Thursday, November 6, 2014

Teaching Economics To Business Students And To Citizens

Noah Smith majored in physics in college and he ended up getting a PhD in economics.  He now teaches economics and finance to business students.  He often writes about economics from the perspective of the philosophy of science.  The social sciences are often guilty of copying the surface characteristics of the physical sciences to distinguish their disciplines from the liberal arts.  The economics profession, which deals primarily with things that can be quantified, considers itself to be the queen of the social sciences because of the progress that it has made in applying mathematics to its discipline.  In this article, Smith reflects on the problems of teaching economics to business students.  I can sympathize with Smith's problem because I have faced similar problems in my career.

Smith teaches game theory to his students but he believes that may not be useful.  Nash won a Nobel prize in  economics for applying game theory to a practical problem but it assumes that the participants in the game are rational.  In that respect, it adheres to the major assumption in the discipline.  That is, it assumes that the players in the game are rational, and that they will figure out to make rational decisions that maximize their outcomes.  Smith points out that business people may not always act rationally.  They may prefer to destroy their competitor even if they might suffer a loss in the process.  There is not always a victor in warfare.

Smith raises an interesting point but it goes well beyond the problem of teaching game theory.  Many of the important decisions made in a business are significantly affected by emotion and uncertainty about the future.  I recall a discussion that I had with the manager of the computer chip division in the firm in which I worked.  He compared his business opportunity to the calculator business developed by Texas Instruments which had become a mature business with a modest volume.  He was a very smart and sophisticated manager, but he could not imagine that his business could evolve to the point in which a company like Apple could sell 35,000,000 smart phones in the first week after releasing the latest version of its product.

The CEO and founder of the firm suffered from a similar lack of vision.  IBM was by far the largest firm in the computer business.  His firm had risen very quickly to the number two position in the industry.  He did not like being in second place.  He wanted to become number one.  Therefore, he invested over one billion dollars in developing a mainframe computer that would be less expensive than IBM's mainframe which provided the majority of IBM's revenue and profits.  His engineering staff did not support that strategy.  They understood that the business would move in the opposite direction.  That is, in the direction of very small computing devices.  They were unable to alter the CEO's opinion and we all know how the industry has evolved.

My approach to teaching economics was influenced by my experience in business.  Every firm participates in an economy that moves through business cycles.  It is important to understand  the business cycle and adapt one's business to an environment that often contains bad weather.  Economists are not as good as weather forecasters in predicting the future, but it is important for a business leader to understand the economic and political climate in which they operate.  Moreover, few of my students will become top executives, but they will all be citizens who need to have a good understanding of political economy.  They need to understand the strengths and weaknesses of economic ideologies which have powerful social effects that are often unrelated to their validity.

The financial crisis provided a perfect opportunity for teaching economics in an MBA program because the students were motivated to learn more about it.  It was a once in career teaching opportunity to make the teaching of economics relevant.  They learned about the failures of  government regulators, whose inaction allowed predatory mortgages to be originated and packaged into securities that were blessed by the rating agencies and sold to poorly informed investors.  Economic ideology, and a poor understanding of the incentive system that motivated the financial industry to make self destructive decisions, was responsible for much of the damage.  The students also learned how the Federal Reserve and Treasury struggled to rescue the badly damaged financial system that would not have survived without government support.  What they did was not perfect but it prevented a second version of the Great Depression.  The students also learned about the development of the shadow banking system that had evolved over time to be as large as the banking system that is described in economic textbooks, but not subject to the safe guards that prevent runs on the banking system.  In passing, they also learned that the financial system was regarded as external to the functioning of the economy and was not significantly represented in the economic models used by central banks to manage the economy.

The collapse of financial system led to a recession that was comparable to the Great Depression.  The recovery has been slow and incomplete.  It provided an excellent opportunity to explore monetary and fiscal policy.  One of the most valuable lessons provided by the Great Recession was the similarity of the political and economic debates to the debates during the Great Depression.  These debates exposed some of the ideology that influences how the economics profession looks at the use of monetary and fiscal policy.  It is not a pretty picture but economics, in practice, cannot be understood in the absence of politics and ideology.  The economy does not operate in a test tube.

I only added my personal experiences to Smith's comments on teaching economics to business students to amplify his concerns about relevance.  Almost none of the information and concepts that were useful in teaching students about the financial crisis, the Great Recession that followed, and our response to the crisis, are covered in the textbooks that are used to teach economics to the great majority of students who only take economics 101.  Textbooks in economics follow the 80/20 rule.  None will be adopted that are more than 20% different from the standard texts which were used prior to the financial crisis and the Great Recession.  The most popular textbook was written by Greg Mankiw who is the head of the Economics Department at Harvard.  The book is very well written but it is very orthodox much like its author.  Mankiw adapts his economics very well to the prevailing winds of the political economy.  One of his books  was very critical of the idea that tax cuts would stimulate enough economic growth to actually increase tax revenue.  The senior George Bush called this voodoo economics when he ran against Ronald Reagan who made this claim during his campaign.  Mankiw removed his criticism of voodoo economics from his textbook following Reagan's election.  Mankiw was also an economics adviser to the junior Bush after he was elected president.  The economy was in a minor recession following the bursting to the dotcom bubble and Mankiw argued that it was necessary to use fiscal policy to stimulate the economy.  He supported the Bush tax cuts, and the deficits that would follow, as an essential tool to stimulate the economy.  Like many conservative economists he was not a supporter of Obama's use of fiscal policy to stimulate an economy in a very deep recession.  Conservative economists, who typically dislike government intervention in the economy,  joined a chorus which regarded deficit reduction as a more important concern than reducing unemployment.  Some economists even argued that deficit reduction would stimulate economic growth.

The great bulk of the research that gets done in the academy satisfies most of the methodological requirements that prevail at any given point in the profession.  Like most academic research in every profession, it is primarily of interest to other researchers.  There is little that is more boring than attendance at an academic conference in which graduate students and young professionals present the results of their research.  That is not unique to the economics profession.  Methodological rigor is valued even when most of the research lacks relevance outside of the academy.  On the other hand, we live a world in which a good understanding of the strengths and weaknesses of economic ideas are very important.  Smith is raising good questions about the relevance of economic ideas that predominate in introductory economics courses.  We live in a political economy that is not well represented in the textbooks.

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