For some obscure reason, Tom's Sargent's Berkeley graduation address from seven years ago is now getting attention in the blogosphere. It's innocuous stuff - basically core ideas in economics boiled down to life lessons for graduating seniors. Paul Krugman seems a little insecure about it though (here and here) and would like you to dismiss parts of it as some sort of right-wing "cockroach" ideas. I can see what Krugman is getting at - he might see these ideas as threatening, as they are at odds with his notion that economic policy is easy, or that large welfare gains from changes in policy are low-handing fruit. But I think you have to be a rather suspicious person to think that Sargent's synopsis of economic ideas represents a particular view on policy. Indeed, the ideas are entirely consistent with how Mike Woodford, or Ed Prescott, thinks about the world.
So, let's go through Sargent's address, so you can see what I mean:
I remember how happy I felt when I graduated from Berkeley many years ago. But I thought the graduation speeches were long. I will economize on words. Economics is organized common sense. Here is a short list of valuable lessons that our beautiful subject teaches.
[I had to think about whether I agree with the "organized common sense" view of economics. If common sense is supposed to be what the average layperson possesses, then economics is not common sense, as it's sometimes (if not often) counterintuitive. For example, Adam Smith told us that greed can be a good thing. That's certainly not part of collective wisdom, I think. But Sargent was trying to put the Berkeley graduates at ease. He's telling them that doing economics is just a matter of putting pieces of straightforward logic together to come up with a coherent set of ideas.]
1. Many things that are desirable are not feasible.
[This is typically one of the first things taught in Econ 101. As a society, and as individuals, we face constraints. But what are society's constraints? That's what economists argue about. Some people think, for example, that the U.S. economy is no more constrained in what it can achieve in 2014 than it was in 2007. Those people think that the decision-makers in the Fed and the U.S. Congress, are somehow not optimizing given their constraints - they think there are more desirable outcomes that are in fact feasible. Others don't agree.]
2. Individuals and communities face trade-offs.
[This is again a key part of any Econ 101 course - opportunity cost. This is about the nature of the constraints we face. Individuals face budget constraints. One can't have a new car without giving up something else - other goods and services in the present, or future consumption. Economic growth models tell us that, as a society, to attain higher productive capacity in the future, we have to give up consumption in the present. But, at the societal level, again, economists have key arguments about what the tradeoffs are. In the 1960s, Solow and Samuelson argued that a Phillips curve tradeoff existed - the central bank could achieve lower unemployment, but only at the expense of higher inflation; Milton Friedman said that this was only a short-run tradeoff, and in the long run no such tradeoff exists; the Phillips curve went out of fashion; the Phillips curve was resurrected in the 1990s by New Keynesians; many macroeconomists are still skeptical.]
3. Other people have more information about their abilities, their efforts, and their preferences than you do.
[I'm glad Sargent included this idea, which is not part of the typical Econ 101 curriculum. But this is at the heart of many contemporary economic issues. Why are there banks, and what do they do? What were the incentive problems that led up to the global financial crisis? What's a financial crisis about anyway? How do we explain unemployment and the process of labor market search? For all of these issues we have to think carefully about private information and how it matters for the functioning of markets and economic institutions. A whole array of economic machinery developed over the last 50 years allows us to come to grips with these things.]
4. Everyone responds to incentives, including people you want to help. That is why social safety nets don’t always end up working as intended.
[This is closely related to #3. Take unemployment insurance (UI), for example. A key problem in designing a UI system is that there is moral hazard - it's hard for the government to observe how much effort the unemployed are putting into looking for a job, and the more generous is UI, the less effort is expended in searching. So, this represents another societal tradeoff. Providing better UI is good, as it provides insurance against a bad outcome - being unemployed. But the better insurance UI provides, the lower is the search effort of the unemployed, on average, and the higher will be the average unemployment rate. The latter is bad for society, as we lose output.]
5. There are tradeoffs between equality and efficiency.
[Closely related to #5. For example, redistribution of income through the income tax system (progressive taxation by which we tax the rich at a higher rate than the poor) can be seen as a form of social insurance. Being born poor is no fault of an individual, and may disadvantage him or her for life. Just like UI, progressive taxation acts to insure people against bad outcomes. But redistribution changes incentives. If I am born poor, the insurance provided by the government discourages me from investing in my own human capital - acquiring education and skills that allow me to do better. Similarly, those born rich are also discouraged. Why acquire high-level human capital if the return on that human capital is low because it is taxed at a high rate? Again, society faces a tradeoff - we can redistribute the pie, but that tends to make the pie smaller.]
6. In an equilibrium of a game or an economy, people are satisfied with their choices. That is why it is difficult for well meaning outsiders to change things for better or worse.
[Note here that Sargent doesn't say it's impossible to make things better - it's just difficult. Here's an example. A typical Econ 101 example of this principle at work is the minimum wage law. Workers and firms engage in private contracts. Firms offer jobs at particular wages - the people who are employed in those jobs have accepted those terms of employment. The firms and workers did the best they could under the circumstances. So why should we intervene in these private contracts, for example by imposing a floor on the wage a firm can offer a worker? Well, we might see this as social insurance, in which case we are back to #5. What's the tradeoff? Further, an issue that comes up here is that the tradeoff might be better if we use one mechanism to redistribute income rather than another. In this case, Econ 101 tells us that we're better off as a society if we redistribute using the tax system, or lump sum payments to the poor rather than by using the minimum wage. One problem with the minimum wage is that we're taxing the firms we're asking to provide employment for the poor.]
7. In the future, you too will respond to incentives. That is why there are some promises that you’d like to make but can’t. No one will believe those promises because they know that later it will not be in your interest to deliver. The lesson here is this: before you make a promise, think about whether you will want to keep it if and when your circumstances change. This is how you earn a reputation.
[Anyone who has had to deal with 2-year-olds - or has been the chair of an economics department - understands this perfectly. The people whose behavior you are trying to shape with your current promises have excellent memories and will punish you forever if you break those promises. This is the basis for limited commitment models in economics. Limited commitment - e.g. the "time consistency" problem - has been highly influential in policy debates, from Kydland and Prescott's watershed work on. Limited commitment is also key to credit relationships, and the use of collateral - again crucial for figuring out the financial crisis, and the role of policy in the crisis.]
8. Governments and voters respond to incentives too. That is why governments sometimes default on loans and other promises that they have made.
[Again, this is critical for thinking about current policy issues - sovereign debt problems for example. Commitment and incentives were at the heart of the Fed's rationale for its recent forward guidance experiments. In New Keynesian macro models, which formed the theoretical backdrop for the policy, promises about the future are important for attaining good results in the present, in contexts where conventional policy doesn't work. But when the future arrives, the policymaker will want to go back on the promise, so commitment to the policy is required. Of course, this is a bad example of commitment at work, as the Fed botched it.]
9. It is feasible for one generation to shift costs to subsequent ones. That is what national government debts and the U.S. social security system do (but not the social security system of Singapore).
[Most of what you need to know about this is in Peter Diamond's 1965 paper. This is one of the neatest tricks in economics. The world consists of overlapping generations of individuals. If we can get each young generation to give a gift to each old generation, then (under some conditions) we can make everyone better off - forever. So there are some circumstances where - indeed - we can get something for nothing. In practice, the gifts from young to old can be accomplished through a social security system, through government debt (as Diamond showed), or through monetary exchange (as Samuelson showed). Very cool.]
10. When a government spends, its citizens eventually pay, either today or tomorrow, either through explicit taxes or implicit ones like inflation.
[This is closely related to #1 and #2. Running a government requires real resources - workers, buildings, fuel, etc. Those resources don't come for free - there are tradeoffs. Some people - Krugman for example - would argue that there are circumstances in which more government spending is effectively free. The argument is that, if there are unemployed workers willing to work, then employing them makes them better off, and gives the rest of us more stuff to boot. In the story, there can even be a multiplier - a free lunch - by which one unit of government spending produces more than one unit of additional GDP. The odd thing about this is the disconnect between modern Keynesians and Old Keynesians on the issue. Multipliers somehow seem convincing - they satisfy the "common sense" test of the person on the street. But the standard multiplier mechanism is nowhere to be seen in a mainstream New Keynesian model. Further, in episodes like World War II with massive increases in government spending, it's clear what the resource costs are - a small drop in current private consumption, and a very large drop in private investment spending (future consumption).]
11. Most people want other people to pay for public goods and government transfers (especially transfers to themselves).
[You can see this in current debates over health care. Some senior citizens receiving medicare benefits see those benefits as some kind of birth right, but object to government programs that attempt to extend health insurance to the previously uninsured. There are some goods and services for which public provision is appropriate - national defense being the leading example. But it's impossible to provide an appropriate amount of public goods if we are going to finance their provision through voluntary contributions (as we do in NPR pledge drives). We have to collectively agree to government confiscation (tax collection) to make this work.]
12. Because market prices aggregate traders’ information, it is difficult to forecast stock prices and interest rates and exchange rates.
[This is just simple financial arbitrage - there are no free lunches available to your average financial market participant. Fama called this the "efficient markets hypothesis." But that's a misnomer, as by now we understand that perfect arbitrage in financial markets can occur in economies which are highly inefficient in the standard economic sense.]
So, Sargent has been pretty terse - that's the way he is. But these 12 ideas are very much mainstream. The ideas are consistent with economic inefficiency, a role for government, and provide a basis for analyzing how governments and central banks can make our lives better. I'm not sure what Paul Krugman is afraid of.