss the point.

Recently, the Organization for Economic Cooperation and Development admitted that their own projections had missed the impact of globalization, fragile banks, and government regulation. The result, as summarized by the Washington Post’s Robert Samuelson: “Not only did the OECD miss the 2008-09 financial crisis, but it routinely overpredicted the recovery’s strength.”

This is nothing new. Following World War II, there was widespread speculation that the U.S. would enter a new Depression. Instead, the nation enjoyed the greatest economic growth in the history of the world. One study showed that economic models failed to account for 85 percent of the growth.

This track record is worth keeping in mind while listening to any political debate about economic projections. Recently, the Congressional Budget Office claimed that President Barack Obama’s proposal to raise the minimum wage might eliminate 500,000 jobs. The White House attacked that report by citing other economists who said the plan would not eliminate any jobs.

Realistically, both estimates are probably wrong. More importantly, they’re probably leaving out the biggest impact of the law, just as earlier economic models missed 85 percent of the factors leading to the post-War economic boom. It’s not that economists are foolish; it’s that an economy of more than 300 million people responding as best they can to daily life will react in ways that are unpredictable.

Recognizing that most minimum wage workers currently get a raise within a year, some businesses might respond by keeping workers at the new minimum for a longer period of time. Others might trim their profits a bit while a different group might trim the pay of those who earn a bit more than the minimum. There could be other positive or negative feedback as well. The point is that nobody really knows. Debates about economic projections are like an episode of “Seinfeld” — a show about nothing.

Rather than betting the farm on unreliable projections, a pragmatic approach would seek reliable data through experimentation. Let states and cities set their own minimum so workers can compare results. Just like ski lift operators who figured out the best way to attract customers, states would quickly figure out the best way to attract workers to their state.

The results are likely to surprise the economists.

Also See,

: Getting a Grip on Realities of the Federal Budget

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