Mankiw’s Mythical Ten Commandments of Theoclassical Economics

By William K. Black
May 16, 2016     Bloomington, MN

This is the second column in a series on the N. Gregory Mankiw’s myths and dogmas that he spreads in his economic textbooks.  The first column exposed the two (contradictory) meta-myths that begin his preface.  This column de-mythologizes Mankiw’s unprincipled “principles” of economics – the ten commandments of theoclassical economics’ priestly caste.  Some of these principles, correctly hedged, could be unobjectionable, but in each case Mankiw dogmatically insists on pushing them to such extremes that they become Mankiw myths.

To understand Mankiw’s mythical 10 commandments, one must understand “Mankiw morality” – a morality that remains hidden in each of his textbooks.  Few people understand how radically theoclassical economics has moved in the last thirty years.  Milton Friedman famously argued that CEOs should operate exclusively in the interest of shareholders.  Mankiw, however, is a strong supporter of the view that CEOs will not only defraud customers, but also shareholders and creditors by looting the firm.  “[I]t would be irrational for savings and loans [CEOs] not to loot.”  “Mankiw morality” decrees that if you have an incentive as CEO to loot, and fail to do so, you are not moral – you are insane.  Mankiw morality was born in Mankiw’s response as discussant to George Akerlof and Paul Romer’s famous 1993 article “Looting: The Economic Underworld of Bankruptcy for Profit.”

Mankiw’s textbooks preach the wonders of the indefensible a system he has helped design to allow elite CEOs to loot the shareholders with impunity – the antithesis of Friedman’s stated goal.  Mankiw morality helps create the “criminogenic environments” that produce the epidemics of “control fraud” that drive our recurrent, intensifying financial crises.  It is essential to interpret Mankiw’s ten myths in light of his unacknowledged immoral views about how CEOs will and should respond to incentives to rig the system against the firm’s consumers, employees, creditors, and shareholders.  His textbooks religiously avoid any disclosure of Mankiw morality or its implications for perverting his ten commandments into an unethical and criminogenic dogma that optimizes the design of a criminogenic environment.

Mankiw’s myths

1. People Face Tradeoffs.
To get one thing, you have to give up something else. Making decisions requires trading off one goal against another.

This can be true, but Mankiw pushes his principle to the point that it becomes a myth.  Life is filled with positive synergies and externalities.  If you study logic or white-collar criminology you will make yourself a far better economist.  You may trade off hours of study, but not “goals.”  If your “goal” is to become a great economist you will not be “trading off one goal against another” if you become a multidisciplinary scholar – you will strongly advance your goal.  If you study diverse research methods you will be a far better economist than if you study only econometrics.

2. The Cost of Something is What You Give Up to Get It.
Decision-makers have to consider both the obvious and implicit costs of their actions.

“Opportunity costs” are an important and useful economic concept, but Mankiw’s definition sneaks ideological baggage into both sentences that turns his principle into multiple myths.  Mankiw implicitly assumes fraud and other forms of theft out of existence in the first sentence.  “Cost” is often not measured in economics by “what you give up to get it.”  If your inherit a home that lacks fire insurance and immediately burns down there is a cost to you (and society) even though you gave up nothing to inherit the home.  If the CEO loots “his” firm he gave up nothing to get the millions, but if he loses those millions he will consider it to have a “cost.”  Theoclassical economists have a primitive tribal taboo against even using the “f” word (fraud).

Decision-makers frequently ignore the “costs of their actions.”  There is nothing in economic theory or experience that supports the claim that the “decision-makers” “have” to consider costs.  It is rare that decision-makers must do – or not do – anything.

It is likely that Mankiw means that optimization requires decision-makers to “consider” all “costs of their actions,” but that too is a myth.  Theoclassical optimization requires perfect, cost-free information, pure “rationality,” and no externalities.  None of these conditions exist.  Car buyers have no means of knowing the costs of buying a particular car.  If they bought a GM car  the ignition mechanism defect could cause the driver to lose the ability to control the car – turning it into an unguided missile hurtling down (or off) a highway at 70 mph.  The car buyer does not know of the defect, does not know who will be driving when the defect becomes manifest, does not know who the passengers will be, and does not know who and what else could be injured or damaged as a result of the defect.  The theoclassical view is that the buyer who “considers” the costs of buying his defective car to others (negative externalities) and pays more money to buy a car that minimizes those negative externalities is not acting ethically, but irrationally.

It is typically cheaper (for the producer, not society) to produce goods of inferior (but difficult to observe) quality.  The inability of the consumer to “consider” even the true costs to the consumer and the consumer’s loved ones of these hidden defects means that economists began warning 46 years ago that “market forces” could become criminogenic.  George Akerlof’s 1970 article on markets for “lemons” even coined the term “Gresham’s” dynamic to describe the process.  A Gresham’s dynamic is a leading form of a criminogenic environment.

[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.

Akerlof was made a Nobel laureate in economics in 2001 for this body of work.  Economics is the only field in which someone would write a textbook ignoring a Nobel laureate whose work has proven unusually accurate on such a critical point.  There is only one reason to exclude this reality from Mankiw’s myths – Akerlof’s work falsifies Mankiw’s myths, so Akerlof’s work disappears from Mankiw’s principles, as does the entire concept of fraud.

3. Rational People Think at the Margin.
A rational decision-maker takes action if and only if the marginal benefit of the action exceeds the marginal cost.

The mythical nature of this principle flows from the multiple errors I have described.  Mankiw is being deliberately disingenuous.  Theoclassical economics does not claim, for example, that a firm produces a product “only if the marginal benefit of the action exceeds the marginal cost.”  Theoclassical economists claim that a firm sells a product “only if the marginal benefit of the action to the seller exceeds the marginal cost to the seller.”  The seller ignores social costs and benefits.

For the sake of brevity, I will summarize that Mankiw’s third principle is a myth for five reasons known to every economist.  First, it implicitly assumes out of existence positive and negative externalities, which means that supposedly rational, self-interested decision-makers he postulates, even if they had perfect, cost-free information, would not contract to maximize social welfare.

Second, as Mankiw morality implicitly admits, the actual optimization principle under theoclassical economics would be determined by the marginal benefits and costs of an action to the decision-maker – the CEO – not the firm, and certainly not society.  Theoclassical economists, however, refuse to admit that explicitly, so it disappears from Mankiw’s 10 commandments.

Third, the information provided by CEOs is often not simply incomplete and costly, but deliberately deceptive.  Where information is merely incomplete, consumers may pay far more for a product than they will benefit from the purchase.  Where the seller provides deceptive information about quality, the buyer and members of the public may be harmed or even killed.   The CEO may also be looting “his” firm as well as the customers.  Mankiw has implicitly assumed perfect, cost-free information and implicitly assumed that fraud does not exist.

Fourth, conflating rationality with optimization of personal costs and benefits is wrong on multiple grounds.  It defines ethical behavior as “irrational” where the consumer or CEO takes into account social costs and benefits and protects the interests of others in an altruistic manner.  Everything we know from behavioral economics also makes clear that humans are not “rational” in the manner predicted by theoclassical economics.  Mankiw has implicitly assumed out of existence thirty years of economic research on how people actually behave and make decisions.

Fifth, firms with monopoly power, according to theoclassical economics, maximize their profits by deliberately reducing production to a point that the social cost of producing the marginal unit is less than the marginal benefit to the consumer.  Mankiw has implicitly assumed away monopolies.

4. People Respond to Incentives.
Behavior changes when costs or benefits change.

I have responded to this myth in a prior article.  The implications of his fourth principle in conjunction with Mankiw morality are devastating for theoclassical economics.  CEOs create the incentives and understand how “behavior changes” among their agents, employees, and subordinate officers in response to those incentives.  Under theoclassical principles this will unambiguously lead “rational” CEOs to set incentives to rig the system in favor of the CEO.  Because fraud and abuse creates a “sure thing” that is certain to enrich the CEO, Mankiw’s fourth commandment predicts that control frauds led by CEOs will be ubiquitous.  Fortunately, many CEOs are ethical and remain ethical unless they are subjected to a severe Gresham’s dynamic.  As a result, Mankiw’s commandments over-predict the incidence of fraud and abuse by CEOs.  Similarly, experiments demonstrate that humans frequently act in altruistic manners despite financial incentives to act unfairly.

5. Trade Can Make Everyone Better Off.
Trade allows each person to specialize in the activities he or she does best. By trading with others, people can buy a greater variety of goods or services.

See my article on faux “trade deals” that exposes this myth.

6. Markets Are Usually a Good Way to Organize Economic Activity.
Households and firms that interact in market economies act as if they are guided by an “invisible hand” that leads the market to allocate resources efficiently. The opposite of this is economic activity that is organized by a central planner within the government.

Again, the key interaction under theoclassical theory is between CEO and consumers, employees, creditors, shareholders, and the general public.  “Markets” are vague constructs and they work best when ethical and legal provisions reduce fraud to minor levels.  When these ethical and legal institutions are not extremely effective against fraud, the incentives created by the market can be so perverse that they create a criminogenic environment that produces epidemic levels of fraud.  Mankiw’s myth is to describe only one possible incentive and treat it as the sole possibility other than what he falsely describes as “the opposite” – a government planner.  The opposite incentive to the so-called “invisible hand” is the Gresham’s dynamic.  Mankiw mythically presents the government as the threat to an effective economy rather than an institution that is essential to producing and enforcing the rule of law that prevents a Gresham’s dynamic.

7. Governments Can Sometimes Improve Market Outcomes.
When a market fails to allocate resources efficiently, the government can change the outcome through public policy. Examples are regulations against monopolies and pollution.

The myth here is that government only has a desirable role where there is a “market fail[ure].”  Mankiw treats “markets” as the norm and implicitly assumes that the government normally has nothing to do with making markets succeed.  Even conservative classical economists admitted that the rule of law was essential to an effective economy and required an effective government.  Well-functioning governments always improve “market outcomes.”  Indeed, they are typically essential to making possible well-functioning “markets.”

Mankiw also fails to explain that “markets” will be fictional and massively distort resource allocation (that is what a hyper-inflated bubble does) when there is an epidemic of control fraud.  As I have explained, Mankiw’s own principles predict (indeed, over-predict) that deregulated “markets” will frequently prove so criminogenic that they will produce epidemics of control fraud.

8. A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services.
Countries whose workers produce a large quantity of goods and services per unit of time enjoy a high standard of living. Similarly, as a nation’s productivity grows, so does its average income.

First, the CEOs of sectors such as finance that are immensely unproductive – so unproductive that they cause enormous losses rather than growth, and receive exceptional income because they loot.  Income is often based not on productivity, but on the CEOs’ wealth and economic and political power that allows them to rig the economy.  A nation’s standard of living also depends on its employment levels, which can be crushed by economic policies such as austerity.

The issue is not what happens to “average income,” but what happens to median income, wealth, the income and wealth of the lowest quartile or particular minorities, and to income and wealth inequality.  A nation can have high average productivity, yet have poor performance for decades in these other critical measures.

Consider what has happened to the folks who tried to do everything right to boost their productivity according to the theoclassical economic “experts’” advice.  This is what has happened to Latino and black households where a head of the household has at least a college degree.  The source is economists at the extremely conservative St. Louis Fed.

Hispanic and black families headed by someone with a four-year college degree, on the other hand, typically fared significantly worse than Hispanic and black families without college degrees. This was true both during the recent turbulent period (2007-2013) as well as during a two-decade span ending in 2013 (the most recent data available).

White and Asian college-headed families generally fared much better than their less-educated counterparts. The typical Hispanic and black college-headed family, on the other hand, lost much more wealth than its less-educated counterpart. Median wealth declined by about 72 percent among Hispanic college-grad families versus a decline of only 41 percent among Hispanic families without a college degree. Among blacks, the declines were 60 percent versus 37 percent.

One of the reasons that college-educated Latino and black families lost so much wealth compared to their white and Asian-American counterparts is that they were more likely to get their degrees from the for-profit colleges that theoclassical economists touted – colleges that frequently provided a very expensive and very poor education, often involving defrauding the students.  Another reason that college-educated Latino and black families lost so much wealth compared to their white and Asian-American counterparts is that they were far more likely to be the victims of predatory home lending – an activity for which theoclassical economists served as the primary apologists.

Mankiw also ignores critical factors that determine “a country’s standard of living.”  Yes, China reports higher growth, but it is also operating in an unsustainable fashion that has destroyed much of its environment and threatens to be a major contributor to the global suicide strategy of causing severe climate change.

9. Prices Rise When the Government Prints Too Much Money.
When a government creates large quantities of the nation’s money, the value of the money falls. As a result, prices increase, requiring more of the same money to buy goods and services.

No, and Mankiw knew this was a myth when he wrote it.  First, “prices rise” for many reasons.  Pharmaceutical prices rise because hedge fund managers take over pharma firms or encourage others to do so in order to increase prices on existing drugs by hundreds, sometimes thousands of percent.  Prices rise because accounting control fraud recipes hyper-inflated the largest bubble in history in U.S. real estate.  Prices rise because of cartels.  Prices rise because oil cartels cause oil shocks.  Prices rise due to real bottlenecks, e.g., shortages of a skill or material.

Inflation has not risen, indeed general price levels have often fallen (deflation) despite record creation of money by central banks and private banks.  Theoclassical economists have regularly predicted hyper-inflation.  As Paul Krugman emphasizes, virtually none of them even admits their serial prediction failures.

10. Society Faces a Short-Run Tradeoff Between Inflation and Unemployment.
Reducing inflation often causes a temporary rise in unemployment. This tradeoff is crucial for understanding the short-run effects of changes in taxes, government spending and monetary policy.

Mankiw ends his ten myths with a series of myths.  Foolish, counterproductive austerity often causes inflation to fall to harmfully low – even negative (deflation) – levels that can lead to prolonged recessions that cause severe damage to people and economies.  Stimulus provides a win-win that improves economic growth and reduces human suffering without causing harmful inflation.

A nation is able to operate at extremely high levels of employment without producing harmful inflation.  Mankiw is a partisan Republican.  When Republican presidents in the modern era are faced with recessions they junk their theoclassical dogmas and adopt stimulus programs, though they generally do so largely through the economically inefficient and less effective means of slashing tax rates for the wealthy.

Democrats: Please Renounce Mankiw’s Myths

Unlike the Republicans, who always rise above their theoclassical principles when their president is in office and faces a recession, the “New Democrats” are the ones who seem to have drunk the theoclassical Kool-Aid and strive endlessly to create the self-inflicted wound of austerity when they are in power.  New Democrats also love to bash Republican presidents for running deficits even when those deficits produced no harmful inflation and helped produce recovery.  It is sensible and honest to point out that tax cuts for the wealthy are a far less effective form of stimulus and to present and support superior alternatives such as job guarantee and infrastructure programs.  It would be superb if Democrats were to point out that by far the most effective, prompt means of cutting taxes to stimulate the economy in response to a recession is to cease collecting the Social Security taxes for several years.  It is not fine to praise Bill Clinton for taking the harmful step of running a budget surplus or to bash Republicans because they – correctly – increased fiscal stimulus (and therefore the short-term deficit) in response to a recession.

Democrats also need to stop spreading the myth that Bill Clinton was an economic marvel.  He was the luckiest president in history in terms of timing.  His economic “success” was the product of two of the largest bubbles in history (the dot.com and real estate bubbles).  The real estate bubble is the only thing that prevented his dot.com bubble from causing an economic collapse during his term.  The real estate bubble was so enormous that it made it easy for the fraudulent CEOs to “roll” (refinance) the fraudulent loans they made, which helped cause the bubble to hyper-inflate.  The saying in the trade is “a rolling loan gathers no loss.”  This meant that the bubble was Bill Clinton and George Bush’s bubble, but it collapsed on George Bush’s watch so Clinton gets the credit for the high employment produced by the twin bubbles and Bush gets the blame for the massive unemployment that a massive bubble will create when it collapses (if it is not replaced by an even larger bubble).