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Title: Review: Debunking Economics Author: Anarcho Date: September 22, 2008 Language: en Topics: economics, book review Source: Retrieved on 29th January 2021 from https://anarchism.pageabode.com/?p=154 Notes: Review of an excellent book on the weaknesses of neo-classical economics.
Debunking Economics: The Naked Emperor of the Social Sciences, Steve
Keen, Zed Books (ISBN: 1864030704)
To paraphrase Nietzsche, economics is dead we have killed it with our
disbelief. To see why, Steve Keen’s excellent book is essential reading
(as is his webpage: www.debunkingeconomics.com). It is an important work
and recommended for any one interesting in finding out about the
limitations of mainstream economics.
And what limitations they are! Keen goes into the crazy assumptions,
methodology and contradictions of neoclassical economics in some detail,
debunking key aspects of the dogma and showing not only when they
contradict reality but also when they are logically inconsistent and
contradict itself. Keen argues that it is impossible to ignore economics
(“to treat it and its practitioners as we these treat astrologers”) as
it is a social discipline and so what we “believe about economics
therefore has an impact upon human society and the way we relate to one
another.” Despite “the abysmal predictive record of their discipline,”
economists “are forever recommending ways in which the institutional
environment should be altered to make the economy work better,” i.e.
make the real economy more like their models (as “the hypothetical pure
market performs better than the mixed economy in which we live”). (pp.
6–8)
Given that since the mid-1970s the promotion of the market and the
reduction of government interference in the economy have become
dominant. The “global economy of the early 21^(st) century looks a lot
more like the economic textbook ideal that did the world of the 1950s
... All these changes have followed the advance of economists that the
unfettered market is the best way to allocate resources, and that
well-intentioned interventions which oppose market forces will actually
do more harm than good.” As such, “[w]ith the market so much more in
control of the global economy now than fifty years ago, then if
economists are right, the world should be a manifestly better place: it
should be growing faster, with more stability, and income should go to
those who deserve it.” However, “[u]nfortunately, the world refuses to
dance the expected tune. In particularly, the final ten years of the
20^(th) century were marked, not by tranquil growth, but by crises.” (p.
2)
These problems and the general unhappiness with the way society is going
is related to various factors, most of which are impossible to reflect
in mainstream economic analysis even if economists could be bothered to
include them (their assumptions and methodology exclude such concerns by
behalf). They flow from the fact that capitalism is a system marked by
inequalities of wealth and power and so how it develops is based on
them, not the subjective evaluations of atomised individuals that
economics starts with.
Anarchists argue that this is unsurprising as economics, rather than
being a science is, in fact, little more than an ideology whose main aim
is to justify and rationalise the existing system. Keen’s book is a
contribution to making economics “less of a religion and more of a
science” by tearing up “the foundations of economics” and, as such, it
should be essential reading for all. (p. 19) Given how comprehensive his
book is, it is difficult to cover all aspects of it. As such, I will
concentrate on some key areas which will indicate why anarchists should
read it.
As Keen argues, neoclassical economics is based on a “dynamically
irrelevant and factually incorrect instantaneous static snap-shot” of
the real capitalist economy. (p. 197) Equilibrium analysis simply
presents an unreal picture of the real world. Not that the stable unique
equilibrium actually exist for, ironically, “mathematicians have shown
that, under fairly general conditions, general equilibrium is unstable.”
(p. 173) Economics treats a dynamic system as a static one, building
models rooted in the concept of equilibrium when a non-equilibrium
analysis makes obvious sense. It is not only the real world that has
suffered, so has economics:
“This obsession with equilibrium has imposed enormous costs on economics
... unreal assumptions are needed to maintain conditions under which
there will be a unique, ‘optimal’ equilibrium ... If you believe you can
use unreality to model reality, then eventually your grip on reality
itself can become tenuous.” (p. 177)
Indeed, the neo-classical theory falls flat on its face. Basing itself,
in effect, on a snapshot of time its principles for the rational firm
are, likewise, based on time standing still. It argues that profit is
maximised where marginal cost equals marginal revenue yet this is
“correct if the quantity produced never changes” and “by ignoring time
in its analysis of the firm, economic theory ignores some of the most
important issues facing a firm.” Neo-classical economics “ignores time,
and is therefore only relevant in a world in which time does no matter.”
(pp. 80–1)
Economics even has problems with its favoured tool, mathematics. As Keen
indicates, economists have “obscured reality using mathematics because
they have practised mathematics badly, and because they have not
realised the limits of mathematics.” Indeed, there are “numerous
theorems in economics that reply upon mathematically fallacious
propositions.” (p. 258 and p. 259) As an example, he points to the
theory of perfect competition which assumes that while the demand curve
for the market as a whole is downward sloping, an individual firm in
perfect competition is so small that it cannot affect the market price
and, consequently, faces a horizontal demand curve. In other words,
economics breaks the laws of mathematics.
A key chapter is Keen’s discussion of the Cambridge Capital Controversy
when dissident economists pointed out that the neoclassical
justification for profits as the contribution of capital to output was
deeply flawed. While leading neoclassical economists admitted that the
critique was correct in the 1960s, today “economic theory continues to
use exactly the same concepts which Sraffa’s critique showed to be
completely invalid” in spite the “definitive capitulation by as
significant an economist as Paul Samuelson.” As he concludes: “There is
no better sign of the intellectual bankruptcy of economics than this.”
(p. 146, p. 129, p. 147) This is important as this theory (theory of
marginal productivity) is used to this day to justify the current
distribution of income, arguing that the widening gap between rich and
poor simply reflects the market efficiently rewarding productiveness.
What is the critique of this mainstay of economic orthodoxy? In essence,
capital goods cannot be aggregated together unless you give them a
price. However, to give them a price involves assuming a rate of
interest equal to the rate of profit. This means that the rate of profit
on capital is meaningless as it is based on circular reasoning and so
profits cannot equal any contribution to production.
Even if you ignore this problem, marginal productivity theory still runs
aground. Keen summarises the arguments, noting that looking at the
economy as a whole, “the desired relationship — the rate of profit
equals the marginal productivity of capital — will not hold true” as it
only applies “when the capital to labour ratio is the same in all
industries — which is effectively the same as saying there is only one
industry.” Thus “when a broadly defined industry is considered, changes
in its conditions of supply and demand will affect the distribution of
income.” This means that a “change in the capital input will change
output, but it also changes the wage, and the rate of profit ... The
distribution of income is to some significant degree determined
independently of marginal productivity ... to work out prices, it is
first necessary to know the distribution of income ... There is
therefore nothing sacrosanct about the prices that apply in the economy,
and equally nothing sacrosanct about the distribution of income. It
reflects the relative power of different groups in society.” (p. 135)
Keen shows the unscientific nature of economics by looking at the notion
of diminishing marginal costs required to produce a downward slopping
supply curve. He presents a summary of the empirical evidence which
contradicts this key assumption of economics. How has economics handled
this consistent evidence accumulated over many decades? By ignoring it.
This speaks volumes for the way that economics handles contrary evidence
to accepted beliefs. Not that this should come as a surprise, given that
the notion was originally invented to ensure that neoclassical economics
did not suggest that the economy would become dominated by big business
(that this was precisely what was happening in the real economy at the
time was considered irrelevant). It should be noted that the empirical
research simply confirmed an earlier critique of neo-classical economics
presented by Piero Sraffa in 1926, a critique Keen ably summarises. (pp.
66–72)
No other science would think it appropriate to develop theory utterly
independently of phenomenon under analysis. No other science would wait
decades before testing a theory against reality. No other science would
then simply ignore the facts which utterly contradicted the theory and
continue to teach that theory as if it were a valid generalisation of
the facts. This strange perspective makes sense once it is realised how
key the notion of diminishing costs is to economics. In fact, if the
assumption of increasing marginal costs is abandoned then so much of
neoclassical economics. It is worthwhile quoting Keen at length on this:
“Strange as it may seem ... this is a very big deal. If marginal returns
are constant rather than falling, then the neo-classical explanation of
everything collapses. Not only can economic theory no longer explain how
much a firm produces, it can explain nothing else.
“Take, for example, the economic theory of employment and wage
determination ... The theory asserts that the real wage is equivalent to
the marginal product of labour ... An employer will employ an additional
worker if the amount the worker adds to output — the worker’s marginal
product — exceeds the real wage ... [This] explains the economic
predilection for blaming everything on wages being too high —
neo-classical economics can be summed up, as [John Kenneth] Galbraith
once remarked, in the twin propositions that the poor don’t work hard
enough because they’re paid too much, and the rich don’t work hard
enough because they’re not paid enough ...
“If in fact the output to employment relationship is relatively
constant, then the neo-classical explanation for employment and output
determination collapses. With a flat production function, the marginal
product of labour will be constant, and it will never intersect the real
wage. The output of the form then can’t be explained by the cost of
employing labour... [This means that] neo-classical economics simply
cannot explain anything: neither the level of employment, nor output,
nor, ultimately, what determines the real wage ...the entire edifice of
economics collapses.” (pp. 76–7)
Demand is just as bad, with neoclassical economics itself proving that
you cannot aggregate individual demand curves unless you apply some very
surreal assumptions. This was forced upon it as the original versions of
utility theory were used to justify the redistribution of wealth. To
avoid that conclusion economists had to show that “altering the
distribution of income did not alter social welfare. They worked out
that two conditions were necessary for this to be true: (a) that all
people have the same tastes; (b) that each person’s tastes remain the
same as her income changes, so that every additional dollar of income
was spent exactly the same way as all previous dollars.” The former
assumption “in fact amounts to assuming that there is only one person in
society.” The latter assumption “amounts to assuming that there is only
one commodity — since otherwise spending patterns would necessary change
as income rose.” The net effect is that one essential building block of
the economic analysis of markets, the demand curve, “does not have the
characteristics needed for economic theory to be internally consistent.”
(p. 24 and pp. 25–7)
This is important because “economists are trying to prove that a market
economy necessarily maximises social welfare. If they can’t prove that
the market demand curve falls smoothly as price rises, they can’t prove
that the market maximises social welfare.” In addition, “the concept of
a social indifference curve is crucial to many of the key notions of
economics: the argument that free trade is necessarily superior to
regulated trade, for example, is first constructed using a social
indifference curve. Therefore, if the concept of a social indifference
curve itself is invalid, then so too are many of the most treasured
notions of economics.” (p. 50)
Keen also debunks Say’s law and the notion derived from it that
involuntary unemployment and recessions are impossible under free market
capitalism. Say’s law “evisage[s] an exchange-only economy: an economy
in which goods exist at the outset, but where no production takes place.
The market simply enables the exchange of pre-existing goods.” This is
“best suited to the economic irrelevance of an exchange-only economy, or
a production economy in which growth does not occur. (p. 194–7) Equally
important is his critique of the standard model of the labour market
which shows that “wages are highly unlikely to reflect workers’
contributions to production” (he notes that economic theory itself shows
that workers will not get a fair wage when they face organised or very
powerful employers unless they organise unions). This is because
economists treat labour as no different from other commodities yet
“economic theory supports no such conclusion.” At its most basic, labour
is not produced for profit and the “supply curve for labour can ‘slope
backward’ — so that a fall in wages can cause an increase in the supply
of workers.” (pp. 111–2 and pp. 118–9)
He stresses that the idea of a backward sloping supply curve for labour
is just as easy to derive from the assumptions used by economists to
derive their standard one. Thus economic theory “fails to prove that
employment is determined by supply and demand, and reinforces the real
world observation that involuntary unemployment can exist” as reducing
the wage need not bring the demand and supply of labour into alignment.
While the assumption of an upward sloping supply curve is taken as the
normal situation, “there is no theoretical — or empirical —
justification for this.” Sadly for the world, this assumption is used to
draw very strong conclusions by economists (arguments against minimum
wages, trade unions and demand management by government are all based on
it). Yet such important policy positions “should be based upon robust
intellectual or empirical foundations, rather than the flimsy substrate
of mere fancy. Economists are quite prone to dismiss alternative
perspectives on labour market policy on this very basis — that they lack
any theoretical or empirical foundations. Yet their own policy positions
are based as much on wishful thinking as on wisdom.” (pp. 121–2 and p.
123)
Keen also debunks the really ridiculous neoclassical theories of the
stock market, noting that the modern theory is rooted in the ideas of a
1920s economist who had the decency to revise his theory when faced with
the 1929 crash. His dissection of the Efficient Market Hypothesis is a
classic, showing how it assumes that everyone is identical in terms of
what they know, what they can get and what they do with knowledge and
cash. This results in a theory which argues that investors correctly
predict the future. He quotes the developer of the theory being honest
enough to state that the “consequence of accommodating” key aspects of
reality “are likely to be disastrous in terms of the usefulness of the
resulting theory ... The theory is in a shambles.” Unsurprisingly, “as
time went on, more and more data turned up which was not consistent
with” the theory. This is because the model’s world “is clearly not our
world.” It “should never have been given any credibility — yet instead
it became an article of faith for academics in finance, and a common
belief in the commercial world of finance.” (p. 233, p. 246 and p. 234)
This insane theory is at the root of the argument that finance markets
should be deregulated and as many funds as possible invested in them.
While the theory may benefit the minority of share holders who own the
bulk of shares and help them pressurise government policy, it is hard to
see how it benefits the rest of society. Keen presents alternative, more
realistic theories which argue that finance markets show endogenous
instability, result in bad investment as well as reducing the overall
level of investment as investors will not fund investments which are not
predicted to have a sufficiently high rate of return. All of which has a
large and negative impact on the real economy.
So, all in all, an important book which should be considered essential
reading by all radicals — otherwise you will be at a disadvantage when
debating those who take economics seriously.