As the first decade of the 21st Century ends, I hope that the economic events of the last thirty-five years finally loosen the hold that neoclassical economics has on public policy. It is widely recognized that the accepted economic models that governments use to shape policy are just not empirically valid. Today’s economies are vastly different from the industrial revolution economies that shaped neoclassical economic theory. Yet, these theories are the basis for setting interest rates, regulating the stock market, determining the level of environmental protection, almost every aspect of government regulation (Smith 2010, p. 65). It is time to modernize the economic theories that are used to guide government and economic policies.
The case against neoclassical economics has been growing in recent years. As Yves Smith (2010) details in her book:
1) Economics is not a real science because it is difficult to do the empirical evidence to validate the models economist develop from their assumptions (pp. 20-21).
2) Many of the core assumptions of neoclassicism (people are totally rational, have complete information, only act to maximize utility, etc.) have been disproved by experiments in behavioral economics (pp. 94-97).
3) Despite the fact that they are working with faulty assumptions, economists claim that the implications derived from the assumptions are still valid because they are good approximations of reality (p. 41 and pp. 47-48).
4) Hard sciences also use simplified models to explain phenomena but the crucial difference is that economists add unrealistic properties to validate their models. For example, economists add the property of perfect information to make supply and demand models work (pp. 48-49).
Some economists counter by admitting that neoclassical economics has these problems but the cure is to do more empirical research. But with more empirical research, the neoclassical assumptions are giving way to a new economic theory – complexity economics.
Eric Beinhocker (2007) surveys the rise of complexity economics in which researchers apply complexity and network theory concepts to economic activities. The main advantage of complexity economics is that its assumptions can be empirically validated and that its findings apply to modern economic phenomena. Thus, this is a better basis upon which to base policy decisions.
Beinhocker’s (2007) core argument is easy to understand. Businesses use a mixture (business plan) of physical technologies and social technologies to compete with other businesses. The businesses that have more fit business plans out-compete businesses with less-fit business plans. Based on this model Beinhocker details several implications for policy makers:
1) The role of markets is to process the immense amount of information from buyers and sellers into the most coordinated and effective manner while also determining how fit a business is. Thus free and open
markets must be maintained by regulations that do not impede the flow of information available to all parties (p. 423).
2) Government’s role is to provide and preserve the vast array of social technologies that make it possible for businesses and markets to exist. Social technologies such as contract law, antitrust enforcement, and securities regulation (p. 425). Therefore, government plays an important role in shaping the fitness determination role of markets (pp. 426-427).
3) Behavioral economics indicates what kind of social programs will be more readily accepted and politically-supported. People will support aid programs that have strong reciprocity – programs designed to help people become functionally independent (pp. 418-421).
4) Countries that score higher on measures of societal trust also have higher economic performance than countries with lower societal trust scores (pp. 432-433). Thus, an important role for American government is to build up social capital in the U.S. (pp. 439-440).
As the above demonstrates, government has a vital role in preserving and strengthening the U.S. economy. The argument of neoclassical economics that government should have little or no role in market economies is a false one and has led to extreme reactions from the Left and the Right. With a clearer understanding of government’s actual role in the U.S. economy policy makers can craft effective policies that preserve the best features of the market system while building up the necessary social capital to strengthen the economy and serve the U.S. people. We just need to move beyond the false answers given by neoclassical economics to the insights of complexity economics.
Beinhocker, E.D. (2007). The origin of wealth: The radical remaking of economics and what it means for business and society. Boston, MA: Harvard Business Press.
Smith, Y. (2010). Econned: How unenlightened self interest undermined democracy and corrupted capitialism. New York: Palgrave MacMillan.
Berreby, D. (2005). Us & Them: The science of identity. Chicago: The University of Chicago Press.
Cassidy, J. (2009). How markets fail: The logic of economic calamities. New York: Farrar, Straus, and Giroux.
Lehrer, J. (2009). How we decide. Boston: Houghton Mifflin Harcourt
Pfaff, D.W. (2007). The neuroscience of fair play: Why we usually follow the golden rule. New York: Dana Press.
Schelling, T.C. (2006). Micromotives and macrobehaviors. New York: W.W. Norton & Company.
Shermer, M. (2008). The mind of the market: Compassionate apes, competitive humans, and other tales from evolutionary economics. New York: Times Books.
Stiglitz, J.E. (2010). Freefall: America, free markets, and the sinking of the world economy. New York: W.W. Norton & Company.
Thaler, R.H., & Sunstein, C.R. (2009). Nudge: Improving decisions about health, wealth, and happiness. New York: Penguin Books.
Ubel, P.A. (2009). Free-market madness: Why human nature is at odds with economics – and why it matters. Boston, MA: Harvard Business Press.