economic theory

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Economics Should Fail Better

Let’s have fun. Let’s pitch Beckett against Nietzsche. First the philosopher:

“The mitigation of our customs is the consequence of our weakness”.

Now the playwright:

“Try again. Fail again. Fail better.”

Nietzsche seems to be arguing that it is a sign of weakness to modify, water down, or otherwise tamper with tradition. He makes no statement about how those traditions emerged, what their purpose is, or even whether they are useful. He is simply, apparently, urging their continuation. More: he is defending our rigid and total adherence to them. He sees such adherence as a virtue of strong willed character. Those customs must stand as infallible statements of our worth. To do without them, or even to modify them, is, somehow a revelation of our weakness.

Beckett is much less strident. He is advocating a fallible approach. He recognizes failure. Indeed he longs for it. He sees that strength can come from repeated failure as long as lessons are learned and that the next failure is more approximate to success. He accepts success as an illusion: he seems to argue that there is no success, just a series of ever more refined failures.

The two visions could not be more contradictory. Nietzsche exudes power and concreteness. Beckett lauds modesty and trial. Nietzsche is carved into rock. Beckett is lost in a cloud.

I see it thus: Nietzsche is profoundly pessimistic. He sees the past as containing all we need to know, and that our customs represent a bulwark against something not worth knowing. In contrast, Beckett is profoundly optimistic. He sees the past a long trail of bold attempts that fell short, and as a ladder we are climbing towards something eminently worth knowing.

The one is expressing a commitment to the past, the other a commitment to the future.

I see this as a metaphor for the current state of economics. There are many who want to rely on the bulwark of orthodoxy. It stands a worthy edifice, testimony to decades of intellectual struggle, and contains some hard won truths. But it isn’t progressing. It has no commitment to the future. Its advocates regard it as settled doctrine and tinker with its details and avoid confronting its failures.

I include many so-called heterodox economists in this category as well. They seem committed to their own version of the past. They too want to avoid heroic failure in the manner Beckett urges.

This conjoint backward looking commitment prevents economics from learning and thus progressing. It infects all discussions with a sterility that no manner of invective or revelation of error can overcome. It reduces to a kind of intellectual trench warfare wherein the best anyone can hope for is to capture a few precious yards at enormous cost, and for no purpose. After the attack a new stalemate ensues and everyone forgets both the victory and its cost.

The capital debates of the 1950’s and 1960’s are an example of this.

The two sides battered each other. Enormous effort went into each attack and riposte.  A giant cloud of intellectual dust was raised. A yard or two was gained. The battle raged until the neoclassical view was sufficiently pummeled and shown to be in error. Viewed objectively the defeat ought to have been decisive. A giant hole sits at the center of what is now orthodox theory. The aggregation problem, issues of substitution, and, ultimately, the inability to derive the return to capital from market forces should surely have been a pivotal moment in the development of post-war economics.

But it wasn’t.

The two sides parted ways. Those neoclassical economists most involved conceded defeat and then went about their ways as if nothing had happened. Aggregation of disparate elements of capital was accepted under the rubric of simplification, and the whole return to capital error was swept under the rug where it was forgotten.

Beckett would have been horrified at the lack of learning. Nietzsche would have applauded the continuation of custom.

As for me: I see both sides as being locked in mortal combat over territory long beyond its worth. We still lack a good definition of capital, which is odd given the endless references by both advocates and critics to our capitalist economy. We still use production functions built upon antiquated views of factors of production. It’s as if the entire twentieth century never existed and that all we need to ponder are the same questions that vexed Ricardo and Marx. They still stand tall as the best defender and critic of industrial capitalism. All the rest is adornment and detail.

No one seems to contemplate a role for energy as a basic factor. Nor does knowledge much enter the equation except via the backdoor of technology now and again. Yet to my eye the entire trajectory of our modern economy has been defined by those two factors. The discovery, use, and deployment of sources of energy and knowledge has allowed us to transform our basic resource substrate into the torrent of wealth that has lifted us all. Unequally perhaps, but equality is an allocation issue not a transformation issue. Shoehorning both transformation and allocation into one theoretical structure is placing too great a burden on it unless it is sufficiently general. In which case the old triumvirate of land, labor, and capital is too specific and too redolent of ideological position. Besides they are proxies for the more general, and modern, triumvirate of resource substrate, energy, and knowledge.

Energy and knowledge provide the work necessary to transform the incoherence of the resource substrate into the coherence of product. A better way to describe this is, perhaps, to say that we do work to instill order. It is from order that we create wealth because we can use ordered resources but not disordered resources. Indeed our consumption of the product of order is simply the disordering or the undoing of the prior transformation.

The distribution of that wealth is not subject to this order-to-disorder cycle. It is an arbitrary outcome of social, institutional, political, cultural, class, gender, and other factors. It does not arise ‘naturally’ from transformation.

Using ideologically loaded words such as labor and capital in both the transformative and allocative models simply muddies our thinking. It masks the contextual origins of classical theory, and it denies the worth of, inter alia, the Marxist, Keynesian, and feminist critiques. It betrays a past still deeply embedded in our intellectual tradition. There is no amount of effort that will squeeze gold from that lead. We need to move on.

We need to embrace the weakness Nietzsche so abhorred. We need to fail better.

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Captain America?

The Economist’s astonishingly tone deaf editorial on Mitt Romney – “America’s next CEO?” – is partisan, wong-headed, and naive. The very title gives away the fundamental error: America does not need a CEO. The popular notion that business experience somehow makes for a more productive president is horribly misguided and displays a misunderstanding of politics that, frankly, the Economist ought to know how to avoid.

That many voters are tired of the gridlock in Washington is understandable. We are stuck in a deeply partisan era, forced on us, by and large, by a recalcitrant extreme wing within the Republican party. So far has that wing been able to shift the center of gravity of the Republicans that none of Eisenhower, Nixon, or even Reagan, would qualify any more as a suitable standard bearer of the GOP cause. The gridlock has not come, as the Economist and many others imply, from an intransigent left wing president. Obama is not a hard leftist. Indeed a major criticism often leveled at him is that he has trimmed too far to the center in order to attempt to reach reconciliation with the hard right. No, Obama is centrist, so the Economist’s comment that Romney’s erstwhile centrism would somehow haul Obama back towards the “ignored middle” is laughable. The middle has been long ignored by the hard right, so much so that the entire thrust of policy over the last thirty years has been designed to support business and upper income interests. Or, at least, that’s the way it has turned out.

Policy after policy, for three or four full decade,s has been designed to open up the economy and deregulate business. Taxes have been asymmetrically cut in favor of the very wealthy. Spending on programs that benefit the middle class most have ben either attacked or left to fade away. We have overspent on wasteful wars. We have underspent on domestic programs. We have to fight tooth and nail to keep cash flowing to the unemployed. We have bailed out banks with abandon. The list is endless. This is hardly testimony to a left of center leaning. It is exclusively a hard right agenda.

So why the need to call Romney’s putative centrism a mitigating influence on Obama?

None. It is simple partisan pleading.

As for the notion that Romney’s business experience will make him more effective – nothing could be less true.

In order for any president, on either side of the political divide, to be effective, the US governance system dictates that there is broad consensus in Congress. This is the very thing we are lacking at present. So no one, absolutely no one, can get much done. I very much fear that this election will change nothing.

The gridlock that ails us is a function of the deep flaws within the US political system itself. The vaunted and much admired – here at any rate – system of checks and balances is designed to prevent the emergence of a strong government. The Senate is deeply undemocratic in structure because it gives far too much power to states with small populations. So it is easy to cobble together opposition to practically any program, whether right or left. It encourages barter and back room dealing. It encourages pork barrel spending in order to buy the votes in order to create coalitions. And Senate rules – not the constitution – allow tiny minorities of Senators to obstruct any policy they object to.

None of this will go away were Romney elected. The Senate will still be an obstacle no matter what.

This is the way the Founders set the game up: they were so terrified of mid eighteenth century monarchical authoritarianism that they wanted to prevent the US from having a powerful central authority. Ever. So they condemned us to weak government. They wanted legislation to be labored and consequent to endless compromise. This was the central virtue they thought they bequeathed us: no one can get anything done unless we all can get along.

Which, when there is a vocal and extreme minority, we can’t. Right now the continued existence of the Tea Party is the single most important blockage to policy making. It is not the competency, or otherwise, of the president. As an example look at the disaster we went through in order to raise the debt ceiling. Romney would have faced the same set of circumstances.

In my opinion a Romney victory in November will not reduce, but enhance, the likelihood of policy gridlock. The extreme right will feel vindicated and will start, in the House of Representatives, to introduce extreme legislation. The Senate will grind to a halt as it debates that legislation. If the GOP controls the Senate it will attempt to pass along that extreme legislation only to face a filibuster by the minority Democrats. If the Democrats control the Senate, they will attempt to modify the extreme legislation, only to run int to a Republican filibuster.

Were legislation to find its way to Romney’s desk he will be faced with a dilemma: does he sign into law extreme right wing policies? Or does he veto his own party? Either he falls into the Obama trap and appears incapable of getting something done. Or he ends up as an enabler of the extremist wing of the GOP. By failing to recognize this trap, the Economist presents a naive and erroneous view of Romney’s prospects.

The conundrum is clear: either Romney falls down as someone who can execute. Or he falls down as being a centrist. In any case he is doomed to fail. The system dictates failure. It as designed that way. It is supposed to create gridlock in the brace of extremism.

Put it another way: Romney cannot be effective – getting stuff done – or centrist at the same time. Not in our current political climate. He has to pick which he wants to be. Just like Obama. There is no difference.

The Founders got it right. Much to our chagrin and frustration.

The solution is to get rid of extremism. Not to elect former executives.

Besides, as I have written about before, CEO’s are not at all adept in democratic circumstances. They are petty dictators. That’s how they get things done in corporations. They rule by fiat and centralized diktat. They have cadres of bureaucrats – aka management – at their bidding. They can make arbitrary decisions without having to face a vote. Popularity is not an issue. Employees cannot vote a CEO out of office because of opposition to an unpopular policy. Indeed many of our most famous CEO’s are proud of being unpopular. That’s how they earned their tough get things done image. At no point did they have to compromise. They trampled on employees to make a profit.

That is fundamental to business: every large corporation is run along the lines of a Politburo. Our CEO’s would be more at home in the old Soviet Union. The idea that a tough CEO can get stuff done in Washington is therefore mistaken. The US is not a corporate style dictatorship. It is run on compromise and public acceptance of policy. Popularity matters. So as soon as a CEO arrives in Washington they have to unlearn the very things that made them a successful CEO.

By the way: this is the same reasoning that exposes CEO hypocrisy about economics. None of them, not one, runs their company along free market rules. Every single one of them runs a Politburo management style. Yet they all endorse free markets outside the boundaries of their business. They seem quite happy with this dualist and internally inconsistent position. Efficiency at the business level requires dictatorship. It requires central planning and control. It is the antithesis of what orthodox economists advocate and model. Efficiency in a closed system is not attainable without ruthless centralization. Efficiency in an open system is simply unattainable due to the vagaries imposed by uncertainty.

I have said it before: in the face of uncertainty, things such as inefficiency, duplication, tolerance for redundancy and other horrors of potential ‘waste’ are essential to long term survival. Inefficiency, in an evolutionary sense, turns out to be a very good thing. It enables more effective adaptation to change. Ergo survival.

But I digress.

The point is that Romney’s business experience was gained in the wrong setting. It is worthless in national politics. Worthless. Romney’s ability to get stuff done as president – which seems to be the reason people are attracted to him – would not be a function of his experience at all. It would be a function of our ideological divide and the political system. Since that doesn’t appear to be going away or changing, he cannot be any different from Obama. Indeed, for the reasons I gave above, there is every likelihood he would be worse.

One last thing: people, seem also to assume that business leaders have an inside knowledge of economic policy. So, they are supporting Romney because he ‘understands’ how to create jobs.

Wrong. Many times wrong.

Macroeconomic policy is far more nuanced than running a business. For one thing there is no bottom line. The US is not a for profit enterprise, so it has no one, single, goal for economic policy. Creating jobs is a major goal, but low inflation is another. The two can conflict. Business does not suffer from this ambiguity, so solutions are easy, clean, and simple. So the Economist’s defense of Romney’s business history – Bain Capital’s success was largely driven by its ability to make arbitrary and narrowly focused decisions without reference to their repercussions on society at large – is both simple minded and misleading: it is a non-transferable skill set. It is enormously useful in the private sector. It is potentially massively damaging for the nation as a whole. You don’t have to quibble about Romney’s job generating history to make this point. It doesn’t matter how good he was at Bain. It is not relevant to being president.

So the Economist, and any other person or organization, arguing that Romney has superior skills to be president because he has been successful in business is simply wrong. They need to read up on American civics; and to get a better handle on the difference between business and economics.

Two things I would have thought the Economist was strong at.

Apparently not.

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Cowen’s Stagnation Muddle

Tyler Cowen created quite a stir earlier this year with his depressingly entitled “Great Stagnation”. He issued it as an electronic book, but such was the fuss that it was later published in the old fashioned way. I am ashamed to say I bought it only when the paper version was available. In a way I am glad I waited: I ended up writing all over it as my temper rose along the way. Somehow I find it therapeutic to scribble in ink.

He suckers us all in with a very sensible sounding argument: a significant reason for the slowdown in growth over the last four decades, and a very significant contributor to our current inability to break free from stagnation, is that the marginal return on most recent innovation is much lower than similar returns from earlier innovation. He calls it the low hanging fruit argument. Think of it this way: the impact of electricity was way more profound than the vaunted impact of the internet – which was, itself, facilitated by electricity. His list is impressive. He mentions not just electricity, but also railroads, washing machines, automobiles and all the well known panoply of industrial era breakthroughs that changed our way of life and made fortunes for the likes of Henry Ford as well. The key point being that those early innovations had a vast material impact on society as a whole, literally changing the way we lived, created millions of jobs, and so lifted wealth for swathes of workers; and propelled growth forward at a hitherto unknown pace.

Indeed the inflection point in growth is well documented and endlessly discussed.

Cowen’s points out that the change in pace, noticeable from the mid to late 1800’s through until about 1970, was never going to be sustainable. Our ability to repeat those kinds of high reward innovations was bound to sputter to a halt. It takes a great deal more effort to innovate nowadays simply because the more accessible parts of science have been thoroughly mined out. We have now moved onto to more difficult stuff, which is not only more costly to exploit, but tends to have less widespread impact. The benefits to wealth tend to stick with the innovator and do not leak more broadly into society.

He applies this marginal argument to two other sources of economic growth: education and land. In education we face the same problem: after expanding high school education to most kids, we cannot go further. The burst in our wealth producing capacity from getting generally better educated population cannot be repeated without extraordinary effort, thus lowering the incremental impact of that effort. Nor can we educate more than 100% of our children. Likewise our reservoir of fertile, but unused, land is now depleted. Expanding our use of land forces us onto less productive acreage thus reducing the incremental impact as well.

So far so good.

I can buy this argument. The easy stuff is done. The hard stuff lies ahead. And, because it is harder to squeeze wealth from that harder stuff the rate of growth will inevitably flatten out. So our ability to reach escape velocity whenever we get stuck in recession is made more difficult. We should, Cowen suggests, get used to less growth and more limited opportunity. This is contentious, but let’s run with it.

I nearly flunked a course in business school for making this exact argument. When I tried to argue that much of US twentieth century growth rested on its inventory of easily deployed material and human resources together with a common language and large population, rather than on exceptionalism or special skills, my professor blew a fuse. Those were the days of US superiority. To argue that it might all have been an easy play and not the result of genius was counter cultural and, well, almost socialist. Those were the days of Reagan after all. I was told to shut up and get with the program. The capitalist program, at the apex of which stood the army of MBA’s being minted at that very school.

Unfortunately Cowen and I diverge at this point.

He goes on to explain, or try to explain, that quite a bit of recent growth was an illusion anyway and that we could have diagnosed the decline in marginal returns had it not been for the illusion of the Reagan years.

Only, of course, Cowen doesn’t blame Reagan the way I do. He, predictably being an orthodox kind of guy, blames government.

Here he gets sneaky.

He couches his argument in the ever so balanced language of someone chiding children for making elementary mistakes. Silly dears, he says, surely you all know that government is just not very efficient. Yes, he admits, government can be quite useful: he mentions, in true libertarian style, our need for police forces. It’s all that other stuff that clutters things up and weighs down on the economy. He doesn’t make his argument overtly political, his ideological skirts reveal only somewhat, but he attempts to be scientific.

Now, being scientific is something right wing economists pride themselves on. Elsewhere, on National Public Radio, another of my favorite non-ideological right wing economists – the much vexed Greg Mankiw – made this startling statement with respect to possible economic solutions to income inequality:

“I think the liberal position is more to try to address the outcomes through a progressive income tax, and I think the conservative point of view is to try to address the causes.”

Think about that.

Conservatives try to address the causes. Liberals dither about in the frothy and unscientific world of redistribution. Conservatives face up to the hard issues and apply serious thought. Liberals get all emotional and tinker with things. Conservatives get to the root of problems and recognize the limits that nature throws in our way. Liberals are always denying the stern realities that prevent all their dreams from coming true.

Quite.

And this isn’t paternalistic or ideological.

Not at all.

Cowen wanders down the same path.

He argues that because we include government expenditures at cost when we compile GDP we have no way of knowing whether that money is being spent efficiently. Especially at the margin. Here he vectors into a variant of Ayn Rand – whom he praises at one point. He slyly uses marginal analysis. One of the big trends of recent years, he tells us, is the ever growing presence of government expenditure. Remember he is about to use his low hanging fruit metaphor. He goes on to argue that a major cause of our economic malaise is that all that incremental government spending must – must – be less productive than the earlier government spending we all can agree we like. This is simply a variant of marginalism. Each extra dollar spent produces a less effective outcome than the dollar immediately prior to it. Why? Because we have exploited all the easy options. Further expansion of government is, inevitably, scientifically, and absolutely, less valuable. No wonder, he says, GDP is having a hard time taking off. We are pouring cash into less and less attractive – marginally speaking – government projects, programs and so on.

How scientific. How hard nosed. How uncontroversial.

Not.

He even says: “This statement is not anti-government; it’s jut common sense.” As if economic theory was so settled. He calmly throws government under the bus, not because he is ideologically pre-disposed that way, but because hard nosed economic theory drives him – perhaps against his better judgement – that way. It is, after all, just common sense.

Oh boy.

Not at all.

First: the marginal revolution in economics was a serious attempt to fend off the Marxist critique of pre-existing classical theory. Right wing economists longed for a scientific – “objective” – rebuttal to Marxist notions of capitalism. Marginal analysis was part of that effort to establish economics as a science. It was, naturally, convenient that this newly discovered scientific footing confirmed the efficacy of market allocation of resources, and “proved” that efforts to tinker with that allocation were as futile as spitting in the proverbial wind.

All Cowen is doing, under the guise of being tough minded and scientific, is to display his predisposition. He is neither tough minded nor sceintific.

How do we know?

Because the marginalist argument he deploys gathers its might from lumping all government spending in one giant pot. Thus an extra dollar spent, on, say, education, draws its marginal decline in value from having been added to the previous dollar which was spent, perhaps, on policing. Apples are thus mixed along with oranges and all sorts of other fruits in a not too subtle attempt to distract us. But government spending is not homogenous. Cowen makes no effort to untangle it all and apply his analysis on the lesser sums. Nor, by the way, does he once back up his marginal argument with anything resembling a fact.

This he doesn’t need to do.

Because he deploys that Swiss Army Knife of orthodox theory: the price mechanism.

We know, absolutely know, that bigger government is a burden rather than a boon, because we carry it on our books at cost. Incremental expenditure is never exposed to the harsh realities of market pricing, and so its marginal worth is opaque. Disregard that this could work to the government’s advantage. We are told firmly that the lack of market pricing means we cannot reveal the value of marginal government spending. Ergo: more government is necessarily a drag, and thus is a very bad thing.

At which point Cowen rests his case. Presumably secure in the knowledge that the science of marginalism has slain the dragon of big government.

I won’t comment, for fear of paining you further, on his attitude towards fiscal stimulus. Suffice to say that it is a rotten failure and that public debt is horrible since it doesn’t create anything.

So the story is: we have exploited all the low hanging fruit. Thus, we should expect lower growth until we come up with new spiffy ideas. Only then will we get back to those impressive marginal rates of return that drove twentieth century wealth accumulation. Until then we should limit government because we all know its marginal value is way beyond the point of marginal decline. Oh, and we should all stop promising ourselves silly entitlements that those prospective low growth rates tell us we can no longer afford. Silly us. If only we had been tough like those conservatives, and had attacked the causes, rather than deluded ourselves like the silly little liberals that we are, we could have foreseen the collapse in marginal returns, the consequent constraint on growth, and thus the futility of trying to protect ourselves from the periodic hiccup in the historic march of capitalism towards nirvana.

His book made waves in Washington. It was the talk of the town. Perhaps they had nothing else to read this summer.

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Time Warp Economics

One of my ongoing complaints about economics is that it seems hidebound and horribly out of date. It seems stuck in the steam age with its references to land, labor and capital. Its models conjure up images of the titans of industry forging new railways across open plains and building vast steel works or cotton mills in once pristine valleys. There are landlords preying on peasants, while workers labor away in Dickensian conditions. Words straight from those bygone years litter its lexicon. The very notion of the margin was born from the forced usage of the worst farmland as the population grew, and from the distances wagons had to travel to market towns in northern Germany.

Not that there’s anything wrong with this, as long as we add more modern stuff along the way.

And that’s the problem.

Even reading the 1950’s work on pricing is an adventure back into an archaic world. Nowhere, or at least not very prominent, are concepts drawn from all the advances of the last couple of decades. It may be useful to talk about production functions and cost plus prices, but they remind me of astrolabes while I live in an era of GPS devices.

Leafing through an average economics paper or book I am left imagining a world largely bereft of mega banks; international companies managed by large self serving bureaucracies; internet sales; digital transmissions; or computer use. Very little seems to be made of the vastly more rapid flow of information, or that many of our products nowadays are entirely information based. It’s as if we never left the industrial era.

This may not matter. But I suspect it does. I suspect that a finer breakdown of labor would reveal very different influences on wage patterns and inequality. Models that treat labor as one big glob probably miss this detail. The same goes for capital.

It may well be that the basic 1800’s categories are sufficient to explain a 21st century economy. But I would like to be sure.

We are often told that capitalism adapts. If so, why are we looking at it through the same old lens? Land, labor, capital. Is that it?

It seems to me that the economy moves from one state to another. Each state being the result of some vastly complex computation based upon a massive set of variables. The space of those states is thus practically infinite. Yet the movement of the economy from one state to another is heavily constrained. We made it thus. We set boundaries by establishing institutions and cultural norms. Its movement is constrained by geography and the resource limits that are associated with location. Our ability to exploit those resources hinges on our knowledge and technology. The networks through which we communicate limit the flow of knowledge and capital. Society with its classes and other fractures gets in the way of smooth operation. And, of course, each configuration of the economy limits the possibilities for the next. Then we must account for the feedback between our current activity and each of these constraints.

It is tempting, in that face of this complexity, to simplify. We build models to explore pieces that interest us. Sometimes we dare to encompass the entire economy in one such simplification, and impute properties like equilibrium to tame the beast sufficiently for our imaginations to explore. We imagine that properties at one level of granularity flow untouched onto other levels either above or below. We remain faithful to the foundations of the discipline.

But if we don’t update our thinking, if we ignore progress, we run the risk of becoming anachronistic. Our models look quaint next to the reality they are supposed to explicate. We are condemned to add ever more sophisticated spheres to our Ptolemeic systems in order to keep up with emerging knowledge. We scramble for ever more ludicrous assumptions, and when all else fails we simply assert axiomatically that the world is the way we need it to be for our steam driven models to remain in touch with the electronic age. It is flat if we only have the tools to examine flat worlds.

One example: it is odd that it took such an effort to insert technology into our models as a driver of growth. In our zeal to cut the problem down to manageable size we eliminated most everything resembling an actual economy, and ended up focusing on allocation or heavily constrained optimization. That is pointless, because we are no longer examining anything that exists. Anyone familiar with complexity, self-organization and evolution is comfortable with systems that mutate, adapt and change from within. Technology is an obvious component of such change. It is entirely ordinary to consider it. Not extraordinary.

The mechanistic, individualistic, reductionist time warp that orthodox economics is trapped in does a disservice to our future. It is inappropriate. It is inaccurate. It is dated. So is the reliance on the same set of alternatives. Kalecki, Keynes, Sraffa, Robinson, the entire lot need to be freshened up. With them we moved from a goods based analysis to one inclusive of credit, money and finance. Now we need to embrace information. We need to move on and not keep arguing over the same time worn issues that occupied our forbears.

Here’s an idea: the information content of the economy has exploded. The products we make now are information intense. The algorithm needed to explain those products is more complicated and lengthy than that needed to explain the average product made seventy years ago. Our thinking about what an economy is needs to keep up.

And that goes for all you DSGE fans too.

Then again I may be wildly wrong. After all an astrolabe would still help you navigate the world. Sort of.

But I know it’s not flat.

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It’s Love “Schumpi” Day

When last I wrote here I repeated a quote by Joseph Schumpeter, that Paul Krugman used to lambast the classical opposition to government interference in the economy.

True to form, I was immediately set upon by the one man Austrian economist defense force – Stephan – who managed to dig out the original text from which the quote was cut. His purpose being to draw my attention to the softer tones used elsewhere in that document.

I agree. Schumpeter was not as clear cut a terror as Krugman made him out to be. While we all know Schumpeter as the inventor of the phrase: “the gales of creative destruction of capitalism”, he was so much more.

His influence was muted by the fact that his long career always seemed to leave him out of the limelight, he was eclipsed by Keynes for instance, and never part of a dominant school of thought. He was a teacher, at Harvard, of a number of subsequent “Nobel” prize winners, but his books and papers put him outside of the emerging mainstream of American economic theory.

In many ways Keynes was more orthodox than Schumpeter.For instance, Keynes, for all his rebellion against classical theory, was still committed to static equilibrium style thinking. That in his system equilibrium could imply less than full employment was startling, and controversial. But his thinking was focused on the properties of economies as they tend toward or away from such equilibrium. It was Patinkin who pointed out that Keyne’s great innovation was to locate the equilibrating force within his novel conception of “effective demand”. Everything else in The General Theory flows from that idea, and the tools Keynes used were borrowed and adapted from others, such as theeconomist Fisher.

By contrast, Schumpeter was never interested in equilibrium. He saw the economy as in perpetual flux and never in the kind of static equilibrium that has come to dominate orthodox economics since the mid-20th century. This is why he was led to discuss “creative destruction”. The central actor in his conception of an economy was the capitalist innovator driven by profit to search for new products and new methods of production. It was this innovation that, in Schumpeter’s view, provided the engine driving wealth creation and social welfare generally. Along the way capitalists make mistakes, they over produce or over invest, this leads to periods of adjustment and the need to revalue assets. These periods are what we call recessions or depressions, and are the times when those mistakes are wiped away. Hence the destruction. Naturally once the adjustment has been made and past mistakes expunged, the now chastened capitalist class powers forward again, driven once more by the profit motive, only this time free of the encumbrance either over valued assets or ill advised investments. Hence the creative aspect to Schumpeterian economics.

Drucker draws the difference between Schumpeter and Keynes nicely. Keynes, he said was merely a heretic. Schumpeter was a full blown infidel.

Unfortunately for Schumpeter his notion of an economy being dynamic and subject to cyclical upheaval flew directly in the face of classical theory whose goal was to place economics firmly into a Newtonian firmament both mechanical and determinist. This misfortune was compounded by the success of people like Arrow and Debreu who, a few years after Schumpeter’s death, were able to create the mathematics necessary to articulate a model of general equilibrium and thus obviate the need for younger theorists to explore the seeming chaos of the Schumpeterian world.

Oddly, sixty years after his death, Schumpeter seems more relevant than before. His ideas could be re-cast as being evolutionary, and the great theme of evolution is one possible way in which economics can regain the relevance and connection with reality it lost after Arrow-Debreu. His importance to current events is even more significant when we consider his long view for capitalism. It was a system, he thought, that would choke itself on its own success. Not through the results posited in the Marxist critique, but because of something altogether more mundane: he feared that capitalism would spawn a great bureaucracy populated by elitist “hangers-on” to the entrepreneurial machine. These elitists would be highly educated workers like lawyers, accountants, and bankers who would eventually sap the system of its vitality through their ability to impose non-productive costs on the innovative process. They would rent seek, draw off funds, and starve capitalists of the means to keep the engine running.

This scenario sounds eerily familiar. It also accords with the work of a protege of his nemesis. It was Minsky, a follower of Keynes, who correctly developed a theory describing the instability within finance – one of Schumpeter’s feared bureaucracies. So, perhaps, within a Minsky moment we can detect the imprint of Schumpeterian creative destruction.

If so, there is hope for a conjunction of the theories of two of greatest non-classical thinkers of twentieth century economics.

And we need all the new ideas we can get.

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