Some lessons in economics for non-economists

One of the occupational hazards of being a professor of economics is that I have to encounter a lot of questions on the state of the economy at family gatherings.

So, in this piece, I try to give some rudimentary lessons in economics to non-economists, hoping that it would help them to understand some of the ‘puzzles’ in economics, including why different economists differ in their analysis and policy prescriptions.

Economic theory has two parts. Microeconomics explains how individual buyers and sellers behave under different market conditions like perfect competition (case of many small firms), monopoly (a single seller), oligopoly (a few big sellers, like in automobiles, telecom). These ideas are not difficult to understand even for laypersons as these mostly correspond to their everyday experiences.

By contrast, the other branch — Macroeconomics — deals with questions like why GDP (Gross Domestic Product or the market value of all goods and services produced in an economy), the overall rate of employment, exports, imports and balance of payments, change over time. In addition, it tries to explain how these economic variables respond to the policies of the government, in particular monetary policy (changing money supply and interest rates), fiscal policy (changing government expenditures, taxes/subsidies), international trade and payments policy (changing taxes and restrictions on international trade and capital movements), exchange rate policy (managing rupee-dollar exchange rate by buying and selling dollars from the market).

The problem is that the entire economy is a highly complex machine which has many moving parts that we cannot see. We observe only the end results and it is not easy to perceive how the different parts of the machine are interacting in the background. For that reason, economists use simplified models with lots of assumptions to approximate and understand the complex reality. In the process, different economists use different models with their different underlying assumptions which may yield conflicting results.

Now, consider a couple of examples of ‘puzzles’ or ‘paradoxes’ in economics. For an individual, saving for the future is considered a good thing or a ‘virtue’. However, this is not true for an entire economy if it is having a shortage of aggregate demand and excess production capacity. In such a situation, policy inducements to save more means less current expenditure on goods and services, which aggravates the demand shortage, leading to further cutback in production and employment, worsening the situation.

On the other hand, if the current problem is one of excess demand and shortage of production capacity, encouraging saving and discouraging current consumption spending would be the right policy. So, the same policy is ‘right’ or ‘wrong’ depending on the policymaker’s reading of the underlying economic situation. The policymaker’s life becomes even more difficult when there is excess demand in some sectors, along with excess supply in others, combined with conflicting pulls from lobbyists from different segments.

Another example. In a situation of falling production and employment in sectors like jute, steel or automobiles, labour unions are advised, and they sometimes do accept, a cut in wages to save jobs. But the same policy would be counterproductive if the entire economy is suffering from demand shortage and a general ‘recession’. An economy-wide cut in wages would further reduce income of workers and hence aggregate demand, production (since here demand is the constraint on production) and overall employment. Consequently, it would not be the right policy.

Economists, when they write articles in professional journals, usually make their model and assumptions explicit so that professional colleagues are able to understand and criticise their results by questioning the appropriateness of the assumed model to study a particular state of the economy. However, when they write popular articles in newspapers or give soundbytes in media, they only state the results of their analysis, without specifying the underlying model or the assumptions. That is an additional reason why the readers or listeners get confused by reading or listening to their ‘conflicting’ views.

On top of this, different economists have different political and philosophical persuasions — on issues like the role of government vs the private sector, growth vs redistribution, degree of acceptable inequality, reservation of jobs for the underprivileged, tribal rights over forest resources, protection of environment vs economic development, appropriate compensation and rehabilitation of land/property losers in development projects— which influence their policy prescriptions. Economics, unlike physics or engineering, is not free of value judgement. Hence, it is not surprising that different economists come up with different policy recommendations.

Let me end with one question which I most often have to face in social gatherings. Since the stock market (as measured by Sensex or Nifty) is doing so well, while bank interest rates on fixed deposits are steadily falling, should people invest more in the stock market?

A person gains by playing in the stock market only if he is able to buy cheap and sell dear. But it is very difficult for an individual to know the proper timing of when to buy and sell a company stock unless the person has some ‘inside’ information or has the time and ability to do adequate research (which most others are not able to do) or is a big enough player who can manipulate the market price by his buying and selling. Since the average retail investors do not fall in any of these categories, it is not possible for them to make consistent profits by playing in the stock market.

At the same time, it is true that a diversified portfolio of stocks (not the stock of any single company) yields a higher rate of return over a long period of time than bank fixed deposits. So, the best bet for an ordinary retail investor is to hold a certain portion of his portfolio in mutual funds (which invest in a well-diversified basket of companies drawn from different sectors) by investing a small amount regularly, every month, through the so-called SIP (Systematic Investment Plan) route. This way, a young man or woman would be able to build a substantial nest egg over a period of time, with higher yield and low risk. However, a senior citizen, unless he has started early, may not have time on his side to be engaged in this investment strategy.

(The writer is a former professor of economics at IIM Calcutta, India, and Cornell University, USA)