Eight Elementary Errors of Economics

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Geoff Davies

The Glob­al Finan­cial Cri­sis, the extreme inequal­i­ty of wealth world-wide, the mate­ri­al­ism of mod­ern life and the dire state of the plan­et are not acci­dents, nor just unavoid­able con­se­quences of the nature of things.  They are the result of the mod­ern prac­tice of eco­nom­ics, which makes ele­men­tary errors of account­ing, evi­dence, per­cep­tion and the­o­ry.

Many of these errors have been not­ed for decades, but only by a dis­sent­ing fringe of econ­o­mists and informed oth­ers.  Their mes­sage is drowned out by the relent­less rep­e­ti­tion of the main­stream free-mar­ket mantra.  Though many peo­ple are uncom­fort­able with econ­o­mists‘ pro­nounce­ments, and some are aware of some of the errors, few seem to realise how many and how basic are the errors, or how far-reach­ing are the con­se­quences.  Here are some of the main errors, spelt out in sim­ple terms.

• The mea­sure of suc­cess is growth of the Gross Domes­tic Prod­uct.  Yet the GDP is sim­ply the total of all activ­i­ty involv­ing mon­ey, with no account tak­en of whether the activ­i­ty is use­ful, use­less or harm­ful.  The costs of dis­as­ters, pol­lu­tion and “defen­sive expen­di­tures” like insur­ance are added to the GDP.  A prop­er account­ing would use a bal­ance sheet and sub­tract the costs from the income, as every shop­keep­er under­stands.  As a result unpaid activ­i­ties like vol­un­teer work, grow­ing back­yard veg­eta­bles or a mother’s lov­ing care are neglect­ed and implic­it­ly dis­cour­aged, though they may con­tribute some­thing like a third of net nation­al ben­e­fit.  Exploita­tive and pol­lut­ing activ­i­ties are implic­it­ly encour­aged because they boost GDP.

•Clear evi­dence of poor per­for­mance is ignored.  Growth, unem­ploy­ment and infla­tion mea­sures in the neolib­er­al era, since 1980, have nev­er been as good as those in the 1950s and 1960s.  In Aus­tralia from 1953 to 1974 unem­ploy­ment aver­aged 1.3% and infla­tion aver­aged 3.3%, and from 1960 to 1974 growth aver­aged 5.2%.  For the whole OECD the fig­ures were unem­ploy­ment (1953–1974) 3.2%, infla­tion (1960–1974) 4.5%, growth (1960–1974) 4.9%.  If free-mar­ket fun­da­men­tal­ists were right then the gov­ern­ment “inter­ven­tion” in the econ­o­my that was rou­tine in the post-war era would have pre­clud­ed such stel­lar per­for­mance.  In fact such fig­ures are now treat­ed as impos­si­ble.

• Mon­ey and debt are exclud­ed from eco­nom­ic mod­els.  Mon­ey is exclud­ed because econ­o­mists treat eco­nom­ic exchange as barter, claim­ing mon­ey is only a neu­tral inter­me­di­ary.  Debt is exclud­ed because pri­vate debt is claimed to have lit­tle influ­ence on eco­nom­ic per­for­mance.  Econ­o­mists claim “one person’s debt is anoth­er person’s asset”, so net pur­chas­ing pow­er is not changed by loans.  That would only be true in a barter econ­o­my, or if banks only loaned from sav­ings deposits.  Yet it is eas­i­ly ver­i­fi­able that banks cre­ate new mon­ey to make loans, so pur­chas­ing pow­er is boost­ed and mon­ey is no longer neu­tral.  Because banks have been dereg­u­lat­ed and the banks’ incen­tive is to increase debt, pri­vate debt has increased dra­mat­i­cal­ly over recent decades.  It was the col­lapse of a mort­gage debt bub­ble in the US that trig­gered the GFC.  Their dis­count­ing of debt is why most econ­o­mists failed to see the GFC com­ing, and have lit­tle idea how to recov­er from it, as they are demon­strat­ing in Europe.

• Mod­ern free-mar­ket the­o­ry, called the neo­clas­si­cal the­o­ry, pre­dicts the econ­o­my will always be close to equi­lib­ri­um.  If that were true it should tick along steadi­ly and sud­den changes should only occur in response to large exter­nal events like nat­ur­al dis­as­ters or wars.  Yet many times over the past two cen­turies finan­cial mar­kets have sud­den­ly col­lapsed with­out any exter­nal cause.  Some of the more recent exam­ples occurred in 1987, 1997, 2001 and 2007.  In 1987 stock prices dropped by 30–40% in a day, though thir­ty per­cent of the world’s fac­to­ries had not been bombed overnight.

• The neo­clas­si­cal the­o­ry is based on assump­tions that are patent­ly absurd or clear­ly shown by oth­er dis­ci­plines to be untrue.  Among the patent­ly absurd, it is assumed our col­lec­tive guess­es about the future are accu­rate, yet peo­ple in 1890 could not have con­ceived how cars, aero­planes, two world wars, nuclear weapons, com­put­ers and dig­i­tal com­mu­ni­ca­tion would rad­i­cal­ly trans­form the world.

• It is assumed that peo­ple are innate­ly indi­vid­u­al­is­tic, com­pet­i­tive and cold­ly “ratio­nal” cal­cu­la­tors.  How­ev­er psy­chol­o­gists have clear­ly doc­u­ment­ed our ten­den­cy to favour coop­er­a­tion by pun­ish­ing cheaters, even at a per­son­al cost.  Almost every mam­malian species lives in groups, and social groups have an innate, and healthy, ten­sion between indi­vid­u­al­ism and coop­er­a­tion.  Most peo­ple under­stand they are bet­ter off if they bal­ance their own wish­es with those of their fam­i­ly and com­mu­ni­ty.  We are obvi­ous­ly strong­ly moti­vat­ed by love, envy, fash­ion and inse­cu­ri­ty, and mar­keters ruth­less­ly exploit these foibles.  Psy­chol­o­gists have also clear­ly doc­u­ment­ed our ten­den­cy to oth­er “non-ratio­nal” behav­iours such as weight­ing a risk of los­ing more heav­i­ly than an equal chance of win­ning.  Nei­ther the fash­ion indus­try nor the mar­ket­ing indus­try would exist if econ­o­mists were right.

• Econ­o­mists assume there are no economies of scale beyond a point of dimin­ish­ing returns, ignor­ing the les­son of Hen­ry Ford’s assem­bly lines.  Economies of scale allow the biggest firm to under­cut oth­er firms and grow faster, until it dom­i­nates a mar­ket.  The exis­tence of many such dom­i­nat­ing firms, such as Microsoft, McDonald’s and Face­book, is also ignored.

•  Econ­o­mists seem to be obliv­i­ous to the exis­tence of emer­gent wealth of land.  This is the val­ue that accrues to a plot when a neigh­bour­ing plot is devel­oped.  The addi­tion­al val­ue is due to the prox­im­i­ty of devel­op­ments, and is addi­tion­al to the indi­vid­ual invest­ed val­ues.  It there­fore belongs to no indi­vid­ual.  Because it is due to the local com­mu­ni­ty of activ­i­ties, it ought to accrue to the com­mu­ni­ty as a whole.  Yet this emer­gent val­ue is allowed to be cap­tured by indi­vid­u­als as unearned wind­fall prof­it, which is one of the major dri­vers of inequal­i­ty.  Worse, in com­bi­na­tion with exces­sive cred­it cre­ation by banks, this leads to land spec­u­la­tion, asset bub­bles and finan­cial crash­es.  This one error leads to indi­vid­ual injus­tice and sys­temic dys­func­tion.

The con­se­quences of these errors are not triv­ial, they rad­i­cal­ly dis­tort our per­cep­tion of the behav­iour of economies.  Free-mar­ket the­o­rists allow that there are “mar­ket imper­fec­tions”, but don’t appre­ci­ate that aban­don­ing any of their cen­tral assump­tions leads to rad­i­cal­ly dif­fer­ent pre­dic­tions of per­va­sive insta­bil­i­ty and unsteady behav­iour.

If we use more defen­si­ble assump­tions we are led to expect a quite dif­fer­ent kind of sys­tem, a com­plex self-organ­is­ing sys­tem, that is always far from equi­lib­ri­um.  Such sys­tems are nei­ther sta­t­ic nor so prone to dra­mat­ic booms and busts, and they are more like liv­ing sys­tems in being unpre­dictable in detail yet hav­ing fair­ly clear gen­er­al char­ac­ter.

To be effec­tive, eco­nom­ic man­age­ment needs to recog­nise quite dif­fer­ent points of inter­ven­tion.  Mar­kets are indeed pow­er­ful, but they need to be care­ful­ly man­aged, because there is no assur­ance in either the­o­ry or prac­tice that they auto­mat­i­cal­ly yield good out­comes.

This is not social­ism, which is gov­ern­ment own­er­ship of large parts of the econ­o­my.  Rather, it is the use of incen­tives like tax­es and sub­si­dies more coher­ent­ly and with bet­ter under­stand­ing and a clear­er pur­pose than we do now.  Gov­ern­ment is the obvi­ous means to effect this man­age­ment.  There is also a case for “nat­ur­al monop­o­lies” to be returned to gov­ern­ment own­er­ship.  The mar­ket-fun­da­men­tal­ist claim that gov­ern­ment is always inef­fi­cient is clear­ly non­sense.  Any large organ­i­sa­tion is prone to inef­fi­cien­cies, and plen­ty of pri­vate exam­ples can be placed next to pub­lic exam­ples.  Try call­ing Tel­stra.

The sub­ject of eco­nom­ics needs to be fun­da­men­tal­ly re-thought.  Free-mar­ket the­o­rists think they are doing sci­ence because they use math­e­mat­ics.  Yet to real sci­en­tists math­e­mat­ics is only a tool.  The essence of sci­ence is the per­cep­tion of pat­terns in the world, which are expressed as hypothe­ses, and the test­ing of the pre­dic­tions of hypothe­ses against new obser­va­tions of the world.  The per­cep­tion of a pat­tern is not a ratio­nal process, it is a cre­ative process.  Math­e­mat­ics is use­ful to draw out the impli­ca­tions of hypothe­ses after they have been con­ceived.

Eco­nom­ics got infat­u­at­ed with the math­e­mat­i­cal part of sci­ence and com­plete­ly missed the test­ing part.  The equi­lib­ri­um pre­dic­tion clear­ly fails the test of com­par­ing to real economies, as the exam­ples of mar­ket crash­es and economies of scale show.  To con­tin­ue with this failed the­o­ry is to prac­tice pseu­do-sci­ence.

The high­ly influ­en­tial econ­o­mist Mil­ton Fried­man even claimed that good the­o­ries can result from obvi­ous­ly wrong assump­tions, and that in fact the bet­ter the the­o­ry the more incor­rect are its assump­tions.  Sci­en­tists can only be aston­ished by his con­fu­sion.  Sci­en­tists do under­stand that every the­o­ry is only an approx­i­ma­tion to observed real­i­ty, but the art of good sci­ence is to find the­o­ries that eco­nom­i­cal­ly yield pre­dic­tions that are use­ful­ly accu­rate over a broad range of con­di­tions.  The­o­ries based on inap­pro­pri­ate or absurd assump­tions can only have super­fi­cial or lim­it­ed coin­ci­den­tal resem­blances to real­i­ty, as fur­ther inves­ti­ga­tion will reveal.

A new con­cep­tion of eco­nom­ic behav­iour based on com­plex sys­tems is devel­op­ing rapid­ly on the fringes of eco­nom­ics.  Many use­ful detailed insights are recount­ed in Eric Beinhocker’s book The Ori­gin of Wealth (Har­vard Busi­ness School, 2006).  There are also imme­di­ate over­ar­ch­ing impli­ca­tions.  For exam­ple, there is not just one way to organ­ise economies, there are many ways, and they can be tai­lored to the wish­es of each human cul­ture.

Through these new ideas economies can be made more humane and less destruc­tive.  They can be returned to their prop­er place, which is sub­or­di­nate to social pol­i­cy.  They can even be made com­pat­i­ble with the liv­ing world, on whose health our sur­vival total­ly depends.

The larg­er impli­ca­tions are devel­oped in my eBook The Nature of the Beast.

Dr. Geoff Davies is a retired geo­physi­cist at the Aus­tralian Nation­al Uni­ver­si­ty and the author of Econo­mia: New Eco­nom­ic Sys­tems to Empow­er Peo­ple and Sup­port the Liv­ing World (ABC Books, 2004) and The Nature of the Beast: How econ­o­mists mis­took wild hors­es for a rock­ing chair (eBook)  He blogs at http://betternature.wordpress.com/.

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, 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 private debts accumulated globally, and our very low rate of inflation.