Archive for December, 2011
I received some skeptical feedback on my earlier post contending that Libertarianism is built on Neoclassical Economics. I was expecting this, although what surprised me the most was that the majority of it was from people who do not identify themselves as libertarians.
I should clarify what exactly I mean by ‘libertarian’. Here is a simple outline:
(1) Generally reject positive liberty and seek only to minimise negative liberty.
(2) Seek to minimise government.
(3) View private property as a vital part of any society.
They differ to some extent; some reject the state completely, such as Rothbard, whilst others actually advocate a reasonable level of public provisions, such as Milton Friedman and Friedrich Hayek. However, a libertarian of any strand would surely accept the above characterisations.
I should also clarify what I mean by ‘built on neoclassical economics’. Libertarians themselves do not necessarily derive their arguments from neoclassicism. However, almost every strand of libertarianism lifts some elements from neoclassical economics, and, had neoclassical economics not been born, libertarianism would not have as clear a framework with which to present the world. As is often the case with blogging, a commenter put it far better than myself:
The combination of ethical foundations of libertarianism and efficiency arguments from economics creates a formidable, or formidable-seeming, political theory with which to analyze the world. This theory seems especially appealing because it contains semi-scientific elements, such as ideas of comparative advantage, which other political theories lack. However, in unlearningecon’s estimation, people would not be swayed nearly as much by these ideas if they were aware of the serious logical gaps in the arguments coming from economics.
This is why my post was primarily a critique of the elements of neoclassicism that I believe are most prevalent throughout libertarianism, rather than directly of libertarianism itself.
In my ‘Free to Choose’ paragraph I effectively tried to sum up an entire book in a short space, and apparently did a bad job. The central point is that, though choice is vital to liberty, choices cannot be presented neutrally and as such the idea that a government is ‘intervening’ in our choices when it regulates advertising and bad products is flawed. The fact is that our choices were already ‘intervened’ in by various other things – including already existing state apparatus – and so were being pushed in a certain direction. Thus, pushing choices in a ‘good’ direction (e.g. a healthy food instead of an unhealthy one) is no less libertarian than pushing them in a ‘bad’ direction, but is of course more morally agreeable. The point here: the central neoclassical idea of rationality is at the base of libertarian perceptions of freedom.
I should also follow up on my point on the importance of political and social institutions. Both neoclassical economics and libertarianism ignore historical context and think that trade spontaneously arises wherever property is defined and people are safe from force. However, a quick look at the history of the world would demonstrate this isn’t the case. Western Capitalism never really took off until democratic institutions were established, and ancient Islamic empire created the religious unification and clear boundaries required for trade. As David Graeber details, there are literally zero examples of barter-style economies arising like magic. Again, the cold, calculating machines of neoclassical economics would not ‘need’ these institutions, but real people do.
But I digress; the specific issues can be debated endlessly. My point is that neoclassical economics and libertarianism are intrinsically linked, not because they come to similar conclusions, but because they present the world from a similar point of view. As such, the ethical foundations of libertarianism can often be linked to the assumptions of neoclassical economics, and criticising one often damages the other.
One response to my post on Neoclassicism and Libertarianism was made by ‘Lord Keynes‘, a prominent critic of Austrian Business Cycle Theory. He provided a list of the different types of libertarians. Though the list is useful, I feel he is simply begging the question: where are these types of libertarianism ultimately derived from? Though the strands they may appear separate at first, it is rarely difficult to link them to neoclassical economics. Here is LK’s list:
Ayn Rand’s primary ‘philosophical’ conclusion is that everybody should pursue their own rational self interest. Do I really have to say it? This is lifted straight out of the textbooks.
(1) the Anarcho-capitalists, like Rothbard and Hoppe;
(2) The minimal state Austrians like Mises (with his praxeology);
Praxeology strikes me as the ultimate copout to justify neoclassical modelling. Allow me to explain:
Person A: “People are rational and self interested and so are best left to pursue their own goals.”
Person B: “No, they aren’t – look at various experimental evidence showing that they are altruistic and also often make mistakes.”
Person A: “OK well they maximise their own utility, and whatever they do fulfills the objectives that make them happiest.”
Person A: “OK, well all human action is purposeful and all actions are justified as they are the rightful response to stimuli. The end result of the action is not as important as the valid agency created by the actions that achieved it. Thus, people should be left to pursue their own actions. Trying to falsify this will only result in its validity.”
Person B: “Erm, OK.”
Randians and praxeologists have their ideas about human action ultimately derived from a neoclassical framework – in Rand’s case, she is seeking to make people behave like the textbooks; in the case of Mises/Rothbard, they are seeking to justify ‘market’ transactions by whatever means possible, the ‘market’ itself being a creation of neoclassicism.
(3) Austrian supporters of Hayek’s economics, with a minimal state;
LK concludes himself that:
paradoxically, the Hayekian version of the Austrian business cycle theory is heavily influenced by neoclassical equilibrium theory via Hayek’s use of Wicksellian monetary equilibrium analysis.
As you can see, wherever a libertarian analysis exists, neoclassical economics is not far off.
His final groups are areas where his knowledge far outweighs mine:
(4) The “orthodox” Austrians who have a moderate subjectivist position (like Israel Kirzner and Roger Garrison);
This is the area where I am willing to concede the most ground. These are the Austrians who have stayed closest to the birth of their school, which genuinely sought to create a non-equilibrium alternative to neoclassicism. However, the fact is that they seem unable to come to conclusions other than ‘government = bad’, and persistently frame issues as governments versus markets, both of which are things that neoclassical libertarians do. After all, is it no coincidence that many libertarians who followed neoclassicism before the crisis have had no trouble choosing the Austrian school over evil Keynesianism? The two schools are simply too compatible for me to consider them completely separate.
(5) Austrian radical subjectivists like Ludwig Lachmann;
II. Non-Austrian libertarians (but influenced by Austrian economics)
e.g., George Selgin
It strikes me that the positions of these economists are not particularly ‘libertarian’, given the amount of ground they are willing to concede. In fact, George Selgin no longer identifies as an Austrian and is also uncomfortable with the libertarian label, which offers some conformation of my point.
Scratching beneath the surface of the different types of libertarians often reveals foundations that can also be found in neoclassical economics: consumer sovereignty; the economy as separate from the political and social spheres, the assumption of an entity called ‘the market’ that is in or close to ‘equilibrium’ and is ‘distorted’ by the hand of government. Until libertarians can prove to me that there is something fundamentally different about the different strands of their ideology, I stand by my argument that it is closely interlinked with neoclassicism.
Sticky wages are the reason for unemployment. The standard academic explanation of this can be found here:
Unemployment is just a labor surplus; since wages are the price of labor, the fundamental cause of unemployment has to be excessive wages.
The fact that wages are an essential component of AD is completely ignored here. Suppose we cut wages across the economy. Following this, there are two possibilities:
(1) Prices fall. Real wages remain unchanged and all that happens is that real private debt increases and the money stock increases, the former being negative and the latter achievable with expansionary monetary policy.
(2) Prices do not fall. Profits and rents are increased by reducing wages, but that effectively means redistributing to the rich, who have a lower MPC. It would not be right to assert that consumption will always fall by reducing nominal wages, but it is fair to expect a drop. And in the face of this falling consumption, are businesses really going to invest their profits?
Number (2) rests on a lot of introspection and supposition. But the fact is that there are no examples in the real world of wage cuts leading to falling employment, quite simply because wages drive demand, which is what drives employment. Nominal cuts didn’t work in the Great Depression, and the period with sustained real wage increases (1945-1973) coincided with very low unemployment, whilst the period of stagnant median wages (1980-present) has generally coincided with higher unemployment.
And, of course, no, Keynes did not argue that sticky wages explained demand side recessions. He argued the exact opposite – that they actually help to nullify them. Sometimes I wonder if anybody has even read TGT.
One of the things that has always put me off libertarianism is that it clearly has neoclassical economics at its heart. The only difference is that all of the flaws – assumptions, rational economic man, framing issues as governments versus markets – are transposed onto a political ideology. After all, it’s no coincidence that much of what libertarians perceive to be objectively bad for the economy is also morally objectionable to them. But once you analyse from a non-neoclassical perspective, a number of substantial flaws appear.
For example, the central libertarian idea that people should be ‘Free to Choose‘ becomes nonsensical once you analyse it from the premise that people are not rational. The problem here, as Thaler and Sunstein detail in Nudge, is that people are constantly having their decisions influenced by advertising, culture, framing and various cognitive biases. Saying that governments are ‘intervening’ in people’s choices makes little sense because people’s choices are always influenced. In fact, the most libertarian argument is for governments to regulate packaging and advertising so people’s choices are influenced as little as possible. If you disagree with this because you don’t have faith in the government being able to steer people’s decisions right, then you are putting your faith in the government being able to frame choices in a way that doesn’t steer people’s preferences at all, which is actually far harder and probably impossible.
The ‘property rights, contracts, force, fraud and theft’ prescriptions of the more hardcore libertarians are reflective of neoclassical economics, as they are, in fact, all that would be necessary for the world to resemble a demand-supply diagram, if the assumptions held. Unfortunately, people do not behave like robots, so they need strong political and social institutions that create trust and cohesion to engage in transactions (trust has actually been cited as a major reason for the slow growth of many developing economies). Defining property rights and fraud is also incredibly complex and open to debate, but neoclassical economics doesn’t really discuss the law in any detail, so, naturally, neither do libertarians. Furthermore, the naive idea that force, fraud and theft can just be rattled off like that ignores the fact that those 3 words basically describe the history of mankind. Again, this is simply not mentioned in textbooks.
Taxation as theft also has its roots in neoclassical framing. In neoclassical economics, the economy is presupposed as arising out of nowhere, and the government then ‘intervenes’. Taxes are a distortionary, external effect on the ‘free market’. This is analogous to the idea of the government coming along and ‘taking’ your income that pervades libertarianism (and often popular culture). This ignores the fact that pretax income is just a money flow that has arisen due to the institutions set up by government, and as a result of the way these institutions were set up. If government policy were changed, the pretax income of many would change; there is nothing inherently just about it. Furthermore, even after tax, income is far higher than if the government didn’t exist, because then the economy as we know it would not exist. The concept of taxation as theft becomes nonsensical as libertarians are forced to accept that they are privileged to be taxed.
Libertarianism completely neglects work and workers. The idea that it is a freedom maximising individualistic belief system ignores work in the exact same way neoclassical economics does – the firm is a ‘box’ where inputs go in and outcomes go out, and we don’t really look into what happens inside it, outside of various ‘marginal’ curves. Libertarianism, like neoclassical economists, is based around the notion of consumer sovereignty, and so the only way it can deal with work is simply to ignore it – the only time Libertarians discuss work are with dismissive assertions like ‘workers should negotiate their own conditions’. The problem is that this ignores power (like neoclassical economics), and the fact that capital is scarcer than labour (despite teaching this explicitly elsewhere). This means working conditions, wages and hours are not determined by individuals engaging in mutually voluntary transactions but by capital*, which naturally has more bargaining power.
How do libertarians deal with the fact that their ideology is built on highly flawed theories? By mocking the real world! Lecturing workers for not accepting pay cuts (which their theory is wrong about, incidentally), attacking institutions that conflict with their policy prescriptions, ridiculing inequality considerations as simple ‘envy‘. Furthermore, they simply implement their policies without considering the starting point, much like neoclassical economics. Effectively, they are saying that even though the world doesn’t behave like the textbooks, we should act like it does, and ridicule or ignore it when it doesn’t. Obviously, that has worked out pretty well.
Maybe this will become a series, as these are quite easy to rattle off, and pretty fun too…
1. The rule of contract is sacred, but it’s fine to force pension cuts and pay freezes on public sector workers.
2. Localism is great! But every single nation on earth should have the same libertarian policies.
4. Emergent properties are logically impossible (see comments) so we should be 100% reductionist. But human action is a meaningful emergent property, meaningful enough to build an entire methodology around.
6. Government intervention in the banking/monetary system is bad for the economy and morally wrong. But the government should force everyone to use gold as their currency.
7. Corporations should maximise profit and take care of their shareholders. But if CEOs are ripping shareholders off, it’s fine, because of the free market.
8. Government intervention is bad, but corporations should be legally required to maximise profit.
9. Liberty! No, wait, dictatorship.
11. When economies succeed, it’s a triumph of the free market over whatever state apparatus exists at the time. But when it fails, that state apparatus (which previously had negligible impact), is to blame.
12. Government guarantees encouraged banks to take too much risk, let’s repeal them. But let’s not repeal limited liability laws on similar grounds.
13. Government intervention is bad, but they need to stabilise the money supply to keep inflation low.
14. Inflation is always and everywhere a monetary phenomenon. Hey, check out my new NAIRU theory!
15. The price system is perfect, but banks shouldn’t have to use mark-to-market accounting to report their financial status.
16. Stimulus doesn’t work, except when the money is spent on the military.
17. If public sector workers are fired, they will be rehired in the private sector, having little net effect on the economy. But if City workers are fired they won’t be rehired and it will be bad for the economy.
18. This despite the fact that public sector workers are lazy, unskilled parasites and City workers are intelligent and productive individuals.
19. Rationality can simultaneously mean a self-maximising agent, and whatever the hell I want it to mean.
20. Capitalism is dynamic and robust. But if you introduce a single regulation or tax it will implode!
21. Capitalist dynamics and relations will always cause certain groups to gain politically at the expense of everybody else. This is an argument in favour of capitalism.
22. Property is great and taking it by force is bad. But we shouldn’t give it back to the indigenous people from whom it was initially stolen.
23. Collectivist institutions are bad. But implementing ‘free market’ policies is an end in itself – it doesn’t matter how many people suffer.
I’ve seen a few things like this, and whilst I agree with the sentiment partially – framing the crisis as ‘government’ or ‘market’ has lost relevance because they have amalgamated and are now one and the same – it seems to imply that big government is somehow associated with crony capitalism, and by extension, that cutting back state spending and regulation is a vital part of reforming capitalism.
But are there any foundations for this argument? No matter how small government is, it will always have the power to:
- Use public money (for bailouts);
- Use force to protect vested interests
Thus it seems a complete non-sequitur to say that big government and big business are part of the same problem.
As usual, free market proponents have done our job for us, taking the rug out from beneath their own feet with Public Choice Theory (PCT). At its most basic level, this implies that governments will make concessions to special interest groups for votes, such as oil subsidies, which cost the average voter close to nothing but benefit certain groups significantly.
PCT suggests that democratic capitalism will always have a government that gives concessions to corporations. Libertarians seem to think this is an argument in favour of capitalism, but of course it brings us to Lipsey and Lancaster’s Theory of the Second Best. We are forced to accept the reality of capitalism: the capitalist class can use government apparatus to advance its own interests. On top of this, there is also no substantial justification that making government smaller will stop this process. Thus, we must conclude that limiting regulations need to be imposed to protect the public from these realities.
Naturally, the crisis offers a clear example of this problem in action. Post-Great Depression, three main regulations were implemented: government guarantees and insurance, Glass-Steagall, and a plethora of financial market limitations. With ‘free markets’ as the intellectual justification, the latter two were swept away, leaving just the former. According to ‘free market’ reasoning, this is good because it more closely approximated the ideal, frictionless state of neoclassical economics. However, according to Lipsey and Lancaster, it may well have been counter-productive. Score one for the Theory of the Second Best.
Our version of capitalism has always involved the government and the wealthy in bed together, and barring some sort of revolution this looks set to continue. Thus, dismantling the state will do nothing but benefit those on corporate welfare, and false equivalences between big government and big business should not be taken seriously.
Those advocating protectionist policies are often met with the stock response of ‘you don’t understand the principle of Comparative Advantage’. But it seems to me that economists haven’t put much thought into it themselves, as Comparative Advantage does not necessarily support free trade, particularly in developing countries. In fact, if you accept the ‘infant industry’ argument, it turns out Comparative Advantage has very little to say for developing countries or industry – it is irrelevant.
Perhaps a statement of Comparative Advantage is due. The idea is that every country should produce what it is most efficient at producing, regardless of what other countries produce – that is, each country should allocate its time as efficiently as possible based on its own strengths, resulting in maximum overall production. Trade barriers create extra costs and therefore inefficiency, which is undesirable.
Furthermore, a brief qualification of the ‘infant industry’ argument: as tariffs direct business to new industries by making them comparatively cheaper, they can develop brand loyalty, benefit from economies of scale and lower costs, gain expertise, establish contacts and trust with suppliers and distributors, and benefit from long term investments due to higher short term profits.
The problem is this: if by producing something, an industry can improve its long term ability to carry on producing it, Comparative Advantage becomes irrelevant in the short term. As with much of neoclassical economics, it is a static snapshot and does not capture dynamics like this. For example, if country A produces coke at 100 gallons a year and milk at 150 gallons a year, while country B produces coke at 50 gallons a year and milk at 25 gallons a year, Comparative Advantage is clear – A should produce milk and B should produce coke, even though A has an absolute advantage in both. This results in the highest net production possible.
However, what if country A’s coke industry and country B’s milk industry are new industries? And by producing milk, B can eventually up its milk yields to 200 gallons a year, whilst A could up its coke production to the same? Suddenly Comparative Advantage has nothing to say, and protecting these industries from competition as they develop seems like a good idea in the long run, both for individual countries and for net production as a whole.
The fact is that, as well as being compatible with one of neoclassical economist’s pet theories, extensive evidence supports the protectionism for development idea. Comparative advantage also has numerous other flaws in its applicability to free trade (one of which, the mobility of capital, was actually noted by Ricardo himself). Overall, it is not clear why it retains its status as some sort of irrefutable truth of the benefits of free trade, given that it actually has little to say about what trade policy should or shouldn’t be.
One of the most common rebuttals by mainstream economists is that critics have ‘straw-manned‘ them, accusing them of supporting policies such as wanton deregulation and environmental neglect, when they don’t. Sometimes, this is a valid complaint. Reading some heterodox books would have you thinking every economist is Milton Friedman (and even he supported some regulations, particularly in the banking industry).
The problem, though, is that this objection has become little more than a stock reply and is rarely accompanied by much substance. Similar stock replies include assertions that economics is value free, just a tool for analysis, with no ideological implications, as well as accusations of ignorance. These kind of dismissive replies lead the heterodox economists to accuse the mainstream economists of arrogance and blindness, say they are beyond help, and give up trying to communicate with them.
In fact, heterodox economics could do itself a favour by acknowledging that much of mainstream economics isn’t the kind of dogmatic stuff you find on the internet. Many economists are centre left in their views, and in most universities a fair amount of time is given to environmental considerations, limitations of models are acknowledged, assumptions are laughed at and so forth. Many policy conclusions economics comes to are also favourable: regulate oligopolies, tax carbon emissions redistribute wealth and income. In fact, the problems economics suffers from are fairly subtle, which is perhaps why its proponents don’t see them in the same way an outsider might.
For example, a major problem is the way it is taught. You are told the area you are studying and the name of the model. You are then presented with a list of assumptions, followed by a diagram. It misses out two points that are crucial in a science:
a) Which problem was the model built to solve, and did it solve it? Why has it survived the test of time? What are/were competing theories?
b) How do you derive the diagram from the assumptions? What exact impact does each assumption have on the analysis?
This ‘here’s how the economy works, learn it’ method tends to instil students with the feeling that they have been gifted with the knowledge of how the economy works. This is why you see so many people deride the public for being ignorant of ‘economics’, when in fact what they mean is neoclassical theory.
Wider context is also incredibly important. Though economics presents the economy as some sort of neutral, ubiquitous entity, it is in fact an emergent property of complex political and social institutions, human psychology, historical context – much of which was characterised by war and empire, areas rarely mentioned by economics – and of course, is contained in and limited by the environment and natural resources. The characterisation of the economy as an emergent property rather than an entity in its own right would be far more accurate and could potentially make economics a lot more interesting.
The point is that correcting these failures doesn’t mean sweeping absolutely everything away, as most of the qualitative material taught in economics does not need to be changed. However, reforming economics does mean ditching the diagrams and many of the assumptions required to derive them. It means putting capitalism in its historical context: how it came about, its flaws, why its rivals failed, rather than taking it as a given. More attention must also be paid to the history of thought: how and why different thinkers came up with their theories, which ones have been discredited and which ones have survived the test of time. Finally, extensive discussion of the failure of economics to explain the recent crisis would be a major positive step.
The problem with the mainstream vs heterodox debate is that there isn’t a debate. According to mainstream economists, heterodox economists are ignorant cranks who straw man their theories. According to heterodox economists, mainstream economists are arrogant and so deep into an ideological hole that they cannot be saved. Perhaps heterodox economists are at risk of overstating their case and alienating the people they are trying to engage – they should be more ready acknowledge the strengths of mainstream economics before they attack its shortcomings.
Differences between ideological factions can often be exaggerated by political polarisation and rhetoric. People are, after all, programmed to win arguments, not to seek truth. However, it strikes me that there are some significant policies that are supported by those at almost any point on the political spectrum. These are the main ones that spring to mind:
An LVT is a great idea
This is the lost ‘free lunch‘ of classical economics. It is unavoidable, because you can’t move land. It cannot be passed on, as it falls entirely on economic rent. The best way to think of this is that the tax is paid whether or not it actually exists as a tax. Since the supply of land is fixed, the price is determined by what tenants are willing to pay. The tax itself does not change these factors – it just means the revenue accrues to the treasury rather than into private hands. In fact, the tax actually encourages use of land and generates growth, as landowners who do not utilise their land for a productive purpose are still charged and so are forced to sell the land or do something that creates value. Hawaii had to repeal theirs because it resulted in too much development.
Since it creates growth and raises revenue, I’m sure we can all agree that is a win win, particularly in our current situation.
The war on drugs has failed
From whichever perspective you view this, it’s hard to defend the war of drugs, at least in its totality. From a utilitarian perspective, it has created massive black markets, crime, and drug use is still widespread. From the perspective of individual freedom, it is obviously a restrictive state intervention. Even from a purely economic perspective, it costs a lot of money and also misses out on a lot of potential tax revenue. Politically it’s potentially explosive but the anti-government narrative is so strong that it could well be harnessed for legalisation.
Naturally, I wouldn’t advocate lifting all restrictions instantly and favour a more pragmatic approach, but even from a libertarian perspective, that’s better than the current situation.
Financial institutions in their current state are an abomination
What effectively happened here was that the half of the New-Deal era regulations that restrained banks, such as Glass-Steagall, were removed, whilst the half that were designed to protect consumers, such as guarantees, remained. This resulted in hybrids that were allowed to exploit the welfare they received from government without having to remain responsible and prudent elsewhere. They grew so big that they were not allowed to fail and their losses were socialised. As John Lanchester puts it, this is nobody’s idea how the world should work. Whatever is to be done, it will involve taking on these institutions head on, and reforming the financial sector. Whilst people disagree on the details of the second step, the first is a necessary prerequisite that can be supported by all.
Patent law is awful
I am overstepping my bounds here in that I know very little about patent law. However, what I do know is that:
- In its current state, British patent law is so complex that you can technically sue yourself.
- Patent law is not only complex in practice, but also in theory. It is vulnerable to the Tragedy of the Anti-Commons, where individual actors find it impossible to negotiate as there are so many different pieces to put together. This results in some goods never making it to market.
- Patents lead to large amounts of lawsuits, and companies are created solely to extract rents from their copyrights, without actually producing anything.
- Large corporations are generally the main benefactors, as they can afford lawyers and large amounts of patents, making it incredibly difficult for rivals or potential rivals to navigate the market and innovate.
The right might like to frame this as a ‘government granted monopoly privilege’ and the left as just another failure of capitalism, but I know that both oppose it, from those at Mises.org to post-Keynesians like Dean Baker. Intellectual property really needs a clean up.
Inflation targeting doesn’t work
The Bank of England has actually spend a reasonable amount of time outside its implicit 1-3% inflation boundary for the past decade, which makes me question how much control they really have over inflation. More importantly, however, the policy has not created macroeconomic stability – far from it. So a new monetary policy target is required, and whilst I (strongly) favour low long-term interest rates, I would be happy if the world’s Central Banks and governments at least acknowledged the failure of inflation targeting and started to consider alternatives, whatever they may be. I suspect that I am not alone in this, as even the inflation hawks at the ASI have highlighted some of the problems with inflation targeting.
Issues like this should be placed into the limelight, as they are areas where genuine progress could be made. Many of them, funnily enough, favour big business, which makes me suspect that’s why debate is steered away from them in a ‘divide and conquer’ style strategy. In fact, the differences between ideologies are greatly exaggerated elsewhere, too – once people actually consider issues rather than rhetoric, they generally find themselves in more agreement than they expected.
*If Dubai came into your head you are confusing two definitions of land. In the economic sense, land includes the sea, the air, and the rest of the ‘space’ part of the space-time continuum.
Economics has come under a lot of criticism recently, and proponents sometimes try to defend themselves by pointing to Milton Friedman’s methodology of positive economics. In this essay, Friedman
loses his mind argues that the assumptions of a theory do not matter as long as its predictions are correct. Of course, even if you accept this there are still plenty of criticisms of neoclassical economics – the theories internally contradict themselves, and it is also incredibly hard to verify empirical predictions in social science, making Friedman’s litmus test somewhat of a damp squib. However, let’s put these objections to one side.
In the essay, Friedman takes us on a typical Friedman logic train to his preordained conclusion and leaves you to puzzle over how you got there. He argues that to be completely realistic a theory would have include everyone on earth’s eye colour, qualifications, etc. But how do you test whether or not to include these things? You see whether evidence corroborates the theory without them! Fantastic – assumptions don’t matter.
In this case, Friedman’s sleight of hand lies in not properly defining the word ‘assumption’. This is, in fact, so significant that it means his paper is effectively advocating any methodology whatsoever (if I assume throwing darts at this board will give me the GDP figures for next year…). The crucial characteristic of assumptions in engineering or science is that they eliminate specific variables. A perfect gas is one where many of the smaller forces between molecules are ignored. Assuming a vacuum eliminates air resistance. This gives us an appropriate method, as ‘relaxing’ an assumption means adding in more variables, and this process can continue for as long as it is practically feasible.
However, many economic assumptions could not be argued to be eliminating a certain variable – assuming that people are rational self maximisers, or that firms calculate expenditure based on marginal costs and revenue, are actually hypotheses, not ‘assumptions’ in the scientific sense of the word. As such, the ‘assumptions’ themselves are empirically falsifiable and cannot be swept under the rug.
Furthermore, in science theories are only deemed as valid as their assumptions are realistic. A theory can always be improved by making the assumptions resemble reality more accurately. So even if we were to accept Friedman’s premise, we could still improve theories by abandoning rationality based on behavioural evidence, or abandoning marginal cost based on surveys*. Unsurprisingly, in the case of widely used economic models such as Arrow-Debreu, it is incredibly difficult to relax assumptions before the theory collapses – if this were true in physics, the model would be abandoned.
To be honest, it is a sad indictment of economics that an essay which contains the passage:
The articles on both sides of the controversy [regarding marginalist analysis]…concentrate on the largely irrelevant question of whether businessmen do or do not in fact reach their decisions by consulting schedules, or curves, or multivariable functions showing marginal cost and marginal revenue.
has to be critiqued formally. A theory’s assumptions are always relevant to its conclusions, and improving them will always yield more accurate results. That much is obvious to the man on the street, but clearly not to economists.
*Friedman argues surveys are as useless as asking octogenarians how they account for their long life. I can only interpret this as him saying businesses have no idea what they are doing, which sort of undercuts him intellectually elsewhere.