Debunking myths about economics

Recently due to the ongoing, unresolved economic crisis, economists have been in the limelight. Many economists are caught in limbo, many come up with differing views and opinions with little consensus. However, this doesn't mean that economics itself is flawed, to understand why is this the case, we need to recognise the fact that economics is a study of the market's ongoing dynamics with different economic agents (businesses, government, consumer, institutions etc) reacting to different incentives. A government policy which originates from good intention to benefit the people, may end up jeopardising the economic development, resulting in more havoc and miseries. A government policy that aims to improve businesses and creates more jobs may end up stifles the private sectors, impedes the progress of economic recovery and therefore prolongs the economic crisis and creates more unemployment instead of increasing employment.


Having recognised this fact, when an economist talks about implementing a certain policy to cure the economy downturn, he will not be able to take into account all the interplay among different economic agents in an economy due to the following limitations:
- ever-changing interactions and dynamics-- a policy have to be implemented at the right timing to be the most effective
- unavailability of data-- lack of the latest data or indicators means that economist can only rely on the past data to draw conclusion or provide policy recommendation
- limited understanding of the economic structure-- as the economy progresses, economic structure of a country 10 years ago could be significantly different from now, for eg: 10 years ago, a country might have a significant portion of agricultural sector, but now, the country has transformed into a manufacturing-based economy, so a policy which was effective 10 years ago might not have the same impact now.


Due to the above limitations, an economist can only provide their policy recommendations based on the best information that they can get, but as new information comes in, they might change their views again. That's how economics works, because people are always reacting differently when new policy is introduced. High oil prices will change people's consumption choice, force them to travel by public transport, share their cars or travel less, but if the high oil price persists, businessmen will find ways to make cars more oil-efficient and less oil-dependent or come out with alternative energy solutions in which will bring down the demand for oil and keep the prices affordable, that's what makes economics forever so interesting.


The moral of the story is, to understand why economists provide different policy recommendations, we must first understand their underlying assumptions and evidence and assess their recommendations base on which one has more realistic assumptions. Therefore, a profound understanding of economics is definitely a must if you want to know which policy will likely to work and which one will do more harm than good to the economy, and not taking the words of the economists or policymakers on its face value. This level of critical thinking and assessment is what differentiates one who studies economics and one who doesn't.


Let's come back to current economic crisis. I believe people who are following the news, but with limited understanding of economics will have a hard time to follow what the economists are proposing. I believe following are a few questions that might arise while reading the recent news:


1. What are the tools available for the government to tackle the present economic crisis?

Ans: Generally, the textbook provides 2 solutions: monetary policy & fiscal policy


Monetary policy involves the use of interest rate to stimulate the economy. How it works? When the central bank lowers the lending interest rate, businesses will be able to borrow money more cheaply and not burdened by high interest payment, therefore, they will be able to expand their production capacity and produce more goods. For consumers, low interest rate discourage them from saving, they will tend to spend the money instead of saving it since saving it doesn't produce as much return in the future as compared to the satisfaction of spending it now. As the consumers spend their money, businesses will become more profitable and that brings the economy out of the recession.


Fiscal policy involves the use of government spending to stimulate the economy. Generally, during economic recession, private sector will be cutting costs, consumers will be saving more instead of spending, so government is the only economic agent who has the ability to spend. Therefore, government can increase spending so that the businesses will not suffer so severely from the economic downturn. Another way is to cut taxes and let the people have more money to spend. The spending by one person will create "multiplier effect"-- which means, when a consumer spends his money, the businessman's business will be more profitable, therefore, he can afford to employ more workers. The workers employed will then spend part of their salary and more businesses will benefit. This compounding effect of spending is called "multiplier effect". That is how fiscal policy works.


2. What are the limitations of monetary policy & fiscal policy?
For monetary policy, there is a limit to how much the central bank can cut the interest rate to stimulate the economy. The lowest the central bank can cut the interest rate is 0%, which is what the US central bank is doing right now. Their interest rate is now at 0%, yet the economy is still mired in recession and there is no sign of recovery in the near future, which means the monetary policy has loses its power of stimulating the economy.


For fiscal policy, if the government cuts taxes, the caveat is that people might save the tax cuts and not consume them. This will not create the "multiplier effect", and therefore, it might not work for an ailing economy like the US. Another reason why the economists oppose the "stimulus plan" is that, we all know public sector is often very inefficient, even involved with corruptions, especially when construction projects are being sublet to the private firms. Companies with political connection tend to be able to get a good deal from the bureaucrats. The higher the amount of the stimulus plan, the more the businessmen with political connections can suck away the resources to their own pockets.

Another reason, which is more specific to the US economy against implementing government stimulus plan is that the US government has already incurred a gigantic amount of debt. The US government does not save during good times, so they have nothing to fall back on during recession. The more the government spends today, the more needs to be repaid (including interest) in the future. There are only two ways the government can repay the debt -- increase taxes or reduce spending. Since there is "no free lunch", the US future generations thus could expect to pay a higher level of taxes. The more debt the US raised to fund their fiscal stimulus plan, the more fragile the economy becomes. This is why a lot of economists have been critical about the need to incur such a high debt to save some banks. It's not that fiscal policy doesn't work, it's because people have no trust in their government, which tends to be inefficient.

Hope my sharing can improve your understanding of the economic issues that are happening around the world!