The Underlying Crisis in Economics – Mistaking the Beast

Extracts from Economia.

The writing ofEconomia was essentially completed in 2003. It was obvious then that the global financial system must come to crisis within a few years.

The Global Financial Crisis, seriousas it is, is only part of a deeper crisis reaching to the core of how modern economies are conceived and managed. The problem is not just that financial markets have acquired excessive power and are greedy, corrupt, unstable and destructive. It is not even that the GFC has not yet shown us its worst, as Steven Keen argues (Declaring victory at half time). It is that mainstream economists have fundamentally mis-identified the nature of the beast they are dealing with.

Mainstream economics hews to the neoclassical theory. The central prediction of this theory is that economies tend to an equilibrium in which all supplies and demands are in balance. This equilibrium is supposed to be the optimum state that maximises outputs for given inputs. It is the theoretical basis of the modern infatuation with free markets and free trade.

Following are two extracts from Economia that summarise conclusions concerning the neoclassical theory. The early neoclassical theory was inspired by, and adapted from, a branch of nineteenth-century physics – the kinetic theory of gases. It depends on a series of assumptions, one of which is that, beyond a “point of diminishing returns”, there are no economies of scale (or strictly, no increasing returns to scale).

Collapse of the General Equilibrium (from Chapter 4)

The evidence for economies of scale and increasing returns to scale is all around us. Economies of scale are well-known throughout the manufacturing and mining sectors. The learning curve effect has been found in virtually all market sectors. Other sources of increasing returns to scale are readily identifiable. Increasing returns to scale are pervasive in modern economies.

The predicted consequence of increasing returns to scale is the dominance of a market by one or a few firms. Such market dominance is indeed the norm in most sectors of the economy. Nor is the growth of dominant firms complete. It continues apace, and news of another giant merger is almost a weekly occurrence.

An immediate implication of dominance and monopoly is that markets can be manipulated. In fact fierce competition between near-dominant firms virtually guarantees that every possible manipulation will be exploited. Thus the first and obvious consequence is that there is no assurance that competition will yield fair prices, wages and supply contracts.

However the implications run deeper. The neoclassical claim of optimality rests on its prediction of a general equilibrium. Monopoly, like any other interference in the idealised neoclassical market, distorts the market away from equilibrium and optimality. Thus there can be no assurance of optimally efficient operation of an economic system. The central claim of the neoclassical theory is lost.

This statement still does not capture the full force of the implications of increasing returns to scale. Dominant firms in new market segments grow exponentially, by progressive doubling. Exponential growth is a form of runaway instability, driven by positive feedback. The pervasiveness of increasing returns to scale and of their symptoms, giantism and market dominance, means that runaway instabilities are bubbling up all the time, one replacing another, tumbling over each other in turmoil. There is no semblance of balance and equilibrium. Instability is pervasive in modern economies. Such internal instabilities are a diagnostic feature of self-organising systems.

The implications of this are fundamental. Modern economies are not tidy, gentle, predictable systems orbiting sedately around an optimal general equilibrium. Large, modern free-market economies are characterised not by equilibrium but by exponential growth and instability. The behaviour of real economic systems is radically different from that predicted by neoclassical theory. Modern economies are untidy, unpredictable systems full of raging instabilities and immense forces of change. It is not remotely possible to identify an optimal state in such a changeable system, and optimality is not a useful concept.

There is no way to soften the conclusion. As Sir John Hicks feared, the wreckage strewn by pervasive economies of scale is “that of the greater part of general equilibrium theory.” On this ground alone, the neoclassical theory fails, and fails comprehensively, as a useful description of a modern economy.

Comparison with physics (from Chapter 6)

It is instructive to compare the subsequent fates of the theories of statistical mechanics and neoclassical economics with which we opened Chapter 3. Physicists have long-since recognised that the simplest, hard-sphere model of atoms is useful only for gases, and even there it yields measurable discrepancies from the behaviour of real gases. It fails totally for liquids and solids, for which the complex interactions of quantum mechanics have to be included.

Physicists have also recognised that equilibrium theories are only useful for nearly isolated systems that are close to a state of equilibrium, or in other words for systems that are changing only slowly and with very little energy exchange with surroundings. By the time neoclassical economics was being formulated, physicists had moved on to formulating the second law of thermodynamics, which has important implications for systems that are not close to an equilibrium. The second law states a limit on how much energy can be extracted from a non-equilibrium system (although it doesn’t allow us to calculate just how much energy will be extracted in a particular situation). The second law prohibits perpetual motion machines.

Within the past few decades, physicists have made major advances in understanding systems that have large energy fluxes through them and are therefore far from equilibrium. The much greater capabilities provided by computers have been central to exploring the behaviours of such systems. Such explorations have revealed the surprising and exciting phenomena of self-organising systems, complexity and chaos.

To summarise, physicists have recognised the limitations of the early theories of gases by comparing their predictions with the real world. The early versions are still useful, but only for particular situations and with limited accuracy. Where they have been able, physicists have developed more elaborate theories that apply in other important situations (such as to solids and liquids). A new realm of non-equilibrium theories, with potentially much broader application, has been opened up more recently with the aid of powerful computers.

In contrast, mainstream economic theories have remained at the equivalent of minor variations of the hard-sphere model of a gas. They remain firmly in the realm of equilibrium theories. They take no account of the second law of thermodynamics, and have a corresponding disregard for inputs of energy and materials and outputs of waste. Many neoclassical theorists are still in the mode of demonstrating mathematical theorems rather using the power of computers to explore beyond the small realm of their restrictive assumptions. Still less do they seriously compare their theories with reality. The mainstream economics of public policy is oblivious to the radically different possibilities of non-equilibrium theories. In spite of such deficiencies, neoclassical theory has been dominant in Western nations throughout the twentieth century. Even at times when government policies did not directly reflect its prescriptions, it has usually been the implicit yardstick of virtue against which other policy programs have been measured.

Blatant discrepancies between predictions and observations have gone unaddressed. Challenges to the fundamentals of the theory, showing how assumptions that are clearly more realistic will change central predictions of the theory, have been brushed off and their proponents marginalised or ignored. The clear impression is that practitioners have become far too enamoured with mathematical sophistication (of a certain restricted kind), and far too attached to the putative general equilibrium. The term pseudo-science is not used here as a mere epithet. It is the most accurate term I can think of to describe the status of the neoclassical theory.

In 1987 a conference at the Santa Fe Institute brought together a select group of prominent physicists and economists to discuss the implications of new theories of complexity and to cross-fertilise their disciplines. The physicists were awe-struck by the economists’ mathematical prowess but startled by their lack of reference to the real world.

They were almost too good,” says one young physicist, who remembers shaking his head in disbelief. “It seemed as though they were dazzling themselves with fancy mathematics, until they really couldn’t see the forest for the trees. So much time was being spent on trying to absorb the mathematics that I thought they often weren’t looking at what the models were for, and what they did, and whether the underlying assumptions were any good. In a lot of cases, what was required was just some common sense. Maybe if they all had lower IQs, they’d have been making some better models.

The economists were startled in turn by the physicists’ casual attitude towards mathematics. If a rough back-of-the-envelope calculation would enable the physicists to compare their theory with observations, they might not worry about doing a fancier calculation. The goal in physics is not a theoretical structure that is as elaborate as possible, the goal is a theory that represents how the real world works to a useful level of approximation. Waldrop quotes the unconventional economist Brian Arthur

They kept pushing us and pushing us,” says Arthur. “The physicists were shocked at the assumptions the economists were making – that the test was not a match against reality, but whether the assumptions were the common currency of the field. I can just see [Nobel physicist] Phil Anderson, laid back with a smile on his face, saying, ‘You guys really believe that?’

Survey of the wreckage (from Chapter 6)

As Sir John Hicks feared, the wreckage wrought by increasing returns, volatile preferences, social interactions, delayed and incomplete information, the unpredictable future, and so on, includes the greater part of the general equilibrium theory. Among the strewn pieces we can discern the claim that free markets promote efficiency, and with that claim goes the conventional argument for free trade. Lying over there is the quaint claim that the financial markets are rational and efficient. In places we have not explored you will find the basis for managing the labour market, the equivalence of capital (meaning money) and capital (meaning factories, the means of production), and the claim that returns on invested money are determined by a notional decreasing marginal revenue product of capital.

You will even find, lying in pieces on the ground, what Steve Keen calls the sacred totem of neoclassical economics: the law of supply and demand (Figure 1.4a). Floating above the wreckage you might notice a fuzzy, pulsating cloud of preference, while a shifting, undulating supply line snakes towards the ground, instead of rising steadfastly and majestically up into the sky (Figure 1.4b).



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