A Unifying Principle for Economics?

Commenter Dan thinks economics has not yet found its watershed moment:

Think about Biology before DNA was discovered or Geology before plate tectonics was understood, both disciplines had learned a lot but they still lacked a comprehensive model that made everything fit into place.

I am sympathetic with this viewpoint. Heterodox criticisms come at economists thick and fast – personally, I think most of these criticisms are valid and very little of neoclassical economics should be left. Yet neoclassical economics persists.

However, in my opinion this isn’t because economics lacks a unifying theory; it’s the exact opposite. Economists already think they have found a unifying concept: namely, the optimising agent. Consumers maximise utility; producers maximise profits; politicians maximise their own interests/their ability to get reelected. Sure, there are a few constraints on this behaviour, but overall it is the best starting point. It all blends together into a coherent theory that can tell a plausible story about the economy. I find economists are resistant to any theory that doesn’t follow this methodology.

I have gone over my problems with this approach many times, so I shan’t repeat myself. The important question is what an alternative theory would look like.

The typical definition of economics is the study of how resources are allocated. Hence, a unifying theory should empirically and logically do a satisfactory job of explaining prices, production and distribution. Such a theory would be able to underlie virtually any economic model in some form, whether being the wider context of a microeconomic phenomenon, or the basis of macroeconomic phenomenon. No easy task, then, but luckily many approaches of this nature already exist.

Alternative Theories of Behaviour

If we want to stick with agent-based explanations of the economy, there are any number of alternatives to the ‘optimising’ agent. Among these are:

• Maslow’s hierarchy of needs.
• ‘Satisficing‘ agents.
• Class-based theories.

I consider all of these approaches useful, but none of them sufficient for the task at hand.

In the case of the first two, replacing ‘optimising’ agents with ‘satisficing’ agents isn’t exactly revolutionary. Maslow’s hierarchy can, in fact, work as a utility function. In both cases, we still run into similar problems of aggregation and of reductionism. And we end up trying to shoehorn every decision into a particular approach. The simple truth is that agents have a lot of different motivations for their actions and sometimes these aren’t always clear, even to them.

My main issue with these, and any agent based approach, is that they aren’t necessarily relevant for the wider question of resource allocation in society. Individualist-based neoclassical economics has to reduce things down to a  few agents with only a few goods in order to have any conclusions whatsoever; I can’t help but feel similar problems would emerge here. Class struggle may determine distribution but it doesn’t tell us much about what is produced and at what price it is sold. In order to understand how production takes place and prices are determined, we will have to look elsewhere.

A Theory of Value

The value approach has a lot of pluses. A theory of value underpins the explanation of relative prices, and also has normative implications that recognize the inevitable value judgments in economics. The only problem I have here is that I’ve yet to find a convincing theory of value – the two most widely known are the neoclassical/Austrian subjective theory of value and the Labour Theory of Value (LTV).

I object to the idea that prices merely reflect subjective valuations for the basic reason of circularity: prices must be calculated before subjective valuation takes place, so they cannot purely reflect subjective values.

I have more sympathy with the LTV (mostly because its proponents seem to have coherent responses to every criticism thrown at it), but I remain unconvinced. The defences of the labour theory of value tend to rest on appeals to ‘the long run’ and ‘averages” of socially necessary labour time. These may be useful, but, like the neoclassical ‘long run’ approach they seem to leave open the immediate question of what’s going on in the economy and what we can do about it.

In my opinion, these approaches both contain some validity, and are not mutually exclusive. I tend to agree with Richard Wolff, who asserts that suggesting one has refuted the other is like saying knives & forks have refuted chopsticks. Both are useful; neither are all-encompassing theories. I also believe both are compatible, to some degree, with my favoured approach:

The ‘Reproduction and Surplus’ Theory

This approach is the one emphasised by Sraffians and Classical Economists. It starts from the basic observation that society must reproduce itself to survive, and that generally society manages this, plus a surplus. The reproductive approach emphasises what I believe to be an important aspect of capitalism, and perhaps all systems: the collective nature of production. Industries are interdependent; people work in teams; various institutions, often state-backed or provided, underlie all of this. Hence, no special moral status is accorded to prices or the allocation of surplus, except that prices must be appropriate for the continued existence of industries and society as a whole.

On first inspection the ‘insight’ that society must reproduce itself might be considered trivial, but following through its implications can yield interesting and useful conclusions. The framework can be used to determine prices technically, independently of either preferences or values. It emphasises the interdependent nature of the economy: if one industry or input fails, it has severe knock on effects. For this reason, it would do a great job of explaining both the oil shocks and resultant stagflation of the 1970s and the 2008 financial crisis, something modern macroeconomics cannot manage.

On top of this, the model is versatile: it can interact with its institutional environment, which determines key variables exogenously (e.g. the monetary system determines interest rates, political power determines distribution). The classical approach is, for example, compatible with class theories of income distribution, post-Keynesian theories of endogenous money and mark-up pricing, and even neoclassical utility maximising individuals! Probably the most promising and complete framework out of them all – I look forward to further developments of this approach.

It is feasible that the task of finding a watershed moment is not possible in the fuzzy world of social sciences. Psychology and sociology are both characterised by competing approaches; psychology in particular has improved since the neoclassicals Freudians were dethroned. If neoclassical economics has taught us nothing else, it’s the importance of not being trapped by particular theories for want of elegance, which is why there is a lot to commend in the institutional school of economics.

Nevertheless, I think there is scope for exploring unifying principles. Progress in neurology may provide such a foundation for psychology; similarly, ideas such as societal reproduction could equally be applied to sociological concepts such as the role of beliefs, class, sports or what have you. As far as economics goes, such a substantial step forward could be what’s required to displace neoclassical economics, whose staying power, in my opinion, cannot be accorded to either its empirical relevance or its internal consistency. Perhaps neoclassical economics persists simply because its building blocks are so well defined that other approaches seem too incomplete to offer their opponents sure footing.

Debunking Economics, Part XVIII: Response to Criticisms (2/2)

This is the second part of my response to criticisms of Keen’s Debunking Economics. In my previous post* I covered some of the fundamental objections Keen had to neoclassical theory. Here, I will cover Keen’s exploration of alternatives: first, a brief note on dynamics and chaos theory; then a discussion of Keen’s own models; finally, his dismissal of the Marxist Labour Theory of Value (LTV).

Dynamics and Equilibrium

Many economists have argued that Keen’s contention that economists do not study dynamics is false. I agree. Keen does not really address the DSGE conception of equilibrium, which is highly different to the typical conception of a steady state. An equilibrium in an economic model occurs when all agents have specific preferences, endowments etc. and take the course of action which suits them best based on this. This can be subject to incomplete information, risk aversion or various other ‘frictions.’ These agents intermittently interact in market exchanges, during which all markets clear. Basically, ‘solving for equilibrium’ means you specify the actions and characteristics of economic agents, then see what happens when markets clear. It’s entirely possible that the subsequent model could exhibit chaotic behaviour.**

Now, there are obviously many problems here. The fact is that the overwhelming majority of people who learn economics will not touch this. They will instead be faced with static-style equilibrium models, which they have been told are unrealistic but ‘elucidate certain principals.’ This is nonsense – they elucidate nothing, and simply need to be thrown out. Nevertheless, many policymakers, regulators and business economists are working under this framework. Furthermore, even those economists who have gone beyond this level seem to have the concepts deeply ingrained into their minds, and regard them as useful.

However, even the more advanced ‘dynamic’ equilibrium clearly has problems. First, the presence of irreducible uncertainty – which, as far as I can see, is a concept entirely misused by economists – means that it is virtually certain not all expectations will be fulfilled, while equilibrium assumes they will be. Second, ‘fulfilled expectations’ is far stronger than economists seem to think – for example, it eliminates the possibility of default! Third, the assumption that all markets clear is obviously false, otherwise supermarkets wouldn’t throw out old food. Anyway, I digress: Keen could easily address all of these criticisms, but for some reason he doesn’t. This is indeed a shortcoming of his book.

Keen’s Models

First, a brief note on Keen’s model of firm behaviour: it seems to make the error of maximising the growth rate of profits, rather than profits themselves. I am not sure if this has been fixed. Nevertheless, I regard it as subsidiary to Keen’s main criticisms. His most important model is the Minsky Model of banking and the macroeconomy.

Keen recently had a debate over his Minsky Model with the Cambridge economist Pontus Rendahl. Andrew Lainton has a  post on this, along with a contentious discussion with Rendahl, over on his blog. In my opinion, Rendahl – though overly dismissive in tone, and not causing as many problems for Keen as he seemed to think – highlighted a number of issues with Keen’s model in its current form:

(1) Say’s Law holds. In Keen’s model, income is simply a function of the capital stock, and there is no role for demand.

(2) In what was generally a model set in continuous time, which used ODEs, there is an equation which uses discrete time intervals. Such equations cannot be solved in the same way, so Keen’s methodology is inconsistent.

(3) There is, as of yet, no role for expectations in Keen’s model.

(4) Rendahl argues that DSGE models are also Stock Flow Consistent (SFC). I think he is correct – see, for example, his own paper, which has agents accumulating stocks of money from previous periods. The major differences between SFC and DSGE appear to be: a lack of micro foundations; continuous functions; use of classes; market clearing; fulfilled expectations; and, of course, with Keen’s, the role of banks and private debt.

In terms of assumptions, I’d say Keen’s model is in the ‘heuristic’ stage – it’s not  completely right and needs development. The criticisms are essentially things that have not yet been added to the model, rather than conceptual or logical problems (save the inconsistent equation). This means they can be added as it develops. However, if the model makes good predictions, it may prove to be useful, even though that should never serve as a barrier to making it more realistic and comprehensive.

Labour Theory of Value

If neoclassical economists want a lesson in how to respond to a critique you strongly disagree with without being vitriolic and dismissive, then they need look no further than the marxist responses to Keen’s critique of the LTV. This is all the more ironic given said economist’s willingness to dismiss marxists as illogical and dogmatic.

Keen’s critique is threefold, so I will discuss it briefly, followed by the marxist responses.

The first critique  is Bose’s commodity residue. The idea is that no matter how far you go back in time, disaggregating a commodity into what was required to produce it, there will always be a commodity residue left over. Hence, no commodity can be reduced to merely labour-power. The problem here is the projection of capitalism into all of history. For Marx, a commodity only resulted from capitalist production. However, if you go back in time you will find non-capitalist production, and eventually you will be able to reduce everything into land/natural resources and labour, which Marx never defined as commodities. Having said this, one question remains: can the natural resources or land not be a source of surplus value? Could this surplus value not have been transferred into capitalist commodities?

Second is Ian Steedman’s Sraffian interpretation of Marx. Simply put, it seems Steedman had his interpretation wrong – Marx’s is not a physical, equilibrium system based on determining factor prices. This is something that actually struck me on the first read of Keen’s LTV chapter: Steedman simply converts Marx into Sraffian form without much justification. If Marx did not intend this to be the case, the criticism is defunct from the outset.Hence, it follows that Steedman’s model is simply a misinterpretation of Marx, and it is not even necessary to go into the maths. There is, of course, a possibility that this is an overly superficial interpretation and I am mistaken.

The third criticism is that Marx’s treatment of use-value and exchange-value is inconsistent: properly applied, it implies that a commodity’s use-value can exceed its exchange value, and hence be a source of surplus value. Now, I remain unsure of this area so I might be wrong in my exposition, but here is my attempt to explain the Marxist response: (warning: the following paragraph will contain a vast overuse of the word ‘value’ in what is already a necessarily convoluted explanation).

Marxists contend that Keen’s is a misinterpretation of use-value, which is simply a binary concept and not quantifiable. Something may have any number of uses which give it a use-value, which is a necessary condition for it to have an exchange-value. However, the exchange-value cannot ‘exceed’ the use-value, because the use-value cannot be measured. It is in this sense that labour is unique in Marx’s conception of capitalism: its specific use-value is the production of surplus for capitalists. It is the only ‘factor of production’ that can do this – after all, capital ultimately reduces to past labour value. If production could take place without labour, prices would fall to zero and, while Marx would be refuted, nobody would care because the problem of economic scarcity would vanish. Hence, surplus production and profits depend on labour producing more than it is rewarded.

I remain neither convinced of the LTV, nor of its critics.*** For me, most discussion of the LTV appears to rest on the LTV as a premise. The debate is split into people who accept the LTV and people who not only reject it, but see no need for it. For this reason, critics seem to misrepresent and misinterpret it continually – a common theme is to try and abstract from historical circumstance, when it’s  clear Marx emphasised that his analysis only applied under capitalism, which he saw as a particular social relation. For me, the main issue remains the same as it is for other theories: what is the falsification criteria for the LTV?

Overall, a couple of points stand out for post-Keynesians for their own theories, both of value and economic systems. The first is that DSGE models are probably not that different to some heterodox models, and identifying the actual differences is crucial to opening up a dialogue between mainstream and heterodox economists.

The second is that I would caution left-leaning economists not to be too hasty to dismiss Marxism as dogmatic (in my experience marxists are anything but), or avoid it simply out of fear of being dismissed themselves. In my opinion, the LTV – while not entirely convincing – is a cut above the neoclassical ‘utility’ conception of value, and I’d sooner be equipped with Marxist explanations of a crisis when trying to understand capitalism. This isn’t to say post-Keynesians haven’t thought about Marx; moreso that the issue is often approached with a degree of bias. At the very least, the distinction between use-value and exchange-value is something that befits post-Keynesian analysis well.

So, as far as theory goes, this is the last post on Keen’s book. I will, however, do some closing notes from a more general perspective. As I said before, if there are any other criticisms of Keen that I have not covered, feel free to discuss them in the comments.

*It is worth noting that in my previous post I was somewhat – thought not totally – off the mark with my discussion of Keen on demand curves. The Gorman conditions for the existence of a representative agent do indeed have many similarities to the SMD theorem and conceptually they are dealing with the same issue: aggregation of preferences. Nevertheless, Keen weaves between the two, when it would have been more accurate to note economists have used two (main) different methods to get around the problem, and critiqued them separately. Similarly, though Keen’s quote from MWG was incorrect, it is true that economists such as Samuelson have used the assumption of a dictator to aggregate preferences. However, the specific one Keen presented was not right.

**However, that does not make it the same as chaos theory.

***For me, claims that worker ownership of production would be desirable don’t really rest on the LTV; instead, the simple point is that workers could employ capital themselves.

Debunking Economics, Part XV: (Not) Keen on the Labour Theory of Value

Yes, yes, I know I’m far from the first person to use the pun in the title.

Chapter 17 of Steve Keen’s Debunking Economics is a rejection of the Marxist Labour Theory of Value (LTV), and with it the most generally accepted analytical form of Marxism. However, Keen does not reject Marx’s ideas outright, instead suggesting and praising an alternative interpretation: one shorn of the LTV, the tendency for the rate of profit to fall, and hence the inevitably of socialism.

Note that this is my first formal introduction to the LTV, so I can’t claim to know the subject in much depth.

The LTV suggests that labour is the only true source of value, as it is the only factor of production that can ‘add’ more than its cost. This can be demonstrated by the simple observation that workers produce more than workers receive in wages. Marx called what workers produced ‘labour power’ and what workers were paid ‘necessary labour time.’ The difference labour power and necessary labour time is the surplus, and the ratio of the surplus to the necessary labour time is the Surplus Value (SV). The rate of profit, on the other hand, was the surplus over the necessary labour plus other inputs (capital).

Because a similar distinction between ‘commodity power’ and ‘commodity’ could not be made for anything else, capital could not produce more than the value that went into it, but labour could. This meant that a higher ratio of machinery to labour would mean less SV for capitalists. Marx argued that over time, capitalists would replace labour with machinery (something they obviously like to do), so SV – and with it the rate of profit – would decline. This would lead to an attempt by capitalists to push down wages and eventually a socialist revolution.

Marx ran into some theoretical problems with this story. The most famous is the Transformation Problem. This arises because capitalists do not care about the rate of SV, but the rate of profit. Marx had already assumed that the SV was constant across industries. Following this logic, a more labour intensive industry would have a higher rate of profit than a more capital-intensive industry, and capitalists would continually move from more capital-intensive to more labour intensive industries in search of higher profits. This complicates the story behind the tendency for the rate of profit to fall.

Marx tried to solve this by arguing that capitalists do not secure only the SV accrued from their own industry, but that they are effectively stockholders in a joint enterprise that comprises the entire economy. Hence, SV and the rate of profit could both be constant between industries. He provided a numerical example to demonstrate that this was feasible: tables showing the various rates of profit, production and surplus, with the rates of profit and surplus uniform between industries. Marx’s example was mathematically correct – in that everything added up – but really it was nothing more than a snapshot of a particular point in time that may or may not have been reality.

At this point Keen channels Ian Steedman’s critique of Marx, which builds on Sraffa’s analysis in Commodities. Steedman starts with a Sraffian economy in which the various industries have to produce enough for the total inputs in the next period (i.e. enough to ‘reproduce’ the entire economy). He tries to convert the inputs and outputs into Marxian ‘values’ based on labour power and SV. From this, he derives output values and converts them into prices. However, he then runs into problems: what starts as an equilibrium destablises and rates of profit diverge, sometimes increasing.

So what happened? Steedman simply concluded that the entire idea of going values to prices was bunk – in his hypothetical economy, it was possible to calculate prices independently of any ‘theory of value,’ as did Sraffa. Sraffians believe that the ‘transformation problem’ is nonsensical  and production should not be analysed from any perspective of utility or value, but from physical quantities and reproduction of industry. Note that this doesn’t necessarily imply that capital doesn’t exploit labour somehow; more so that Marx took a wrong turn in justifying this idea.

So it is hard to tell a consistent story that builds from labour value and ends up with a falling rate of profit and a uniform, economy-wide SV. Marx attempted to justify it with a special case snapshot, but Steedman showed  there was no reason to expect the economy to be in or remain in this state, and no need to invoke ‘value’ in the analysis at all.

Furthermore, there is another significant problem with Marx’s theory of value in and of itself, one that he seemed to acknowledge elsewhere. The very premise that labour is the only source of value can be subjected to an incredibly simple, powerful critique.

Classical economists, including Marx, used to distinguish between two features of a commodity: the ‘exchange value‘  - what it sold for on the market – and the ‘use value‘ – how much it is worth to the buyer. Clearly, though, if this is true of commodities, then one can have a higher use value than exchange value, and hence can be a source of SV for a capitalist. This is a neat observation that can make Marxism a highly appealing analytical framework with which to analyse capitalism, one with the modification that socialism is not inevitable (even if it may be desirable on other grounds).

So, the LTV is quite hard to defend: Marx had to make some arbitrary assumptions that don’t seem to hold; his supposed equilibrium in which the rates of SV and profit would be constant turned out to be unstable; his premise contradicted his own distinction between use value and exchange value. Having said all this, Keen thinks that Marxism is stronger once it is rid of the LTV, and that Marx’s broader analysis of commodities and production is still a highly illuminating framework with which to analyse capitalism.