Specialization and Trade - A Reintroduction to Economics

That's the tile of Arnold Kling's newest book. It's published by the Cato Institute and is available in e-book format on Amazon for a mere $3.19. You can also download a PDF copy here free. Arnold Kling is an MIT trained economist who spent the bulk of his professional economic career at the Federal Reserve and Freddie Mac. Kling's blog, one of the best on the web in my opinion, is always thought-provoking. As the title of his blog suggests, he makes every effort to understand and fairly state the positions of those with whom he disagrees.

I read a couple of blurbs about the book last week and have only just finished the first chapter. So, rather than write a review, I'll reproduce a section of the Introduction that gives a short description of each chapter. Kling certainly has a unique perspective and I suspect I'll learn a lot from this relatively short book.

“Filling in Frameworks” wrestles with the misconception that economics is a science. This section looks at the difficulties that economists face in trying to adopt scientific methods. I suggest that economics differs from the natural sciences in that we have to rely much less on verifiable hypotheses and much more on hard-to-verify interpretative frameworks. Economic analysis is a challenge, because judging interpretive frameworks is actually harder than verifying scientific hypotheses. 

“Machine as Metaphor” attacks the misconception held by many economists and embodied in many textbooks that the economy can be analyzed like a machine. This section looks at a widely used but misguided approach to economic analysis, treating it as if it were engineering. The economic engineers are stuck in a mindset that grew out of the Second World War, a conflict that was dominated by airplanes, tanks, and other machines. Their approach fails to take account of the many nonmechanistic aspects of the economy. 

“Instructions and Incentives” deals with the misconception that economic activity is directed by planners. This section explains that although people within a firm are guided to tasks through instruction from managers, the economy as a whole is not coordinated that way. Instead, the price system functions as the coordination mechanism. 

“Choices and Commands” is concerned with the misconceptions held by socialists and others who disparage the market system. This section explains why a decentralized price system can work better than a centralized command system. Central planning faces an information problem, an incentive problem, and an innovation problem. 

“Specialization and Sustainability” exposes the misconception that we must undertake extraordinary efforts in order to conserve specific resources. This section explains how the price system guides the economy toward sustainable use of resources. In contrast, individuals who attempt to override the price system through their individual choices or by imposing government regulations can easily miscalculate the costs of their actions. 

“Trade and Trust” addresses the misconception among some libertarians that the institutional infrastructure needed to support specialization and trade is minimal. Instead, this section suggests that for specialization to thrive, societies must reward and punish people according to whether they play by rules that facilitate specialization and trade. A variety of cultural norms, civic organizations, and government institutions serve this purpose, but each of those institutions has its drawbacks. 

“Finance and Fluctuations” deals with the misconceptions about finance that are common among economists, who often fail to appreciate the process of financial intermediation. This section looks at the special role played by financial intermediaries in enabling specialization. Intermediation is particularly dependent on trust, and as that trust ebbs and flows, the financial sector can amplify fluctuations in the economy’s ability to create patterns of sustainable specialization and trade. 

“Policy in Practice” corrects the misconception that diagnosis and treatment of “market failure” is straightforward. This section looks at challenges facing economists and policymakers trying to use the theory of market failure. The example I use is housing finance policy during the run-up to the financial crisis of 2008. The policy process was overwhelmed by the complexity of the specialization that emerged in housing finance. Moreover, the basic thrust of policy was determined by interest-group influence. The lesson is that a very large gap exists between the economic theory of public goods and the practical execution of policy. 

“Macroeconomics and Misgivings” argues that it is a misconception, albeit one that is well entrenched in the minds of both professional economists and the general public, to think of the economy as an engine with spending as its gas pedal. This section presents an alternative to the mainstream Keynesian and monetarist traditions. I argue that fluctuations in employment arise from changes in the patterns of specialization and trade. Discovering new patterns of sustainable specialization and trade is more complex and subtle and less mechanical than what is assumed by the Keynesian and monetarist traditions.