It’s been a difficult year for economists, who’ve had to endure a combination of criticism when they apparently had the wrong ideas and being ignored when perhaps they had the right ones. Even amongst themselves, they’ve been criticizing huge portions of their own field. But economics marches on, and occasionally it unearths some truths that can help us to understand our world and live better. Here are a few of the highlights from the year in economic theory and research. If you have more to add, please do so in the comments.
Fiscal stimulus helps the economy to grow during a downturn. For the past couple of years, Alan Auerbach and Yuriy Gorodnichenko of the University of California, Berkeley have been investigating a topic of prime importance today: whether government spending creates economic growth or just replaces activity in the private sector. In recessions after World War II, they found that $1 of government spending added between $1 and $1.50 to gross domestic product. Spending on the military, infrastructure, and other long-term investments added $2 or more. This is a hugely important result for the debate on Keynesianism versus austerity, and the authors have confirmed it using a second set of statistical methods.
Obamacare may raise living standards. A big part of the Affordable Care Act is extensions of Medicaid to working-class families, but several states have balked at the changes. Covering people with Medicaid is costly, but a new paper suggests that it may make them healthier and more productive – perhaps enough to justify the cost. In 2008, Oregon expanded its Medicaid coverage by offering previously ineligible, uninsured people a chance to sign up for the program. Demand far exceeded the supply of 10,000 slots, so the state randomized enrollment. Comparing the families who got in to those that didn’t gave Amy Finkelstein of the Massachusetts Institute of Technology and her colleagues a chance to test the effect of becoming insured. After just one year, the newly insured people used more primary and preventive care and reported better physical and mental health than the control group of lottery losers. As the authors track these changes over more time, they may be able to estimate the total economic impact insuring the uninsured.
Tax subsidies for retirement saving don’t increase saving overall. Harvard’s Raj Chetty joined colleagues from Harvard and Denmark to see what happened to Danish saving after the government reduced a tax subsidy for pension contributions (like we have for IRAs and 401(k) plans) in 1999. They found that only 15 percent of people reduced their retirement saving, and those who did moved the money into other saving accounts. Overall, every $1 that the government gave up in tax revenue only raised overall saving by $0.01. To the extent that American behavior is similar, our tax incentives for saving are having no effect on retirement security or economic growth, except by forcing the government to raise more revenue with higher taxes elsewhere.
Social networks hold a key to economic growth. Alessandra Fogli of the University of Minnesota and Laura Veldkamp, a colleague of mine in the economics department at New York University’s Stern School of Business, wanted to find out whether connections between people affected livings standards. Specifically, they thought that close-knit networks made up mostly of mutually friendships might be less open to the adoption of new ideas and technology than “individualist” networks where people have more diverse connections. To test the idea, they looked at countries suffering to various degrees from contagious diseases. Like ideas, disease spread more easily across individualist networks, so much so that they eventually kill off the individualists and only the close-knit networks are left. And indeed, using contagious disease as a proxy of sorts, the authors found that the societies with more close-knit networks had less technology diffusion and significantly lower incomes. With the Internet now encouraging much more individualist networks around the world, we may eventually see a substantial uptick in living standards in regions that were previously left behind.
It’s time for microeconomics to get real. Microeconomic theory, the theory of how individuals and firms make decisions, is based on the idea that people make the best choices they can using all the information available to them. In reality, however, there is often a cost to gathering, processing, and just thinking about all that information. People can’t always invest enough time and effort to make the best decision, a situation economists call “bounded rationality”. Even though this concept has been around for decades, no one formalized it at the core of microeconomics… until now. Xavier Gabaix of the Stern School’s finance department has created the mathematical framework to make microeconomics more boundedly rational, and it centers on a concept called the “sparse max”: a way to maximize a function when only the most important variables can be assessed. Using the sparse max makes calculations more complicated – one-dimensional curves turn into two-dimensional planes because of the implied flexibility of decision-making – but it allows us to test which microeconomic concepts are robust to bounded rationality, and therefore more realistic. For example, Milton Friedman’s assumption that “money illusion” only existed in the short run may need to be re-examined. Xavier’s framework is a great tool that will open up new horizons in the science, and that doesn’t happen very often.