The worldly turn

Economics is once again becoming a worldly science | Aeon Essays
Photo by Martin Roemers/Panos Pictures

After generations of ‘blackboard economics’, Berkeley and MIT are leading a return to economics that studies the real world

Tom Bergin is an investigative financial journalist for Reuters. His work has prompted parliamentary inquiries and won numerous awards in Britain, the United States and Asia. He is the author of Spills and Spin: The Inside Story of BP (2011) and Free Lunch Thinking: How Economics Ruins the Economy (2021). He lives in London.

For the workers who are curious why their wages have not increased in the past decade – while the incomes of some, such as footballers, have soared – the Bank of England’s website has a reassuring message: ‘There is a method to this madness: the economic theory of supply and demand’. The bank’s website provides an ‘idiot’s guide’ to the economy that explains how ‘Supply and demand is a bit like an economist’s version of the law of gravity. It decides how much everything costs: a cup of coffee, a house and even your salary.’

The US Federal Reserve Bank provides similar explainers for Americans who want to understand how their country’s wealth is created or allocated, including a colourful downloadable infographic that shows how higher prices create additional supplies of goods, and lower prices create additional demand. On its website, the International Monetary Fund notes that supplydemand and price are ‘magic words’ that make the economist’s ‘heart beat faster’.

For the economists in the neoclassical tradition, as most are, the world can be understood as a series of supply-and-demand curves – the X-shaped graphs that Alfred Marshall first made for his book Principles of Economics (1890) and that now litter almost every chapter of almost every economics textbook. Humans might be occasionally irrational but, en masse, orthodox economics says they respond to prices in a consistent and proportional way. People have what economists call ‘price elasticities’ that make their behaviour predictable and open to manipulation.

Other factors such as technology, taste, the weather and institutions can also influence human economic behaviour. But economists see their impact either as modest or predictable, and thus capable of being factored in to supply-and-demand models.

This neoclassical perspective is widely, although not uniformly, accepted by world political leaders. It informs and underpins policies on taxation, spending, labour market regulation, health, the environment and more.

The problem, and a key reason why economic policy often fails, is that, while Isaac Newton’s law of gravity can predict behaviour at all times anywhere on this planet, these and other supposed economic laws often fail.

Take labour markets: the Bank of England’s and the US Federal Reserve’s claims that supply and demand determine wage rates, and that wage rates determine labour supply and demand, is not based on the best evidence. Economists know this too (we’ll get to that soon).

According to these supposed economics ‘laws’ (and a cheery video on the Federal Reserve Bank of St Louis’s website), higher wages make people work more, and lower wages discourage people from seeking employment. In the real world, however, study after study over the decades has failed to find evidence of people working longer hours in response to higher net wages (be that through direct salary increases or tax cuts). Over the long term, the data even more strongly tell us that labour supply does not respond to wage rates. Since the mid-19th century, real wage rates have risen sharply but hours worked by individuals have fallen significantly. The labour supply curve doesn’t slope up as the supposed economic ‘laws’ dictate but downward. To put it in terms the Bank of England might understand, the labour supply curve defies gravity.

Data from the Bank of England’s report ‘A Millennium of Macroeconomic Data for the UK, 1860-1980’

In practical terms, this means that if policymakers are trying, for example, to bring more women into the labour market, then assessing the issue via the lens of neoclassical supply-and-demand curves is unlikely to help them formulate effective solutions. Hence the failure of so many tax cuts or relaxations of employment protection rules to nudge the economies in Europe and North America towards higher employment and growth levels.

Labour supply is more a function of culture and institutions than price, and this is not a new idea. In 1978, the American Nobel Prize-winning economist Robert Solow stated plainly that the neoclassical article of faith that all markets clear – which is to say, settle on a price, where demand and supply are matched – was nonsense. ‘It is plain as the nose on my face that the labour market and many markets for produced goods do not clear in any meaningful sense,’ Solow wrote…


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