The 'Laws of Economics' Don't Exist

Our debates about immigration, budgets, and debt are framed by ideas of supply, demand, and growth that are more like guidelines than ironclad rules

800 adam smith.jpgAdam Smith [Wikimedia Commons]

In a world increasingly framed by economic debates, the phrase "the laws of economics" has become ever more prevalent. As the U.S. Senate prepares to unveil a new immigration bill, much of the discussion centers on the economics of illegal immigration and the incentives for employers to hire undocumented workers. Said a recent Barron's article: "Immigration policy is a game governed by classic economic rules, especially by Say's Law, which says supply creates its own demand ... Whether the new applicants are seeking stoop-labor jobs in California's Central Valley or high-tech jobs in Silicon Valley, the laws of economics dictate the outcome: more immigration."

How about the war on drugs? Said one recent analysis: "We're losing the war on drugs because it's a war that defies the laws of economics. We might as well be fighting a war on gravity."

And how about what history can tell us about our current policies? Said one recent review of Amity Shlaes' biography of Calvin Coolidge, which makes the case for Coolidge as an exemplar of responsible economic policy:  "Our current political leadership ‑- and we who elect them ‑- are spending the country into ruin. The laws of man can be bent and broken; the laws of economics can not."

This is just a smattering of examples over the past few weeks. Increasingly, our debates about -- and our solutions to -- pressing issues such as immigration, budgets and debt are framed in the context of all-powerful economic laws that dictate what is and is not possible. There's just one slight problem: There are no laws of economics.

For sure, many economists and large parts of society believe there are. The high levels of anxiety about deficits and government debt, not just in the United States but throughout the euro zone and much of the world, stem from the belief that if central banks create too much money, it will inevitably lead to inflation. Why? Because the "laws of economics" say the supply of money will cause inflation if overall output stays the same. In the developed world, clearly, there has been an increase in money supply via the Federal Reserve, the Japanese Central Bank and to a lesser extent the European Central Bank, yet growth is minimal everywhere. While there is no statistically discernible inflation as of yet, the "laws" strongly indicate that there soon will be.

Unless, of course, those laws are wrong, or simply not "laws." Some, such as Paul Krugman or other equally strong (but less vociferous) believers in the precepts of John Maynard Keynes, would say inflation isn't increasing because that's what happens in recessions. When demand is depressed, more money only closes that gap between demand and supply. That, too, depends on a basic "laws of economics," that of supply and demand, which is one of the first precepts students of economics learn and one of the most widely disseminated -- if often misunderstood -- principles of economics.

Yet even here, the idea that these are ironclad laws breaks down. So much of economics depends on the theory that we are all "rational actors." Yet as behavioral economists such as Daniel Kahneman have shown, we are rarely rational actors. Patterns of individual behavior are very different from what economic laws assume. People sell when prices are falling, and buy when prices are rising, even though their interests would be served by doing the opposite.

Institutions and states are not much different; they make decisions all the time that do not "maximize their utility." To put it more plainly, they often make decisions based on fear and hope rather than on a rational calculus of what will best serve their interests over the long run. Governments cut spending when they should increase it (austerity in difficult times) and expand spending when they should cut it. Companies often don't invest when they are unclear about the future and business is soft, which is precisely when they should be investing if the goal is to maximize long-term profitability and viability.

The notion that economics is a science with irrefutable laws appeals to economists (who have long tried to elevate the profession out of the realm of observation and description and into the realm of science) and to the widespread human desire for certainty. But even science isn't quite so set, as any good scientist knows. The laws of gravity may be set, until the laws of quantum mechanics throw a wrench. Our ability to measure the world increases, and our understanding of laws evolves.

Economics is based on a limited amount of information compiled over the past hundred or so years. We have no way of knowing with any exactitude the gross domestic product of imperial Rome, of Spain in its 16th century golden age or of the United States in 1820s. We can try to fill in the blanks retrospectively, but that's all. We don't know because those numbers didn't exist. All these economic laws are based on what a few cogent thinkers such as Adam Smith and David Ricardo observed at the end of the 18th century and what a new set of 20th century statistics (GDP, unemployment, inflation) suggest.

In short, even if there are laws of economics, we haven't been observing them for long enough to know what they actually are. And given the vagaries of human behavior and the mercurial nature of states, people and institutions, the notion that there's some grand mechanistic, master system that explains all and predicts everything is at best a comforting fiction and at worst a straitjacket that precludes creativity, forestalls innovation and destroys dynamism.

Referencing "the laws of economics" as a way to refute arguments or criticize ideas has the patina of clarity and certainty. The reality is that referencing such laws is simply another way to justify beliefs and inclinations. I may agree that the war on drugs is flawed, but not because it violates "laws of economics," but rather because it fails in most of its basic goals. The test of whether government spending or central bank easing is good policy should be whether they succeed in ameliorating the problems of stagnant growth and high unemployment, not on what the "laws of economics" erroneously say about certain future outcomes.

Liberating ourselves from the fictional cage of these laws will not suddenly reveal hidden answers. But it will allow for more pragmatic examination of what is working and what is failing and why. Economic theories are guides, ones that have substantial utility. But once elevated to the realm of laws, they fall short and do us no good.

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Zachary Karabell is Head of Global Strategy at Envestnet, a financial services firm, and author of The Leading Indicators: A Short History of the Numbers that Rule Our World. More

At River Twice Research, Karabell analyzes economic and political trends. He is also a senior advisor for Business for Social Responsibility. Previously, he was executive vice president, head of marketing and chief economist at Fred Alger Management, a New York-based investment firm, and president of Fred Alger and Company, as well as portfolio manager of the China-U.S. Growth Fund, which won a five-star designation from Morningstar. He was also executive vice president of Alger's Spectra Funds, which launched the $30 million Spectra Green Fund based on the idea that profit and sustainability are linked. Educated at Columbia, Oxford, and Harvard, where he received his Ph.D., he is the author of several books, including Superfusion: How China and America Became One Economy and Why the World's Prosperity Depends on It (2009), The Last Campaign: How Harry Truman Won the 1948 Election, which won the Chicago Tribune Heartland Award, and Peace Be Upon You: The Story of Muslim, Christian, and Jewish Coexistence (2007), which examined the forgotten legacy of peace among the three faiths. In 2003, the World Economic Forum designated Karabell a "Global Leader for Tomorrow." He sits on the board of the World Policy Institute and the New America Foundation and is a member of the Council on Foreign Relations. He is a regular commentator on national news programs, such as CNBC and CNN, and has written for The Wall Street Journal, Newsweek, Time, The Washington Post, The New Republic, The Los Angeles Times, The New York Times, and Foreign Affairs.

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