Part 1 of 2: How Do The Public Understand Economics – And Why It Matters

This is the first of a two-part post. This part looks at why it’s worth studying how the public understand economics, and the second looks at a few things we know about how they do.

Economists have begun to take an academic interest in how non-economists think about the economy.

At first this might sound like a snide dig at economists – a profession seen as hyper-rational turning its intellectual firepower on the persistent question of why non-economists are so irrational. But actually, it’s a very good idea. In a new paper, ‘How laypeople understand economics’, Professor David Leiser of Ben Gurion University and Zeev Krill, a senior researcher at the Israeli ministry of finance, review the literature on the topic, and in doing so compile a good case that what the public understands about the economy has its own economic consequences.

Its message is interesting both to economists and anyone who’s in the business of communicating it.

So – what exactly is the point of studying how the public understands the economy?

Financial literacy

Most prosaically, there is the question of whether we know what we’re doing when we buy financial products. It turns out many of us don’t:

“Recent research has documented great gaps in the ability of savers to manage their savings, due to lack of basic financial knowledge (Lusardi & Mitchell, 2011)”.

Which is an issue, given that:

“recent changes in the labor market, growing availability of debt vehicles like credit cards, and recent pension reforms, in particular the shift from Defined Benefits to Defined Contributions plans, have placed the onus of financial management on the individual consumer.”

This is timely. In Britain, individuals are being given more freedom to spend their pension as they want. This raises the possibility of greater pensioner debt at exactly the time when economists – like Dr Gertjan Vlieghe of the Bank of England’s Monetary Policy Committee – are beginning to recognise that higher debt levels have macroeconomic effects.

Economics Relies on Assumptions about how People React

Many policy recommendations are based on assumptions about how people will respond. But what if their responses are different from economists’ expectations because they understand the economy differently? If economists are recommending policy, they might need to take that into account. 

Take inflation. As the authors put it,

“inflation is perceived as something bad that befalls prices and money: money is worth less, prices are higher. Its consequence is a lower value of the local currency and devaluation.”

Take a scenario where a central bank cuts rates to generate inflation. Now imagine that the public hears of the cut, assumes inflation will follow, worries that their money will be devalued, and concludes they had better save more in nominal terms to stabilise their saving in real terms. If this aggregate saving is large enough to put downwards pressure on consumption and demand, then the cut will produce less inflation than expected. It would take a bigger cut to generate the level of inflation than the Central Bank had expected.

In other words, public perceptions can make monetary policy harder to get right.

Bad for Democracy

An uninformed public can have political consequences.

The paper quotes Philip Inman’s argument that

“when people consistently misunderstand economic debate, it ‘stagnates into discussions between small elite groups over small differences behind the backs of an increasingly disillusioned and unrepresented public. This … is a grave threat to our democracy”

Economists seek solutions, politicians seek votes

I’m sure some people will look down on this kind of research, arguing that academics should be advancing the frontiers of knowledge, not putting their energy towards studying people whose understanding falls well short of them.

But I disagree. Social sciences are not like natural sciences where the pursuit of knowledge is just an end in itself. They also hold out the prospect of being a means to change society through policy.

In democracies, that only works when the policies social scientists recommend can be enacted. But even when social scientists agree on a policy change, politicians will only do it if there are votes in it, and there will only be votes in it if enough people think it needs doing. So to have policy enacted, economists will sometimes find themselves getting stuck into the messy arena of public debate and public understanding.

In short, public misconceptions can severely dampen social scientists’ ability to make themselves useful.

The paper gives the example of pensions. Retirement funding, it points out, is often:

“actuarially untenable, due to a combination of increased life expectancy, lowered return on investments, and demographic changes. In responsibly run countries, this concern requires certain policy changes. The consequence is often that members of the public, who do not understand how pension funds function, feel they are being cheated of their hard-earned rights”.

It also makes the implicit argument that the better the public understand economics, the more likely it is that politicians will. It mentions President Erdogan of Turkey rallying against the governor of the Bank of Turkey for cutting interest rates. Why? Because no matter what econ 101 says, he believed a rate cut would reduce inflation.

(Nor is this example designed to belittle Turkey; Ted Cruz wants to put the US back on the gold standard).

So how do the public understand economics? I’ll look at that in the second post.

Vintage Woodcut Orange