by Robert Litan
Contents
Preface
Chapter 1: Introduction: Economists as Innovators Organization of the Book
My Personal Interest (and Bias)
Notes
Chapter 2: An Easy Introduction to Economics Rationality
Markets
Market Failures
The Macro–Micro Distinction
Economic Growth in the Short and Long Run
The Equity–Efficiency Tradeoff
Innovation and Growth: The Role of Economists
The Bottom Line
Notes
Part I: The Power of Economic Ideas: Direct Use in Business Chapter 3: The Price Is Right The Bloomberg Way of Pricing
Auctions
Different Prices for Different Folks
The Bottom Line
Notes
Chapter 4: Minimizing Costs Optimization
Learning by Doing
The Bottom Line
Notes
Chapter 5: Beyond Moneyball A Brief Guide to Regression Analysis
The Business of Forecasting
The Business of Economic Consulting
Data Analytics and Big Data
Econometrics and Sports: Moneyball
Regulatory Moneyball
The Bottom Line
Notes
Chapter 6: Experiments in Economics and Business Economics in the Lab: Vernon Smith and Experimental Economics
Lab Experiments in Business: Focus Groups
Economic Experiments in the Field: Randomized Controlled Trials
Business Experimentation in the Field
Innovation and Entrepreneurship: Experimentation as the Foundation of Growth
The Bottom Line
Notes
Chapter 7: Matchmaker, Matchmaker A Gentle Introduction to Market Design and Matching Theory
Matchmaking in the Labor Market
Matchmaking and Online Dating
The Bottom Line
Notes
Chapter 8: Economists and Mostly Good Financial Engineering Not Putting Your Eggs in One Basket: The Rise of Index Investing
Efficient Markets and Their Implications
Behavioral Finance
Valuing Options: Upsides and Downsides
The Bottom Line
Notes
Part II: Economist-Inspired Policy Platforms for Private Business Chapter 9: Planes, Trains, and . . . Trucks Origins of Transportation Regulation
Airline Deregulation
Trucking Deregulation
Railroad Deregulation
Deregulation’s Impact: The Transportation Industry
Deregulation as a Business Platform
The Bottom Line
Notes
Chapter 10: Economists and the Oil and Gas Revolution The Origins and Decline of Price Regulation of Fossil Fuels
The Oil and Gas Supply Revolution
The Energy Revolution as a Platform Technology
The Bottom Line
Notes
Chapter 11: Economists and the Telecommunications Revolution Economists in a Quick History of Communications
When Natural Monopolies End: The Run-Up to the AT&T Antitrust Case
Competition in Telecommunications: The Benefits of AT&T’s Breakup
Economists and Price Cap Regulation
Economists and Spectrum Allocation
The Bottom Line
Notes
Chapter 12: Economists, Financial Policy, and Mostly Good Finance Economists and Competition in Brokerage Commissions
Economists as Detectives: Accelerating Automated Trading
Economists and the Financial Crisis
How Did the Crisis Happen? A Quick and Easy Guide
Subprime Lending
Excessive Leverage: An Introduction
The Pre-crisis Demise of SEIR
The Glass–Steagall Debate
The Bottom Line
Notes
Part III: Looking Ahead Chapter 13: Economic Ideas in Waiting: Business Applications Prediction Markets
Potentially Good Financial Innovations
Congestion Pricing
The Bottom Line
Notes
Chapter 14: Economic Ideas and Challenges on the Policy Shelf: Business Implications Federal Budget Deficits as Drivers of Policy Change
Premium Support for Medicare and Medicaid
Taxing Consumption
Taxing Carbon
The Bottom Line
Notes
Chapter 15: The Future of Economics: What It Means for Business and Economists The Revolution in Economics
How Economics Will Continue to Affect Business
Implications for Economists
Concluding Thoughts
Notes
Appendix: Prizes in Economics
About the Author
Index
End User License Agreement
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Trillion Dollar Economists
How Economists and Their Ideas Have Transformed Business
Robert E. Litan
Cover image: © iStock.com/solvod
Cover design: Mochael J. Freeland
Copyright © 2014 by Itzy. All rights reserved.
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Library of Congress Cataloging-in-Publication Data:
Litan, Robert E., 1950–
Trillion dollar economists : how economists and their ideas have transformed business / Robert E. Litan.
pages cm
Includes index.
ISBN 978-1-118-78180-7 (hardback) — 1. Decision making. 2. Economists. 3. Economics. 4. Commerce. I. Title.
HD30.23.L578 2014
338.5—dc23
2014013664
Dedicated to
Dr. Michael Boyle
Johns Hopkins Medical School
and
Dr. Steven Stites
Kansas University Medical Center
Preface
Many, and possibly most, authors have a love–hate relationship with what they do. Writing every day, or trying to, can be a painful experience. Some days you have it and the words flow, and other days, your head is in a fog and you struggle to write a single sentence or paragraph.
I have had numerous jobs throughout my career where writing was not my main function, but in each one of them, writing memos, briefs, and articles was one element of what I was hired to do. I also had the good fortune through most of my working life to be employed by organizations that either paid me to write books or encouraged me to do so. And, to be honest, I have that love–hate attitude toward writing that I just described.
But not for this book; I wrote it while I was 63, at or near the culmination of my career, and every day I spent working on it was a joy. Like the swimming I look forward to each day, I couldn’t wait to sit down for however long I was able to do it, and at least write a few paragraphs or, ideally, several pages.
It’s not my age that explains this, but the subject matter (or matters), to be more precise. I hope that as you read the book, you can tell that I love economics and I am grateful to have a career in which I have been able to meet and occasionally work with so many outstanding, brilliant individuals. This book is kind of an ode to all of them and to the subject in general.
I got the inspiration to write it from three basic sources. First, I felt after the financial crisis that the economics profession, while somewhat justifiably criticized, was also misunderstood by many in the media and many non-economist friends. Second, for a long time I have felt that many hardheaded people in business give too little credit to economists and their ideas. Many of them, as I argue in what you are about to read, probably are not even aware of where certain ideas originated that have powered businesses quite successfully, maybe even their business. This book is an effort to correct these misimpressions, while ideally helping many undergraduate students and perhaps some graduate business students taking their first or intermediate-level economics course to understand why the subject matters and how it has been, and will continue to be, highly useful in the real world. This is true even as the field of economics changes and conceivably morphs into other social sciences, as I will comment on in the last chapter.
Third, although I don’t know him, I want to credit Steven Leavitt, the award-winning economist at the University of Chicago, and his coauthor, Stephen Dubner, of the highly successful Freakonomics series, with demonstrating that there is a real market, maybe even a hunger, for books about economics in plain English. I was inspired by Leavitt’s and Dubner’s success and hope that this book will achieve at least some significant fraction of the attention and admiration that their books have.
No book can be completed without a lot of help from a lot of people. This work is no exception. I want to thank Rob Barnett, Barry Bosworth, Will Baumol, Patrick Driessen, George Kaufman, Richard Levine, Bruce Owen, Roger Noll, Chris Payne, Brian Rye, and Hal Varian for reviewing parts of the draft manuscript. I am indebted to my good friend Phil Auerswald for coming up with the title. I pride myself on coming up with titles for my own books and for others, but on this one Phil outdid me and for that I am grateful.
I am also grateful for the excellent initial drafting assistance in Chapters 5, 7, and 15 provided by Miguel Garrido, my close former colleague at Bloomberg Government. I also want to thank several others at Bloomberg: Dan Doctoroff, president and chief executive officer of Bloomberg, L.P., and Don Baptiste, head of Bloomberg Government, for their encouragement and support for this project, and Marialuisa Mendiola for providing research assistance. I also want to specially thank Norman Pearlstine, formerly chief content officer at Bloomberg and currently the chief content officer at Time, Inc., for reading the initial chapters of this book, and giving me his enthusiastic reaction that sustained me through the long months of drafting the rest of the book.
I also owe a deep debt of thanks to all my colleagues, some of whom are no longer with us, at the Brookings Institution, where I spent roughly two decades of my professional life, and where I am now a nonresident senior fellow. Certain of these economics superstars inspired me to go on to graduate school to get my PhD, along with my law degree (you’ll see why I did both at the beginning of the first chapter). Arthur Okun, the great economist who left us far too early, was the first to take a chance on me (on the recommendation of Lawrence Klein at the University of Pennsylvania), by hiring me as his research assistant for two years. While there I was also asked to work with two other great economists who are no longer with us, Ned Gramlich and Joe Pechman, the longtime director of economic research at Brookings. I also was greatly influenced by and privileged even-to-eat-regularly-with the likes of Alice Rivlin (who has been one of my mentors throughout my professional life), George Perry, Tony Downs, Barry Bosworth, and Charles Schultze, and also with (then) young Brookings stars, including Robert Crandall, Bill Gale, Cliff Winston, and Josh Epstein. You will read short biographies of or references to many of these individuals in the course of this book, and if my long experience at Brookings makes me biased toward emphasizing their influence on the profession, public policy, and indirectly on business (of which many of them may be unaware), then I plead guilty. I couldn’t have been more fortunate to work with a more committed, brilliant, and compassionate group of scholars, who became (and still are) like my own family.
Finally, every good book (and I hope readers will agree with me about the adjective) benefits from excellent editing, and here too, this book is no exception. I am grateful to my editors at John Wiley & Sons, Judy Howarth and Tula Batanchiev, and everyone else at Wiley for deciding to publish and market this book.
Robert E. Litan
September 2014
Chapter 1
Introduction: Economists as Innovators
Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.
—John Maynard Keynes
Kids ask the best questions, like the one I am sure most economists who have children get at some point in their lives: Mom or Dad, what do you actually do? Not only have my own children asked that question, but even my mother couldn’t understand why I wanted to go on after finishing college to earn a doctorate in economics (she told me to go law school instead because it would enable me to get a real job, so I went to a school that let me earn both degrees, on the theory that at a relatively young age it would be best to diversify). One reason I have written this book is to tell you why my instincts about economics were right, not just for me but many others in the very practical world of business and policy making.
I suspect most everyone who is not an economist thinks economists are trained to be soothsayers, predictors of how the economy will perform over coming months, and perhaps a year or two, or longer: to tell us how much inflation or unemployment will rise or fall, and how fast total output (GDP or gross
domestic product) will or will not grow. Perhaps even more important, many non-economists may believe that economists can tell them what’s going to happen to the stock market, and maybe their particular stocks, and to the prices of their houses. Some highly respected economists have essentially agreed. As the late Nobel laureates Milton Friedman and Lawrence Klein have argued, the ultimate test of the worth of economics is the accuracy of its predictions.1
If that is the case, then the financial crisis of 2007 to 2008 and the subsequent Great Recession and slow recovery since have probably changed a lot of minds about economists, but not for the better. Few economists warned of these events in advance or in time for most people to sell their stocks or not to borrow so much against their houses, or buy them at all before housing prices in many areas began to fall in 2006. If instead many economists had issued their warnings in time, maybe policy makers in the United States and elsewhere would have clamped down on extending easy credit to many U.S. homeowners who couldn’t afford them, especially for mortgages requiring little or no money down, thus minimizing the growth of the housing bubble. Maybe elected officials wouldn’t have pressed the two housing giants, Fannie Mae and Freddie Mac, to buy or guarantee so many securities backed by subprime mortgages that later went sour. And maybe financial regulators would have pressed the nation’s banks, especially the largest banks, to fund more of their assets with shareholders’ money so they would have had a greater cushion against mortgage losses that later would bring some of them down and put others in the desperate position of having to take government investments to keep them afloat.
