Eight Elementary Errors of Economics

[This is my most recent attempt to encapsulate the deep flaws in mainstream economics, and the sensible alternative struggling for recognition.  Posted 7 June at Real World Economics Review blog, with a lively discussion following.]

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 the errors are, nor 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, when governments involved themselves substantially in the economy.  From 1953 to 1974 unemployment averaged 1.3% and inflation averaged 3.3%, and from 1960 to 1974 growth averaged 5.2%.  If free-market fundamentalists were right then government intervention would have kept the economy well below this performance.  In fact such figures are now treated as impossible even with free markets.

• Money and debt are excluded from economic models.  I’m not making this up.  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 spending 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 aeroplanes, two world wars, nuclear weapons, computers and digital communication would radically transform the world.

• 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.

• It is assumed that people are innately individualistic and competitive, but 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.  Economists treat us like reptiles.

• It is assumed we are coldly “rational” calculators, yet 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 being risk averse.  Neither the fashion industry nor the marketing industry would exist if economists were right.

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 erratic 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 more like living systems in being unpredictable in detail yet having fairly clear general character.  Economic management needs to recognise quite different points for effective intervention.  Markets are indeed powerful, but they need to be carefully nudged and guided into behaviour that is beneficial.

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 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.  Economies can be subordinate to societies, and treat people humanely.  Economies could even be brought into compatibility with the living world, on whose health our survival totally depends.  The larger implications are developed in my eBook The Nature of the Beast.

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18 thoughts on “Eight Elementary Errors of Economics

  1. Stuart Davies

    Fantastic article, Mr. Davies. This is probably the best explication of why economics is, indeed, the dismal “science”. I think your point that Money and debt are excluded from economic models needs to be expanded upon significantly, however, since this touches upon not only what is arguably the greatest flaw in conventional economic theory, but is also the root cause of everything that is dysfunctional about our society, our political systems, and the way we live on this planet.
    What I am referring to is the fact that our monetary system is debt based, and privately owned. Most people are still unaware of where money comes from, or how it is created. The fact that money is created AS debt by privately owned banks is lost on the large majority of people… so of course the root cause of the rich getting richer and the rest of us getting poorer remains a mystery. The fact that banks create only the principle, but NOT the interest required to pay back loans when they issue credit (create money) means that cyclical, widespread bankruptcy for many borrowers is inevitable.

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    1. Geoff Davies Post author

      Thanks Stuart. I agree about money. I wrote much the same thing in Economia (see tabs at top). I’ve downplayed it a bit lately because Steve Keen persuaded me the growth mechanism is not so simple. It’s not the quantity of money that counts, it’s the rate of circulation, which might increase. I think the tendency is the same as you say nevertheless, but I want to think about it more rigorously. In any case I agree we should have interest-free money. See Nature and Roles of Money and Banks, 25 May, and some earlier posts.

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    2. Derek R

      The fact that banks create only the principal, but NOT the interest required to pay back loans when they issue credit (create money) means that cyclical, widespread bankruptcy for many borrowers is inevitable

      That’s only true if the banks don’t have any costs. However real banks need to pay wages to employees and to pay dividends to shareholders. Those wages and dividends are then spent with the firms who took out the loans, allowing them to pay back not just the principal but also some or all of the interest.

      The interesting point here is that when interest rates are too low the amount of money spent by the banks will be higher than the amount of interest to be repaid by the firms. Hence in this situation the firms will make a profit and the banks will make a loss. On the other hand when interest rates are too high the amount of money spent by the banks will be lower than the amount of interest to be repaid by the firms. So in that situation the firms will make a loss and the banks will make a profit.

      Only when the banks spend all the interest and no more back into the economy will both banks and firms break even on average. Luckily they do because they redistribute their profits (the interest) as wages and dividends when they are in surplus and they sack staff and cancel dividends to cut spending when they are in deficit.

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  2. scottonthespot

    Another absurdity of neo-classical economics is how it leaves out the most important factor of production: Land (Land, in classical economics, means ALL of nature’s resources, non-manmade). Without Land, humans cannot survive. Land, unlike capital, which it is now falsely conflated with, cannot be produced by Man, is finite, is unmovable by location (which is why urban land is always more valuable than rural land), generally appreciates over time with population growth (while true capital depreciates as it wears out, becomes obsolete etc.). Mason Gaffney talks about the deliberate removal of Land as a factor of economics, often by land-grant universities, in his book, “The Corruption of Economics.” The last great economist to put Land in its proper place was Henry George. It’s no coincidence that he, along with all classical economics, was deliberately expunged for decades after his death. It’s also no coincidence that Rent on Land – in various forms – now accounts for over 1/3 of GDP, and goes mainly into private hands, vastly inflating the wealth of the 1%, while the bottom half of the country has less wealth than the top 450 individuals.

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    1. Geoff Davies Post author

      Hi Scott. I’ve been looking for a good account of Henry George’s thinking, but I find they’re either not very clear or seem to take everything he said as gospel (such as that you wouldn’t need any other tax – well things have changed in the past century, so that needs to be debated). But I’m persuaded it is a fundamental point. I just want to get the implications clearer.

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      1. Derek R

        Best to read the man himself, Geoff. His prose may be a bit wordy by modern standards but it’s positively concise for a 19th century author. Overall he writes clearly and quite engagingly on his topic. Try the first couple of chapters of “Progress and Poverty” online and if you can see any value in it you can move onto some of his other books and essays.

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      2. Geoff Davies Post author

        Thanks Derek, I’ll track him down. A skim of Charles Eisenstein’s Sacred Economics suggests he has the ideas pretty clear. I’ve ordered it.

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  3. Alan Page

    While I see no basic disagreement with the dysfunctions mentioned in the piece above and comments, correcting these deficiencies without addressing the appropriate method of assessing “growth” would leave the whole system still based on fraud. We use the unencumbered function: fv=pv x (1+p)n , as the basis for IRR, NPV, PNW etc. The short run use of this formula and the costs of a transaction may not diverge very far from one another, but let the interest rate (p) or the time (n) become significant and the result (fv or future value) approaches infinity. This is an impossibility on a finite world.
    Any situation that is based on this model will be treated as a mine when the limits are pushed (n or p) and the lender will receive many times more than was contributed initially yet this is the basis for all wealth management.
    The fact that the whole notion of debt is not considered important by an economist is cause enough to relegate their contribution to the rubbish heap. No natural system in a finite environment can be described by the above formula for very long.

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  4. Geoff Davies Post author

    To be clear to everyone, we’ll all agree there are more than 8 errors. I stopped at 8 to keep the piece short and because it alliterates. 🙂
    It seems to be working so far.

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  5. takenomics

    An equally fundamental error is the neoclassical redefinition of “rent.” Classical economics divided the returns to production factors between wages for labor, interest for capital, and rent for land. Neoclassical economics redefined “rent” as a return in excess of opportunity cost, with the result that workers with special skills are claimed to be pocketing “rents”, while landowners don’t: the share of wealth they take from production in return for nothing (the land was already there, ready to use, with no help from them or anyone else) is ignored because it is assumed (efficient market hypothesis) to be no more than they could get via other “investments” (i.e., they get no “excess” return). This is literally like trying to build a science of mechanics around a definition of “force” that includes temperature but excludes friction. By comparison, rationality assumptions and use of GDP as the measure of economic progress are trivial and easily corrected errors.

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  6. Stuart Davies

    Geoff- When you respond “I’ve downplayed it a bit lately because Steve Keen persuaded me the growth mechanism is not so simple. It’s not the quantity of money that counts, it’s the rate of circulation”, I assume you are alluding to my point about cyclical bankruptcies (or widespread defaulting on loans) being caused by insufficient volume of money in circulation to cover both principal and interest…because banks only create the principal.

    While it its certainly true that there are many inputs which can influence the volume or speed of money circulation, and that a higher velocity of circulation can alleviate this problem to some degree, there really is no way to get around this essential flaw in a debt based monetary system, particularly when you consider that the primary influence on the velocity of money is itself intrinsically tied to the boom and bust cycle. When the credit cycle is in the boom phase you inevitably have higher velocity because new money is being constantly injected into the economy from new credit/debt, and when there is plenty of money in circulation everyone spends more because money is relatively easy to come by. A larger supply of money tends to spur higher velocity, and on the flip side, when banks cut back on lending and shrink the monetary supply, the natural reaction is for people to become much more conservative and start spending less and saving what they can, so velocity slows. You have a positive feedback loop increasing velocity on one hand, and a negative feedback loop slowing it on the other.

    All of this speaks to the central flaw in a debt based monetary system. However, there is another crucial flaw in the particular debt based monetary system we are using… and that is simply that it is privately owned. This means that a very few people have been granted the exclusive franchise on creating money from nothing, and lending it out at interest. You can add a large book’s worth of expansive detail to expound further upon something that we can all see as plain as day – the fact that the rich are getting ever richer while most of the rest of us get poorer – but you need not look any further than this for the root cause of this phenomenon.

    The fact that ownership of the mechanism of money creation has been ceded a tiny minority of the world’s citizens,,, has had dire consequences for the rest of us. Though they have very effectively managed to obscure this fact, the world’s central banks are indirectly owned and controlled by large commercial banks. Contrary to common perception, the Fed is not part of the federal government, it is a trust owned by the regional reserve banks (53 percent owned by the NY Fed) which in turn are owned by large commercial banks. There is an extremely complex web of interlocking multinational ownership among the world’s commercial banks, and this same complex web of interlocking ownership extends between this international banking cartel and most of the world’s corporations.

    These are the people that own the media. Increasingly, they own our educational systems, especially higher education. They have thoroughly corrupted our political systems and effectively infiltrated and taken over
    governments at all levels in most parts of the world. As long as we allow them to own the goose that lays the golden eggs, they will own US.

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    1. Derek R

      I assume you are alluding to my point about cyclical bankruptcies (or widespread defaulting on loans) being caused by insufficient volume of money in circulation to cover both principal and interest…because banks only create the principal.

      Honestly, this is not a problem. Take a look at these toy economies, which show step by step how all the borrowers can repay principal plus interest to a banker even when the total amount is more than the total money stock. The first tab (BFC) and the second (BFCS) demonstrates with one borrower, the third tab (KBFCS) demonstrates with two borrowers. The secret lies in the recirculation of money round the monetary circuit.

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    2. Geoff Davies Post author

      Thanks Derek. I should remember my own lessons!

      I did the equivalent of your toy economies in my simple models
      https://betternature.wordpress.com/2011/03/11/value-of-simple-models/

      The bank charges interest but businesses and employees are still able to pay their way with the money available, which has to circulate a bit faster than it would otherwise. That doesn’t mean the bank’s charge is justified, beyond a modest fee for service.

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  7. Geoff Davies Post author

    Stuart –
    I agree that what you say about rate of circulation and quantity of money may well be true. My problem is only that I would like a more rigorous accounting of rate of circulation, which doesn’t seem to be something commonly quantified.
    To be clear about my terminology, there are two independent factors. One is the quantity of money in circulation. The other is the rate of circulation, by which I mean the average frequency with which a given dollar is spent. (Being a physical scientist, I don’t like the term “velocity” used in this context.) Combined, these give the volume of circulation.
    Given that measures of quantity of money seem to be so sloppy, I’m not optimistic that reliable data could be obtained.
    I take your suggestion that during a recession, because people tend to save, the rate of circulation may decrease, but it may still be hard to separate falls in quantity from falls in rate.
    Another possibility is that, in order to pay interest, the rate needs to increase without limit, which would be absurd. I did a bit of modelling of that a while back but haven’t finalised any conclusions.

    Regarding the right to issue money, I totally agree that it’s folly to cede the right to a few private people. Ditto media.

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  8. garrettconnelly

    Hello Geoff,

    I read your article and the responses here and Real World Economics Review. Your books sound interesting but I don’t have an eBook reader.

    Your point about economies of scale leaves me a little unsatisfied in that many theoretical economies of scale are in fact subsidies granted by corporatist governments via tax structure, direct subsidy, military support or systemic inclusion of negative externalities. Many of today’s ills can be correct by accountants, from this perspective.

    China Mielville has an interesting point in Un Lun Dun when the corpoatists seeking an alliance with the evil character, Smog, hire people to write E = A on city walls, Effluence = Affluence. I gave quite a bit of thought to E = A and eventually concluded that dA + dE and the tautology completes itself in modern financial bubbles with equality for the second derivatives as well.

    On that all encompassing intellectual note I close recommending “Wealth, Virtual Wealth and Debt” by Frederick Soddy.He is an interesting writer who won a Prize for describing the transmutation of elements during nuclear reactions. I bring this up because he was a scientist who approached economics and finance from a thermodynamic perspective which is quite interesting.

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  9. Geoff Davies Post author

    Garrett, thanks for your comments.

    I agree some economies of scale are not legitimate (manipulation of markets and governments for example). However my point comes mainly from M. Rothschild, Bionomics (Henry Holt, 1990), a business consultant who records that the learning curve effect occurs pervasively through the economy. A consequence is that the quicker a firm produces the quicker it learns, giving an advantage to the biggest firm.

    I learnt about Frederick Soddy from Daly and Cobb’s For the Common Good. I prefer to describe debt (and money) as potential wealth rather than virtual wealth, but it’s a minor quibble.

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  10. Pingback: Eight elementary errors – discussion from Real World Economics | Better Nature: commentary by Geoff Davies

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