Why the public needs to know that economics is intellectually unsound

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Why the public needs to know that economics is intellectually unsound

From Steve Keen’s “Debunking Economics: The Naked Emperor of the Social Sciences CH.1

These extracts were compiled from the opening paragraphs of each chapter. Most chapters also have 2 sections which briefly explain the argument to follow: "The kernel", which gives the essence of the ideas covered in a chapter, and "The roadmap" which summarises the argument step by step.

1 No More Mr Nice Guy:    Why the public needs to know that economics is intellectually unsound

Why have we handed over the running of the world to economists? It is hardly because economics has won the intellectual equivalent of a popularity poll or election. In fact, if anything, economics is deeply unpopular, and its unpopularity spans all social spectra. The demonstrations against the IMF and other institutions in Seattle, Washington, Davos, Melbourne and Prague were fundamentally demonstrations against the proposition that the world should be reshaped in accordance with economic theory. Those events were simply the most dramatic of many protests which have frequently cut across the standard left-right divide of political debate, uniting the most unlikely of bedfellows against the policy recommendations of economists...

2    The Calculus of Hedonism:     Why the pursuit of individual self-interest does not maximise social welfare

The corollary to Maggie Thatcher’s famous epithet that ‘There is no such thing as society’ is The Life of Brian’s ‘You are all individuals’. Maggie’s masterpiece succinctly expresses the economic theory that the best social outcomes result from all individuals looking after their own self-interest: the market will ensure that the welfare of all is maximised.

This hedonistic, individualistic approach to analysing society is a source of much of the popular opposition to economics. Surely, say the critics, people are more than just self-interested hedonists, and society is more than just the sum of the individuals in it?

Economists will concede that their model does abstract from some of the subtler aspects of humanity and society. However, they assert that treating individuals as self-interested hedonists captures the essence of their economic behaviour, while the collective economic behaviour of society can be derived by summing the behaviour of this self-interested multitude. The belief that the economic aspect of society is substantially more than the sum of its parts is misguided.

This is not true. Though mainstream economics began by assuming that this hedonistic, individualistic approach to analysing consumer demand was intellectually sound, it ended up proving that it was not. The critics were right: society is more than the sum of its individuals members, and a society’s behaviour cannot be modelled by simply adding up the behaviours of all the individuals in it. To see why the critics have been vindicated by economists, and yet economists still pretend that they won the argument, we have to take a trip down memory lane to late 18th century England...

3    The price of everything and the value of nothing    Why most products cost less to produce as output rises

We have already seen that the demand half of conventional economic analysis is unsound: economics cannot derive a smooth, downward-sloping market demand curve from its theory of individual behaviour. But on the supply side, surely it makes sense that, to elicit a larger supply of a commodity, a higher price must be offered?

There is, in fact, an alternative proposition, which held sway in economics for its first century. This was the argument of the classical school of economics that price was set by the cost of production. When this proposition is put in the same static form as economics uses to describe a commodity market, it translates as a horizontal (or even a falling) supply curve, so that the market price doesn’t change as the quantity produced rises (and it can actually fall). This chapter shows that, though the modern position is superficially more appealing and apparently more sophisticated, there are logical problems with it which mean that the classical position is a more accurate description of reality...

4    Size does matter     Why the economic argument against monopolies is invalid

The historical record gives many reasons to be critical of monopolies. Some of today’s most respectable names accumulated fortunes in the 19th century by grossly unethical means, and held on to their economic wealth by the abuse of the many forms of power that wealth can confer. This record of 19th century corporate lawlessness is the major explanation for America’s distinctive anti-trust laws, which enable the judiciary in this bastion of capitalism to dismantle corporations that have acquired the position of ultimate market power.

Economists have reduced this plethora of reasons to be critical of monopolies to just one: the size of a monopolist relative to the size of the market. According to economists, monopolies are worse than the alternative of competitive markets simply because the absence of competitors allows a monopoly to set price above marginal cost. Perfectly competitive industries, on the other hand, set price equal to marginal cost. Economists argue that monopolies are therefore necessarily bad, and that small, competitive firms are necessarily good, because monopolies produce a lower output for a higher price, thus restricting the supply of their products and exploiting consumers by over-pricing. However, the ‘proof’ of this argument makes the fundamental mathematical mistake of equating a very small quantity to zero. When this mistake is corrected, the economic argument against monopolies collapses, as does the economic theory of competition...

5        To each according to his contribution    Why productivity doesn’t determine wages

One of the most striking aspects of the late 20th century was the increase in the gap between the poorest worker and the richest. While many bemoaned this increase in inequality, economists counselled that the growing gap merely reflected the rising productivity of the highly paid.

The basis for this advice is the proposition that a person’s income is determined by her contribution to production–or more precisely, by the marginal productivity of the ‘factor of production’ to which she contributes. Wages and profits–or ‘factor incomes’ as economists prefer to call them–reflect respectively the marginal product of labour and of capital. The argument that highly paid workers–managers of major corporations, stock and money market traders, financial commentators, etc.–deserve the high wages they receive compared to the less highly paid–nuclear physicists, rocket scientists, university professors, school teachers, social workers, nurses, factory workers, etc.–is simply an extension of this argument to cover subgroups of workers. Members of the former group, we are told, are simply more productive than members of the latter, hence their higher salaries.

I’ll defer discussion of the proposition that profits reflect the marginal productivity of capital until the next chapter. Here we’ll consider the argument that wages equal the marginal product of labour. Once again, the argument relies heavily on concepts we have already dismissed: that productivity per worker falls as more workers are hired; that demand curves are necessarily downward sloping; that price measures marginal benefit to society; and that individual supply curves slope upwards and can easily be aggregated. Even allowing these invalid assumptions, the economic analysis of the labour market is still flawed...

6    The holy war over capital     Why the productivity of capital doesn’t determine profits

The economist Dharma Kumar is said to have once remarked that “Time is a device to stop everything from happening at once … and space is a device to stop everything from happening in Cambridge”.

Nevertheless, a lot did happen at Cambridge during the 1960s and 1970s, where ‘Cambridge’ refers to both Cambridge, Massachusetts USA and Cambridge, England. The former is home to the Massachusetts Institute of Technology (better known by its initials MIT), the latter is the home of the famous University of Cambridge. MIT was the bastion for the leading true believers in economics, while the University of Cambridge housed an important group of heretics.

For twenty years, these two Cambridges waged a theoretical ‘Holy War’ over the foundations of neoclassical economics. The first shot was fired by the heretics, and after initial surprise the true believers responded strongly and confidently. Yet after several exchanges, the leading bishop of the true believers had conceded that the heretics were substantially correct. Summing up the conflict in 1966, Paul Samuelson observed that the heretics “merit our gratitude” for pointing out that the simple homilies of economic theory are not in general true. He concluded that, "If all this causes headaches for those nostalgic for the old time parables of neoclassical writing, we must remind ourselves that scholars are not born to live an easy existence. We must respect, and appraise, the facts of life." (Samuelson 1966)

One might hope that such a definitive capitulation by as significant an economist as Paul Samuelson would have signalled a major change in the evolution of economics. Unfortunately, this was not to be. While many of the bishops have conceded that economics needs drastic revision, its priests preach on in a new millennium, largely unaware that they lost the holy war thirty years earlier...

7        There is madness in their method    Why assumptions do matter, and why economics is so different to the true sciences

Economics would have us believe that it is a science, fully able to stand tall beside the more conventional physical sciences and mathematics.

After the preceding chapters, you may be inclined to doubt that belief. Surely, whatever ‘science’ is, one might hope that it is undertaken with more impartiality, regard for the facts and logical consistency than economics has displayed.

However, the critiques of conventional economics which form the substance of this book were devised by critical economists (and sometimes, inadvertently, by conventional economists themselves) and some of these critiques have been acknowledged as valid by some conventional economists. There is also a small but robust minority working on other approaches to economic analysis, as you’ll find in Chapter 14. There are thus some systematic and logical aspects to what economists in general do, which could qualify as scientific behaviour.

The position I favour is that economics is a science, but a rather pathological one. I am particularly critical of what has occurred since 1950, but I still hold out hope of better behaviour in the future.

But before better behaviour can take widespread root, economics will have to wean itself from a methodological myth. This is the proposition, first put by Milton Friedman, that a theory cannot be judged by its assumptions, but only by the accuracy of its predictions.

Leaving aside the question of whether economics has ever accurately predicted anything, the argument that “the more significant the theory, the more unrealistic [are] the assumptions” is simply bad philosophy...

8    Let’s do the Time Warp again     Why economics must finally treat time seriously

Forget everything you know about riding a bicycle, and imagine that someone who purports to be a ‘bicycle guru’ has convinced you that there are two steps to learning how to ride a bike. In step 1, you master balancing on a stationary bike. In step 2, you master riding a moving bike, applying the skills acquired at step 1.

After several difficult months at step 1, you would know that to remain upright, you must keep your centre of gravity directly above the point of contact between your wheels and the road.

Step 2 arrives. Applying the lessons in stage 1, you keep your bike at a perfect 90 degrees to the ground, balance against the uneven pressure of your legs, get up some speed and you’re away.

So far, so good. But what if you want to change direction? The handlebars appear to provide the only means of turning, so you rotate them in the direction you wish to go–and fall flat on your face.

What went wrong with this apparently logical advice? ‘Elementary, my dear Watson’: the centripetal force which keeps you upright when a bike is moving simply doesn’t exist when it is stationary. Manipulating this force is what enables you to turn a moving bike, and the lessons learnt in the static art of balancing a stationary bike are irrelevant to the dynamic art of actually riding one.

Replace the bicycle with the economy, and the point still stands: the procedures which apply in a static economy are irrelevant to a dynamic, changing one; the forces which apply in a static economy simply don’t exist in a dynamic one. Lessons learnt from managing an economy in which processes of change either don’t occur, or in which changes occur instantly, are irrelevant to an economy in which change does occur, and takes time to occur...

9    The sum of the parts    Why Keynes’s criticisms of conventional economics are still relevant today

Macroeconomics is the study of the economy at the aggregate level, with particular emphasis upon output, employment and inflation. The focus of this book, on the other hand, is overwhelmingly on what economists call ‘microeconomics’–the study of disaggregated markets, where the theory attempts to derive market behaviour from the assumed characteristics of individual firms and consumers.

The major reason for this focus is because, by the end of the 20th century, macroeconomics had been almost totally subsumed by microeconomics.

The crowning glory of this process came with the development of ‘representative agent’ macroeconomics. This approach assumes that an economy can be modelled as if it consists of a single consumer/producer-the representative agent. As discussed in Chapter 2, economists invented this fiction because they had proven that it was impossible to treat collective welfare as simply the sum of the welfare of individuals (if individuals differed in tastes, or if tastes changed with income, which of course they do). The representative agent is clearly a fantasy, yet this fantasy became the standard way in which ‘respectable’ economists did macroeconomics.

It is stating the obvious to call the representative agent an ‘ad hoc’ assumption, made simply so that economists can pretend to have a sound basis for their analysis, when in reality they have no grounding whatsoever. Yet ironically, the prelude to this farce was the contention that macroeconomics was too ad hoc, because it was not grounded in microeconomic theory...

10    The Price is Not Right     Why finance markets can get the price of assets so badly wrong

The Internet stock market boom is the biggest speculative bubble in world history.

Other manias have involved more ridiculously overvalued assets, or more preposterous objects of speculation–such as the tulip craze in 17th century Holland, the South Sea Bubble and Mississippi Bubble of the 18th century, or Japan’s 1980s Bubble Economy speculation over Tokyo real estate. But no other bubble–not even the ‘Roaring Twenties’ boom prior to the Great Depression–has involved so many people, speculating so much money, in so short a time, to such ridiculous valuations.

But of course, an economist wouldn’t tell you that. Instead, economists have assured the world that the stock market’s valuations reflect the true future prospects of companies. The most famous–and fatuous–such assurance is given in Dow 36,000, which its authors were defending even when the Dow had officially entered a correction from its all-time high of March 2000, and the Nasdaq was firmly in bear market territory (Time, 22 May 2000: 92-93). The mammoth valuations, argued Hassett and Glassman, were simply the product of investors reassessing the risk premiums attached to stocks, having realised that over the long term, stocks were no riskier than bonds.

Economists were similarly reassuring back in 1929, with the most famous such utterance being Irving Fisher’s comment that:

Stock prices have reached what looks like a permanently high plateau. I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels, such as Mr. Babson has predicted. I expect to see the stock market a good deal higher than it is today within a few months (Irving Fisher, 15 October 1929).

This was published less than two weeks before ‘Black Monday’, 28 October 1929, when the Dow Jones Industrial Average closed 12.8% below its previous level, and fell another 11.7% the following day. In just 15 days of wild gyrations from the day of Fisher’s comments, the market fell over 120 points (from a level of about 350): twice as far as even Fisher’s bearish rival Babson had predicted, and twice as much as Fisher had believed would ever be possible. Three years later, the stock market indices had fallen 90%, and many a once-rich speculator was bankrupt. Investors who trusted economists back then lost their shirts. Trusting souls who accept economic assurances that markets are efficient are unlikely to fare any better this time when the Bull gives way to the Bear...

11        Finance and economic breakdown    Why stock markets crash

The efficient markets hypothesis says that the stock market’s volatility is due to the random arrival of new information that affects the equilibrium value of shares. Allegedly, if it were not for the arrival of new information from outside the market, the market itself would be quiescent.

However, there is an alternative explanation that attributes most (though not all) of the market’s volatility to its own internal dynamics. Remarkably, these two explanations can predict statistical outcomes for share market prices that are almost indistinguishable...

12        Don’t shoot me, I’m only the piano    Why mathematics is not the problem

Many critics of economics have laid the blame for its manifest failures at the feet of mathematics. Mathematics, they claim, has led to an excessive formalism in economics, which has obscured the inherently social nature of the subject.

While it is undeniable that an inordinate love of mathematical formalism has contributed to some of the intellectual excesses in economics, generally this reaction is as erroneous as blaming the piano for the discordant notes of a bad piano player. If anything should be shot, it is the pianist, not the piano. Though mathematics has definite limitations, properly used, it is a logical tool that should illuminate, rather than obscure. Economists have obscured reality using mathematics because they have practised mathematics badly, and because they have not realised the limits of mathematics...

13    Nothing to lose but their minds     Why most Marxists are irrelevant, but most of Marx is not

Marxian economics is clearly one of the alternatives to the neoclassical way of ‘thinking economically’, and by rights I should be discussing it in the next chapter, which looks at alternatives to conventional economics. However, in an illustration of the fact that conservative economists do not have a monopoly on unsound analysis, Marxian economics is hobbled by a logical conundrum as significant as any of those afflicting neoclassical economics.

This conundrum has split non-orthodox economists into two broad camps. One tiny group continues to work within what they see as the Marxian tradition, and spends most of its time trying to solve this conundrum. The vast majority largely ignore Marx and Marxian economics, and instead develop the schools of thought discussed in the next chapter...

14         There Are alternatives    Why there is still hope for a better economics

Maggie Thatcher’s second best-known comment, in defence of following monetarist economic policies, was “There is NO alternative”. A similar attitude pervades economics: if not neoclassical economics, then what else?

In fact, there are many alternative schools of thought within economics. In addition to Marxian economics, the main alternatives are:

•      Austrian economics, which shares many features in common with neoclassical economics, save a slavish devotion to the concept of equilibrium;
•     Post Keynesian economics, which is highly critical of neoclassical economics, emphasises the fundamental importance of uncertainty, and bases itself upon the theories of Keynes and Kalecki;
•     Sraffian economics, based on Sraffa’s concept of the production of commodities by means of commodities;
•     Complexity theory, which applies the concept of nonlinear dynamics and chaos theory to economic issues; and
•     Evolutionary economics, which treats the economy as an evolving system along the lines of Darwin’s theory of evolution.

None of these is at present strong enough or complete enough to declare itself a contender for the title of ‘the’ economic theory of the 21st century. However, they all have strengths in areas where neoclassical economics is fundamentally flawed, and there is also a substantial degree of overlap and cross-fertilisation between schools. It is possible that this century could finally see the development of a dominant economic theory which actually has some relevance to the dynamics of a modern capitalist economy.

I would probably be regarded as partisan to the Post Keynesian approach. However, I can see varying degrees of merit in all five schools of thought, and I can imagine that a 21st century economics could be a melange of all five.

In this chapter I will give a brief overview of each school, emphasising the ways in which they are superior to neoclassical economics, but also noting when they share its weaknesses, or have problems of their own. This will necessarily be an inadequate survey–doing a proper survey would necessitate another book. But as I commented earlier, it is essential to at least outline the alternatives, to debunk the myth that there is no alternative...

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Debunking Economics takes you behind the sanitized, airbrushed view of economics given by its textbooks, and details the many critiques which have been ...