Economist Roger E. A. Farmer’s slim but dense book How the Economy Works is slightly mistitled. A better description would be Various Theories of How People Think The Economy Works But Really How The Economy Doesn’t Work Very Well At All. I guess it just didn’t have that ring to it though. Farmer’s text isn’t going to win any awards for its prosody. He writes, like Hemingway, in short declarative sentences but without the poetry. But if you’re looking for a survey of economic theory from Adam Smith and David Hume right up through Fed gnome Alan Greenspan, the book’s a boon.
Farmer spends the lion’s share of How the Economy Works tilling the field of the development of economic theory. In (very) broad (very) layman strokes Adam Smith, in 1776, was all like “Invisible Hand! Yippee!” Then Leon Walras was all like, “I’m formalizing this into General Equilibrium Theory! Killer!” Then Scot David Hume was like “As for goods, it shall be so with money!” All these dudes were into the idea of the market always being right. These people were called (at the time?) Classical Economicists.
But then the Great Depression came and people were sad and poor. Economist John Maynard Keynes developed a theory — duh! — that perhaps sometimes the markets need a little governmental nudging every now and then to correct itself when unemployment or inflation get weirdly out of whack. He suggested a combination of monetary policy (lowering the interest rate to increase expenditure) and fiscal policy (increasing government spending and setting the tax rate) to jump start or reign in the economy. That was cool until the 1970’s when stagflation set in because stagflation — a Long Island Iced Tea of high unemployment and high inflation — was mathematically impossible using Keynesian theory. So then all these Keynesians went batshit and two new theories emerged called New Classical Economics and New Keynsians and blah blah blah.
If you’re looking for a riveting personality driven account of what went wrong in the great financial crisis, this book isn’t for you. Try Michael Lewis’ new book The Big Short instead. Farmer’s big contribution here, and he’s very proud of it, is the notion that really none of this mathematical theory really matters. You can talk about natural unemployment levels and search technology theory until you’re out of a job and blue in the face; what really matters is investor confidence. “Confidence is an independent fundamental driving force in the business cycle,” Farmer writes. [Each of those words is important in a jargony way but you don’t have to understand why to get his basic premise.]
As for solutions, Farmer offers a revolutionary not-very-capitalist sounding one. Who knew behind the ruddy fustiness of Farmer lay a Che? Farmer wants the national central bank to create and trade a stock index fund consisting of “all publicly trading companies,” encourage private banks to buy shares of this index and then to guarantee a price path for that it.
“By stabilizing large market movements, both up and down, the central bank [could] prevent these movements from adversely affecting the economy. Control of an index fund is the ideal way to implement this idea, because it would not require a national central bank to directly own stock in private corporations.” The plan sounds nice, real nice, maybe too nice. After spending the entire book outlining the epic fails of various economic theories from 1776 to present, it’s difficult to have much confidence in this new plan. And, as Farmer argues, confidence matters.