Basic Economics: A Rant About Those Hard Core Free Market Types

There are quite a few people who object to my strongly Keynsian view of economics. They don’t like stimulus packages; they hate nationalization; they produce scads of analyses showing definitively that the government causes all sorts of problems; and they adore monetary policy. Plus, strangely, they all seem to be big Ayn Rand fans. In short they all hew closely to the Chicago school of economics with the necessary addenda added by the likes of Lucas, Barro, and Sargent.

Well, now that the warfare within economics is open to the public I have to say that I am surprised by the extent of the bitterness and name calling I come across.

Enough.

Here’s the thing: like it or not, Keynes demonstrated conclusively that markets do not always clear efficiently. There may be more than one equilibrium. And that labor, specifically unemployment, can be a source of instability because of wage rigidity. In these circumstances there can be a drop in demand that will not be filled by the market, and so the government should step in and fill the gap. It was with this analysis that Keynes invented, single handedly, macroeconomics. It is also why Keynes book “The General Theory of Employment, Interest, and Money” was the most important economics book of the twentieth century.

The subsequent efforts of the Chicago school [aka ‘neoclassical economics’] particularly Friedman and Lucas, to discredit Keynes was not purely based upon a search for economic ‘truths’, but was also ideological: they abhorred the notion that markets were not the be all and end all of economic activity. So they constructed an alternative system of Ptolemaic complexity based upon exotic assumptions to ‘prove’ that government interference in markets is futile and perhaps pernicious. They proved no such thing. Their system is a self referential mess: it starts by asserting that people [Friedman calls them ‘economic units’] are rational and all knowing, and then explains that because people are rational and all knowing, markets are too. In other words it is tautological. It proves its own assumptions and nothing more. A a claim about a real economy is is entirely empty. But the math sure looks pretty.

Further: an outgrowth of this neoclassicism was the development of financial economics based around the supposition of ‘rational expectations’ and ‘efficient markets’. To the ear of an outsider these two little concepts may sound innocent enough, but in the hands of sophisticated mathematicians they can be extraordinarily dangerous. From these two assumptions, both of which are at the core of neoclassicism, clever people derived models of behavior to describe the financial markets. But the truth is that they actually created the markets they claimed to have studied. Sociologists call that being ‘performative’. Burton Malkiel’s book “A Random Walk Down Wall Street” is still a hot seller. Models like the Black-Scholes-Merton model for option pricing; the Modigliani-Miller capital model; and the Capital Asset Pricing Model are all logical extensions of neoclassical economics. They described economic objects and situations that then came into being: the Chicago Options Market is an example. Prior to Blach-Scholes options trading was banned in many places as being gambling. After Black-Scholes gave it intellectual validity [and after Friedman called the SEC in support!] the options market exploded. Many Nobel prizes were awarded for the development of these theories. Friedman, Lucas, Modigliani, and Scholes, from just that list are all Nobel winners.

And they are wrong.

Black-Scholes is the enabling intellectual theory that supports the derivatives market. It is flat out wrong. Its math is incorrect. Case in point: our current mess. Black-Scholes fails to embrace so-called ‘fat tailed’ probability distributions. It is based upon ‘Gaussian’ math which in context is fine. This is just the wrong context.

Lucas has a fatal blind spot also: his adherence to rational markets prevents him from modeling anything that exists away from an equilibrium. Indeed he treats as axiomatic that the economy will tend toward equilibrium. Hence the nonsense about markets ‘always correcting themselves’. Price perturbations are assumed to be random. There is no path dependency. History doesn’t matter. There is no memory so the market is assumed to adjust perfectly all the time: it cannot, by definition, wander off along an inefficient track. There can be no bubbles. It is one small step from that to the argument that anything that gets in the way of a market will stop market corrections and is thus wrong. This wrongheaded theory brought us deregulation and fed Alan Greenspan’s view that damping down the real estate bubble was unnecessary because market forces would be a more efficient way of getting the desired correction. Let me repeat that: in the eyes of these folks there can be no bubbles. Why? Because markets always price assets efficiently.

Whoops.

So, in order for free market advocates and opponents of government intervention to have credibility in their attacks on Keynsian solutions they first need to explain why it is that their theory, the basis for economic policy and the financial markets over the past two and a half decades, should not be consigned to the trash heap. It brought us to where we are.

Obviously I think neoclassical economics, famed for denying the need for empirical support, has just met its disproof. Big time. But I understand their difficulty: after being so rampant and intellectually imperial for so long it must feel strange to have to swallow failure on such a scale. That plus irrational behavior allows snake oil like neoclassicism to persist for ages. After all there are still flat earth apologists, astrologers, and alchemists out there. Why not neoclassical economists too?