Economists and the Powerful

If you rarely read to the end of a post, here’s my executive summary:

Read this book – Economists and the Powerful: Convenient Theories, Distorted Facts, Ample Rewards.

For others, read on.

Harling and Douglas intensify the attack on the accepted mainstream economic dogma with this outstanding contribution that brings back logic, evidence and honesty to the economics profession.  A thorough review by Michael Hudson is here.

What impressed me most about Economists and the Powerful is the evidence-based view taken when assessing the usefulness of economic models.  They don’t reject every single mainstream economic theory.  They simply explain, on the basis of the evidence, when, and under what conditions, the policy prescriptions of mainstream theory appear to apply, and when they do not. Unfortunately for your mainstream economist, the answer is that a very particular set of circumstances is usually required for their predictions to hold.  Once you account for other dimensions of human nature, particularly the existence of groups and social networks, and the realities of social and political institutions, you get a very different outcome.

Haring and Douglas also include a long list of evidence supporting alternative theories, which resonate with a common-sense view of the economy far more than mainstream theory.

What continues to surprise me about the economic profession is the religious attachment to a certain set of principles that make little sense in reality.  In mainstream models there are never groups with common interest who may extend their power without direct coordination.  When economists do try and incorporate groups in their thinking, like Becker’s classic 1983 article that defined interest group theory, they generally treat groups as individuals, ignoring their wealth and endowments, and assuming that absolute income is a goal, rather than relative income.  Simply put, a desirable market outcome will ensue.

But in reality income rank, or relative income, matters more than absolute income. Which means small powerful groups will generate pressure for inefficient policy to increase their relative income, and with it their relative power.

The fundamental mainstream economic principles can essentially be boiled down to;

  1. there is a single equilibrium
  2. diminishing returns to scale exist,
  3. factors of production are paid at their marginal productivity, and
  4. individual preferences are the exogenous determinants of economic outcomes.

Together these principles, or more accurately assumptions, allow neat mathematical formulations whose solutions are generally regarded as “proofs”.  These proofs simply demonstrate that a set of assumptions is internally consistent, and when further assumptions are required to generate such consistency, they generally get bundled in with little actual economic interpretation.

How a group of social scientists, ostensibly trying to understand trade and social organisation, came to accept a rather bogus model that has little empirical support as their core analytical tool has always been a mystery to me.

But what Harling and Douglas show is that this core theory is the result of relentless US dominated propaganda machine.  The Cold War US propaganda machine funded the economics discipline and guided it towards this mathematical, yet unrealistic foundation. They note:

“It is hard to overestimate RAND’s impact on the modern economics mainstream let alone society.  As a quick indicator, to date, some 32 recipients of the Nobel (Memorial) Prize, primarily in the fields of economics and physics, have been involved or associated with RAND at some point in their career.  Among other things, it had a big role in de-emphasizing empirical real-world oriented research in favor of axiomatic, mathematical deduction across the fields it touched.”

Turning the economics profession into an instrument of propaganda is a classic Edward Bernays move (for all those fans of Adam Curtis who enjoyed Century of the Self).  I would argue that present day Australia is not immune from the vested interests in academia and the economics profession at large – I have been very critical of this in the past, and will probably write more in the future about why a code of ethics for economists could help improve to corrupted public debate (why don’t economists need to declare their funding sources in their writings?).

Pervasive business interests define the acceptable scope of theoretical arguments, and they brush aside empirical evidence with evermore absurd interpretations (eg. unemployment as a coordinated holiday).  The profession itself has turned into a self-perpetuating lobbying machine.

Indeed, why do hot-shot economists who sit on the President’s advisory boards, multiple bank boards, and many other prestigious positions need to continue to dominate the introductory theory by writing economics textbooks? Especially when so much of what is contained within their pages must be obviously false to someone with at least some real world business exposure.  It would only make sense in a world where a single ideology needs to be drummed into the next generation.

To ground this discussion a little more, consider the neo-classical treatment of the labour market.  The authors write:

“There is no power in the neoclassical labor market.  Everybody has plenty of alternative and everybody is thus indifferent as to whether thay are fired or retained.  Armen Alchian and Harold Demsetz (1972), two influential members of the market-emphasizing Chicago school of economics, made that explicit:

The firm has no power, no authority, no disciplinary action any different in the slightest degree from ordinary market contracting between two people.  Wherein then is the relationship between a grocer and his employee any difference from that between a grocer and his customer?

This is obviously a caricature of the labor market, albeit a very influential one.  Kaufman (2007) calls the perfectly competitive labour market not just unrealistic, but logically impossible.  He is certainly correct.  If the labor market were perfectly competitive, it would not exist.  With no transaction costs, full information, and perfectly specified contracts, firms would not employ workers.  In fact, there would be no firm and not labor market, and this is why:

A firm is an organization with a certain amount of capital in the form of buildings and equipment, and a number of workers who are hired for an extended period to do work together using that equipments according to the orders of the employer.  If the assumptions necessary for perfect competition were met, the entrepreneur would rather buy intermediate products from other self-employed entrepreneurs, so an economy would consist entirely of single-person companies.”

This is all the more true when you realise that marginal costs curves are assumed to be upward sloping, or at best flat.  Smaller firms will always produce at less cost until such time as everyone is a single-person firms and the labour market disappears.  One of the puzzles for economists is why firms exist.  Which should only be puzzling if you believe in the neo-classical market model.  The theory of the firm somewhat sidesteps this question by inserting some economies of scale, but the puzzle essentially remains ignored.

The overarching message in the book seems to be that no market is perfect, and indeed, perfect markets are almost never a reasonable approximation.  Profits are not zero (as they are in neo-classical economics), and this means that there is a surplus, or economic rent, for various groups to bargain over.  This also means that particular groups, be they firms, industry associations, or political parties, may accumulate bargaining power for these social rents over time.

And what is most surprising is that all the pioneers of economics prior to the Second World War generally accepted that different classes had different bargaining power, and there is a trade-off between the share of economic rents to asset owners and wage earners.

In sum, this is the book I wish I had written. For an economic insider it provides some explanation of the collective myopia of the profession.  And it provides a lot of motivation to improve the profession and advance new empirically testable theories.

Tips, suggestions, comments and requests to [email protected] + follow me on Twitter @rumplestatskin

Comments

  1. At the risk of repetition, this is why the science’ of economics is far more akin to ‘Christianity’ than ‘Chemistry’ : “.. It would only make sense in a world where a single ideology needs to be drummed into the next generation.

  2. I like this part;

    “(why don’t economists need to declare their funding sources in their writings?).”

    Spot on.

  3. I’ll tell you why economics isn’t a science.

    In physics and chemistry he laws/rules of nature are fixed and we develop our methods of observation and description around them.

    The rules governing money are not fixed or applied evenly

    Imagine if HSBC were gravity, we would have shit flying all over.

    Behavioral shifts over a number ideology based analysis imo.

  4. If I read the Amazon sites correctly, Australians ripped off by the international publishing world yet again:

    UK Amazon Kindle edition GBP 1.79 = USD 2.86 @ USD1.60 = GBP1

    US Amazon kindle edition USD 14.99

    This would persuade me that illegal downloading is no worse a crime than regional abuse of monopoly pricing by IP owning entities.

    • Yes – I noticed that as well – that is a very low price that UK price even by e-book standards.

      I have noticed a few times that when a book is “imported” into Australia (ie picked up for local publication) the price for the e-book often jumps.

      E-books that have not been ‘released’ in Australia by a local publisher are often cheaper.

      I have assumed it is the result of parallel importing regulations and Amazon have agreed that when an Australian publishes picks up the local rights (and thus the ability to set the price to Australians) they will price accordingly based on IP addresses or if they are members of the Australian Amazon store.

      Perhaps that is not be what is happening here (as it looks like the locals are just importing copies) and it is just a good old fashioned shake-down where Amazon are adjusting prices according to geographic markets.

      Angus and Robertson have the paperback listed for $44 and Abbeys have it for $39 on discount.

      Amazon have the paperback for $19

      All things considered I decided I would lash out and download the free kindle sample and try before I buy.

      My kindle is groaning under the weight of past impulse purchases of cheap e-books !!

  5. “But in reality income rank, or relative income, matters more than absolute income. Which means small powerful groups will generate pressure for inefficient policy to increase their relative income, with (sic) with it, their relative power.”

    Heart of the matter, right there. At a certain level of wealth that is largely unimaginable to the common man, “influence” becomes more about increasing one’s power than increasing one’s income.

  6. One of the amazing things is that there seems to be gross conflict in understanding some basic things:
    1. how is credit created in the US and Australia
    2. whether QE puts lendable money into the private sector or are the funds locked into the interbank/central bank system
    3. is the modern monetary theory of the government use of a fiat currency correct (assuming that there is in fact a unified theory) ie governments are not revenue or tax constrained and ought deficit spend to maintain employment, perhaps even to the extent of a job guarantee.

    How about it? Aren’t these macro issues worthy of discussion and clarification?

    • Indeed they are worth discussing and why it may be interesting watching what the Japanese do this year.

      It is possible that the new government is simply planning some old school methods – namely, sell bonds to the public/pension funds and use the money to build infrastructure or some traditional QE aimed at the banking sector to get it lending.

      But there are suggestions they are considering something far more radical to stimulate economic activity and possibly a bit of inflation.

      For example:

      Engage in some creative accounting entries.

      Cut taxes so that households hold onto more of their income and thus give them additional spending power directly.

      Fund the ‘fiscal’ impacts of the taxh custs by selling bonds to the Bank of Japan – who make some appropriate accounting entries to pay for them.

      If we really want to see if the consumption shy Japanese household can be woken from their slumber and whether inflation can be generated that is the way to go about it.

      Put money into the hands of those who are mostly likely to spend it on things that they need.

      It is only a matter of time before governments consider going the final step in their desperation to find a ‘politically’ less painless way of dealing with the various debt mountains (public and private) around the globe and the consequent lack of consumer/ business mojo.

      I can hear it right now.

      “By using HFQE “Household Focused Quantitative Easing” and thereby reducing taxes on working families, economic growth will be stimulated thereby facilitating debt repayment and employment”

      “Economists now believe that the risk of inflation is low and Central Banks and governments have the ability to take quick a decisive action if they are mistaken ”

      Apart from Central Banks holding bits of paper from their governments in return for some accounting entries no new private or public “private debt” (held by the private sector) is required.

      Sure some of those households will use their tax breaks to pay down their level of household debt (and thus will not stimulate economic activity immediately) but that would a good thing as paying down debt will have little effect on inflation and eventually improve their economic mojo as their overall level of indebtedness falls.

      Sounds peachy to me.

      • This is in essence a form of debt jubilee. The level of cash in the hands of households is immediate due to the tax cuts.

        Those with debts can deleverage and those without can spend or save as they please. If everyone is a sourpuss and saves the overall level of debt will fall and there will be no economic activity but also no inflation.

        Those that had no debt will have higher savings and those with debt will have less.

        If it looks like people are getting excited and start spending and start driving up inflation then turn off the taps and increase taxes.

        The level of govt debt will of course rise but as it is all held by the Central Bank who cares.

        The only real catch is trusting the pollies and the central banks to turn off the taps if inflation gets up a head of steam.

        It is only a matter of time before someone gives HFQE a go!!!

        The ‘progressive’ MMT crowd prefer that government do the spending permitted by the ‘accounting entries’ on ‘useful stuff like infrastructure and make work schemes rather than the households so considered this libertarian MMT. 🙂

  7. Economists end up serving vested interests because those whose theories are at odds with vested interests eg. Gessell (bondholders), Henry George (landowners), end up being seen as cranks.

    If you want to be remembered as a great economist, it’s better to be an obscurantist, libertarian ideologue like Milton Friedman.

    • “If you want to be remembered as a great economist, it’s better to be an charismatic, intelligent, correct about pretty much everyting, libertarian like Milton Friedman.”

      Fixed your post to make it accurate.

      Friedman was an absolute genius and would nail modern economists to the floor in any debate. He is hated by leftists simply for being right, nothing else.

      • Really? My reading is that he was often self-contradictory and often wrong. What examples are you referring to?

        • really? why?

          the people of Estonia who built there economy after the fall of the wall on his works alone might beg to differ..

      • Who cares if he was charismatic or intelligent. His theories are completely overrated and many would argue wrong.

        He basically copied the Keynesian theory of money demand (liquidity preference) and then pretended that his work was the only development in monetary theory since Hume. He misdiagnosed the cause of the great depression, and came up with a monetary policy rule which was a spectacular failure. Macro was in better shape before Milton Friedman.

        • its important to separate many of his macro ideas which were not good (considered leftist by many) and his libertarian roots which was more micro based..

          many like him for the latter.

  8. Given the gutter politics going on, perhaps your “pubic debate” typo is apt.

    What is the sentiment like at UQ in the economics department? I thought that university was very much in the camp of mainstream theory.

    I hope you will be alright with your heretical thoughts!

      • I do sessional lecturing at QUT from time to time in the Urban Economics course. I am now a PhD candidate at UQ.

        UQ is very mainstream. But at least I know what I am up against.

        As far as vested interests, it seems that once you are an academic economist, detached from the day-to-day politics, it is very hard to see the forest for the trees. I hope to straddle this reality/politics/academia divide, much like John Quiggin and a few others.

  9. “…economics is like a fable…there to stimulate ideas, directly inspire practice perhaps, but certainly not to direct or determine practice…”

    “Economics is not a science and should not be there to advise policy”

    Anti Fragile, Nassim Nicholas Taleb (another must read book).

    • For once I agree with you 3d1k. You should have added to your list:

      – “The economy is not a small business.”

      Claims by would be presidents, prime ministers, treasurers, premiers etc that they are suited to running a state or country due to having once run a fish and chip shop need to be taken with a grain of salt, particularly given the complexity of the economy.

      But who has challenged this urban myth that “small or big business owner = good political leader?”. Answer: no one.

      The next phase of the sheeple’s development is waking up to this fact and to stop tinkering with notions that ex hedge fund managers, investment bankers, and other unscrupulous types (typically lawyers) are in the main suitable for leading the community. Our history of dirty politics from ALL parties at ALL levels is testament to that.

      As noted by Tony Fitzgerald, it is time to get rid of the two party system and career politicians and inject integrity into the system via significant parliamentary reform (not just electoral laws).

      There are plenty of non-lawyer, non ex-business owning, non-career politicians out there with plenty of expertise who could help drive this country in a new direction. Hell I’d happily vote for DC, Phf007, Rusty Penny or a number of other commentators on MB based on their economic platforms, rather than cast a vote for a mainstream politician with an unknown agenda who is running on a platform of ‘trust me, I’m not X’ (whatever party is disliked at the time in that jurisdiction).

      Australians might feel good about ‘punishing’ the politicians by voting them out in force; but when the choice is another party with 95% of the same policy platform – what’s the point?

      The neo-liberal economic agenda has broadly failed. The economists in prestigious institutions and universities around this country seem to have no answer or imagination e.g. witness the RBA dreaming of Jeannie for a return to a housing construction boom to save us all. I mean, is that it? Is that the best they can do?

      Our private debt levels are testament to RBA and government incompetence. It’s time to stop letting the financial lunatics run the asylum. The RBA mandate should be revisited as well as its group membership given their economic pedigree and theoretical systems and the ZIRP corner into which they have painted Australia).

  10. “In all recorded history there has not been one economist who has had to worry about where the next meal would come from.”
    Peter Drucker
    American (Austrian-born) management writer (1909 – 2005)

  11. “Markets are imperfect because they are created by imperfect people” – [forgotten who said this]

    Markets aren’t perfect, they they are far better than the alternative, government control, excessive regulation and bureacracy, that is killing Europe and threatens to engulf the US and Australia.

    • Markets aren’t perfect, they they are far better than the alternative, government control, excessive regulation and bureacracy, that is killing Europe and threatens to engulf the US and Australia.

      This is what’s called a false dichotomy.

      As usual, people who worship before a deity, cannot contemplate that deity being capable of failure.

    • Hasn’t MB put forward a reasonable argument in its articles that effective markets (and money) is all about rules?

      It stands to reason that if a system of rules is too lax to enforce reasonable behaviour on behalf of the participants, then unethical behaviour will in fact flourish; subverting the intent of the market rules and hence ultimately the intent of the law. If participants at large don’t trust the markets because they are rigged MattR, then people will simply lose faith and refuse to participate completely.

      For instance, take this example – here is high frequency trading clearly exploiting a rule on the number of cancelled orders per second.

      http://www.zerohedge.com/news/2013-01-04/dear-sec-hft-cheating-its-most-obvious-regards-everyone-else

      “Each exchange has been setting limits for the number of canceled orders allowed per second. We know that one exchange has a limit of 300 canceled orders per second per stock.. It’s rare to find 300 or more canceled orders in one stock in any one second from that exchange. But you will find tens of thousands of seconds where a stock has 299 canceled orders.

      In the charts below, we show a new strategy they have cooked up: send a blast of orders (all immediately canceled) over a very short period of time, 100 milliseconds (ms) in this case, and then silence for the balance of the second. They know that exchanges measure the number of canceled orders on a per second basis, so that blast of orders sent in 100ms will be diluted by another 900ms of silence. But networks operate on a much smaller time-scale, microseconds. A microsecond is a millionth of a second.”

      So MattR, this is an example where despite the presence of a rule, sophisticated cheating (quote stuffing) is going on in order to facilitate rapid price moves so that (presumably):

      “… instigate other participants to buy or sell quickly, the instigator of momentum ignition can profit either having taken a pre-position or by laddering the book, knowing the price is likely to revert after the initial rapid price move, and trading out afterwards.”

      http://www.zerohedge.com/news/2012-12-14/momentum-ignition-markets-parasitic-stop-hunt-phenomenon-explained

      In accordance with your theory MattR, this rule of limiting the amount of cancelled orders would actually be ‘unwarranted government interference’ in the market and thus undesirable. Your solution would mean 1000s or 10,000s of cancelled orders in order to enable even more volatile movements in stock prices so that someone, somewhere could profit from a fancy computer algorithm with high-speed, close proximity connections to the exchange which no other market participant has.

      This is clearly an unfair advantage which would be made all the worse by scrapping this rule.

      The problem is MattR, that if we removed many of the few rules which remain in the markets(and which are already regularly flouted with ease), then the system would be 100% rigged for the rich (currently its only at about the 80% rigging rate).

      HFT is only one example of the market where rules are definitely needed, but they are plenty of others. Rules help prevent abuse of market structure and topology and are certainly nothing to be scoffed at.

  12. Good article. Other economic issues/theories that largely go unchallenged include:

    – “The money multiplier” wherein credit money is allegedly created via a system of fractional banking (wrong: credit money is created out of thin air first and fiat money follows a year later)

    http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/

    – Prof Keen also notes in Debunking Economics:

    * economics has not derived a coherent theory of consumer demand from its premise that people are no more than self-interested hedonists. Thus economic theory can’t justify the supposed smooth fall in demand for a product as its price rises

    * the economic theory of the firm is logically inconsistent. When inconsistencies are removed, “price is set by supply and demand” & “equating marginal cost to marginal revenue maximises profits” are shown to be FALSE

    * economic theory cannot distinguish between competitive firms and monopolies, despite its preference for small competitive firms over large ones

    * the theory of supply is flawed, because conditions which are needed to make the theory work don’t usually apply in practice e.g. diminishing marginal returns are unlikely in practice, supply curves are likely to be flat or downward-sloping

    * flaws in labor market theory imply that wages are not based on merit and their supposed contribution to production

    * the theory of capital is logically inconsistent e.g. profit does not reflect capital’s contribution to output and changing the price of capital relative to labor can have perverse impacts on demand for factors of production

    * static economic analysis applied to a dynamic economy is useless and thus policy derived from this reasoning is spurious and harmful

    * the Efficient Markets Hypothesis is a crock. In the real world, investors will not have identical, accurate expectations of the future and equal access to unlimited credit. Thus financial markets are NOT efficient and finance and debt DO effect the real economy

    * economists continue to persist with the inappropriate use of static equilibrium analysis of the economy when it is actually a dynamic, non-equilibrium social system that requires the use of different tools

    This is not exhaustive BTW. When economists in the main start talking about: Human Minsky’s Financial Instability Hypothesis and non-linear and monetary models of economics incorporating DEBT as the key factor, then we might be getting somewhere.

    Until then, many theoretical economists should be placed firmly in the ‘Clown’ category, particularly if they are trying to defend the status quo.

    • i would reccommend you take Keen seriously but not too seriously, you seem to have your lips firmly placed on his behind

      • [MB friendly reply given original deleted]

        I’m sorry TS, I must have missed the rebuttal of Keen’s ideas in your reply.

        Given the global economic system is currently a disaster, I do believe that it is time to look at alternative theories backed which are backed by data. Prof Keen provides that in droves.

        Feel free to provide links or ideas at your leisure that counter these ideas above touched on above.

        • I agree with many of Keens ideas but im not a disciple of the church of Keen either..

          Im naturally wary of anyone whos character is very much krugman-esque..

        • the basic summary is: I too have read debunking economics, but dont think it should be in every hotel room as bible

  13. “Kaufman (2007) calls the perfectly competitive labour market not just unrealistic, but logically impossible. He is certainly correct. If the labor market were perfectly competitive, it would not exist. With no transaction costs, full information, and perfectly specified contracts, firms would not employ workers.”

    This is not plausible. It ignores complexity, the significance of time, the exercise of choice, the various benefits available from pooled effort, the properties of specialisation and the asymmetric distribution of capital/s.

    But the book sounds like a good read. I will get a copy and send you my review. Cheers.

  14. I fail to see why people are so hung up on “perfect” markets, when they so clearly do not exist. It is just like arguing about the number of imaginary angels that can fit on a pinhead.

    But just as surely as there are no angels, there are real markets, and the object ought to be to describe them as they actually are. Isn’t this really just about how we develop learning? About the iterative matching of data and theory to observed reality, and trying to get better at it?

  15. Peter Drucker had a lot of insight, but he was a writer who never had to manage anything, or make any economic predictions either. He had the advantage of being able to think freely without having the responsibility of making decisions.