Whassup with the Economy? Questions for Econ Guru Roger E. A. Farmer

"Of all the economic bubbles that have been pricked," the editors of The Economist recently observed, "few have burst more spectacularly than the reputation of economics itself." Indeed, the market collapse in 2007 rippled through every sector of business, resulting in the loss of American jobs and homes. 

How and why did this happen?

By relying too heavily on either the Classical or Keynesian theories of economics, argues Professor Roger E.A. Farmer in How the Economy Works.  In this new book, Farmer--who is the UCLA Economics Department Chair and a member of the Financial Times Economists Forum--offers a jargon-free exploration of the current crisis. In 11 easy-to-read chapters he covers Classical and Keynesian economics, the impact of the central bank, why the stock market matters, and much more.

Taking it one step further, Farmer proposes a new theory that combines the best of Classical and Keynesian economics to correct market excesses without stifling capitalism. In the wake of bank bail-outs and grim unemployment statistics, we talked to Professor Farmer about why it's important for everyone to have a basic grasp of economics and understand how our economy works (or doesn't). 

Amazon.com: Why does the stock market matter to every American?

Roger E.A. Farmer:  In the 1930s, stock market wealth was much more concentrated than it is today. Middle and low income Americans held their savings in banks and it is for that reason that the collapse of the banking system in the 1930s was so devastating. In the 21st century, most middle class Americans own pension plans that invest in the stock market.

US wealth is roughly two-fifths houses and three-fifths factories and machines that are indirectly owned by households through their ownership of financial intermediaries such as bank accounts and pension rights. When the stock market plummets but recovers quickly, as it did in 1987, the effect on private households is minimal. When the stock market falls, as it did in 2000, but house prices keep rising, the effect is again small since households can borrow against housing wealth to maintain consumption. When houses and stocks fall together as they did in 1929 and again in 2008, the effect can be devastating.

Amazon.com: What is the difference between the Classical and Keynesian approach to macroeconomics?

Farmer: Classical economics sees the economy as self-correcting. Keynes thought that the stabilizing mechanisms in the private market system are nonexistent or, at best, very slow. In How the Economy Works, I put it like this:

The classical Norwegian economist Ragnar Frisch likened the economy to a child’s rocking horse. The horse is regularly buffeted by shocks. Think of a child hitting the horse with a stick. According to Frisch, these blows are like major economic events. A war in the Middle East. A hurricane in the Midwest. An airline pilots’ strike. After each shock, unemployment might rise temporarily as the economy readjusted to the blow but it would quickly return to its equilibrium level just as the rocking horse will come to rest if left alone. This is a good physical analogy to the classical idea of a self-correcting economic system.

Keynes had much less faith in the free market. In Keynesian economics the economy is like a boat on the ocean with a broken rudder. Gusts of wind represent major economic events. A war in the Middle East. A hurricane in the Midwest. An airline pilots’ strike. After each shock, unemployment rises or falls permanently and there is no self-correcting mechanism to return it to a unique equilibrium: Just as a sailboat will be becalmed wherever it comes to rest, the unemployment rate can end up anywhere. The classical economists saw the economy as a stable self-correcting system. Keynes did not. 

Amazon.com: What are you hoping readers will take away from this "jargon-free" exploration of the current economic crisis?

Farmer: I hope that the reader will understand three things. First, that the current crisis is just the latest in a series of crises that have plagued market economies since the inception of capitalism. Second, that politics and economics are irrevocably entwined and that government responses to financial crises have a symbiotic relationship with the evolution of the history of economic thought. Third, that the correct response to the crisis is to learn from it, and to develop new tools. In the words of Francis Bacon, “He that will not apply new remedies must expect new evils; for time is the greatest innovator.” (Francis Bacon, Essays, 11. 1884 Of Great Place).

Read more of our exclusive interview with Roger E.A. Farmer, check out videos, and read the book's prologue.

--Jessica Schein and Lauren Nemroff