Steve Keen is a senior lecturer in economics and finance at the University of Western Sydney. His book Debunking Economics (Pluto Press, $38.95) was released this month.
Quelle économie enseigner à l’université?
L’économie entre empirisme et mathématisation
How the economists got it wrong
Back to reality
When an immovable object the economist meets an irresistible force the man in the street market forces take on a whole new meaning, writes Steve Keen (email@example.com)
Among the many banners in London’s M1 demonstration was one that demanded "Replace capitalism with something nicer!" This amusingly vague protest is far from the full extent of the moral opposition to untrammelled market forces. No less a figure than the Pope has recently voiced the common complaint that the market is amoral, and must therefore be controlled for the betterment of society. Speaking to the Pontifical Academy of Social Sciences, with noted economists Edmond Malinvaud, Kenneth Arrow and Susmita Dasgupta in the audience, the Pope argued that "universal common good ... demands that control mechanisms should accompany the inherent logic of the market".
Unfortunately, neither the M1 protesters nor the Pope are likely to sway the opinions of economists one jot. The accusation that the market is amoral means nothing to an economist because, from the economic perspective, amorality is precisely the point. Economists perceive the market not as some enforcer of social standards, but simply as the means by which society achieves its ends. If some people object to what the market economy delivers, then they should attempt to reform society and social attitudes, not the market.
This belief in the independence of economy and morality is enshrined in the dominant definition of economics as "the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses". When Lionel Robbins coined that definition in the 1930s, he emphasised that economics makes no moral judgments. Whether what consumers desire is base or exalted is irrelevant: "Economics is entirely neutral between ends; that, in so far as the achievement of any end is dependent upon scarce means, it is germane to the preoccupations of the economist. Economics is not concerned with ends as such."
Consequently, economists have been, and will remain, unfazed by criticisms that they ignore the social or moral dimensions of economic policy. From their perspective, it is not their role to make the aesthetic judgment as to whether the countryside looks better or worse with or without dairy farms. They believe it is their role, however, to tell us that milk will be more costly in a countryside where dairy farms are maintained by government regulation.
Economists are impervious to moral criticism. The Achilles heel of economics is not morality, but logic.
Though most economists today would concur with Robbins that economics is "a body of generalisations whose substantial accuracy and importance are open to question only by the ignorant or the perverse", that belief reflects their own ignorance, rather than that of the critics. Whenever economic theory is examined minutely, or measured by the intellectual standards of true sciences, it fails the test.
The ultimate root of these failures is the desire that economists have to make understanding and managing the economy appear no more complex than understanding the behaviour of an isolated individual on a desert isle. If coconuts take more effort to find, Robinson Crusoe switches to fishing; if there is an abundance of coconuts, Crusoe values them little. All the economic homilies about utility and value, effort and price, ring true.
The key to life’s simplicity for the shipwrecked is that there are no feedback effects: all that has to be considered are the direct consequences of any action. But those of us who live in a complex market economy with its millions of firms and billions of consumers are surrounded by feedback effects all the time. Thus if an individual employer cuts her wages bill, she will definitely be better off; but what are the consequences going to be for the demand for her products if all other employers also cut wages?
The answer to such questions should be what economics is about. But when these questions are posed and confronted honestly, the simple homilies which economists believe become problematic. The feedback effects in this instance, the negative impact of reduced demand counteracting the positive impact of reduced costs can outweigh the direct effects.
Economists have coped with this dilemma by constructing economic theory so that feedback effects can be ignored. The most famous such construct is, of course, the ceteris paribus assumption: the "other things being equal" clause which is used to justify studying a single market in isolation from all others in supply and demand theory. But whereas economists can rightly claim that this assumption is dropped in high theory, it is also true that even more extreme assumptions are made as the economic model is extended. For example, the economic theory of consumer demand easily shows that any choice a single consumer makes maximises his utility, that he will buy more of a good as its price falls, and his welfare will rise because of the price fall. But the same is not true of market demand: if the price of a good falls, market demand for it could go up or down, welfare could fall rather than rise, and consequently the choices made by the market don’t necessarily maximise social utility.
The logical response to this result is to acknowledge that perhaps the M1 protesters and the Pope are on the right track: the market doesn’t produce the best outcome for society, and social welfare could benefit if "control mechanisms" were imposed on the market economy.
But how have economists responded to this? By dreaming up two assumptions that eliminate the issue. The first assumption is that all individuals have the same tastes. The second is that the distribution of income doesn’t matter. As the profession’s signature textbook, Hal Varian’s Microeconomic Analysis, puts it, the dilemma that the market doesn’t maximise social welfare can be avoided by supposing "that all individual consumers’ indirect utility functions take the Gorman form ... [where] ... the marginal propensity to consume good `j’ is independent of the level of income of any consumer and also constant across consumers ... This demand function can in fact be rationalised by a representative consumer ..."
This ruse eliminates the issue of the interaction between people. If you assume that all people have the same tastes, and that spending patterns remain the same as income rises, then you assume that the distribution of income is irrelevant. But the point of many of the moral objectors to the market economy is that, in their opinion, the distribution of income is unfair. Economists dismiss their concerns, not because they have proved them wrong, but because they have assumed the problem away.
Such behaviour is a mark of irrationality, not of science. And it is far from an isolated instance. A similar pair of assumptions are made in the economic theory of the stock market, and for the same reason. Economists can explain the behaviour of any one investor, but can’t aggregate from that to a coherent model of the whole market without imposing patently absurd conditions. In this case, the assumptions are that we can all borrow as much money as we want on equal terms, that we all agree on the future prospects of all companies and (implicitly) that our expectations of the future are accurate. Once again, the effect of the assumptions is to eliminate the impact of feedback from one investor to another: why bother asking what your neighbour thinks of the prospects of a given company, when you know that he has exactly the same opinion that you do, and you know that your shared opinion is correct?
(A dinner party in Econoland would be a very boring affair indeed, wouldn’t it? With everyone having the same tastes and the same opinion about all assets, what on earth would you talk about?)
Here at least, the theory’s developer recognised that his assumptions were extreme. William Sharpe commented: "Needless to say, these are highly restrictive and undoubtedly unrealistic assumptions." But he defended them on the grounds that "the proper test of a theory is not the realism of its assumptions but the acceptability of its implications".
This methodological proposition is superficially reasonable, but on close examination, it is a furphy used to justify all manner of ills in economic theory. As first put by Milton Friedman, the argument was that "truly important and significant hypotheses will be found to have `assumptions’ that are wildly inaccurate descriptive representations of reality, and, in general, the more significant the theory, the more unrealistic the assumptions (in this sense). The reason is simple. A hypothesis is important if it "explains" much by little, that is, if it abstracts the common and crucial elements from the mass of complex and detailed circumstances surrounding the phenomena to be explained and permits valid predictions on the basis of them alone."
This proposition is valid when the assumption in effect says that the issue being assumed away is of negligible significance. Friedman gave the example of Galileo ignoring the effect of air resistance. This, said Friedman, was an unrealistic assumption air resistance exists, and it did make a slight difference as to which ball hit the ground first (apparently the lighter ball beat the heavier one by about a foot).
However, while this argument has some merit when used to dismiss issues that are of minor significance, it is invalid when used to dismiss issues that are clearly not minor. Sharpe admitted as much about his theory of finance, acknowledging that "the consequence of accommodating such aspects of reality are likely to be disastrous in terms of the usefulness of the resulting theory ..." If we introduce the reality that different people have different credit limits and pay different rates of interest for loans, and that different people have vastly different opinions of how different investments will fare over time, then "the theory is in a shambles".
Equally, it is not valid simply to ignore differences in tastes, the distribution of income and changing spending patterns as incomes change when attempting to explain how the market works.
But economic assumptions go beyond assuming away the problems. In many pivotal parts of economic theory, the assumptions are not merely unreal, but mutually inconsistent.
One such example is the economic theory of perfect competition. The theory simultaneously assumes that the market price falls as output rises, while demand for each firm is constant regardless of its output. A bit of careful mathematics shows that these two assumptions are mutually inconsistent. If market demand falls as output rises, then each firm must also face a "downward sloping" demand curve; if every firm faces a horizontal demand curve, then the market demand curve must also be horizontal. Yet much of economic theory depends on the peaceful coexistence of these two mutually incompatible assumptions. And there are many other such logical conundrums.
The key reason why economics can practise its "science" so badly is that economics cannot conduct experiments to decide between competing theories: there is no equivalent for economics of dropping two iron balls off the Leaning Tower of Pisa. As a result, economics behaves like a pre-Galilean science. Before Galileo, scientists decided such issues by appealing to a priori logic, rather than by an interplay between experiment and reasoning. A priori reasoning made it obvious that a heavy object would fall faster than a light one and besides, Aristotle said so.
A priori reasoning in the physical sciences began its death in Pisa, but lives on in economics because, in effect, economics has no Leaning Tower. There is no economic system on which we can test competing theories without damaging the experimental apparatus, or without being overwhelmed by extraneous influences which cloud the issue of whether a particular theory was verified or falsified.
For example, critics of Friedman’s monetarism often cite the failure of the monetarist policies of Margaret Thatcher. But monetarism lives on albeit no longer fashionably because monetarists contend that Thatcher’s policies weren’t implemented credibly enough, or that international forces conspired against her, and so on.
There is a fledgling movement for experimental economics, but even that tends to be infected by economics’ predilection for a priori logic. Most of the experiments are attempts to verify predictions of economic theory, and the researchers are normally bemused and befuddled when the experiment doesn’t confirm the theory.
For example, one group of researchers tried to verify the theory of consumer behaviour by conducting an experiment with the price of a limited range of commodities at a shop in a psychiatric institution. They were surprised to find that the inmates’ purchases didn’t conform to the economic definition of rational.
A similar result befell an experiment with university students the students weren’t behaving "rationally", according to the economic a priori definition of rational.
A scientific response would be to contemplate that perhaps the a priori definition of rational behaviour is flawed. But instead, the researchers mused as to what could possibly have disturbed the results. In their minds, the a priori definition of rationality remained sacrosanct.
Modern economic theory thus explains what life would be like if there were no feedback effects, when critics from the Pope down are complaining about the effect of applying economic theory to a world in which feedback effects abound.
The criticisms of the market, and globalisation, and the economic arguments in favour of them, are therefore as much logical criticisms as they are moral ones. As Keynes observed in the 1930s, when criticism of conventional economics was equally widespread, the public is objecting because while professional economists may not be disturbed "by the lack of correspondence between the results of their theory and the facts of observation", the public is. As a result, the "man in the street", from the M1 protester to the Pontiff, has a "growing unwillingness to accord to economists that measure of respect which he gives to other groups of scientists whose theoretical results are confirmed by observation when they are applied to the facts".
All this paints a bleak picture of economics, but there are some practitioners of economics who are as disturbed by the state of economic theory today as Keynes was in the 1930s and are trying to do something about it.
At a technical level, that means designing an economics which explicitly confronts the reality that a complex market economy will be dominated by complex feedback effects: feedbacks between people, since humans are more than simple selfish utility maximisers; between industries, so that the many complex dynamic linkages between industries take the place of ceteris paribus; and between economies, so that the distributional impacts of globalisation and free trade can be analysed rather than simply being assumed away.
An economics that confronts those feedbacks head on will be a very different beast to the current orthodoxy, and building it won’t be easy. Fortunately, a small but not insignificant minority are quietly attempting that task today. And a fair number of them are also barracking for the protester, and the Pope.