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2011

The global crises of financial and housing markets are now being superseded by new crises of governments. The fiscal challenges for the weaker members of the eurozone are early warnings, as are analogous problems in American state governments weighed down by unfunded pension and healthcare liabilities. Without action, this new crisis of state competence could soon become just as damaging as its recent financial predecessor.

This week's US debt deal, along with the prospect of debate on fiscal solutions in the run-up to the 2012 elections, provides some room for optimism. But America's fiscal problems have deep roots. The recession of 2007-2009 stemmed from the unprecedented bust in the housing market, driven by reduced lending standards and propelled by congressional pressures on private lenders and the reckless expansions of Fannie Mae and Freddie Mac. It is, however, important to recognise that this mistake is now understood and will not be repeated.

In the aftermath of the debt ceiling agreement there will be calls for further stimulus for America's economy. This would be a grave mistake. In the financial turmoil of 2008, bail-outs by the US and other governments were unfortunate, but necessary. However, the subsequent $800bn American stimulus package was largely a waste of money that sharply enlarged the fiscal hole now facing our economy.

President Barack Obama's administration has consistently overestimated the benefits of stimulus, by using an unrealistically high spending multiplier. According to this Keynesian logic, government expenditure is more than a free lunch. This idea, if correct, would be more brilliant than the creation of triple A paper out of garbage. In any event, the elimination of the temporary spending is now contractionary and, more importantly, the resulting expansion of public debt eventually requires higher taxes, retarding growth.

I agree that budget deficits were appropriate during the great recession and, for that reason, the kind of balanced-budget rule currently proposed by some Republicans should be avoided. However, since government spending is warranted only if it passes the usual hurdles of social rates of return, the fiscal deficit should have concentrated on tax reductions, especially those that emphasised falls in marginal tax rates, which encourage investment and growth.

Despite relief at the debt-ceiling agreement, America's fiscal situation remains deeply problematic. Any attempt to head off a crisis of government competence must begin with serious long-term reform. Reductions in the long-term path of entitlement outlays have to be put on the table, with increases in ages of eligibility a part of any solution.

We also need sharp reductions in spending programmes initiated or expanded by Mr Obama and his extravagant predecessor, George W. Bush. Given the inevitable growth of the main entitlement programmes, especially healthcare, increases in long-term federal revenue must be part of an overall reform.

So what, specifically, can be done? An effective future tax package would begin by setting US corporate and estate tax rates permanently to zero, given these taxes are inefficient and generate little revenue. Next, it would gradually phase out major "tax-expenditure" items, such as tax preferences for home-mortgage interest, state and local income taxes, and employee fringe benefits.

The structure of marginal income-tax rates should then be lowered. Marginal rates should particularly not increase where they are already high, such as at upper incomes. The bulk of any extra revenue needed to make up the difference should then be raised via a broad-based, flat-rate expenditure tax, such as a value added tax. A rate of 10 per cent, with few exemptions, would raise about 5 per cent of gross domestic product.

Of course, such a new tax would be a two-edged sword: a highly efficient tax, but politically dangerous. To paraphrase Larry Summers from long ago, we don't have VAT in the US because Democrats think it is regressive, and Republicans think it is a money machine. We will get VAT when Democrats realise it is a money machine, and Republicans realise it is regressive. Obviously, I worry about the money machine property, but I see no serious alternative for raising the revenue needed for an overall next-stage reform package.

The raucous debt-ceiling debate represents a good start in forging a serious long-term fiscal plan. Substantial additional progress will be needed, sadly much of which will probably have to await the outcome of the next US election. Yet progress must be made - or the impending crises of governments, signalled by possible downgrades of US debt, will make the 2008-2009 recession look mild.

Ronald Reagan and Barack Obama have at least one similarity. They both were confronted by great economic challenges when they became president.

Mr. Reagan's immediate challenge was that inflation and interest rates were out of control. He met this great test by allying with the Federal Reserve chairman, Paul Volcker, in accomplishing a return to price stability, even through the 1982 recession when the unemployment rate hit 10.8%.

Reagan's success is not in doubt. Inflation and interest rates were reduced dramatically, and the recovery from the end of 1982 to the end of 1988 was strong and long with an average growth rate of real GDP of 4.6% per year. Moreover, Reagan focused on implementing good economic policies, not on blaming his incompetent predecessor for the terrible economy he had inherited.

Mr. Obama was equally in position to get credit for turning around a perilous economic situation that had been left by a weak predecessor. But he has pursued an array of poor economic policies, featuring the grand Keynesian experiment of sharply raising federal spending and the public debt. The results have been terrible and now, two and a half years into his administration, Mr. Obama is still blaming George W. Bush for all the problems.

Friday's downgrade of the U.S. credit rating by Standard & Poor's should have been a wake-up call to the administration. S&P is saying, accurately, that there is no coherent long-term plan in place to deal with the U.S. government's fiscal deficits.

The U.S. Treasury could have responded in two ways. First, it could have taken the downgrade as useful information and then focused on how to perform better to earn back a AAA rating. Instead, it chose to attack the rating agency as incompetent and not credible. In this respect, U.S. officials were almost as bad as Italian Prime Minister Silvio Berlusconi, who responded to warnings from S&P and Moody's about Italian government debt by launching police raids on the offices of the rating agencies in Milan last week. The U.S. Treasury's response also reminds me of Lehman Brothers blaming its financial problems in the summer of 2008 on evil financial analysts and short-sellers.

The way for the U.S. government to earn back a AAA rating is to enact a meaningful medium- and long-term plan for addressing the nation's fiscal problems. I have sketched a five-point plan that builds on ideas from the excellent 2010 report of the president's deficit commission.

First, make structural reforms to the main entitlement programs, starting with increases in ages of eligibility and a shift to an economically appropriate indexing formula. Second, lower the structure of marginal tax rates in the individual income tax. Third, in the spirit of Reagan's 1986 tax reform, pay for the rate cuts by gradually phasing out the main tax-expenditure items, including preferences for home-mortgage interest, state and local income taxes, and employee fringe benefits—not to mention eliminating ethanol subsidies. Fourth, permanently eliminate corporate and estate taxes, levies that are inefficient and raise little money.

Fifth, introduce a broad-based expenditure tax, such as a value-added tax (VAT), with a rate around 10%. The VAT's appeal to liberals can be enhanced, with some loss of economic efficiency, by exempting items such as food and housing.

I recognize that a VAT is anathema to many conservatives because it gives the government an added claim on revenues. My defense is that a VAT makes sense as part of a larger package that includes the other four points.

The loss of the U.S. government's AAA rating is a great symbolic blow, one that would cause great anguish to our first Treasury secretary, Alexander Hamilton. Frankly, the only respectable reaction by our current Treasury secretary is to fall on his sword. Then again, "the buck stops here" suggests that an even more appropriate resignation would come from our chief executive, who, by the way, is no Ronald Reagan.

The United States is in the third year of a grand experiment by the Obama administration to revive the economy through enormous borrowing and spending by the government, with the Federal Reserve playing a supporting role by keeping interest rates at record lows.

How is the experiment going? By the looks of it, not well.

The economy is growing much more slowly than in a typical recovery, housing prices remain depressed and the stock market has been in a slump—all troubling indicators that another recession may be on the way. Most worrisome is the anemic state of the labor market, underscored by the zero growth in the latest jobs report.

The poor results should not surprise us given the macroeconomic policies the government has pursued. I agree that the recession warranted fiscal deficits in 2008–2010, but the vast increase of public debt since 2007 and the uncertainty about the country’s long-run fiscal path mean that we no longer have the luxury of combating the weak economy with more deficits.

Today’s priority has to be austerity, not stimulus, and it will not work to announce a new $450 billion jobs plan while promising vaguely to pay for it with fiscal restraint over the next 10 years, as Mr. Obama did in his address to Congress on Thursday. Given the low level of government credibility, fiscal discipline has to start now to be taken seriously. But we have to do even more: I propose a consumption tax, an idea that offends many conservatives, and elimination of the corporate income tax, a proposal that outrages many liberals.

These difficult steps would be far more effective than the president’s failed experiment. The administration’s $800 billion stimulus program raised government demand for goods and services and was also intended to stimulate consumer demand. These interventions are usually described as Keynesian, but as John Maynard Keynes understood in his 1936 masterwork, “The General Theory of Employment, Interest and Money” (the first economics book I read), the main driver of business cycles is investment. As is typical, the main decline in G.D.P. during the recession showed up in the form of reduced investment by businesses and households.

What drives investment? Stable expectations of a sound economic environment, including the long-run path of tax rates, regulations and so on. And employment is akin to investment in that hiring decisions take into account the long-run economic climate.

The lesson is that effective incentives for investment and employment require permanence and transparency. Measures that are transient or uncertain will be ineffective.

And yet these are precisely the kinds of policies the Obama administration has pursued: temporarily cutting the payroll tax rate, maintaining the marginal income-tax rates from the George W. Bush era while vowing to raise them in the future, holding off on clean-air regulations while promising to implement them later and enacting an ambitious overhaul of Wall Street regulations while leaving lots of rules undefined and ambiguous.

Is there a better way? I believe that a long-term fiscal plan for the country requires six big steps.

Three of them were identified by the Bowles-Simpson deficit reduction commission: reforming Social Security and Medicare by increasing ages of eligibility and shifting to an appropriate formula for indexing benefits to inflation; phasing out “tax expenditures” like the deductions for mortgage interest, state and local taxes and employer-provided health care; and lowering the marginal income-tax rates for individuals.

I would add three more: reversing the vast and unwise increase in spending that occurred under Presidents Bush and Obama; introducing a tax on consumer spending, like the value-added tax (or VAT) common in other rich countries; and abolishing federal corporate taxes and estate taxes. All three measures would be enormously difficult—many say impossible—but crises are opportune times for these important, basic reforms.

A broad-based expenditure tax, like a VAT, amounts to a tax on consumption. If the base rate were 10 percent, the revenue would be roughly 5 percent of G.D.P. One benefit from a VAT is that it is more efficient than an income tax—and in particular the current American income tax system.

I received vigorous criticism from conservatives after advocating a VAT in an essay in The Wall Street Journal last month. The main objection—reminiscent of the complaints about income-tax withholding, which was introduced in the United States in 1943—is that a VAT would be a money machine, allowing the government to readily grow larger. For example, the availability of easy VAT revenue in Western Europe, where rates reach as high as 25 percent, has supported the vast increase in the welfare state there since World War II. I share these concerns and, therefore, favor a VAT only if it is part of a package that includes other sensible reforms. But given the likely path of government spending on health care and Social Security, I see no reasonable alternative.

Abolishing the corporate income tax is similarly controversial. Any tax on capital income distorts decisions on saving and investment. Moreover, the inefficiency is magnified here because of double taxation: the income is taxed when corporations make profits and again when owners receive dividends or capital gains. If we want to tax capital income, a preferred method treats corporate profits as accruing to owners when profits arise and then taxes this income only once—whether it is paid out as dividends or retained by companies.

Liberals love the idea of a levy on evil corporations, but taxes on corporate profits in fact make up only a small part of federal revenue, compared to the two main sources: the individual income tax and payroll taxes for Social Security and Medicare.

In 2009-10, taxes on corporate profits averaged 1.4 percent of G.D.P. and 8.6 percent of total federal receipts. Even from 2000 to 2008, when corporations were more profitable, these taxes averaged only 1.9 percent of G.D.P. and 10.3 percent of federal receipts. If we could get past the political fallout, we could get more revenue and improve economic efficiency by abolishing the corporate income tax and relying instead on a VAT.

I had a dream that Mr. Obama and Congress enacted this fiscal reform package—triggering a surge in the stock market and a boom in investment and G.D.P.—and that he was re-elected.

This dream could become reality if our leader were Ronald Reagan or Bill Clinton—the two presidential heroes of the American economy since World War II—but Mr. Obama is another story. To become market-friendly, he would have to abandon most of his core economic and political principles.

More likely, his administration will continue with more of the same: an expansion of payroll-tax cuts, short-term tax credits, promises to raise future taxes on the rich, and added spending on infrastructure, job training and unemployment benefits. The economy will probably continue in its sluggish state, possibly slipping into another recession. In that case, our best hope is for a Republican president far more committed to the principles of free markets and limited government than Mr. Bush ever was.

Keynesian economics—the go-to theory for those who like government at the controls of the economy—is in the forefront of the ongoing debate on fiscal-stimulus packages. For example, in true Keynesian spirit, Agriculture Secretary Tom Vilsack said recently that food stamps were an "economic stimulus" and that "every dollar of benefits generates $1.84 in the economy in terms of economic activity." Many observers may see how this idea—that one can magically get back more than one puts in—conflicts with what I will call "regular economics." What few know is that there is no meaningful theoretical or empirical support for the Keynesian position.

The overall prediction from regular economics is that an expansion of transfers, such as food stamps, decreases employment and, hence, gross domestic product (GDP). In regular economics, the central ideas involve incentives as the drivers of economic activity. Additional transfers to people with earnings below designated levels motivate less work effort by reducing the reward from working.

In addition, the financing of a transfer program requires more taxes—today or in the future in the case of deficit financing. These added levies likely further reduce work effort—in this instance by taxpayers expected to finance the transfer—and also lower investment because the return after taxes is diminished.

This result does not mean that food stamps and other transfers are necessarily bad ideas in the world of regular economics. But there is an acknowledged trade-off: Greater provision of social insurance and redistribution of income reduces the overall GDP pie.

Yet Keynesian economics argues that incentives and other forces in regular economics are overwhelmed, at least in recessions, by effects involving "aggregate demand." Recipients of food stamps use their transfers to consume more. Compared to this urge, the negative effects on consumption and investment by taxpayers are viewed as weaker in magnitude, particularly when the transfers are deficit-financed.

Thus, the aggregate demand for goods rises, and businesses respond by selling more goods and then by raising production and employment. The additional wage and profit income leads to further expansions of demand and, hence, to more production and employment. As per Mr. Vilsack, the administration believes that the cumulative effect is a multiplier around two.

If valid, this result would be truly miraculous. The recipients of food stamps get, say, $1 billion but they are not the only ones who benefit. Another $1 billion appears that can make the rest of society better off. Unlike the trade-off in regular economics, that extra $1 billion is the ultimate free lunch.

How can it be right? Where was the market failure that allowed the government to improve things just by borrowing money and giving it to people? Keynes, in his "General Theory" (1936), was not so good at explaining why this worked, and subsequent generations of Keynesian economists (including my own youthful efforts) have not been more successful.

Theorizing aside, Keynesian policy conclusions, such as the wisdom of additional stimulus geared to money transfers, should come down to empirical evidence. And there is zero evidence that deficit-financed transfers raise GDP and employment—not to mention evidence for a multiplier of two.

Gathering evidence is challenging. In the data, transfers are higher than normal during recessions but mainly because of the automatic increases in welfare programs, such as food stamps and unemployment benefits. To figure out the economic effects of transfers one needs "experiments" in which the government changes transfers in an unusual way—while other factors stay the same—but these events are rare.

Ironically, the administration created one informative data point by dramatically raising unemployment insurance eligibility to 99 weeks in 2009—a much bigger expansion than in previous recessions. Interestingly, the fraction of the unemployed who are long term (more than 26 weeks) has jumped since 2009—to over 44% today, whereas the previous peak had been only 26% during the 1982-83 recession. This pattern suggests that the dramatically longer unemployment-insurance eligibility period adversely affected the labor market. All we need now to get reliable estimates are a hundred more of these experiments.

The administration found the evidence it wanted—multipliers around two—by consulting some large-scale macro-econometric models, which substitute assumptions for identification. These models were undoubtedly the source of Mr. Vilsack's claim that a dollar more of food stamps led to an extra $1.84 of GDP. This multiplier is nonsense, but one has to admire the precision in the number.

There are two ways to view Keynesian stimulus through transfer programs. It's either a divine miracle—where one gets back more than one puts in—or else it's the macroeconomic equivalent of bloodletting. Obviously, I lean toward the latter position, but I am still hoping for more empirical evidence.

The way to restoring America's AAA credit-rating starts with President Obama moving beyond blaming the economy on the admittedly inept George W. Bush. 

Standard & Poor's recent downgrade of the U.S. government shows how far the world has moved into a crisis of governments.

The official reactions to the S&P action have not been promising. The Obama administration attacked S&P's competence, and the U.S. Congress has threatened hearings, apparently aimed at bullying S&P and the other agencies from further downgrades.

The main substantive criticism was that S&P made a $2 trillion mistake in its baseline projection of 10-year deficits. Of course, these projections came from the Congressional Budget Office, which lost its credibility in these matters when it scored President Obama's health care reform plan as reducing 10-year deficits - mostly because of the inclusion of phantom reductions in Medicare payments to doctors.

In truth, S&P's downgrade stemmed mainly from its legitimate concern that the U.S. government has no coherent medium- or long-term plan to eliminate budget deficits and stabilize the path of public debt. This judgment is accurate and courageous and goes some distance in offsetting the hit to S&P's reputation that came from the AAA ratings that it gave not so long ago to mounds of mortgage-backed securities built on subprime garbage.

Unfortunately, Obama's main response to S&P's downgrade and the economic crisis more generally has been to continue blaming almost everything on his admittedly inept predecessor, George W. Bush, and on the Republican Congress.

Another familiar theme is the unwillingness of the evil rich to pay more taxes. (I have one modest proposal that could save the President valuable time in this regard. Rather than continuing to repeat the long phrase "millionaires and billionaires," I suggest a merger: "mibillionaires." I know it looks funny and is hard to say on a first try, but after three or four repetitions it becomes strikingly mellifluous.)

Enough.

The way forward to restoring our AAA rating begins with Obama taking seriously the surprisingly sound report by his recent bipartisan debt and deficit commission. Building on those recommendations, I have constructed a fiscal plan:

• Make structural reforms to the main entitlement programs starting with increases in ages of eligibility and a shift to an economically appropriate indexing formula.

• Eliminate the unwise increases of federal spending by Bush and Obama, including added outlays for education, farm and ethanol subsidies, and expansions of Medicare and Medicaid.

• Lower the structure of marginal tax rates in the individual income tax.

• Pay for the rate cuts by gradually phasing out the main tax-expenditure items, including preferences for home-mortgage interest, state and local income taxes, and employee fringe benefits.

• Permanently eliminate federal corporate and estate taxes, levies that are inefficient and raise comparatively little money.

• Introduce a broad-based expenditure tax, such as a value-added tax (VAT). Depending on the structure of exemptions, a rate of 10% should raise about 5% of GDP in revenue.

The VAT system is present in most developed countries and can be highly efficient because it has a flat rate, falls on consumption and has built-in mechanisms for ensuring compliance. However, a VAT is also a magnet for criticism by conservatives - who worry about the promotion of a larger government.

I share this concern and would defend a VAT only if it can be firmly linked to the other parts of the reform package. But more fundamentally, given the projected path of entitlement spending, I see no reasonable alternative.

It is hard to imagine President Obama becoming the leader of this kind of broad fiscal initiative. Though he has endorsed some pieces of some of these components, the embrace has been halting. He is hedging, not leading.

Thus, as S&P observed, uncertainty about our fiscal path will likely not be resolved at least until the outcomes of next year's crucial elections.

The one person with the power to eliminate part of this uncertainty is the President, who could nobly decide not to stand for reelection, thereby following in the footsteps of Lyndon Johnson and Calvin Coolidge. Johnson was forced out by a different type of crisis, Vietnam, and he hung on too long, delaying his announcement until he saw his poor performance in the New Hampshire primary and in subsequent electoral polls. Coolidge is a more dignified model, as he opted out in 1927 while things were going fine. In fact, Obama could borrow Coolidge's memorable phrase, "I do not choose to run."

2005

The insurgency in Iraq goes on, but attention has shifted toward the structure of an independent government. One key issue is whether the new regime will have a state religion, as envisioned by the U.S.-imposed transitional administrative law. Research by Rachel M. McCleary and me at Harvard University's Project on Religion, Political Economy & Society suggests that the Iraqi government will have an official religion. Although separation of religion and state has long been a Western ideal, it seems politically unrealistic for Iraq.

The consequences of state religion are complicated in practice. We find that the presence of state religion encourages participation in formal religious services (likely because of governmental subsidies to organized religion) and provides a smaller boost to religious beliefs. There is a weak negative impact on economic growth. And although some rich countries such as Britain and most of Scandinavia maintain religious liberties despite having official religions, state religions tend to coincide with curbs on religious freedoms.

In our research, we used international data to isolate the demographic, social, and economic factors that lead to the establishment of a state religion. Most important is whether a country has a diversity of religions or is concentrated in a single faith. For example, in 2000, the largest U.S. group was Protestants, with 44%, whereas in Morocco it was Sunni Muslims, with 98%. We estimate that this difference made the probability of a state religion in Morocco (which had one) higher by 69 percentage points than in the U.S. (which did not).

LESS CLEAR IS WHETHER the identity of a country's main religion influences the likelihood of state religion. In 2000, among the 40 countries where more than 50% of the people were Muslim, 28 (or 70%) had a state religion. In contrast, among the 91 countries with more than 50% in a single non-Muslim religion, 42 (or only 46%) had a state religion. We found that half of the Muslim/non-Muslim difference arose because the share of population that adhered to the most popular religion was higher in Muslim countries. The rest of the difference involves a greater tendency by government to curb religious freedoms in Muslim countries.

Another important factor is that communist countries rarely have a state religion (if communism does not count as a religion). However, this influence lacks staying power: Since 1990, 15 ex-communist countries, including six Muslim ones, set up state religions.

The size of a country matters; neither very small nor very large countries tend to have state religions. For small nations, the cost of maintaining an official religious administration is simply too great. For large countries, even a small proportion of the population in minority religions constitutes a large number of people and, therefore, creates resistance to a monopoly religion supported by the government.

For Iraq, a big question is whether the stronger force toward state religion is the 96% of the population that is Muslim or the 61% that is Shiite Muslim. We analyzed this issue using estimated breakdowns of Muslim populations into Sunni, Shiite, and other sects. Sunni is by far the largest worldwide, and only Iran is mainly Shiite (86% of the people). Only a few Muslim countries have substantial representation in more than one category: Azerbaijan, Bahrain, Iraq, Kuwait, Oman, and Yemen. Some other Muslim countries -- Afghanistan, Pakistan, Syria, Turkey, and the United Arab Emirates -- are 10% to 20% Shiite. But our results suggest that overall Muslim share, not size of the most popular sect, is what influences the creation of state religion.

No model predicts perfectly, but ours gets the right answer more than 80% of the time. Thus, it is instructive that the model's probability for a state religion in Iraq is 96%. True, our method also gives neighboring Turkey an 88% probability for state religion, even though it has been officially secular for decades. One can view this mistaken prediction two ways. One is that, despite forces that favor state religion, Turkey can be a model for Iraq on how to separate church and state. The other is that Turkey's secular status represents hard-to-duplicate political influence by its strong President, Mustafa Kemal Ataturk, in the 1920s and '30s. Conceivably, the factors that favor a state religion will eventually generate an Islamic state in Turkey. That reversal seems more likely than Iraq's becoming a secular state.

Robert J. Barro is a professor of economics at Harvard University and a senior fellow of the Hoover Institution.
2003
Barro, Robert J, and Rachel M McCleary. 2003. “Religion and Economic Growth”. Abstract

Empirical research on the determinants of economic growth has typically neglected the influence of religion. To fill this gap, we use international survey data on religiosity for a broad panel of countries to investigate the effects of church attendance and religious beliefs on economic growth. To isolate the direction of causation from religiosity to economic performance, we use instrumental variables suggested by an analysis of systems in which church attendance and beliefs are the dependent variables. The instruments are variables for the presence of state religion and for regulation of the religion market, the composition of religious adherence, and an indicator of religious pluralism. We find that economic growth responds positively to religious beliefs, notably those in hell and heaven, but negatively to church attendance. That is, growth depends on the extent of believing relative to belonging. These results accord with a model in which religious beliefs influence individual traits that enhance economic performance. The beliefs are an output of the religion sector, and church attendance is an input to this sector. Hence, for given beliefs, more church attendance signifies more resources used up by the religion sector.

2002

Since the 1970s, Robert Barro's academic research has significantly influenced macroeconomic theory. For more than a decade, his writing has also enlivened the pages of publications such as the Wall Street Journal and Business Week. In Nothing Is Sacred, Barro applies his well-honed free market arguments to a remarkably diverse range of issues. These include global problems such as growth and debt, as well as social issues such as the predictive value of SAT scores, drug legalization, the economics of beauty, and the relationship between abortion rights and crime reduction.

The book opens with a series of essays on famous economists, past and present, and other prominent figures whose work has economic implications, including Joe DiMaggio and Bono. In the book's second part, Barro discusses the economics of social issues. In the third part, he considers democracy, growth, and international policy, and in the final part he examines fiscal policy, monetary policy, and the macroeconomy. Throughout, he shows that even the most widely held beliefs are not sacred truths but are open to analysis.