Neoclassical Economics: mad, bad, and dangerous to know

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The whole of the most recent Real World Eco­nom­ics Review (for­merly known as the Post-Autistic Eco­nom­ics Review) is devoted to the ques­tion of “How should the col­lapse of the world finan­cial sys­tem affect economics?”.

My paper, which led vol­ume 49, is repro­duced below. If you’d like to read the entire vol­ume, click here for the online ver­sion and here for the PDF. You can also go here for back issues, and to sub­scribe for free.

The most impor­tant thing that global finan­cial cri­sis has done for eco­nomic the­ory is to show that neo­clas­si­cal eco­nom­ics is not merely wrong, but dangerous.

Neo­clas­si­cal eco­nom­ics con­tributed directly to this cri­sis by pro­mot­ing a faith in the innate sta­bil­ity of a mar­ket econ­omy, in a man­ner which in fact increased the ten­dency to insta­bil­ity of the finan­cial sys­tem. With its false belief that all insta­bil­ity in the sys­tem can be traced to inter­ven­tions in the mar­ket, rather than the mar­ket itself, it cham­pi­oned the dereg­u­la­tion of finance and a dra­matic increase in income inequal­ity. Its equi­lib­rium vision of the func­tion­ing of finance mar­kets led to the devel­op­ment of the very finan­cial prod­ucts that are now threat­en­ing the con­tin­ued exis­tence of cap­i­tal­ism itself.

Simul­ta­ne­ously it dis­tracted econ­o­mists from the obvi­ous signs of an impend­ing crisis—the asset mar­ket bub­bles, and above all the ris­ing pri­vate debt that was financ­ing them. Para­dox­i­cally, as capitalism’s “per­fect storm” approached, neo­clas­si­cal macro­econ­o­mists were absorbed in smug self-congratulation over their appar­ent suc­cess in tam­ing infla­tion and the trade cycle, in what they termed “The Great Mod­er­a­tion”. Ben Bernanke’s con­tri­bu­tion to this is worth quot­ing at length:

… the low-inflation era of the past two decades has seen not only sig­nif­i­cant improve­ments in eco­nomic growth and pro­duc­tiv­ity but also a marked reduc­tion in eco­nomic volatil­ity…, a phe­nom­e­non that has been dubbed “the Great Mod­er­a­tion”. Reces­sions have become less fre­quent and milder, and … volatil­ity in out­put and employ­ment has declined sig­nif­i­cantly… The sources of the Great Mod­er­a­tion remain some­what con­tro­ver­sial, but … there is evi­dence for the view that improved con­trol of infla­tion has con­tributed in impor­tant mea­sure to this wel­come change in the econ­omy … (Bernanke, 2004; empha­sis added)

It is all very well to have eco­nomic the­ory dom­i­nated by a school of thought with an innate faith in the sta­bil­ity of mar­kets when those mar­kets are for­ever gaining—whether by growth in the phys­i­cal econ­omy, or via ris­ing prices in the asset mar­kets. In those cir­cum­stances, aca­d­e­mic econ­o­mists aligned to PAECON can rail about the log­i­cal incon­sis­ten­cies in main­stream eco­nom­ics all they want: they will be, and were, ignored by gov­ern­ment, the busi­ness com­mu­nity, and most of the pub­lic, because their con­cerns don’t appear to matter.

They can even be put down as crit­ics of capitalism—worse still, as pro­po­nents of socialism—because it seems to those out­side acad­e­mia, and to neo­clas­si­cal econ­o­mists as well, that what they are attack­ing is not eco­nomic the­ory, but cap­i­tal­ism itself: “You think mar­kets are unsta­ble? Shame on you!”

The story is entirely dif­fer­ent when asset mar­kets crash beneath a moun­tain of debt, and the ensu­ing fall­out threat­ens to take the phys­i­cal econ­omy with it. Now it should be pos­si­ble to have the crit­ics of neo­clas­si­cal eco­nom­ics appre­ci­ated for what we really are: crit­ics of a fun­da­men­tally false the­ory of the oper­a­tions of a mar­ket econ­omy, and ten­ta­tive devel­op­ers of a new, real­is­tic analy­sis of the nature of cap­i­tal­ism, warts and all.

Chang­ing Pedagogy

Given how severe this cri­sis has already proven to be, the reform of eco­nomic the­ory and edu­ca­tion should be an easy and urgent task. But that is not how things will pan out. Though the “irre­sistible force” of the Global Finan­cial Cri­sis is indeed immense, so to is the iner­tia of the “immov­able object” of eco­nomic belief.

Despite the sever­ity of the cri­sis in the real world, aca­d­e­mic neo­clas­si­cal econ­o­mists will con­tinue to teach from the same text­books in 2009 and 2010 that they used in 2008 and ear­lier (lazi­ness will be as influ­en­tial a fac­tor here as ide­o­log­i­cal com­mit­ment). Rebels econ­o­mists will be embold­ened to pro­claim “I told you so” in their non-core sub­jects, but in the core micro,  macro and finance units, it will be busi­ness as usual vir­tu­ally every­where. Many under­grad­u­ate eco­nom­ics stu­dents in the com­ing years will sit gob­s­macked. as their lec­tur­ers recite text­book the­ory as if there is noth­ing extra­or­di­nar­ily dif­fer­ent tak­ing place in the real economy.

The same will hap­pen in the aca­d­e­mic jour­nals. The edi­tors of the Amer­i­can Eco­nomic Review and the Eco­nomic Jour­nal are unlikely to con­vert to Post Key­ne­sian or Evo­lu­tion­ary Eco­nom­ics or Econo­physics any time soon—let alone to be replaced by edi­tors who are already prac­ti­tion­ers of non-orthodox thought. The bat­tle against neo­clas­si­cal eco­nomic ortho­doxy within uni­ver­si­ties will be long and hard, even though its fail­ure will be appar­ent to those in the non-academic world.

Much of this will be because neo­clas­si­cal econ­o­mists are gen­uinely naïve about their role in caus­ing this cri­sis. From their per­spec­tive, they will inter­pret the cri­sis as due to poor reg­u­la­tion, and to gov­ern­ment inter­ven­tion in areas that should have been left to the mar­ket. Aspects of the cri­sis that can­not be solely attrib­uted to those causes will be cov­ered by appeal­ing to embell­ish­ments to basic neo­clas­si­cal the­ory. Thus, for exam­ple, the Sub­primes Scam will be por­trayed as some­thing eas­ily explained by the the­ory of asym­met­ric information.

They will seri­ously believe that the cri­sis calls not for the abo­li­tion of neo­clas­si­cal eco­nom­ics, but for its teach­ings to be more widely known. The very thought that this finan­cial cri­sis should require any change in what they do, let alone neces­si­tate the rejec­tion of neo­clas­si­cal the­ory com­pletely, will strike them as incredible.

In this sense, they are like the Maxwellian physi­cists about whom Max Planck remarked that “A new sci­en­tific truth does not tri­umph by con­vinc­ing its oppo­nents and mak­ing them see the light, but rather because its oppo­nents even­tu­ally die, and a new gen­er­a­tion grows up that is famil­iar with it” (Kuhn 1970,  p. 150).

But physics is charmed in com­par­i­son to eco­nom­ics, since it is inher­ently an empir­i­cal dis­ci­pline, and quan­tum mechan­ics gave the only expla­na­tion to the empir­i­cally quan­tifi­able black body prob­lem. Planck’s con­fi­dence that a new gen­er­a­tion would take the place of the old was there­fore well-founded. But in eco­nom­ics, not only will the neo­clas­si­cal old guard resist change, they could, if eco­nomic cir­cum­stances sta­bilise, give rise to a new gen­er­a­tion that accepts their inter­pre­ta­tion of the cri­sis. The is how the suc­cess of the Key­ne­sian counter-revolution came about, and it is why we have we entered this cri­sis with an even more rabid neo­clas­si­cism than con­fronted Keynes in the 1930s.

The first thing that the global finan­cial cri­sis should there­fore do to eco­nom­ics is to gal­vanise stu­dent protest about the lack of debate within aca­d­e­mic eco­nom­ics itself, because dis­si­dent aca­d­e­mic econ­o­mists will be unable to shift the tuition of eco­nom­ics them­selves with­out mas­sive pres­sure from the stu­dent body.

I speak from my own expe­ri­ence, when I was one of many stu­dents who agi­tated against neo­clas­si­cal eco­nom­ics in the early 1970s at Syd­ney Uni­ver­sity, and cam­paigned for the estab­lish­ment of a Polit­i­cal Econ­omy Depart­ment. Were it not for the protests by the stu­dents against what we then rightly saw as a deluded approach to eco­nom­ics, the non-neoclassical staff at Syd­ney Uni­ver­sity would have been unable to affect change themselves.

Though we won that bat­tle at Syd­ney Uni­ver­sity, we lost the war. The eco­nomic down­turn of the mid-1970s allowed for the defeat of what Joan Robin­son aptly called the Bas­tard Key­ne­sian­ism of that era, and its replace­ment by Friedman’s “mon­e­tarism”. Our protests were also wrongly char­ac­terised as being essen­tially anti-capitalist. Though there were indeed many who were anti-capitalist within the Polit­i­cal Econ­omy move­ment, the real tar­get of stu­dent protest was a poor the­ory of how cap­i­tal­ism oper­ates, and not cap­i­tal­ism itself.

Sim­i­lar obser­va­tions can be made about the PAECON move­ment today, where stu­dent dis­sat­is­fac­tion with neo­clas­si­cal eco­nom­ics in France spilled over into a world­wide move­ment. Though the ini­tial impact of the move­ment was sub­stan­tial, neo­clas­si­cal dom­i­nance of eco­nomic ped­a­gogy con­tin­ued unabated. The move­ment per­sisted, but its rel­e­vance to the real econ­omy was not appre­ci­ated because that econ­omy appeared to be boom­ing. Now that the global econ­omy is in cri­sis, stu­dent pres­sure is needed once more to ensure that, this time, real change to eco­nomic ped­a­gogy occurs.

Busi­ness pres­sure is also essen­tial. Busi­ness groups to some degree naively believed that those who pro­claimed the virtues of the mar­ket sys­tem, and who argued on their side in dis­putes over income dis­tri­b­u­tion, were their allies in the acad­emy, while crit­ics of the mar­ket were their ene­mies. I hope that this finan­cial cat­a­stro­phe will con­vince the busi­ness com­mu­nity that its true friends in the acad­emy are those who under­stand the mar­ket sys­tem, whether they crit­i­cise or praise it. As much as we need stu­dents to revolt over the teach­ing of eco­nom­ics, we need busi­ness to bring pres­sure on aca­d­e­mic eco­nom­ics depart­ments to revise their cur­ric­ula because of the finan­cial crisis.

Chang­ing Economics

The ped­a­gogic pres­sure from stu­dents and the wider com­mu­nity has to be matched by the accel­er­ated devel­op­ment of alter­na­tives to neo­clas­si­cal eco­nom­ics. Though we know much more today about the innate flaws in neo­clas­si­cal thought than was known at the time of the Great Depres­sion (Keen 2001), the devel­op­ment of a fully-fledged alter­na­tive to it is still a long way off. There are mul­ti­ple alter­na­tive schools of thought extant—from Post Key­ne­sian to Evo­lu­tion­ary and Behav­ioural Eco­nom­ics, and Econophysics—but these are not devel­oped enough to pro­vide a fully fledged alter­na­tive to neo­clas­si­cal economics.

This should not dis­suade us from dis­pens­ing com­pletely with the neo­clas­si­cal approach. For some sub­stan­tial period, and espe­cially while the actual econ­omy remains in tur­moil, we have to accept a period of tur­moil in the teach­ing of and research into eco­nom­ics. Hang­ing on to parts of a failed par­a­digm sim­ply because it has com­po­nents that other schools lack would be a tragic mis­take, because it is from pre­cisely such relics that a neo­clas­si­cal vision could once again become dom­i­nant when—or rather if—the mar­ket econ­omy emerges from this crisis.

Key here should be a rejec­tion of neo­clas­si­cal micro­eco­nom­ics in its entirety. This was the miss­ing com­po­nent of Keynes’s rev­o­lu­tion. While he tried to over­throw macro­eco­nom­ics shib­bo­leths like Say’s Law, he con­tin­ued to accept not merely the micro­eco­nomic con­cepts such as per­fect com­pe­ti­tion, but also their unjus­ti­fied pro­jec­tion into macro­eco­nomic areas—as with his belief that the mar­ginal pro­duc­tiv­ity the­ory of income dis­tri­b­u­tion, which is fun­da­men­tally a micro con­cept, applied at the macro level of wage determination.

From this fail­ure to expunge the micro­eco­nomic foun­da­tions of neo­clas­si­cal eco­nom­ics from post-Great Depres­sion eco­nom­ics arose the “micro­foun­da­tions of macro­eco­nom­ics” debate that led ulti­mately to ratio­nal expec­ta­tions rep­re­sen­ta­tive agent macro­eco­nom­ics, in which the econ­omy is mod­elled as a sin­gle util­ity max­imis­ing indi­vid­ual who is blessed with per­fect knowl­edge of the future.

For­tu­nately, behav­ioural eco­nom­ics pro­vides the begin­nings of an alter­na­tive vision as to how indi­vid­u­als oper­ate in a mar­ket envi­ron­ment, while multi-agent mod­el­ling and net­work the­ory give us foun­da­tions for under­stand­ing group dynam­ics in a com­plex soci­ety. They explic­itly empha­sise what neo­clas­si­cal eco­nom­ics has evaded: that aggre­ga­tion of het­ero­ge­neous indi­vid­u­als results in emer­gent prop­er­ties of the group which can­not be reduced to the behav­iour of any “rep­re­sen­ta­tive indi­vid­ual” amongst them. These approaches should replace neo­clas­si­cal micro­eco­nom­ics completely.

The changes to eco­nomic the­ory beyond the micro level involve a com­plete recant­ing of the neo­clas­si­cal vision. The vital first step here is to aban­don the obses­sion with equilibrium.

The fal­lacy that dynamic processes must be mod­elled as if the sys­tem is in con­tin­u­ous equi­lib­rium through time is prob­a­bly the most impor­tant rea­son for the intel­lec­tual fail­ure of neo­clas­si­cal eco­nom­ics. Math­e­mat­ics, sci­ences and engi­neer­ing long ago devel­oped tools to model out of equi­lib­rium processes, and this dynamic approach to think­ing about the econ­omy should become sec­ond nature to economists.

An essen­tial ped­a­gogic step here is to hand the teach­ing of math­e­mat­i­cal meth­ods in eco­nom­ics over to math­e­mat­ics depart­ments. Any math­e­mat­i­cal train­ing in eco­nom­ics, if it occurs at all, should come after stu­dents have done at least basic cal­cu­lus, alge­bra and dif­fer­en­tial equations—the last area being one about which most econ­o­mists of all per­sua­sions are woe­fully igno­rant. This simul­ta­ne­ously explains why neo­clas­si­cal econ­o­mists obsess too much about proofs, and why non-neoclassical econ­o­mists like those in the Cir­cuit School (Graziani 1989) have had such dif­fi­cul­ties in trans­lat­ing excel­lent ver­bal ideas about credit cre­ation into coher­ent dynamic mod­els of a mon­e­tary pro­duc­tion econ­omy (c.f. Keen 2009).

Neo­clas­si­cal eco­nom­ics has effec­tively insu­lated itself from the great advances made in these gen­uine sci­ences and engi­neer­ing in the last forty years, so that while its con­cepts appear dif­fi­cult, they are quaint in com­par­i­son to the sophis­ti­ca­tion evi­dent today in math­e­mat­ics, engi­neer­ing, com­put­ing, evo­lu­tion­ary biol­ogy and physics. This iso­la­tion must end, and for a sub­stan­tial while eco­nom­ics must eat hum­ble pie and learn from these dis­ci­plines that it has for so long stu­diously ignored. Some researchers from those fields have called for the whole­sale replace­ment of stan­dard eco­nom­ics cur­ric­ula with at least the build­ing blocks of mod­ern thought in these dis­ci­plines, and in the light of the cat­a­stro­phe econ­o­mists have vis­ited upon the real world, their argu­ments carry sub­stan­tial weight.

For exam­ple, in response to a paper crit­i­cal of trends in econo­physics (Gal­le­gatti et al. 2006), the physi­cist Joe McCauley responded that, though some of the objec­tions were valid, the prob­lems in eco­nom­ics proper were far worse. He there­fore sug­gested that:

the econ­o­mists revise their cur­ricu­lum and require that the fol­low­ing top­ics be taught: cal­cu­lus through the advanced level, ordi­nary dif­fer­en­tial equa­tions (includ­ing advanced), par­tial dif­fer­en­tial equa­tions (includ­ing Green func­tions), clas­si­cal mechan­ics through mod­ern non­lin­ear dynam­ics, sta­tis­ti­cal physics, sto­chas­tic processes (includ­ing solv­ing Smoluchowski–Fokker–Planck equa­tions), com­puter pro­gram­ming (C, Pas­cal, etc.) and, for com­plex­ity, cell biol­ogy. Time for such classes can be obtained in part by elim­i­nat­ing micro– and macro-economics classes from the cur­ricu­lum. The stu­dents will then face a much harder cur­ricu­lum, and those who sur­vive will come out ahead. So might soci­ety as a whole. (McCauley 2006, p. 608; empha­sis added)

The eco­nomic the­ory that should even­tu­ally emerge from the rejec­tion of neo­clas­si­cal eco­nom­ics and the basic adop­tion of dynamic meth­ods will come much closer than neo­clas­si­cal eco­nom­ics could ever do to meet­ing Marshall’s dic­tum that “The Mecca of the econ­o­mist lies in eco­nomic biol­ogy rather than in eco­nomic dynam­ics” (Mar­shall 1920: xiv). As Veblen cor­rectly sur­mised over a cen­tury ago (Veblen 1898), the fail­ure of eco­nom­ics to become an evo­lu­tion­ary sci­ence is the prod­uct of the opti­mis­ing frame­work of the under­ly­ing par­a­digm, which is inher­ently anti­thet­i­cal to the process of evo­lu­tion­ary change. This rea­son, above all oth­ers, is why the neo­clas­si­cal mantra that the econ­omy must be per­ceived as the out­come of the deci­sions of util­ity max­imis­ing indi­vid­u­als must be rejected.

Eco­nom­ics also has to become fun­da­men­tally a mon­e­tary dis­ci­pline, right from the con­sid­er­a­tion of how indi­vid­u­als make mar­ket deci­sions through to our under­stand­ing of macro­eco­nom­ics. The myth of “the money illu­sion” (which can only true in a world with­out debt) has to be dis­pelled from day one, while our macro­eco­nom­ics has to be that of a mon­e­tary econ­omy in which nom­i­nal mag­ni­tudes matter—precisely because they are the link between the value of cur­rent out­put and the financ­ing of accu­mu­lated debt. The dan­gers of exces­sive debt and defla­tion sim­ply can­not be com­pre­hended from a neo­clas­si­cal per­spec­tive, which—along with the inabil­ity to rea­son out­side the con­fines of equilibrium—explains the profession’s fail­ure to assim­i­late Fisher’s pre­scient warn­ings (Fisher 1933; few peo­ple realise that Friedman’s pre­ferred rate of infla­tion in his “Opti­mum Quan­tity of Money” paper was “a decline in prices at the rate of at least 5 per cent per year, and per­haps decid­edly more”; Fried­man 1969, p. 46, empha­sis added).

The dis­ci­pline must also become fun­da­men­tally empir­i­cal, in con­trast to the faux empiri­cism of econo­met­rics. By this I mean bas­ing itself on the eco­nomic and finan­cial data first and foremost—the col­lec­tion and inter­pre­ta­tion of which has been the hall­mark of con­tri­bu­tions by econophysicists—and by respect­ing eco­nomic his­tory, a topic that has been expunged from eco­nom­ics depart­ments around the world. It, along with a non-Whig approach to the his­tory of eco­nomic thought, should be restored to the eco­nom­ics cur­ricu­lum. Names that cur­rently are absent from mod­ern eco­nom­ics courses (Marx, Veblen, Keynes, Fisher, Kalecki, Schum­peter, Min­sky, Sraffa, Good­win, to name a few) should abound in such courses.

Iron­i­cally, one of the best calls for a focus on the empir­i­cal data sans a pre­ced­ing eco­nomic model came from two of the most com­mit­ted neo­clas­si­cal authors, 2004 Nobel Prize win­ners Finn Kyd­land and Edward Prescott, when they noted that “the report­ing of facts—without assum­ing the data are gen­er­ated by some prob­a­bil­ity model—is an impor­tant sci­en­tific activ­ity. We see no rea­son for eco­nom­ics to be an excep­tion” (Kyd­land & Prescott 1990, p. 3). The fail­ure of these authors to live up to their own stan­dards1 should not be repli­cated in post-neoclassical economics.

Ref­er­ences

About Steve Keen

I am a professional economist and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous debts accumulated in Australia, and our very low rate of inflation.
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