How to Unlearn Economics

As the title of this blog is ‘Unlearning Economics’, I thought I’d start by noting a few of my main objections to economics as taught in schools and universities. Neoclassical theory injects a certain type of framing and a number of hidden assumptions into your head, many of which become second nature, even amongst left leaning economists. They are all, of course, interlinked, and together they can form an incredibly skewed world view.

The framing of issues as governments versus markets

It pains me to see otherwise intelligent critiques of market fundamentalism held back by this framing. The idea that there exists some entity, a ‘market’, which is then passively ‘intervened in’ by government simply makes no sense in the real world. To start, well-defined property rights are necessary for a capitalist economy to function effectively*. But defining property rights is highly complicated – intellectual property, public property, zoning, environmental property rights are all open to debate. Contracts, too, are highly complex; ask anyone trained in law. Fraud is also open to interpretation – predatory lending and ‘looting’ can both be considered types of fraud; some consider FRB and fiat to be fraud. The line between fraud and information asymmetry is blurry to the point of non-existence.

Furthermore, there are many ‘regulations’ that are not commonly considered to be interventionist. Limited liability laws are one, as are immigration restrictions, and laws that protect shareholders and define shares themselves. Where the government levies taxes will also affect the workings of an economy, as will what they choose to accept as payment. I could go on – but my point is clear: from the start, decisions made by the government about the legal system will affect how the economy works. Any line they supposedly cross at some point, that means they are ‘intervening’ and as a consequences the result is now a ‘government failure’, is arbitrary.

I will accept that direct government provision of goods and services makes sense as a government failure, but short of that it’s simply not credible to label some regulation as more interventionist than the last.

Adam’s Fallacy

In the interests of consistency I have named this after Duncan Foley’s book of the same name, though admittedly it might be unfair to attribute it to Smith, who would surely not endorse what current economists have made of his work.

Adam’s Fallacy refers to the separation of the economic sphere from the political and social spheres, classifying it as one where private self interest is optimal and any ‘interventionist’ action is unnatural. Thus, if we implement a regulation, we are forced to follow the responses of private actors to their logical conclusions, without questioning them along the way.

One of the most persistent example can be seen in the recent crisis. It is often asserted that government guarantees, encouragement of homeownership or regulation x led companies to invent CDOs, CDSs and engage in fraud. The fault is then attributed to the government for getting involved, rather than simply questioning the responses of these actors. This is equivalent to a vandal defending himself by pointing out that ‘someone just left a pile of bricks next to the shop window’. It is a glaring example of begging the question, but one that is completely hidden and, as a consequence, rarely noticed.

The real economy as a deviation from models

You will often see an academic economist say something along the lines of ‘in the real world, we accept that conditions for perfect competition are rarely, if ever, fulfilled’. At first glance, this sounds OK. But imagine if physicists modelled orbits as perfectly circular, and then noted that ‘the conditions for perfectly circular orbits are rarely, if ever, fulfilled’. You’d immediately be inclined to ask: why on earth do you still model orbits as circular?

Yet economists do not question the presence of perfect competition models**. Similar logic is applied to the Arrow-Debreu theorem – economists start from a remarkably unrealistic premise and proceed to ‘tweak’ the model to try to make it resemble the real world (in the case of Arrow-Debreu they are unable to tweak it much before it collapses, which is perhaps a further sign they should abandon it). This is what makes economics so vulnerable to the Theory of the Second Best, which on its own is enough to refute many of the policy prescriptions of the last few decades. Eliminating these unrealistic models as a starting point for analysis is crucial if we want to understand the real economy.

These errors and others like them are the anatomy of what it means to ‘think like an economist’, something many regard with a strange triumphalism, even in the wake of the field’s recent failures. They erect, as Keynes put it, a ‘vast logical superstructure’, ominous and impenetrable to outsiders. This is what allows economists to cut themselves of from criticism and dismiss non-economists as ignorant. The reality is that the economists themselves are mostly ignorant to how the economy works, and many fail to grasp the internal contradictions of their own models.

The economy is a complex, dynamic system whose structures are defined by the government, no matter how small that government is. It is not, at any point, in a particularly special or sacred state, and as such new rules and regulations should not be treated as an unnatural intervention or deviation from an ideal.

*There are a few examples of vaguely anarcho-capitalist societies, but the fact is that the most successful capitalist economies have had states.

**I am aware that most of microeconomics is based around oligopolistic analysis, but this doesn’t change the fact that perfect competition is still taught, and competitive markets are often cited by economists in the public eye as a starting point. Also, defending neoclassical oligopoly models is probably not a great position to be in, something I will cover in due course.

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  1. #1 by Jack Bouchard on November 27, 2011 - 3:12 am

    “from the start, decisions made by the government about the legal system will affect how the economy works. Any line they supposedly cross at some point, that means they are ‘intervening’ and as a consequences the result is now a ‘government failure’, is arbitrary.”

    The line is crossed when the government moves away from protecting property rights. It is perfectly consistent to encourage government action in preventing theft or fraud, while still opposing price controls, tax incentives for favored industries and other interventions. The difference is that where the former aims to set basic rules for all market actors to follow, the latter attempts to load the dice in favor of certain outcomes. Current agricultural policy in the US comes to mind as an example of interventionist policy. So while you are technically correct that the government “intervenes” whether it’s arresting thieves or setting rent controls, you miss the distinction between the two types of intervention.

    • #2 by Unlearningecon on November 27, 2011 - 12:54 pm

      Well as I highlighted in the article, deciding how property rights are defined and what exactly constitutes fraud are two big things that will affect the workings of the economy massively. I’d also be interested to see if you oppose limited liability laws, any sort of immigration restrictions, laws outlining how companies operate and so forth.

      It’s a bit of a libertarian fantasy that capitalism just ‘arises’ like magic. It requires a lot of social cohesion and trust which means robust political institutions. Also note that peasants originally had to be forced into factories by the state, which is never mentioned in the textbooks.

  2. #3 by moiracathleen (@moiracathleen) on December 22, 2011 - 6:31 pm

    Brilliantly written post. I especially appreciated: “imagine if physicists modeled orbits as perfectly circular, and then noted that ‘the conditions for perfectly circular orbits are rarely, if ever, fulfilled’. You’d immediately be inclined to ask: why on earth do you still model orbits as circular?” Powerful analogy.

    I have a few questions. First, what exactly is the “framing” you mention that injects all these assumptions that yield the “incredibly skewed worldview?” It seems to me that the major problem in economics is the assumption that all problems are purely economic. This assumption creates a logical incoherence that few in the field of economics seem willing to confront. (The same thing happens in law, instead of economic models we call them constructions of law and applications of law. Both yield logical incoherence that many legal practitioners just explain away by twisting facts) Economic models are a prediction of what will happen in a market where certain conditions exist, which you point out rarely ever exist. When the economic model fails, then the failure is explained away using facts such as “people never work” or the “government doesn’t collect taxes.” Or the government didn’t pump enough money into the system or the government started pumping money into the system too late.

    Second, does the study of economics elevate the market to something that exists separate and apart from society in which the market operates? If this is the case, then isn’t this also an assumption that market should dictate political and legal choices rather than the people (aka government)?

    Take the 2008 reference in your article. The question became: Should there be a bank bailout? Some argued the bank bailout was necessary to prevent “economic crisis.” Others argued that allowing the banks to fail would balance the system that was clearly unstable and wildly out of control. Both answers presuppose that the crisis was simply a liquidity problem. The only difference is the way a liquidity problem should be handled.

    The problem wasn’t purely economic in 2008. The problem is also the result of legal choices made by elected officials when they established a regulatory system that ultimately failed and necessitated a bank bailout in 2008. It reflects legal choices made again after the 2008 crisis to continue to allow banks and financial institutions to operate under a regulatory system that has already failed to protect the public welfare. Moreover, the problem also stems from political choices regarding the concentration of control over money and credit. Clearly deposit insurance in a system with regulations that prevent the concentration of control over money and credit is substantially different than deposit insurance in a system without regulations to prevent the concentration of control over money and credit. See the Money Trust Investigation: http://fraser.stlouisfed.org/publication/?pid=80&tid=

    These legal and political problems were obscured by this notion that 2008 was a liquidity problem. In fact, isn’t it true that the liquidity problem was the consequence of bad laws and political choices that placed the immediate need of the day ahead of the long future? Why don’t economists instead ask whether it is possible that maybe economic models provide necessary but insufficient responses to the crisis?

    That aside, the bank bailout has been an enormous failure as evidenced by the fact that just three years later we are once again confronted with another crisis that is sure to be an even larger calamity than the first. Unemployment levels remain largely the same or worse. More and more people are dependent on government aid for basic necessities like housing and food. In the midst of all this, the same largest TBTF banks are even larger and more systemically important today than they were in 2008 because they have taken over the financial intermediaries. Again the largest banks are under stress because borrowers (this time sovereign debtors) are unable to pay back debt. Financial intermediaries are under stress because they arranged credit default swap deals between banks and investors whereby investors have promised to pay the banks in the event the bank’s borrowers default. Under the terms of these deals, the financial intermediaries must pay where the investors are unable to pay the banks once the borrowers default.

    What does the economist say today? Austerity is the new answer from the economists. Does this economic solution presuppose that the only problem is public debt, when in fact private debt remains a real problem in countries that are at risk of defaulting on public debt and also in those that are not at risk of defaulting on public debt?

    • #4 by Unlearningecon on December 22, 2011 - 7:59 pm

      Thanks for your post.

      ‘First, what exactly is the “framing” you mention that injects all these assumptions that yield the “incredibly skewed worldview?’

      It is just the way problems are discussed. You are correct to say that ‘the market’ is spoken of as an entity that more or less magically appears, and issues are often framed as if the state is the opposite of the market, which of course is nonsense. You also hit the nail on the head with this:

      ‘It seems to me that the major problem in economics is the assumption that all problems are purely economic.’

      Read something like the Adam Smith Institute or Milton Friedman. It seems like you are entering a different world – their views are so skewed it’s just surreal. Of course if you mention this they will say that you ‘just don’t understand economics’, which they don’t realise is a good thing.

      The 2008 crisis is a fantastic example of the immense cognitive dissonance academic economists suffer from. Economists are unable to model it as anything other than an exogenous shock and they basically view it as ‘noise’ that will eventually go away; unforeseeable by anybody, unrelated to the preceeding ‘boom’. The best and funniest example of this can be found here.

      Mention the level of private debt and you will be told that it doesn’t matter at a macro level because ‘someone’s asset is another persons liability’. This ignores the incredibly robust empirical link between private debt and growth
      .

      Also if you allude to democracy as a legitimate institution – as you have – many will reference public choice theory as if it somehow invalidates millenia of political debate. It really is a sight to behold.

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