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.
Excellent post! While I agree in prinicpal, there should be a few caveats.
First, neoclassical or traditional economics needs to be understood in the context it actually evolved rather than the dumbed down Cliff Notes descriptions popularized by talk radio, newspaper columnists etc. People who actually read “Wealth of Nations” and “A General Theory of Employment, Interest and Money” will have a much different understanding of neoclassical economics than those who merely read Paul Krugman or Robert Samualson (although both should be read regularly).
Second, recognize that, at its core, economics is the study of human behavior as it pertains to labor, production, exchange, consumption etc. And human behavior changes over time. The behavioral theories which accurately explained relationships between classes, genders, racial groups, religions etc in the 18th century were out of date by the 19th, arcane in the 20th and offensive in the 21st. This does not negate the scientific validity of behavioral studies but does show the need for consistently revisiting the subject.
Third, understand that entirely too many economic evangalists latch onto a theory developed to explain a singular set of circumstances at a specific point in time and apply the related economic prescription in ways never intended by the original author of the theory while denegrating any competing theories as voodoo economics. The well known “competition” between Keynesian and Supply Side economics is one example. Both are valid theories which have led to useful economic policies when applied correctly and both have led to disaster when misapplied. Unfortunately their strengths and weaknesses are often understood least by the advocates shouting the loudest.
Finally, remember that economic and political theory are separate disciplines even though each is often used to prop up the other. The strongest argument supporting free markets is their ability to maximize freedom. Prosperity is often a desirable byproduct of free markets but not their primary goal.
Thank you, Peter! I agree with the caveat on not judging economics by what the popular media and political advocates portray. Believe me, I have been thinking about these issues since my first economics course as an undergrad which also happened to be the first time I was introduced to chaos theory. In fact, I have been mulling this post over for the last six months because I wanted to make sure that I was making a good argument. It is rather presumptuous to claim that a well-established field with thousands of researchers is fundamentally flawed without having compelling evidence to back up your claim.
But, as I was taught in college debating, examine the assumptions underlying the arguments before you start challenging the arguments. And the more I read about Keynesian economics versus Supply-Side economics, the more I was convinced that the assumptions underlying many of the points were just unprovable or not well-supported by empirical evidence. I became more convinced of this when I read the latest research on game theory and how neuroscience was overturning many of the concepts in that field.
Complexity economics is a nascent field and there is a lot of work to be done. But I feel it is going in the right direction and the key findings to this point make more sense than what neoclassicism has prescribed. The two biggest advantages that complexity economics has is that it deals with emergence and the role of knowledge in economic transactions. Neoclassical economics with its quest for equilibrium could not deal with either emergent phenomena nor how economic actors acquire and use knowledge.