[Published at Pearls & Irritations, 22 Sept.]
Most scholarly disciplines, be they history, physics or ecology, have a conception of appropriate standards by which the evidential basis of an argument is presented and the reasoning leading to conclusions is explained. The goal is to shed light on the workings of the world, and a criterion for a successful study is that observations or records are consistent with the study’s conclusions.
Neoclassical economics, the strand of economics that has dominated world policies for several decades, fails these criteria. Its conclusions are regularly contradicted by developments in the real world. A dominant criterion for a successful study is that its logic is internally consistent; it thus confuses mathematics with the science it claims to be. It is variously claimed that assumptions on which a theory is based don’t matter, or that the better the theory the more unrealistic the assumptions, or that all theories are wrong. It imagines its theories are useful approximations to reality, and fails to appreciate that more reasonable assumptions can lead to radically different conclusions, so its theories may be deeply misleading.
Neoclassical economics originated late in the nineteenth century and claimed to build on the ‘classical’ economics of Adam Smith, David Ricardo and others. Whereas Smith thought markets could in some circumstances result in satisfactory outcomes for all participants, he also required that markets are embedded in and restrained by society and morality. He was really railing against the corrupt alliance of merchants and the government in setting up colonial trading monopolies. He warned that wherever merchants might congregate one should suspect a conspiracy to defraud customers.
Neoclassical economists created a mathematical theory that purported to show that ‘free’ markets will always bring an economy to a general equilibrium in which all supplies balance all demands. Furthermore, this general equilibrium was shown to be an optimum, in the sense that outputs would be maximised for given inputs of land, labour and capital.
When rich people heard about this theory they started paying neoclassical economists lots of money to keep saying that free markets are best. It means rich people should keep making money as fast as they can. It means government is bad, because it gets in the way of rich people. Adam rolled over.
However certain assumptions were required to get the mathematics to yield this brave new world vision. There can be no economies of scale (beyond a point of diminishing returns), there should be no social interactions, and everyone should be rational calculators. People are reduced to transacting atoms, to rational economic man, to what I call calculating reptiles.
The flow of time has to be suspended. It was regarded as a triumph when it was shown that if we can all assign probabilities to all future contingencies then the general equilibrium is still possible. So it is assumed we each have this power, and a computer the size of the universe to implement it. Physicists and applied mathematicians might recognise that this amounts to telescoping the unknown future into the known present; it is analogous to transforming your system of equations from hyperbolic to elliptic. It gets rid of the path-dependence of solutions. History doesn’t matter and the future is assured.
If any of these stringent assumptions is changed to something more reasonable, equilibrium is no longer possible. Not just hard to find, impossible. For example, Henry Ford and Jeff Bezos have understood that economies of scale can allow you to undercut your rivals, gain more market share, increase your economies of scale and further undercut your rivals in a runaway, unstable process until you gain near-monopoly in your market segment. The technological homogeneity of the internet puts this tendency on steroids. If a potent new software or strategy comes along, you empire is at risk of being overthrown. There is no equilibrium.
If there is no general equilibrium, then nothing can be said about optimality, because optimality emerges from the general equilibrium. It means there is no basis for claiming free markets are efficient.
The accumulation of absurd assumptions in neoclassical economics can be recognised as a desperate attempt to exclude instability and thus to preserve the old conclusion. Neoclassical economists became infatuated with equilibrium, contorted their theories to maintain it, and lost all connection with reality.
A regular defence, offered for example by another faux-Nobelist, Paul Krugman, is that their theories are helpful to maintaining systematic thinking. That requires the theory to bear some useful approximation to reality. In a widely-cited paper, Milton Friedman in 1953 apparently tried to argue that no theory can fully represent reality (correct), so all theories are approximate (correct) and that the biggest pay-offs of insight come from rough, general approximations (sometimes correct). His statements are so garbled and contradictory, however, it is hard to tell if that is really what he was trying to say. So some people take him to have said assumptions don’t matter, etc. Unfortunately, as their own theories demonstrate, hopelessly unrealistic assumptions will get you a hopelessly unrealistic theory.
Why were neoclassical economists taken by surprise by the Global Financial Crisis of 2008? They said it was a black swan event, something no-one could have anticipated. Except that some well-known people did anticipate it, on the basis that there was far more debt than people were likely to be able to repay. People did fail to repay, there was a cascade of defaults and the global financial system seized up.
The problem, you see, is that neoclassical economists exclude money and debt from their theories. Why? Well, aside from the ill-informed excuses they advance, if you allow for debt then the present becomes linked to the future (when the debt is supposed to be repaid), and the future involves risk, such as the possibility of cascading defaults. Our modern token money is itself a form of debt. So arguably the most potent forces in a modern economy, money and debt, are left out of their theories. So they did not see the GFC coming, and their predictions of prosperity just around the corner regularly fail.
Another bit of inconvenient reality: cascading defaults can trigger a financial market crash, and a market crash is an obvious manifestation of instability. There was no equilibrium. There are many sources of instability in an economy when you look: technological innovation, economies of scale, money and debt, social interactions, ‘irrational’ herd behaviour among others. Economies are always far from equilibrium, which makes them complex self-organising systems, like organic systems, with radically different behaviours: as different as wild horses from a rocking horse.
As I noted in Part I, the illusion of an agile, self-correcting economy, and society, allows economists to expect, and then to conclude, that the gross global disruption of serious global warming will merely shave a few percent off the global GDP.
There is a fringe of dissenting economists, and the odd scientist like me, who have been pointing out for many years that neoclassical economics is misleading nonsense. The dissident economists are excluded from the best jobs, the best journals and positions of influence by what James Galbraith calls a ‘Politburo for correct economic thinking’.
Scholars in other disciplines need to be alerted to the presence of this imposter in their midst. Neoclassical economics is pseudo-science, assertions dressed up in mathematics to look like science. It fails basic scholarly criteria, like changing your theory when it completely fails to accord with reality. It is profoundly confused about what good scholarship and good science involve. Its professional criterion for a successful career is conformity to its groupthink.