Reforming Economics: Pluralism is Not Enough

[Published at Real World Economics Review Blog, 5 Dec 14.]

Much of the current discussion of reforming economics focusses on the need for pluralism, particularly in teaching curricula.  Pluralist teaching is seen as challenging, because heterodox economic ideas are diverse, have little coherence, and are to a significant extent mutually incompatible.

This theme crops up frequently in discussions on RWER.  Now Cameron Murray, in the first issue of Inside, published by the Institute for Dynamic Economic Analysis, proposes to identify over-arching themes that can bring out the relationships among the various approaches.  This is commendable but it will not, on its own, result in a reformed economics.

I think the perceived difficulty of teaching heterodox economics comes from expecting too much from the exercise.  It will result in better-educated economists, and that is a very good thing.  Breaking the academic dominance of neoclassical economics would also be a very good thing.  However coherence in economics will not result from trimming and hammering existing fragmented ideas into a new box.

Coherence in economic theory will only come from deeper insights into how economies work.  Newton did not propose a more general framework that could accommodate the ideas of Ptolemy, Copernicus and Kepler, with excisions of a few difficult bits.  Rather, he found a deeper relationship that implied Kepler’s version of Copernicus’ system, and left Ptolemy’s system, by comparison, clumsy, limited and inaccurate.  It also explained falling apples and flying cannon balls.

Of the three main aspects of economic reform – teaching, theory and policy – the way forward is, perhaps paradoxically, most evident for policy.  Theory is the most challenging.  The approach to teaching can be clarified when it is considered in relation to theory and policy.  Here I will address policy and teaching reform in the context of a more fundamental approach to theory.

Much current economic policy is so misguided it is not hard to identify policies that would be less harmful, and hopefully even beneficial.  This comes into sharper focus if we identify some of the sources of mainstream nonsense.  Beyond that first step, a more coherent and fundamental view of the operation of economies can, I will argue here, be inferred from well-known observations in conjunction with modern ideas of self-organising systems.

I would identify three central follies of mainstream economics:  the neoclassical general equilibrium, the neglect of the roles of debt, money and banks, and the misuse of GDP to measure welfare.  There are other follies, to be sure, but if we got these idiocies out of policy thinking the world would already be a much better place.  More sensible policy approaches are already evident in broad outline, and future work can refine them.

Critiques of the neoclassical theory are plentiful, but not all of them are as fundamental as they might be, so I will summarise here my own assessment, from my book Sack the Economists.  The assumptions required to obtain a theoretical general equilibrium are absurdly unrealistic:  we must all be able to predict the future, there must be no increasing returns to scale beyond an ill-defined point of diminishing returns, we must all have complete and timely knowledge, we must not be influenced by third parties (thus excluding fashion, manipulative marketing and herd behaviour in financial markets), and so on.  The predictions of the theory are also blatantly contradicted by observations of real economies.

Both theory and observation tell us real economies are unstable.  Theory first: if you relax any of these assumptions, your system is likely to become unstable.  This is most obvious for increasing returns to scale, which can allow the biggest firm to grow at the expense of all the others.  Delayed or incomplete information implies delayed or weak feedback, which can result in overshooting instabilities.  Herd behaviour exaggerates trends, also yielding overshoot, as is most obvious in financial markets.  The whole point of marketing and fashion is to cause one product to “go viral”, at the expense of all others, another kind of instability.  So a more realistic theory of economies will involve internal instabilities (otherwise why would neoclassicists restrict themselves with such glaringly unrealistic assumptions).

Now observation:  instabilities are easy to identify in real economies.  A market crash is an obvious example.  The growth of one firm to dominance in a market segment is an instability so common that many market segments are dominated globally by a handful of firms, through the operation of increasing returns and other mechanisms, both economic and political, legitimate and not.  Henry Ford and Microsoft are the cliche examples.  The distribution of wealth tends to become highly concentrated, a form of instability.  Herd behaviour in financial markets, due to following trends and rumours rather than “fundamentals”, is commonly remarked, and it drives rapid fluctuations.

If your system is full of internal instabilities, there can be no general equilibrium.    Without equilibrium, the neoclassical claim of optimality is lost.  The fundamental consequence is that there is no basis whatsoever to conclude free markets are best.  An unfettered market might yield results that are desirable and efficient, or they might be undesirable, or inefficient, or both.  The central claim of the neoliberal ideology that dominates the world is lost.

A system that is full of internal instabilities will be a self-organising system, and it may be far from equilibrium all the time.  Its behaviour may be simple (like the neoclassical system), not-so-simple, complex or chaotic.  Evidently, given their erratic behaviour, our modern economies are in the regime of complexity or chaos.  From the theoretical perspective, a complex self-organising system is a radically different beast from the gently oscillating, near equilibrium neoclassical system.  Equilibrium is not a useful first approximation, to understand it you must start from a quite different place.  You have to ask quite different questions about it, such as whether you can recognise general trends or “character” in its behaviour, and identify the main drivers of those trends.  You also have to be humble, because a strongly interconnected system will not respond simply to interventions.

All of this means you cannot make any general claims about a “free” market, you have to look and see what it is doing.  If it is doing bad things, like trashing the planet, then you need to look at the incentives that drive it to such behaviour.  It is not hard to identify incentives to profit by dumping pollution or over-exploiting natural resources.  Many such perverse incentives are actually due to interventions in the market (on behalf of rich sponsors).  If we just got rid of subsidies to the fossil fuel industry, the world would be better off.

If removing perverse incentives (intentional or not) does not improve markets’ behaviour sufficiently, then actively introducing benign incentives may be advisable.  A cap-and-trade scheme for reducing greenhouse gas emissions is an example.

Thus, despite the perhaps-daunting conclusion that economies are complex systems, improved policy approaches are readily evident.  We already intervene a lot in economies, we just do it incoherently, guiltily, or for perverse ends.  If we intervened more coherently and with a clearer vision, we might find our world improves with amazing speed.  At the very least, we would be better off if we stopped accelerating toward a precipice.

The role of academic economics in this conception will be to refine and better quantify the ideas just outlined.  Old questions will recede and new questions come to the fore.  Thus, it is important to clarify which are the most important feedbacks in the system, and which behaviours they most influence, and that will be a large and continuing task.  Questions like “Why do firms exist?” are secondary, until more basic things are sorted out.  Questions like “What is my optimal investment strategy for the next fifty years?” become irrelevant.

There are already some strongly developing correctives to the second major folly of mainstream economics, the neglect of debt, money and banks, both commercial and central.  Commercial banks and other private financial institutions generate money and debt endogenously to the system.  A number of prominent people identified the role of excessive debt in the Global Financial Crisis (or Great Recession) starting in 2007.  Steve Keen has perhaps the best-developed theory of how debt renders a whole economy dynamically unstable.  I have given a very simple but instructive model of how a weakly restrained debt build up can lead to overshoot and crash.

The other major institutions involved with money and debt are the central banks.  The group promoting Modern Money Theory has shown that the operations of central banks are almost the opposite of the intuitions of most economists and politicians.  J. D. Alt’s explanations in Diagrams and Dollars are the easiest to follow.  They argue, for example, that the role of taxes is not primarily to balance a budget, but to “pull” the circulation of official money, which the central banks produce.  A government with money-creating power can never go broke, and never default on its debts.  Nor need “printing money” yield ruinous inflation unless the economy is already at full capacity, which is certainly not true in the post-GFC world.  They fully expose the folly of austerity policies, which exacerbate recession and depression.

The third major mainstream folly is the misuse of the GDP to measure the overall welfare of a society.  This misuse grossly distorts our priorities.  Things that involve money are promoted, while the many good things that do not involve money are neglected or disparaged.  Anything that involves money counts as a positive, even cleaning up pollution, recovering from a natural disaster, or suffering the consequences of ill health or a car crash.  There is a well-developed, unholy and unspoken alliance between unscrupulous businesses and politicians to promote anything that involves money, no matter how destructive, because it simultaneously increases the firms’ profits and the GDP.  The drive to endlessly increase the GDP is destroying the planet.

There are well-developed alternatives to the GDP that could be quickly deployed.  They involve balance sheets:  positives, negatives and a net benefit.  Some yield one number, like the Genuine Progress Indicator, others three numbers, like triple bottom line, and yet others may not be reduced to simple numbers, like reports on the state of society or the natural environment, and whether or not they are improving.

Thus broad policy alternatives to mainstream doctrines are readily identifiable, to manage markets, to manage banks, money and debt, and to measure or characterise the effects of policies.  Other aspects of the economy can also be addressed without a lot of theory, such as promoting more responsible forms of collective ownership than corporations, and promoting business models that strengthen beneficial market feedbacks.

How economics is to be taught is still somewhat challenging, but the framework just outlined clarifies an approach.  The new ideas can be taught, and in fact taught more readily, because they are not as highly elaborated as the neoclassical theory.  One reason neoclassicism now dominates curricula is that it requires the mastery of difficult mathematics applied to a great many aspects of the imaginary neoclassical world.  These can all be dispensed with, and the new ideas taught more readily and quickly.

(As a scientist, a non-economist, I observe among some heterodox economists a tendency to think that any replacement of neoclassical economics will necessarily have to be highly developed mathematically.  In fact much economic management relies on experience and qualitative assessments, because neoclassical models have little to say about much of the economy, like banks, and because the inadequacy of the neoclassical theory is recognised in practice, if not commonly admitted or articulated.  Also, when economies are understood as complex systems, there is a limit, a kind of uncertainty principle, to how much quantification is useful.  This is because such systems are not predictable in intimate detail, but only in general trends and character, like climate, or animals.  Thus the lack of a theory as highly elaborated as the neoclassical theory is not a problem.)

The difficulty Murray addresses is that non-neoclassical economics comprises many distinct schools that are diverse and not uncommonly incompatible with each other.  No doubt there is much of value that can be carried over into a new, more integrated economics, and over time much else might be discarded.  I am no expert in all of that, except to note that many habits of thought from old schools and paradigms will need to be let go, and that is not easy.

In the context developed here, the existing schools of thought can be sensibly taught the way the history of economics is taught.  Murray’s proposal to identify over-arching domains that can bring some coherence to this teaching is certainly constructive, but it does not change the nature of the exercise, which is still more like history.  As I have already argued, pluralism, on its own, will not generate a new and coherent economics.

Coherence will only be brought to economics when a sufficiently fundamental insight is identified.  I have argued above that recognising economies as complex self-organising systems is such an insight.  How well this hypothesis serves to make sense of economies can be explored and debated.  It may be supported, or it may be superseded, but for now it brings more coherence to understanding economies and is therefore a useful framework both for teaching economics and for further research.

Though some may recoil from mention of the “s” word, this is just how science proceeds to improve our understanding of the world.  Newton gave us an insight into the motions of falling apples and orbiting planets.  Subsequently Einstein gave us a more accurate and more general insight into how gravity works.  Nevertheless Newton’s version was, and remains, very useful.

To those who are not comfortable with the idea that economics can be a science I would offer several observations.  First, modern science is moving beyond the reductionist clockwork universe of Descartes.  The power of systems theory is that it can be holistic:  it can embrace living things without killing them, and we can understand more about them without pretending they are predictable, determinist automatons.  (Indeed that pretence is a central deficiency of neoclassicism.)  There is room for free will.

Second, there are such things as historical sciences.  In my own field of Earth science, we cannot run experiments with alternative Earths.  We must make do with evidence from the remote past or the remote interior, but it is still possible to pose hypotheses and test them for consistency with observations.  The Earth is rather messy and the details of its development are affected by myriad details, but it is still possible to gain a broad understanding of its development.  Human societies are even messier and more erratic, but historians and social scientists are still able to draw out coherent broad narratives.

Third, mathematics can be useful, but it is not science.  Mathematics is a tool that is sometimes useful in science.  Sometimes it is appropriate to use elaborate mathematics, or to work at high precision, but in other contexts a rough estimate using simple algebra may yield important insight.  Many neoclassical economists seem to believe that sophisticated mathematics makes their work scientific, but neoclassical economics is pseudo-science:  it is a system of belief, with no useful relevance to the observable world, dressed up in mathematics to look like science.  Just because neoclassical economics abuses mathematics does not mean mathematics has no place in economics.

Fourth, only in some fields, like experimental physics, is the point of science to make accurate predictions of the future.  In the historical and living sciences the point is to gain broad understanding of how something works, without expecting to predict what will happen next.  Market crashes, in their nature, will not yield to accurate predictions of when they will occur.  However if we can better identify the conditions under which they are likely and adjust things so they are less likely, then economics can be extremely useful and beneficial.

Fifth, if the point of economics is to give us useful guidance on how real economies work, and if some ideas are abandoned because they don’t fit what we can see, then to my understanding it is science, in the most general sense.  If you don’t agree with my semantics, but you agree we are trying to elicit useful guidance about the observable world, then let’s not get hung up on the semantics, let’s just get on with it.