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SiS Review & Essay 14/01/15

The Intelligent Person's Guide to Economics

There are at least 9 different schools of economics but neoclassical free-market ideology continues to dominate academia, even after massive failures Prof Peter Saunders

A fully referenced version of this article is posted on ISIS members website and otherwise available for download here

Introduction

Ha-Joon Chang’s latest book, Economics: The User’s Guide [1], is true to its title. It starts from the premise that most people have two mistaken views about economics. The first, which is also believed by the majority of economists, is that it is a science like physics or chemistry and that consequently there is only one correct answer to any question and we can rely on the professionals to find it. The second is that the subject is far too difficult for any ordinary person to grasp; we just have to accept the experts’ word for how things are.

Chang points out that what is widely accepted as the theory of economics, the so-called neo-classical school, is actually only one of many different kinds of economic theory. He describes nine of them in terms that you can follow and with enough background and detail to give you a reasonable grasp of the differences among them and an understanding of why he believes that the current dominance of neo-classical economics is harmful. By the time you have finished the book, you will probably agree with him. Or if you do not, at least you will have a better understanding of what you do believe.

The dominance of free market economics

For a long time now, the idea of the free market has dominated politics and commerce in most of the world. The market, we are told, is better than any other conceivable mechanism for delivering the right goods and services to the right people at the right costs [2], and this must make it the best basis for understanding and managing an economy.

As long as we resist the temptation to interfere, the market will achieve the best possible outcome. Above all, we must not complain if a small number of people are doing far better out of this than we are; that is part and parcel of the deal. If we try to share the cake more fairly, we will inevitably reduce the amount to be shared and we will all end up with less.

This is the dogma that led to the big bang of the 1980s, the 1999 repeal of the Glass-Steagall Act, which was passed in the middle of the last major depression and separated main street banks from investment banks in the US; the Commodity Futures Modernization Act of 2000, which stopped the US government from regulating derivatives; and the policy of “light touch” regulation in the UK.

There was also widespread privatisation, justified by the claim that anything – utilities such as energy and water, railways, schools, whatever – is bound to be more efficient and more effective if it is governed by a market. If there isn’t a natural market, then we must create an artificial one, with hospitals competing for patients and primary schools competing for pupils. (Ironically, privatised companies like railways and energy now negotiate targets and prices with the government, which is disturbingly similar to the system that was used in the Soviet Union until its economy collapsed.)

Clearly this has worked well for the better off. They gain the most from lower income and capital gains taxes and a relaxed attitude towards tax avoidance. (The one tax that UK governments have felt able to increase is VAT, which hits the poor more than the rich because they spend a larger proportion of their income on goods that are subject to it.) If the market turns out in the end not to be the best way of running schools and hospitals, that doesn’t matter to the rich because they don’t use the state system.

When industries and utilities are privatised, the prices are deliberately set low to make sure that the shares are sold, but it is only people with money to spare who can take advantage of this. Soft touch regulation allowed people in the City and on Wall Street to make eye-watering amounts of money through activities that contributed nothing to the country and left massive bills for everyone else to pick up when the bubble burst.

Less clear is what all this was doing for those not so well off, which is most of us. Inequality, which had fallen in developed countries from about 1910, began to rise again in the 1980s and the gap between rich and poor continues to widen [3], [4] (Capitalism and the Inexorable Rise of Inequality, SiS 63).  But as long as things appeared to be going well, the majority of economists and politicians did not consider this a matter for concern. The tide was rising; sooner or later all the boats would be lifted.

After the Crash

There have always been some who doubted that the so called neo-classical theory of economics really is the best foundation for economic and social policy. Leaving everything to supply and demand may be an effective way of running corner stores and restaurants and automobile companies, but does that make it suitable for taking major decisions at a national or international level? And even car manufacturers benefit from subsidies, tariffs, and the shelter of government assistance when things are bad.

Until recently these voices were drowned out by the conventional wisdom. We were told that the ‘science’ of economics had proven this was the only sensible way of running an economy. The free market was responsible for the prosperity of the West [2] and it is through the free market that it and the rest of the world will continue to prosper.

Actually that’s not what history tells us. One of Chang’s chief criticisms of economists is that they generally ignore history, presumably because they believe that a theory that is so self-evidently true needs no empirical verification. In fact, both the UK and the US developed their economies by shielding their industries from the operation of the market. Britain had an empire to ensure a monopoly of trade. America built up its economy behind a high tariff wall: the very policy that it prevents developing countries from adopting today. Chang also reminds us that the advanced capitalist economies grew fastest between the 1950s and the 1970s when there were more regulations and higher taxes than in the period that began with Ronald Reagan and Margaret Thatcher.

The crash of 2008 has changed things. The rich of course came through largely unscathed. The burden fell on the rest of us. As long as the middle income groups had been doing reasonably well, it wasn’t hard to convince them that if the rich were doing even better, that was a necessary part of the process. When they too started to feel the pinch, they began to see the astronomical earnings of investment bankers and CEOs for what they are: not a necessary part of a thriving market economy but people with power grabbing an ever increasing share of the national wealth.

But there has also been a serious blow to the confidence – a better word might be arrogance – of the economists. Here was the most significant economic phenomenon since the crash of 1929, and their theory had totally failed to predict it. It wasn’t just that they didn’t say exactly when it was going to happen, or under what circumstances, or precisely how great it would be. They hadn’t see it coming at all.

Does this colossal failure tell us that all the economists have written from Adam Smith in the eighteenth century to the present day is worthless? According to Chang the problem is rather that we have a great deal of knowledge and understanding but the vast majority of economists have chosen to concentrate on only one part of it. There are indeed other influences on the economy, but they are very much seen as secondary. The answers to the big questions are, they insist, to be found in the neoclassical theory.

The economy is far too complex to be adequately described by a single theory. As Chang writes, “There are many different types of economic theory, each emphasizing different aspects of complex reality, making different moral and political value judgements and drawing different conclusions.” He lists nine different schools of economic theories and for each he gives a one sentence summary (see Box) and also a description of what he sees as its strengths and weaknesses. When you’ve finished the book, you still won’t be an expert but you’ll be in a much better position to judge how far you should believe what those who claim to be experts are telling you.

Neoclassical economics is not just used to take decisions about policy. It also concentrates our attention onto just one aspect of the economy, exchange and consumption, i.e. the market. The neo-classical definition of the subject of economics is still the one given by Lionel Robbins in 1932 [5]:  “the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.”

Chang’s list of nine schools of economic theory and what they say

Classical (Adam Smith): The market keeps all producers alert through competition, so leave it alone.

Neoclassical (Alfred Marshall): Individuals know what they are doing, so leave them alone except when markets malfunction.

Marxist (Karl Marx): Capitalism is a powerful vehicle for economic progress, but it will collapse, as private property ownership becomes an obstacle to further progress.

Developmentalist (Alexander Hamilton): Backward economies can’t develop if they leave things entirely to the market.

Austrian (Carl Menger, Friedrich von Hayek): No one knows enough, so leave everyone alone.

Neo-Schumpterian (Joseph Schumpter): Capitalism is a powerful vehicle of economic progress, but it will atrophy as firms become larger and more bureaucratic.

Keynesian (John Maynard Keynes): What is good for individuals may not be good for the whole economy.

Institutionalist (Thorstein Veblen): Individuals are products of their society, even though they may change its rules.

Behaviouralist (Herbert Simon): We are not smart enough, so we need to deliberately constrain our own freedom of choice through rules.

Matters such as production, technology and the skills of the work force, for example, are largely ignored. Pay and conditions of work are assumed to be solely the outcome of the labour market, rather than of political decisions (including, Chang reminds us, the abolition of slavery) and the rise of trade unionism. Neoclassical economics only grudgingly takes into account what are called ‘externalities’, all the costs and benefits of an economic activity that are experienced not by the participants but by others, often the taxpayer (an obvious example is pollution).

Because those who work in the market are imagined to be the people who really make things happen, they are the ones paid the most. As a result, many of the most able graduates in science and engineering are attracted into finance and banking, though of course this is not a problem if you believe that innovation and production will happen automatically providing only that the City is content.

Neoclassical economics and neo-Darwinism

As a number of authors have pointed out [6, 7], there is an obvious parallel between neoclassical economics and neo-Darwinist evolutionary theory. Both claim to be able to explain a highly complex phenomenon on the basis of a very simple theory – ignoring HL Mencken’s warning: “For every complex problem there is an answer that is clear, simple, and wrong.”

Thus for example, neoclassical economics has little if anything to say about production; it is assumed that if there is a demand for a product then factories will spring up and skilled workers will appear to operate them. Similarly neo-Darwinism assumes that if there is a need, whatever is needed to fill it will appear through a chance mutation. And like neo-classical economists, neo-Darwinists will assure you that they take all sorts of things into account in their work, but in practice they use natural selection as the basis of all their explanations.

If we assume that the system we are describing is either at or very close to equilibrium,  it follows that the status quo is either the best of all possible worlds, or inevitable, or both. So just as evolutionary theory is often used to back up a writer’s prejudices, for example about the differences between men and women, those who are doing well out of the present economic system find the neoclassical approach attractive.

Another similarity is that as Chang points out, the widely accepted Robbins definition of economics means that it is defined by its theoretical approach rather than by its subject matter. Neo-Darwinists do much the same, often using the terms ‘evolution’ and ‘natural selection’ as synonyms. Both consider anyone who sees things differently not just as a follower of a different school but as not an economist or an evolutionist at all. Of course it is much easier to claim that there is a consensus within a profession if you insist that those who disagree don’t count.

The future of economics

The majority of economists seem to have been largely unperturbed by the spectacular failure of their subject. There is, however, a growing feeling among students that something is seriously wrong. As one put it in a recent documentary (in which Chang was also interviewed) [8], it is embarrassing to have to admit to your family and friends that you are studying economics at university but have no more idea about how the crash occurred than they do because there’s nothing about it in your course.

One of the earliest signs of student unrest was at the University of Manchester but the Economics Department there was able to resist the pressure for change [8]. There is now, however, an international movement, the International Student Initiative for Pluralism in Economics, a collaboration of 65 groups from 30 countries that are campaigning for a much broader economics curriculum [9].  

There has been some movement from the profession. The Institute for New Economic Thinking, a research group funded by George Soros, is sponsoring the CORE project to design a new syllabus for undergraduate economics [10] and several major universities around the world are participating. Some leading economists, for example George Stiglitz of Columbia University and Andy Haldane at the Bank of England also support the need for change.

There is also a growing number of biologists trying to move their subject away from the dominance of neo-Darwinism: for some examples see the web site www.thethirdwayofevolution.com. It is not easy to change a paradigm; it is many years since the editors of SiS published their first works on the need for a new approach [11, 12].  But things may move faster now that the weaknesses are being recognised as inherent in a whole way of approaching complex phenomena rather than just one subject.

Economics is too important to be left to economists. If we are going to vote wisely, we need to understand what the politicians are telling us, and Chang’s User’s Guide is an excellent place to start.

There are 6 comments on this article so far. Add your comment
Rory Short Comment left 14th January 2015 19:07:08
The accuracy of the foundational elements of any subject are fundamental to the viability of any structures that are constructed using these elements. As I understand it financial economics is founded upon the values of exchangeable items, be they goods or services, reflected in money. Now under the current monetary system the value of money is unstable. That the value of money is a constantly moving target is borne out by constant inflation in the monetary prices of goods and services. It is hardly surprising therefore that any structures [theories] that include money as one of their foundational elements will be unreliable. This does not have to be the case however. The value represented by money could be stabilised. All that is necessary to realise this stability in value is that any new money issued should only be issued to an individual wanting to make a purchase and having insufficient money to do so. Subsequently the individual concerned would be required to sell something, a good or a service, to the value of the issued new money. By writing off the money received from the sale the value of the new money would be validated thus preventing inflation in monetary prices.
algimantas k bronisas Comment left 14th January 2015 19:07:46
a free market economic ideaology is just that, an ideology; it works beautifully on the small scale[E.F.SCHUMACHER....SMALL IS BEAUTIFUL...economics as if people and nature matter]however on the national and international level,the political process rears its ugly head.For political process read institutionalized corruption.Now free market morphs into private market for the chosen banks and financial institutions,oil companies,defense industry maintained manufacturers,global agro businesses and a real trickle down economy to their countless subsidiaries.This is perfectly reflected in the beacon United States economy.By law,the government is of the corporation ,by the corporation,and for the corporation as corporations are now legal persons as defined by the US Supreme Court.The chairmen of the federal reserve and their cronies know about all the pending economic demolitions in the making.The fall in the price of oil is orchestrated to destabilize and bring the world to yet another conflict and brink of world war.Economists are at best Oracles of Delphi,at worst Hippocrites like Allen Friedman who said oops i made a mistake.
algimantas k bronisas Comment left 14th January 2015 19:07:50
please correct my just sent comment.....Alan Greenspan should be substituted for Allen Friedman2
Todd Millions Comment left 15th January 2015 09:09:52
Heads up for Mr.Chang: -"Merchants can't gather for wine nor merriment,without a whispered plot afoot to set prices and harm the public."-from:'Wealth of Nations' by Adam Smith.Via my memory hole as I currently lack a copy.Its from near the front.Last I checked, the Cliff and Cole notes didn't include a reference.As for the banks that pay for the economists-This is what happens when tape worms fancy themselves vampires.The affected host can go along with the delusion -but shouldn't.
Aquifer Comment left 14th January 2015 21:09:05
I suggest you add to your list of "movements" CASSE, the Center for the Advancement of the Steady State Economy, headed by Herman Daly, oft referred to as the Father of Ecological Economics who has been writing on the subject for decades. He points out what should be rather obvious - that economies are subsets of, and necessarily bounded by, the natural environment, and not vice-versa. All sorts of things become rather clear when you acknowledge this fact, as you cannot have infinite growth on a finite planet .... Ha-Joon Chang is one of my favorites - his work, such as "23 Things They Didn't Tell You About Capitalism", is clear, simple and speaks in basic logical terms that almost all of us can relate to .. I think he should be required reading in all econ courses .... i look forward to reading his latest work!
William Croft Comment left 19th January 2015 09:09:46
http://sacred-economics.com/about-the-book/ by Charles Eisenstein... "Sacred Economics traces the history of money from ancient gift economies to modern capitalism, revealing how the money system has contributed to alienation, competition, and scarcity, destroyed community, and necessitated endless growth. Today, these trends have reached their extreme—but in the wake of their collapse, we may find great opportunity to transition to a more connected, ecological, and sustainable way of being."

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