Good Economics for Hard Times: It is all about the bigger picture

The book ‘Good Economics for Hard Times’ by 2019 Nobel Prize winners Abhijit V. Banerjee and Esther Duflo is a walkthrough of past decades’ central contributions to the economic literature. It introduces the concept of “randomized controlled trials” to a broader audience. In light of the current corona crisis, their ideas have become highly relevant.

GED reads looks at the most important debates of our time

In GED reads, we take a closer look at the cutting-edge debates of our time. In Good Economics for Hard Times, Banerjee and Duflo do not concentre on one specific issue. They elucidate the most prevalent topics from their professional point of view – driven by a progressive attitude towards economic research.

What is special about Banerjee and Duflo’s work is their approach setting partial insights in a broader context. Often ignored by economists, this is highly important for the transfer of economic insights into practice and developing public policy.

This post will briefly discuss the central aspects of some of their chapters touching specifically on trade, migration, climate change, digitalization and importantly, policy.

Migration: Many wrong beliefs

The perception of the number of immigrants is far above the share of people actually immigrating to a certain destination. Astonishingly, the fewer immigrants there are in a certain place, the less they are liked by natives. Also widely believed is that immigrants impose downward pressure on wages.

Simple economics 101, with a focal point on partial equilibria, would indicate that this is due to an increase in the labor supply. But in the real world, this argument is too simplistic, and empirics show that it does not hold. Little about the labor market is in line with the standard story of supply and demand.

But why so? Immigrants spend money which primarily leads to low-skilled jobs, they do jobs many are reluctant to do, and the re-organization of processes can lead to new roles in the economy for natives. Also, hiring a worker is more complex than just buying a good, even when the law would allow firing easily.

Also misunderstood is the reason why people leave their country. A bad economic situation is seldom the reason, but the political situation or natural disasters often are. Comfort and connections play limiting roles for would-be international migrants.  Immigrants face a lot of uncertainties. Why these mistaken beliefs? People naturally use the status quo as a benchmark. They perceive loss and hate to lose more than they like to win.

The book from Banerjee and Duflo makes a crucial point in measuring the impact of public policy measures correctly. We cannot naively compare those who are in and those who out. Put differently, and we cannot observe the counterfactual. We do not know what would have been the outcome for those who did not participate if they might have participated.

As an example, we cannot naively compare the earnings of migrants with the earnings of those staying at home. Immigrants possibly have better skills and more stamina compared to their peers at home. Amongst several statistical methods to account for this issue of ‘selection bias’ randomized controlled trials (RCTs) is another approach that is now better known due to the work of Banerjee and Duflo. Admittedly, while well-conducted RCTs have high internal validity, external validity is always a consideration.

Trade: Knowledge exchange represents the largest gain

Opening up for trade increases the gross national product, but often it simultaneously increases inequality. Direct gains from trade are quantitatively quite small – but economic growth is a long-lasting process and that those small gains can be huge over time.

Apart from those direct gains, what comes with trade is the international exchange of knowledge. Therefore, trade is much about the capability to enhance productivity due to an international exchange with other people.

But trade often simultaneously leads to an increase in inequality. Due to the emergence of clusters, regions can be left behind when they are hit by free trade from specializations that are done cheaper somewhere else. Some workers do not look for jobs in other sectors, nor do they move.

Older people, especially, stay where they are often for good reasons related to their personal lives. However, a sticky economy also means a sticky trap. Removing trade barriers without compensating the losers of free trade is not enough and still a puzzle to solve.

Politics: Lots of prejudices at work

In the US, being white was the strongest predictor of support for Donald Trump. This is a tremendous insight into the context of new democratic opportunities that come along with the internet. Unfortunately, social networks often do not lead to exchange across opinions. They lead to the manifestation of prejudices. The internet is repetitive. It encourages directness and abbreviation, as well as enables automatic customization.

But how do we exchange opinions and tackle prejudices properly? Randomized controlled trials showed that interpersonal contact, when done under appropriate conditions, is one of the most effective ways to reduce biases. Mixed schools, universities, and neighborhoods are, therefore, key to decreasing prejudices in the population.

Climate Change: Consumption patterns need to change as technological progress will not do all the trick

Climate change is at odds with economic growth: an increase in income by 10 percent comes along with an increase in CO₂ emissions by 9 percent. Rich countries produce and consume the most CO₂ while poor countries bear most of the consequences: the 10 percent largest polluters account for 50 percent of pollution and vice versa.

Technological progress is a critical component in tackling climate change. However, we have to be aware of a rebound effect as technological progress could lead to more possibilities for consumption, and this could, in turn, have negative consequences for the climate – depending on consumption patterns. A simple change of a few habits could, therefore, do some of the trick.

Work & Inequality: Avoiding social divide

Digitalization could lead to the displacement of workers. Despite that, employment (prior to the pandemic) in many countries increased – so, in the end, jobs probably won’t vanish. What rather could be a risk is that middle-skilled jobs could decrease dramatically. This, in turn, could lead to higher inequality, and for this issue, solutions need to be found.

Another intriguing aspect that Banerjee and Duflo throw up is that labor is taxed higher than capital nowadays in most places in the world. This kind of ‘so-so’ automation could give an incentive for automation, even if it is not useful: it is productive enough to be implemented given the tax code, but it does not raise overall productivity.

A simple approach to the reduction of inequality is a rise in the top marginal tax rate. This does not solely work by directly taxing the rich more. It can reduce pre-tax inequality because companies do not pay their CEOs so much in the first place as rather they anticipate what will be on their paychecks. This increase in the marginal tax rate could motivate managers to work for other things than money, such as reputation among employees.

Universal Basic Income: Helpful in poor economies

Universal basic income has become an increasingly popular idea. The assumption is that people know what is best for themselves. Such a program does not need to monitor people and is therefore cost-effective. It could give the poor the incentive to do what they are aspiring to do.

A UBI could be helpful in poor countries as a form of insurance – or as Banerjee and Duflo put it more precisely: ultra universal basic income. More appropriate for developed countries could be the Danish flexicurity system. In this system, people can get laid off quite easily, but if so, they get largely subsidized. Other ideas include subsidizing workers at the beginning of their working life or after a job change until they are productive enough to be employed without subsidies.

Conclusion

Some parts of the economics profession should rethink their premises. They need to honestly evaluate which of their assumptions fit reality. This is not always easy: The good and the bad stand close by each other. We have to be aware that problems are multifaced and set them into the context of a bigger picture: Economics is too important to be left to economists.

Banerjee, A., & Duflo, E. (2019). Good Economics for Hard Times. New York, NY: PublicAffairs.