Review: Naked Economics

Economics could be called the study of common sense. Underneath all the dressings of charts and complex math, it’s really just an examination of how people make decisions.

This focus on choices is why it’s called the “dismal science.” Unfortunately, we can’t both have cake and eat it, too.

Author Charles Wheelan’s premise is to strip economics down to its bare essentials, and explain its core concepts using real-world examples. As such, it reminds me of what I wished my Economics 101 class was like. Originally published in 2002, this second edition came out in 2010, fresh on the heels of the Great Recession. It therefore includes many discussions about what went wrong, what went right, and how (in hindsight) to avoid similar mistakes. There's a third version, published in 2019, but I just found out about it today. :-(

• Chapter 1 is about the power of markets. Given that we have a finite amount of resources, we all assign prices of some sort or another for our time, our labor, and even for the use of our money. Markets are not perfect, but can be compared to democracy – the worse system, except for all the others.
  
  
• Chapter 2 talks about incentives, community resources, free riders, externalities, and the principal-agent problem. As Communist systems showed, the most effective way to ensure good performance is to tie it to self-interest. Sadly, the Great Recession showed how even capitalism and free markets can get mis-align incentives. Even so, the answer is not to trash the system, but to capture the true costs of externalities by re-aligning incentives.
  
  
• Chapter 3 explains how government is needed to set the rules for markets, and looks closer at the idea of capturing the true costs of externalities, whether it’s carbon emissions, bongo-drum playing neighbors, or road taxes. Whereas libertarians suggest that markets would do fine if only government got out of the way, a good government is one that makes markets possible. Property rights, uniform application of law (including contracts), prosecution of fraud, infrastructure maintenance, and preservation of a sound currency are all hallmarks of a good government.
  
  
• Chapter 4 is about the opposite – what governments should not do. They shouldn’t be the sole provider of a good or service unless the private sector can’t do it. Nor should government influence the private sector’s allocation of credit or production resources – it makes for good politics, but is not good economics. Similarly, government should not bow to special interests in creating barriers to entry or superfluous credentialing. And supply-side economics is a sham.
  
  
• Chapter 5 discusses information asymmetry – decisions that are made with incomplete information. This has implications for hiring minorities in the absence of a background checks, health care, insurance, racial profiling, and marketing (specifically branding).
  
  
• Chapter 6 covers the concept of human capital – the true “wealth of nations” – and how productivity is the real key to prosperity. It refutes the zero-sum labor fallacy – the idea that one country’s job growth is another’s loss – and casts doubt on whether income inequality is bad.
  
  
• Chapter 7 talks about financial markets and their four principal functions: raising capital, protecting capital, hedging risk, and speculating. Unfortunately, efficient financial markets are a lot like picking the fastest line in the grocery store – at best, you have just as much information as everyone else. The best personal finance advice is to exercise disciplined patience, take appropriate risk decisions, and diversify.
  
  
• Chapter 8 discusses organized interests. If the federal budget is a Christmas tree, everyone wants to hang an ornament on it that benefits their district. Farm subsidies, tax shelters, protectionism, and inertia concentrate benefits but disperse the costs. Yet while pork barrel politics sound bad when others do it, everyone loves the politician who brings home the bacon.
  
  
• Chapter 9 explains factors that are used to compare economies: GDP per capita, how long it takes a worker earning the average wage to buy a specific good (like a loaf of bread), demographics, national savings, current account deficit, poverty, unemployment, size of government, and income inequality.
  
  
• Chapter 10 is about the Federal Reserve – what it is, how it works, and why that matters. Wheelan explains the origin and nature of inflation, and what makes managing the economy so difficult.
  
  
• Chapter 11 covers international economics, how Iceland got burned in the Great Recession, and how currencies are affected by national priorities. Among convertibility, price stability/foreign exchange stability, and control of interest rates, a country can only choose two. When they try for all three, a crisis inevitably pops up eventually which forces a painful change (U.S. gold standard in the 1930s, British pound in 1992, and Argentine peso in 2001-2002, etc.) The World Bank is like the world’s welfare office, while the International Monetary Fund is like the fire station.
  
  
• Chapter 12 evaluates the effects of globalization on developing nations. Although leftists staged huge protests against the World Trade Organization in 1999 (and remember – this was first written in 2002), global trade has been responsible for lifting hundreds of millions of people out of poverty. Despite salaries and working conditions that rightfully appall Western labor advocates, trade is the most effective route for national development.
  
  As Nobel laureate Paul Krugman explained, the Bangladeshi children who were put out of work by Senator Tom Harkin’s 1992 Child Labor Deterrence Act didn’t go back to school or home to prosperous families – they typically found worse jobs, lived on the streets, or were forced into prostitution. [Source]
  
  
• Chapter 13 addresses how nations can best develop. Wheelan advocates for strong property rights, development of human capital, abstinence from war, respect for women’s rights, free trade, fiscal discipline, independent institutions, and free flowing credit markets (as opposed to crony capitalism).
  
  Surprisingly, natural resources are not necessary, or even preferable. Given that former colonies typically have infrastructure designed for extraction, rather than free flow of good and services, I can see how this would be the case.

Despite this book's second revision now being a decade old, this book is still valuable as a primer on the basic principles of economics. To the extent that economics – as a field – faces criticism as a social science, Wheelan offers a cogent defense: the economic failures in our world come not from ignorance of these principles, but from a refusal to abide by them.

There is only one point on which I disagree with Wheelan – his perception of the dangers of income inequality. As he puts it, economists are ambivalent about income inequality. On the positive side, it sends signals to the economy about what skills are in greater demand, and the gap between rich and poor doesn’t really matter if everyone gets better and better off.

However, the reality is that the second condition hasn’t been the case in the 21st Century. Although the World Bank data for the Gini coefficient in the U.S. seems to show income inequality has mostly plateaued since about 1994 [Source], real wages for most workers haven’t changed since the 1970s. [Source]

The majority of Americans see the rich getting richer and richer, while normal folks have suffered through the Dot.com bust, the Great Recession, and (now) the 2020 coronavirus pandemic. It's a contributing factor for a lot of voter anger.