Archive for June, 2012

How Not to Criticise Economics

I like to question almost every aspect of economic orthodoxy. However, I am also interested in forming a coherent view of what is actually wrong with economics, rather than a caricature. So it pains me to see misguided criticisms such as Suzanne Moore’s piece a few weeks back, whose characterisations of economic theory will only serve to misguide the uninformed and elicit dismissive reactions from economists themselves. So here I present a list of things not to highlight when attacking neoclassical economics, in the hope of assisting would-be critics of the discipline.

Criticising early assumptions

Don’t get me wrong, criticising economist’s perversion of the use of assumptions is fair game. However, critics often go down the path of criticising ‘pure rationality’ or ‘perfect information.’ Whilst these are elements of core models (and these models should be attacked because of this, but with the caveat that the core models are the target), they are generally not found in the higher echelons of economics. Many of these assume imperfect information, bounded rationality, and can also incorporate other biases.

Most specifically, idea that economic theory assumes everybody is a selfish, emotionless self-maximiser is common trope, but as Chris Dillow noted in the link above, it’s not entirely true. More importantly, it is also defensible as an assumption – a heuristic by which to approximate behaviour, at least until something better comes along. It is important to distinguish between good and bad assumptions from a scientific standpoint, rather than how absurd they appear to be at first glance.

Equilibrium

Many critics of economics, including well-informed ones, make the mistake of arguing that economics always assumes the economy is in equilibrium, tending to equilibrium, oscillating closely around equilibrium, or something along these lines. It is true that many economic models do this; it is also true that economic models start from the assumption that the economy is in equilibrium, and see what happens from there. However, economists generally mean something very different  to other scientists when they say equilibrium. From the horse’s mouth:

An equilibrium in an economic model is characterized by two basic conditions which hold in all of the model’s time periods: i) all agents in the model solve the maximization problems implied by their preferences, resource constraints, information sets, etc; and ii) markets for all goods in the model “clear.” An equilibrium is not a snapshot of the model economy at one point in time. Instead, it is the model’s entire time path.

Even on first inspection, this type of equilibrium clearly has problems of its own, but I will save them for another post. The important thing to remember is that this, rather than a stable state, is what economists often mean when they talk about equilibrium.

Economist’s Political Beliefs

Economists are not all free marketeers – in fact, they generally lean to the left. Neoclassical economics, broadly speaking, concludes that we should: regulate oligopolies, monopolies and banking; do more to protect the environment and intervene in the case of other externalities; have some public provision of health, education and welfare; and as that survey shows, economists are generally approving of things such as safety regulations.

As I have said before, I think economic theory as taught lends itself to being used by free marketeers, because of the way the ‘market’ is presented as natural and the government ‘intervenes.’ I also object to the fact that economics applies the same analysis to every market from apples to education to labour. And it is true that the market is presented as generally equilibrating and efficient, except in a few choice cases. However, the impact of these things is not that all economists support ‘right wing’ policy prescriptions, but that neoclassical theory can generally be coopted to provide justification for them.

Naturally, I sympathise with many who try to criticise economics, as they correctly notice that the field’s empirical record (at least in macro) is not great; that many of the policy prescriptions seem to favour the rich whilst hurting the poor; that some of the models taught in economics are unintuitive and perverse. Economists are also partly to blame for not communicating their discipline well to the public, seemingly preferring to dismiss critics as ignorant and revel in their mastery of (what I consider a wholly useless) field.

Having said this, it’s important that in order to engage economists properly, the right questions are asked – ones that economists find difficult to answer. Economists have stock responses to many of the ‘pop’ criticisms of their discipline, so using them will only serve to reinforce economist’s belief in their own knowledge and create further barriers to engagement.

Of course, failing all of this, you can just repeat ‘why didn’t you see the crisis coming?’ over and over.

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‘Debunking Economics’, Part I: Demand Curves Can Have Any Shape

The first substantive chapterof Steve Keen’s book Debunking Economics explores the idea that the demand curve for a market does not necessarily slope downwards, as is the norm in economics textbooks. Instead, once you move past the individual level, then according to neoclassical principles a demand curve can have any shape at all, as long as it doesn’t double back or intersect itself.

This idea was first expounded by the (neoclassical) economist William Gorman in 1953. Gorman, on discovering this, went to great lengths to introduce assumptions that nullified the result, but these assumptions effectively amounted to assuming there was only one consumer, what Keen calls a ‘proof by contradiction:’ starting from an analysis of market demand curves, but eventually having to assume the demand curve is not for a market but for an individual. Keen does an impressive job of communicating this argument, which is obscurely and abstractly stated in Gorman’s paper.

Keen starts with the observation that price changes can have many different impacts, due to the interlinked nature of markets. Demand curves depend on the condition that income remains constant, so that we can study changes in price independent of other effects.  However, if we consider somebody buying a ‘basket’ of goods, an increase in the price of one good might make another good unaffordable. The resultant boost in income (from not buying the second good) may well increase demand for the good whose price went up. The various interactions between goods depending on whether they are necessities, luxuries and so forth can create some interesting looking demand curves.

Economists are well aware of this problem, and have of course managed to assume it away! This is known as the Hicksian compensated demand function. I won’t go into too much detail here, but this involves adjusting income until utility is the same level as before, then allowing for adjustments in income. This allows us to separate out the ‘income effect’ (the one listed above) and ‘substitution effect’ (the ‘pure’ effect of price on demand).

The problem is that once you introduce more than one party to the economy, it is impossible to separate out changes in income from changes in demand, as one person’s spending is another’s income. This interplay between spending and income brings back all the problems glossed over by the Hicksian demand function. This is well documented, and known as the Sonnenschein–Mantel–Debreu theorem.

Naturally, economists have managed to assume this away, too. But here their assumptions jump the shark. Here is Gorman in his 1953 paper:

The necessary and sufficient condition quoted above is intuitively reasonable. It says, in effect, that an extra unit of purchasing power should be spent in the same way no matter to whom it is given.

Even when stated in this form, this is obviously not a reasonable proposition. If you give Peter money, he’s not going to spend it in the same way as Paul. It’s really that simple. However, Gorman is slightly disingenuous with this statement, as the real conditions are laid bare later on in the paper:

The older work of Allen and Bowley was based on the assumption that the classical Engel curves for difference individuals at the same prices were parallel straight lines, but this has been rejected in the more recent work of Houthakker in favour of a doubly logarithmic form. However, the earlier assumption fits the data remarkably well.

Keen points out that since all utility functions pass through (0,0) (zero consumption yields zero utility), and all parallel straight lines that pass through the same point are the same line, this amounts to an assumption that consumers are all exactly the same – effectively, that there is only one consumer.

In other words: the only way we can make a market demand curve the same as an individual demand curve, is if we assume that it is an individual demand curve. There is an obvious logical problem with this approach.

The funny thing about this chapter is that Keen concludes that, generally speaking, “there are reasonable grounds to expect that…demand will rise as price falls.” So why go to all the trouble?

The first reason is to show that ‘more is different’ – theories should not necessarily be built up from individual behaviour. Keen notes that the assumptions that all consumers are the same is only defensible if one analyses from the classical perspective of different classes, something the neoclassicists were trying to avoid.

The second reason is to show that, despite economist’s assertions to the contrary, it cannot be proved that a market economy will necessarily maximise social welfare, as, even on their own terms, it is logically possible to have multiple equilibria, some of which are more socially desirable.

The third reason is that the SMD conditions also establish that it is impossible to measure these things independent of the distribution of income, highlighting more general problems with neoclassical ceteris paribus analysis.

I myself experienced some cognitive dissonance when Keen came to that conclusion (I don’t know what it is about studying economics that creates this), but the fact is that this kind of logical inconsistency must be exposed, and, contra Friedman, this does not depend on whether the conclusions are completely sound or not. As I noted in my opening, these problems are all well documented by neoclassical economists themselves. So how can they excuse ignoring them?

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Debunking Economics: Overview & Opening Notes

I have been reading Steve Keen’s Debunking Economics, and thought I’d do a chapter by chapter guide to highlight the main concepts (and also help me to understand them fully). I’m about half way through at the moment, but so far I’m really enjoying it. I’ll offer a review-esque opening, with a few broad observations that struck me when reading the book.

First, dismissals of Keen as a crank or ideologue are misplaced. Keen’s tone thought the book is civil, technocratic and as ideology free as you will get. He spends part of chapter 4 arguing that monopolies are probably more efficient than neoclassical economists make them out to be, and incorporates insights from a plethora of economists across the political spectrum. His references reveal a broad depth of knowledge, both of the foundations of neoclassicism, the recent developments, and of practices and methods in other sciences. I may be wrong, but I doubt many of his detractors have as broad a knowledge of the literature as he does (after all, if you broadly accept neoclassicism, you’re less likely to root through its foundations).

Second, a peculiar recurrence throughout the book is how often these holes in economic theory were discovered – accidentally, or otherwise – by neoclassical economists themselves. It is relatively well known that Solow expressed distaste at the widespread used of his RBC models, and Hicks repudiated his IS/LM interpretation of Keynes. But it was also a neoclassical economist, William Gorman, who showed that a market demand curve, derived from neoclassical principles, can have any shape at all. Furthermore, some of the primary evidence for endogenous money came from Kydland and Prescott, and no less than neoclassicism’s founders, Jevons and Walras, expressed significant doubts over the usefulness of equilibrium theory, particularly if technology enabled economists to use more complex methods (as it has). If economists want to attack Keen, they must too question the work of many in their own ‘camp’, including some highly celebrated figures.

Third, I expect skeptics have a ready list of rebuttals to heterodox thinkers in general, and perhaps specific ones to Keen, perhaps to the extent that they do not deem his book worthy of their time. I can say with confidence that Keen has almost definitely addressed your objections in the book, as it is revised from his version 10 years ago and he has spent a lot of time since then debating his critics. I haven’t finished the book so I can’t be sure, but it may well be true that Keen doesn’t address every single development at the frontier of economics. But it is also true that none of these models reliably predicted – or can yet model – the crisis we’ve just experienced, whilst Keen’s did. Keen’s model is also a lot more simple than the convoluted mess of assumptions you’re generally presented with during a more advanced DSGE paper – bear in mind simplicity, rather than predictive power, was the reason Ptolemaic astronomy was abandoned.

If any neoclassical economists are thinking of buying Keen’s book, or at least following this guide, then Arnold Kling’s ‘review‘ of Keen’s book offers a fantastic demonstration of how not to approach reading it. Kling meanders off at the beginning about how deregulation didn’t cause the crisis (I won’t address that here, but suffice to say Kling appears to think regulation is a dial we can turn up and down).

Kling goes on to assert that what he admits are ‘unrealistically stringent’ conditions required for downward sloping demand curves are ‘uninteresting’, and that having a benevolant dictator redistribute resources prior to trade (seriously) is not ‘unrealistically stringent’. He says he is too dense to grasp that there is no supply curve unless perfect competition rules, but from his lack of engagement with the issue it’s plain he just doesn’t want to try. Kling also demonstrates why it is important to abandon the idea that the economy is a battle between the state and private actors before one can engage in purely technocratic arguments such as the ones put forth by Keen.

If you are a laymen and therefore worried the book will go over your head, I wouldn’t worry too much. The first two substantial chapters (3 & 4) are on the demand and supply curves respectively, and are the hardest to understand. The complexity then steadily declines – by the time time Keen gets onto talking about his own models, anyone with a cursory knowledge of economics should be following him fully. Keen avoids maths and alerts readers before he indulges in some of the more technical arguments, giving them an opportunity to skip the section, but not to the detriment of the book as whole.

I have some criticisms of this book. The first is that Keen would do better to acknowledge that not all economists are market fundamentalists, and that many of the conclusions of neoclassical economics are fairly moderate and at odds with what the public often sees. Whilst he doesn’t exactly paint all economists as Friedmanites, he does misrepresent the average political viewpoint, at least in my experience.

Secondly, Keen’s efforts to keep his book accessible are possibly stretched too far when his discussion necessitates mathematical equations. Writing something like ‘the rate of change of unemployment plus the level of investment’ is just as likely to confuse non mathematicians as writing the equations themselves, and will probably take some mathematicians with it on the way. I think a degree of maths is inevitable, and some equations would help communicate the ideas effectively.

But these are minor points. The book is a comprehensive and constructive critique of mainstream economics, coupled with a positive vision for a model of capitalism put forward by Keen himself, and deserves to be read by anybody. Neoclassicals who assume Keen is wrong have nothing to lose, and will gain a deeper understanding of their own models and confidence in them despite the decades of criticisms. Those who question neoclassicism will find their arguments strengthened substantially.

Discussion of the chapter on demand curves to follow.

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Zombie Criticisms of Keynes

Recently, a debate erupted between Austrians and Keynesians on Daniel Kuehn’s blog, and then later elsewhere, concerning matters that I, in my naivete, had long thought were settled. Sadly, it appears that once again, Henry Hazlitt’s supposed chapter by chapter ‘refutation‘ of TGT has been dredged up from the gutters of history, along with assertions about Keynes’ alleged totalitarianism.

I will start by briefly addressing some comments on Robert Vienneau’s previous exposition of Hazlitt’s book. There seems to be some confusion among the commenters who criticise Vienneau. It is quite clear that Hazlitt does not understand the concept of the marginalist supply curve, which posits that workers trade off leisure for work. Here he mistakenly asserts:

The ‘supply schedule’ of workers is fixed by the wage-rate that workers are willing to take. This is not determined, for the individual worker, by the ‘disutility’ of the employment – at least not if ‘disutility’ is used in its common-sense meaning.

He blatantly confuses the equilibrium between demand and supply with the curves themselves, an incredibly elementary mistake. Vienneau is correct to say that:

Obviously, then, the equality of the wage and the marginal productivity of labor is not enough to determine either wages or employment.

The marginalist theory require us to know both the wage rate  and the hours worked to determine employment. Do these people really expect us to take Hazlitt seriously when he can’t even describe the marginalist theory of employment?

Anyway, let’s move on to another section – hopefully everyone can agree that Liquidity Preference is central to Keynes’ theory, so I will focus on Hazlitt’s criticisms of this. Here is Keynes:

Thus the rate of interest at any time, being the reward for parting with liquidity, is a measure of the unwillingness of those who possess money to part with their liquid control over it.

Hazlitt begins with a typically snarky comment:

The economic system is not a Sunday school; its primary function is not to hand out rewards and punishments.

How petty. Keynes’ use of the word ‘reward’ is irrelevant in this case; he’s merely saying that interest is an incentive to get people to part with liquidity. Hazlitt is latching onto something quite meaningless here. Let’s continue:

If you wish to sell me tomatoes, for example, you will have to offer them at a sufficiently low price to “reward” me for “parting with liquidity”—that is, parting with cash. Thus the price of tomatoes would have to be explained as the amount necessary to overcome the buyer’s “liquidity-preference” or “cash preference.”

Keynes is obviously saying that cash has a role as a store of value as well as a medium of exchange. If it is not currently being used for the latter then it will be stored; should it be stored, a certain rate of interest will be necessary to make the buyer part with their liquidity and buy a bond or deposit it in a bank. Hazlitt completely fails to distinguish between the two uses and offers up a false equivalence based on this misunderstanding.

Hazlitt then appears to agree with Keynes for a while:

[People] hold cash (beyond the needs of the transactions-motive) because they distrust the prices of investments or of durable consumption goods; they believe that the prices of investments and/or of durable consumption goods are going to fall, and they do not wish to be caught with these investments or durable goods on their hands.

Here Hazlitt isn’t actually criticising Keynes at all, but simply restating his theory of the speculative motive. He tries to paint this as a disagreement by splitting hairs over the word ‘speculative’ – which is fairly typical of the blunderbuss contrarianism you will find throughout his book – but it’s quite clear that this is simply a restatement of Keynes.

Hazlitt goes on:

If Keynes’s theory were right, then short-term interest rates would be highest precisely at the bottom of a depression, because they would have to be especially high then to overcome the individual’s reluctance to part with cash—to “reward” him for “parting with liquidity.” But it is precisely in a depression, when everything is dragging bottom, that short-term interest rates are lowest.

That interest rates move pro-cyclically is no sufficient to disprove the LP theory of interest, as it is not the only factor determining the interest rate – in a boom demand rises and this pushes up interest rates; the latter happens in a depression. This is entirely compatible with Keynes’ economics and does not mean LP effects are absent or unimportant.

It is worth noting at this point that Keynes was mostly concerned with long term rates, which are what businesses actually use when making investment decisions. To this end, Hazlitt resumes agreeing with Keynes:

It is true that in a depression many long-term bonds tend to sell at low capital figures (and therefore bear a high nominal interest yield), but this is entirely due, not to cash preference as such, but to diminished confidence in the continuation of the interest on these bonds and the safety of the principal.

Right, in other words: their preference for cash or liquidity over more uncertain bonds. Which is what Keynes said.

As a brief note on Keynes totalitarianism: this seems to be based on Keynes mentioning several times that certain policies – both flexible wages (of which he disapproved) and various exchange rate mechanisms & capital controls, as well as active fiscal & monetary policy (of which he approved) – are more easily applied under totalitarian conditions. These observations are quite clearly true –  any economic policy, implemented word for word, is easier to apply under totalitarian conditions. This does not mean that totalitarianism is desirable, and you will not find Keynes saying anything of the sort. Furthermore, even if he did say such things, this is irrelevant to his economics.

There are good criticisms of Keynes to be made, but you will not find them with the likes of Hazlitt and Rothbard, who were quite clearly motivated by an overarching desire to ‘own’ Keynes, rather than debate. Rothbard actually wrote an entire book attacking Keynes as a person, which really is all you need to know about what he had to say. These people were not scholars, and their work is best consigned to the dustbin of history.

Addendum: Daniel Kuehn strengthens the argument about Keynes’ preface to the German edition of TGT.

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Milton Friedman on Corporations

Milton Friedman famously argued that corporations have no social responsibility, only a responsibility towards their customers and shareholders to maximise profit. In fact, he even supported legislation to makes them to do this. Funny how legislation is OK when…no, forget it (again).

Friedman’s position is obviously an odd one. If corporations have no social responsibility, then presumably they are, in abstract, permitted to steal, defraud and coerce for their customers and shareholders? My guess is Friedman wouldn’t support this position. This leaves two possibilities:

(1) They shouldn’t do these things because they are constrained by the law. In other words: they should obey the law, just because it’s the law. I can’t imagine Friedman supporting a position like this, either.

(2) They shouldn’t do these things because they have a moral obligation apart from the law. In other words, they have some social responsibility.

Presuming Friedman doesn’t think corporations are allowed to coerce, defraud and steal, and presuming he doesn’t think laws should be obeyed simply because they are laws, the only conclusion can be that corporations have some moral and social obligations. The question then becomes where these lie.

As with much of libertarianism, on close inspection, the dichotomies become blurred, and the debate collapses back to where it’s always been.

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On The Similarities Between Austrian and Neoclassical Economics

I have alluded to the fact that I see neoclassical and Austrians economics as broadly part of the same intellectual movement. At first, I was unable to pinpoint exactly why this was, other than the fact that they both shared a governments versus markets mentality, and the only major policy difference between neoclassical libertarians and (minarchist) Austrian libertarians was the latter’s disdain for central banking (I am also informed that Milton Friedman repudiated his support for Central Banking later in life. But didn’t he argue…eh, forget it).

Regardless, I have realised that the more substantive reason for this equivalence is that the two share the same methodology. Whilst Austrians might reject this at first glance, allow me to go through each methodological tool, as expressed by Arnsperger & Varoufakis, used by neoclassical economics and compare it to Austrian analysis:

(1) Methodological individualism. This one is not particularly controversial – both neoclassicals and Austrians build up their economic models from the behaviour of individual agents. Austrians are generally more reductionist, whilst neoclassicals are prepared to abandon it for AD/AS analysis, but the majority of neoclassical theories retain this approach.

(2) Methodological instrumentalism. This means behaviour is generally preference driven, and action is defined to attain some end state. For neoclassicals this is utility maximisation:

Economists use the term utility to describe the satisfaction or enjoyment derived from the consumption of a good or service. If we assume that consumers act rationally, this means they will choose between different goods and services so as to maximize total satisfaction or total utility.

For Austrians it does not necessarily revolve around maximising anything, but still shares the same ‘actions are aimed to achieve some end’ characteristic:

Human action is purposeful behavior. Or we may say: Action is will put into operation and transformed into an agency, is aiming at ends and goals, is the ego’s meaningful response to stimuli and to the conditions of its environment, is a person’s conscious adjustment to the state of the universe that determines his life.

In both cases the theories revolve around revealed preference – what people actually do is meaningful, and we will build our theories around that assumption.

(3) Methodological equilibration. This means that analysis asks what behaviour we should expect, given the economy is in equilibrium. This is the one most likely to be resisted by Austrians, who generally insist that they study the economy as if it is permanently evolving and in disequilibrium. However, this paper on the subject disagrees:

Mises’ understood the of market process as a series of shifting imperfect equilibria, or plain states of rest. Hayek had views similar to Mises on equilibrium, but he added in the concept of a personal state of rest to Austrian theory. Lachmann accepted the basic elements of the Mises-Hayek theory of shifting equilibrium.

Mises and Hayek’s approach of starting in equilibrium and then asking whether that equilibrium is unique and stable echoes the approach of neoclassical economics, which generally assumes equilibrium to begin with, then looks at whether the system has a tendency away from that equilibrium, towards others or to stay in the same place.

Blogger ‘Lord Keynes’ has also commented on the reliance of many Austrians on some form of equilibrium analysis, noting that Mises and Rothbard thought the economy had a long term tendency towards equilibrium, whilst Hayek used equilibrium as an epistemological starting point. LK appears to think that Lachmann did not fall into these traps, in opposition to the paper above, but I am not sufficiently well versed in Lachmann’s work to comment.

It’s reasonably uncontroversial to note that elements of the neoclassical and Austrian school have the same origins in Menger and Walras, and the Austrians originally split from the neoclassicals to pursue a different path. However, it seems they still took many of the important concepts with them when they left, and to me its clear that many of these remain today.

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Why Tax Increases Can Be Expansionary

In my quest to rationalise my desire for the state to control every aspect of people’s lives, I have formulated and collected together a few reasons that tax increases may actually be expansionary. This is an ex post justification, in light of apparent empirical evidence that they don’t have the negative effects so often attributed to them.

To understand why tax increases might be expansionary, we don’t have to abandon the logic of ‘econ101′ entirely – that is, if you reduce the reward somebody gets for doing something, or increase its cost, they will do it less. However, a couple of real world mechanics – which are omitted from economic thinking – can use this logic to conclude that tax increases could potentially be expansionary:

(1) Many productive activities are tax-deductible. Profits that are reinvested are not taxed; similarly, corporation tax is deducted from the cost of employing someone. So the higher these taxes, the greater the incentive to engage in these activities. There is potentially a point where the negative impact of the tax outweighs these positive effects, but we don’t appear to be anywhere near it.

(2) Economic rents are highly pervasive, particularly at the top. Taxing this activity discourages it and hence encourages productive activity. According to Michael Hudson, this was the intent of the original income tax. A clear example of this effect is the Land Value Tax – if landlords are charged for sitting on their land doing nothing, it encourages them to make some money, or sell the land to someone who does.

There are also some other mechanisms that suggest tax increases might be expansionary, some of which I have explored in earlier posts:

(3) The fact that the income effect is stronger than the substitution effect can mean that higher income tax makes people produce more; that is, when faced with higher taxes, people will have to work longer hours to recoup their post-tax income. This adds to gross national product.

(4) Cutting taxes at the top can simply inflate the price of positional luxury goods and hence do nothing to help real production; if that money were redistributed, it would be spent on ‘normal’ goods and hence have more impact on growth.

(5) Governments can spend your money better than you, so higher taxes and spending will increase the productive potential of the economy.

(6) Another interesting proposition from James Kroeger: tax and spend means more money is spent.

The crux of the argument is that it is reasonable to say the population as a whole has a Marginal Propensity to Consume (MPC) of less than one – they save some of their income. The government, on the other hand, has an MPC of at least one. Hence, should money be taxed and spent, there is a high possibility that this increases national income.

Kroeger also notes that people often confuse the expansionary effects of borrowing with those of tax cuts. To fund tax cuts, the government often has to borrow to sustain current levels of spending. However, in this case it is the borrowing that is expansionary, rather than the tax cuts. To truly see the effects of reducing taxes, we’d have to reduce taxes and spending by the same amount.

Another point worth noting is that, whilst taxes might have a deadweight loss in the area to which they are applied, the money that would have been spent does not disappear – it can go into other areas. In other words: if you tax cars then people might spend less on cars, but they’ll also have more to spend elsewhere. So taxes are more likely to change the composition of national income than the total.

Some of these effects are stronger than others; maybe some are negligible or based on faulty reasoning. But the overall combination of conflicting effects makes the story far less clear cut than the basic ‘econ101′ approach to taxes would have you believe.

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Assuming Away the Economy

Recently, a thought occurred to me regarding the disconnect between economic models/assumptions and the economy they purport to represent. It is demonstrated aptly by a quote, via Jonathan Catalan, from Frank Knight:

To begin with a general abstract answer, it will be evident to anyone with a rudimentary understanding of economic processes and analysis that profit (always in the sense of pure profit) would be absent under the conditions of equilibrium with “perfect competition,” (which may be defined in more than one way). The”tendency” of the competitive processes of buying and selling and the control of production is to impute the whole product to the productive agencies which create it, leaving nothing for entrepreneurship as a distinct function (except for monopoly gain, referred to below). This means that under the conditions of ideal equilibrium (stationary or moving) the function of entrepreneurship itself is entirely absent from the economy.

This isn’t the only time that economic assumptions undermine themselves. For example, another problem with perfect competition is that it assumes everyone is a ‘price taker'; that is, they cannot set prices themselves. But if everybody is a ‘price taker’ and nobody can be a ‘price maker’, how is there a price?

The assumption of perfect information also undermines the study of the economy, for it assumes away most real world services. Obvious examples are pure data processing companies: if everybody had access to, and the capacity to retain, information on this level, then the companies would simply not exist.

Furthermore, many services are born because of information asymmetries lack of information. If you hire a lawyer, it’s primarily because you don’t have a comprehensive knowledge of the law; if you hire a stockbroker, it’s because you don’t know what to do with your stocks, or how to do it; if you use a teacher, it’s because you don’t know something that you want to know.

Rationality also potentially undermines entrepreneurship. Consider this quote from blogger Matt Sherman:

The process of going from nothing to something…is inherently irrational…To embark on it is to leave the world of economic modelling…[P]rogress requires madness, that is, the freedom to pursue choices whose rationality can’t be measured.

A rational, reasonably emotionless, utility maximising individual, when faced with the choice between steady wage income – which they can casually trade off against leisure as they please – and the alternative of highly volatile and uncertain profits, would clearly opt for the former.

Perfect competition, perfect information and pure rationality are not always used in the higher echelons of modern economics, but that’s not the point. The fact is that they are often used as starting points, and are still taught in most courses, despite their clear incoherence.

Capitalist economies thrive on the inefficiencies and ‘frictions’ presumed to be the only obstacle to the economy functioning ‘efficiently’, in the sense of economics textbooks. Should you remove all these ‘frictions’, it seems that the foundations of economic theory would leave us in a world with no firms, no entrepreneurship and few business opportunities. In other words, large portion of economics could barely be said to be a theory of capitalism.

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