The Real Analysis Starts

One of the great victims of our current economic malaise is the economics profession itself. The infighting and bickering between our foremost economists over what to do about the crisis is a shameful reminder to all of us that economic theory is a fledgling not a fully grown phenomenon. For those of you who want to taste this bunfight go to Paul Krugman’s Blog at the New York Times. Here is his attack: Dark Ages of Economics

He is never one to mince words and has now managed to stir up a storm by calling some of his erstwhile colleagues ‘barbarians’ who are stuck in the ‘Dark Ages’. Such language would be fun to follow were not one or two of his targets Nobel Prize winners. Such is the mess that economics is in that there seems to be an economist to defend any and all political position from far right free market ideologues to far left socialists. So much for scientific theory. So much for what they call ‘positive economics’.

We arrived at this parlous state of affairs because economics was hijacked in the mid twentieth century by a group of intensely pro-market, anti-government, mathematicians who threw their technical virtuosity into ‘proving’ that markets are more efficient at allocating wealth and resources than a central planner would be. The debate became one of decentralization versus centralization.

There was great urgency and need for a scientific economic theory to emerge on the side of capitalism back then because memories of Fascism and the threat from Communism were still real. Minds were focused on ‘proving’ the virtues of the ‘free market’ system. Indeed during the great debates that took place in the 1930’s it was not at all obvious that capitalism as we now know it would survive the contest from those other forms of government and economic allocation.

The ‘proof’ when it emerged was a cobbled together set of ideas that formed an overall theory. It included much of the older ‘Classical’ economics developed during the mid and late 1800’s; it added mathematical technique; it solved various problems such as the problem of identifying consumer preferences; and it adopted some assumptions necessary to allow the whole structure to be made ‘formal’ [i.e. mathematical].

Unfortunately the cost of this effort was any pretense to reality. The theory, which now goes under the general name of the New Classical or NeoClassical economics, is deeply flawed as a representation of real world economies. Many of these flaws extend directly from the assumptions that were necessary to bang the structure into shape. For instance it has at its root the notion that all consumers know everything about all products and prices everywhere at all times. They are omniscient. This may seem a little odd to you but to economists it is a necessary generalization. Their models would not work well without it. Similarly it is assumed that consumers will always behave ‘rationally’: they have ‘rational expectations’. This is despite decades of solid research in the cognitive sciences that humans are quirky in their decision making to say the least. Even more odd is that economists are completely comfortable with the idea that their models don’t model actual people, but rather model ‘agents’ who are totally predictable. Both Walras and Pareto, two of the founding fathers of NeoClassicism, made disparaging comments about real people, with Pareto going so far as to say that his ideas assumed people out of the equation. Little wonder that economists are so defensive about the foundations underlying what they do.

To an outsider economic theory looks like an exercise in navel gazing. It purports to make statements about the real world based upon the intense study of models all of which have no empirical footing. The assumptions appear absurd. Yet one of our most famous economists, Milton Friedman, defended that absurdity as something to be overlooked because the theory produced the ‘right results’.

And therein lies the rub.

What did Friedman mean?

I think the only conclusion one can come to is that the ridiculous and other worldly nature of the assumptions underlying NeoClassical theory are tolerated amongst economists precisely because they produce the answer that free markets are to be preferred to central planning. That’s the answer the theory was designed to produce. So much for science. No wonder that so many economists sound as if they are merely Republican shills. Reaganism was built on the Friedman foundation. NeoClassicism was not ‘positive’, in the sense that it followed a scientific method to whatever conclusion best explained the real world. Instead it was ‘normative’, in that it set out to prescribe a course of action: set markets free. There was no attempt to allow the messy facts get in the way of being able to make the claim that free, unencumbered, deregulated, markets are more efficient as allocation devices than any alternative. Economic theory adopted Winston Churchill’s famous maxim about democracy: he said that democracy is the worst form of government except all the rest; but economists forgot his humor and went one further. They claimed to have proved the superiority of markets. Markets like that for Mortgage Backed Securities, for example. No need for regulation there!

We were duped. All along we thought that there was some theoretical and scientific underpinning for the market system. Economic theory as told in textbooks was the story of the superiority of markets with aberrations being described as ‘market failures’. This fed the American public’s pre-existing inherent distrust of big government and created a symbiotic, almost magical, coming together of ideology and science. The American Way was scientifically proven to be better than the opposition [i.e. the Soviet Way]. The collapse of the Soviet Union merely reinforced this miraculous result and the past three decades have been one long homage to the greatness of NeoClassical theory, especially the ‘pure’ form taught at the University of Chicago.

The deregulation and bias against government that brought us the current debacle were formed as much in the minds at Chicago as they were in those of the Republican think tanks like the Cato Institute.

This extended comment is by way of letting you all know that the economics profession has a lot to answer for. And the infighting is underway.

Meanwhile it falls to journalist/economists to make the early going. Here are two long articles [I apologize for the length, but this is a big crisis so please take the time to educate yourselves]. First the New York Times Magazine:
Magazine Preview – The Big Fix – Can Barack Obama Really Transform the U.S. Economy?

And, second, from a left wing political blog: Two Santa Clauses

I will continue this discussion in the future. You have been warned!

Note:

Thanks to Krishin and Tom for the links.