Naked Economics: Undressing the Dismal Science

“Economists sometimes ask, ‘Who feeds Paris?’—a rhetorical way of drawing attention to the mind-numbing array of things happening every moment of every day to make a modern economy work. Somehow the right amount of fresh tuna makes its way from a fishing fleet in the South Pacific to a restaurant on the Rue de Rivoli. A neighborhood fruit vendor has exactly what his customers want every morning—from coffee to fresh papayas—even though those products may come from ten or fifteen different countries. In short, a complex economy involves billions of transactions every day, the vast majority of which happen without any direct government involvement. And it is not just that things get done; our lives grow steadily better in the process. It is remarkable enough that we can now shop for a television twenty-four hours a day from the comfort of our own homes; it is equally amazing that in 1971 a twenty-five-inch color television set cost an average worker 174 hours of wages. Today, a twenty-five-inch color television set—one that is more dependable, gets more channels, and has better reception—costs the average worker less than ten hours of pay.”

Wheelan writes this at the beginning of the book as a way to introduce the complexities of a modern economy. As shoppers, we may pay little attention to the goods on a store’s shelves, such as how they got there and where they’re from. This book is an attempt to explain this, as well as how our lives have improved over the years. The latter is not only about purchasing cheaper TVs, but about improvements in medicine, living longer, and having more leisure time outside of work. The author pulls back the curtain, so to speak, on things we take for granted, to explain through economics how we arrived at them.

“I will argue that a market economy is to economics what democracy is to government: a decent, if flawed, choice among many bad alternatives. Markets are consistent with our views of individual liberty. We may disagree over whether or not the government should compel us to wear motorcycle helmets, but most of us agree that the state should not tell us where to live, what to do for a living, or how to spend our money. True, there is no way to rationalize spending money on a birthday cake for my dog when the same money could have vaccinated several African children. But any system that forces me to spend money on vaccines instead of doggy birthday cakes can only be held together by oppression.

Markets are consistent with human nature and therefore wildly successful at motivating us to reach our potential. I am writing this book because I love to write. I am writing this book because I believe that economics will be interesting to lay readers. And I am writing this book because I will soon have two children in college. We work harder when we benefit directly from our work, and that hard work often yields significant social gains.”

This passage boils down the author’s take on the market system: the best among alternatives, if still imperfect. It’s the best because it aligns with our values and with human nature. Personal freedom and free will are a part of both this economic system and a democratic society. People are motivated by having the power to choose and following their interests; any other system is less efficient.

“This was one of Adam Smith’s insights in The Wealth of Nations: ‘It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.’ Bill Gates did not drop out of Harvard to join the Peace Corps; he dropped out to found Microsoft, which made him one of the richest men on the planet and launched the personal computer revolution in the process—making all of us better off, too. Self-interest makes the world go around, a point that seems so obvious as to be silly. Yet it is routinely ignored. The old slogan ‘From each according to his abilities, to each according to his needs’ made a wonderful folk song; as an economic system, it has led to everything from inefficiency to mass starvation.”

The heart of economics is human behavior, or why people do what they do. It all boils down to incentives, and the strongest incentive is self-interest. This is one of the main themes of the book. It should be noted that some people might drop out of Harvard to join the Peace Corps; it depends on personal utility, and someone other than Bill Gates might find great personal utility in serving in the Peace Corps. This is one of Wheelan’s points as he discusses incentives—that they differ for everyone, and the best system allows each of us to choose how we want to act.

“Capitalism can be a brutal, cruel system. The innovation inspired by markets can be devastating for the losers. We look back and speak admiringly of technological breakthroughs like the steam engine, the spinning wheel, and the telephone. But those advances made it a bad time to be, respectively, a blacksmith, a seamstress, or a telegraph operator. Creative destruction is not just something that might happen in a market economy. It is something that must happen.”

Here Wheelan emphasizes both the reality and the necessity of creative destruction. For the milestones of technology he mentions, along with so many others, we usually think only of the progress, forgetting that it came at the expense of those relying on a suddenly obsolete technology. His word choice (“brutal, cruel”) is apt, squarely facing the fact that creative destruction involves real people and their livelihoods. At the same time, growth and progress demand that it happen.

“Anyone who tells you that markets left to their own devices will always lead to socially beneficial outcomes is talking utter nonsense. Markets alone fail to make us better off when there is a large gap between the private cost of some activity and the social cost. Reasonable people can and should debate what the appropriate remedy might be. Often it will involve government.”

This quotation shows that markets cannot be expected to deal successfully with everything. They allocate resources well; they do not solve social problems. Wheelan is describing externalities here (see Index of Terms), noting that another method must be found to deal with them. This usually involves governments because of their authority and the scale on which they operate. The passage touches on the theme of choosing the kind of world we want, as Wheelan is not fatalistic about markets, stressing that we have choices.

“Government is good at doing some things and tragically bad at doing others. Government can deal with significant externalities—or it can regulate an economy to the point of ruin. Government can provide essential public goods—or it can squander enormous tax revenues on ineffective programs and pet projects. Government can transfer money from the wealthy to the disadvantaged—or it can transfer money from common folk to the politically well-connected. In short, government can be used to create the foundations for a vibrant market economy or to stifle highly productive behavior. The wisdom, of course, lies in telling the difference.”

Wheelan tempers his enthusiasm for government action by noting some of the ways it can cause real harm. Chapters 3 and 4 cover different ends of the spectrum; the former emphasizes positive government action, the latter negative. The point Wheelan is making again is that we have choices. Government has tremendous power, and we need to use it wisely in economic and social affairs.

“The more subtle and pervasive kind of government involvement is regulation. Markets work because resources flow to where they are valued most. Government regulation inherently interferes with that process. In the world painted by economics textbooks, entrepreneurs cross the road to earn higher profits. In the real world, government officials stand by the road and demand a toll, if they don’t block the crossing entirely. The entrepreneurial firm may have to obtain a license to cross the road, or have its vehicle emissions tested by the Department of Transportation as it crosses the road, or prove to the INS that the workers crossing the road are U.S. citizens. Some of these regulations may make us better off. It’s good to have government officials blocking the road when the ‘entrepreneur’ is carrying seven kilos of cocaine. But every regulation carries a cost, too.”

This passage is a good example of Wheelan’s writing style. It’s in keeping with his pledge to avoid charts and equations. Instead, he paints a mental picture here for readers, using an extended metaphor to get his point across. It’s not only clever, but it works, illustrating how government regulation can both support and hinder markets.

“Compare that to the billboard advertising Chuck’s Big Burger. Chuck’s may offer one of the best burgers west of the Mississippi. Or it might be a likely spot for the nation’s next large E. coli outbreak. How would you know? If you lived in Omaha, then you might be familiar with Chuck’s reputation. But you don’t; you are driving through Nebraska at nine o’clock at night. (What time does Chuck’s close, anyway?) If you are like millions of other people, even those who find fast food relatively unappealing, you will seek out the golden arches because you know what lies beneath them. McDonald’s sells hamburgers, fries, and, most important, predictability.”

This illustrates the power of information in economics. Greater information leads to better decisions. In the hypothetical example of someone driving across Nebraska at night, a lack of familiarity with the area leads to a lack of information about one element in the situation (the local restaurant, Chuck’s Big Burger). Because we know McDonald’s from its ubiquitous uniformity, most of us would choose that over Chuck’s. Why take a chance on a late-night meal? Information is what gives McDonald’s the edge, even when we know its food is average.

“Over the course of the twentieth century, the average work year has fallen from 3,100 hours to about 1,730 hours. All the while, real gross domestic product (GDP) per capita—an inflation-adjusted measure of how much each of us produces, on average—has increased from $4,800 to nearly $60,000. Even the poor are living extremely well by historical standards. The poverty line is now at a level of real income that was attained only by those in the top 10 percent of the income distribution a century ago. As John Maynard Keynes once noted, ‘In the long run, productivity is everything.’”

This passage illustrates the power of productivity. During the 20th century, while the amount of time workers spent at work each year fell by almost half, real income increased by a factor of 12. In other words, Americans became much richer while working less, all through efficiency created by being more productive. It’s clear from this why Wheelan agrees with Keynes and holds up productivity throughout the book.

“When it comes to personal finance (and losing weight), intelligent people will toss good sense aside faster than you can say ‘miracle diet.’ The rules for investing successfully are strikingly simple, but they require discipline and short-term sacrifice. The payoff is a slow, steady accumulation of wealth (with plenty of setbacks along the way) rather than a quick windfall. So, faced with the prospect of giving up consumption in the present for plodding success in the future, we eagerly embrace faster, easier methods—and are then shocked when they don’t work.”

Chapter 7 discusses the financial markets, and the above quotation sums up well the author’s overall message. People are always looking for a “get rich quick” scheme in the stock market, and even very intelligent people believe it’s more than a rarity or a fluke. Wheelan explains why it’s nearly impossible, starting with the fact that everyone else has the same information you do to base their decisions on. He states that research has shown buying and holding index funds (based on a group like the S&P 500) virtually always outperforms funds whose managers claim to have a special method or algorithm for picking winners.

“Still, the financial markets do for capital what other markets do for everything else: allocate it in a highly productive, albeit imperfect, way. Capital flows to where it can earn the highest return, which is not a bad place to have it flowing (as opposed to, say, into businesses run by top communist officials or friends of the king). As with the rest of the economy, government can be enemy or friend.”

Here the author is again affirming his belief in open markets. The financial markets are like any other: flawed, but better than the alternatives, and efficient in allocating resources (in this case, capital). Government has a role to play in establishing and upholding the laws that make markets possible, as well as in creating enough regulation to discourage wrongdoing. Anything beyond that can produce barriers and be a drag on markets.

“The problem is that we don’t get the benefits of the new economic structure if politicians decide to protect the old one. Roger Ferguson, Jr., former vice chairman of the board of governors of the Federal Reserve, explains, ‘Policymakers who fail to appreciate the relationship between the relentless churning of the competitive environment and wealth creation will end up focusing their efforts on methods and skills that are in decline. In so doing, they establish policies that are aimed at protecting weak, outdated technologies, and in the end, they slow the economy’s march forward.’”

This refers to the idea of creative destruction and why it is necessary. Wheelan spends some time explaining how entrenched interests work to protect themselves against newcomers. They often appeal to politicians for assistance by seeking favorable policies that create barriers for others. This goes back to open markets being the best way to allocate scarce resources. When regulation hinders this process, economic growth is also hindered.

“Having said all that, GDP is, like any other statistic, just one measure. Figure skating and golf notwithstanding, it is hard to collapse complex entities into a single number. The list of knocks against GDP as a measure of social progress is a long one. GDP does not count any economic activity that is not paid for, such as work done in the home. If you cook dinner, take care of the kids, and tidy up around the house, none of that counts toward the nation’s official output. However, if you order out food, drop your kids off at a child care center, and hire a cleaning person, all of that does. Nor does GDP account for environmental degradation; if a company clear-cuts a virgin forest to make paper, the value of the paper shows up in the GDP figures without any corresponding debit for the forest that is now gone.”

In this passage, Wheelan points to some of the drawbacks of using GDP to represent social progress. While it’s a widely used statistic, it’s incomplete and omits some key indicators. The question is whether anything else is a better measurement. People have different ideas about what to include, leading Wheelan to conclude that it all boils down to how progress is defined.

“Economists are belatedly beginning to probe this phenomenon, albeit in their own perversely quantitative way. For example, David Blanchflower and Andrew Oswald, economists at Dartmouth College and the University of Warwick, respectively, found that a lasting marriage is worth $100,000 a year, since married people report being as happy, on average, as divorced (and not remarried) individuals who have incomes that are $100,000 higher. So, before you go to bed tonight, be sure to tell your spouse that you would not give him or her up for anything less than $100,000 a year.”

This quotation is another example of Wheelan’s writing style, this time of the humor he brings to the text. Here he first discusses a study about marriage before adding a quip based on the findings. Often his humor is self-deprecating, which can have the effect of making him more relatable to readers. Instead of receiving a lecture by an Ivy League professor, you find yourself in conversation with a down-to-earth friend. Along with omitting graphs and complex equations, this adds to Wheelan’s unique approach to presenting economics.

“Are we getting any better at all of this? Yes, we are. The United States has gone through eleven recessions since World War II. None, including the 2008 financial crisis, was of the same order of magnitude as the Great Depression. From 1929 to 1933, real GDP fell by 30 percent while unemployment climbed from 3 percent to 25 percent. In contrast, GDP fell by 5 percent during the financial crisis and unemployment peaked at 10 percent. Prior to the Great Depression, the United States regularly experienced deep recessions, including financial panics, far worse than anything in your lifetime or mine. We haven’t made the economic bumps go away, but they are smaller bumps.”

This passage refers to the business cycle—the recurring pattern of boom and bust—that still seems to plague economies. Although the cycle has not been defeated, Wheelan notes that it’s important to realize it has been lessened compared to the past. Here he shows that the lessons learned from the Great Depression were applied to the most recent financial crisis (in 2008), making it nowhere near as damaging. Elsewhere he notes that Ben Bernanke, the Fed chair during the recent recession, and Christine Romer, the top economic adviser to President Obama at that time, are both scholars of the Great Depression. Their expertise in that area almost certainly prevented the 2008 crisis from being worse than it was.

“The Fed must also reckon what kind of impact a change in interest rates will have and how long it will take. Will a quarter-point rate cut cause twelve people to buy new Jeep Cherokees in Des Moines or twenty-seven? When? Next week or six months from now? Meanwhile, the Fed has the most control over short-term interest rates, which may or may not move in the same direction as long-term rates. Why can’t Jerome Powell work his magic on long-term rates, too? Because long-term rates do not depend on the money supply today; they depend on what the markets predict money supply (relative to demand) will be ten, twenty, or even thirty years from now. Fed chair Powell has no control over the money supply in 2043.”

This describes how monetary policy works and illustrates why it is so tricky. On the one hand, the Fed chair wields enormous power to make decisive, immediate changes that can affect the economy. On the other hand, these changes are limited to the present and their exact effects are not known. All this requires a deft hand and an ability to analyze a situation and make a careful assessment of which tools might have the intended effects.

“The most instructive way to think about inflation is not that prices are going up, but rather that the purchasing power of the dollar is going down. A dollar buys less than it used to. Therein lies the link between the Federal Reserve, or any central bank, and economic devastation. A paper currency has value only because it is scarce. The central bank controls that scarcity. Therefore a corrupt or incompetent central bank can erode, or even completely destroy, the value of our money.”

Wheelan discusses inflation in several places in the book, always emphasizing how destructive it can be. Here he notes how the Fed (or central bank of any country) must have a sober, clear-eyed outlook on the role it plays regarding currency. These days, paper currency is no longer backed by gold or silver, making its value based only on the level of its supply (as well as people’s belief in its purchasing power). The Fed must curate that supply carefully to maintain the currency’s value. A nation’s economy can be destroyed by the missteps of a central bank, as shown, for example, in Argentina in the early 1990s.

“International economics shouldn’t be any different than economics within countries. National borders are political demarcations, not economic ones. Transactions across national borders must still make all parties better off, or else we wouldn’t do them. You buy a Toyota because you think it is a good car at a good price; Toyota sells it to you because they can make a profit. Capital flows across international borders for the same reason it flows anywhere else: Investors are seeking the highest possible return (for any given level of risk). Individuals, firms, and governments borrow funds from abroad because it is the cheapest way to ‘rent’ capital that is necessary to make important investments or to pay the bills.

Everything I’ve just described could be Illinois and Indiana, rather than China and the United States. However, international transactions have an added layer of complexity. Different countries have different currencies; they also have different institutions for creating and managing those currencies. The Fed can create American dollars; it can’t do much with Mexican pesos. You buy your Toyota in dollars. Toyota must pay its Japanese workers and executives in yen. And that is where things begin to get interesting.”

This passage illustrates how international trade is like any other kind of market transaction and yet different. Borders between countries are arbitrarily drawn and goods are still exchanged. The difference lies in the various currencies used and how their exchange rates are determined. In theory these rates should be set by purchasing power parity (PPP), or the amount of each currency it takes to purchase the same amount of goods. However, other factors, including government intervention, often make rates vary widely from what PPP would suggest. This alters the nature of the trade relationship.

“A government that deliberately keeps its currency undervalued is essentially taxing consumers of imports and subsidizing producers of exports. An overvalued currency does the opposite—making imports artificially cheap and exports less competitive with the rest of the world. Currency manipulation is like any other kind of government intervention: It may serve some constructive economic purpose—or it may divert an economy’s resources from their most efficient use. Would you support a tax that collected a significant fee on every imported good you bought and used the revenue to mail checks to firms that produce exports?”

One of Wheelan’s strengths in this book is rewording things to look at a phenomenon from a different angle. Here he discusses actions by a government that manipulate the value of its currency. Keeping the value artificially low can make that country’s exports attractive to other countries because of their low price. This can be beneficial to the country as revenue flows in from selling imports. However, it has a negative effect on that country’s consumers; as this points out, it amounts to a tax paid on imports that is then turned over to exporters. Put that way, currency manipulation doesn’t look so favorable.

“The easiest way to appreciate the gains from trade is to imagine life without it. You would wake up early in a small, drafty house that you had built yourself. You would put on clothes that you wove yourself after shearing the two sheep that graze in your backyard. Then you would pluck a few coffee beans off the scraggly tree that does not grow particularly well in Minneapolis—all the while hoping that your chicken had laid an egg overnight so that you might have something to eat for breakfast. The bottom line is that our standard of living is high because we are able to focus on the tasks that we do best and trade for everything else.”

In another example of viewing something from a different angle, this passage cleverly illustrates the vast benefits of trade by removing it from the picture and seeing what is left. This shows how little we actually produce ourselves and how much we get via trade. Most people would agree it’s not a very attractive lifestyle. The phrase “the tasks that we do best” in the last sentence refers to specialization, which Wheelan later describes as the key to productivity (see quotation 23).

“According to a study by the Center for Business and Economic Research at Ball State University, 85 percent of the 5.6 million U.S. manufacturing jobs lost between 2000 and 2010 were lost to technology—not to China or Vietnam or Mexico. Machines are doing what people used to do, particularly the work formerly done by low-skilled workers.”

This statistic sheds light on the role of international trade, which often gets blamed for job losses in America. People think losses here automatically mean gains in developing countries (an example of the “lump of labor fallacy”; see Index of Terms). The truth is that only 15% of jobs lost in the US in the first decade of this century went to other countries, while the vast majority were lost to automation. Getting the facts right is important, as they have ramifications in both politics and economics.

“Productivity is what makes us rich. Specialization is what makes us productive. Trade allows us to specialize. Our Seattle engineers are more productive at making planes than they are at sewing shirts; and the textile workers in Bangladesh are more productive at making shirts and shoes than they are at whatever else they might do (or else they would not be willing to work in a textile factory).”

In this quotation, Wheelan neatly sums up why free and open markets are so beneficial, one of the main themes of the book. Simply put, trade leads to specialization, which leads to productivity, which leads to wealth. It’s good for all parties involved, making them better off. He also touches on what a poor country like Bangladesh can offer a rich nation like the US, and how Bangladesh benefits from the interaction as well. The work Bangladesh does allows US workers to specialize, or apply their skills to areas they are best at, and Bangladeshi workers have an option that is better than the alternatives offered by their economy at this point in its development.

“Again, Peruvian economist Hernando de Soto has done fascinating work. He and fellow team members documented their efforts to open a one-person clothing stall on the outskirts of Lima as a legally registered business. He and his researchers vowed that they would not pay bribes so that their efforts would reflect the full cost of complying with the law. (In the end, they were asked for bribes on ten occasions and paid them twice to prevent the project from stalling completely.) The team worked six hours a day for forty-two weeks in order to get eleven different permits from seven different government bodies. Their efforts, not including the time, cost $1,231, or 31 times the monthly minimum wage in Peru—all to open a one-person shop.”

This comes in the chapter on what is needed to improve developing economies. It illustrates the pernicious effects of excessive regulation and corruption. As Wheelan writes just above these lines, they “go hand in glove.” Countries without unhindered markets end up like in this example from Peru—creating an atmosphere in which the cost to open a simple business is prohibitively expensive, which stifles initiative and growth, keeping the economy underdeveloped.