The Fourth Principle of Economics, which N. Gregory Mankiw assures us is accepted by almost all economists is: People Respond To Incentives. This is obviously true, so it’s good that almost all economists agree. Neoliberals agree as well; it’s the basis of their understanding of human nature that people respond to money, and not much else.
Here are the examples. When the price of apples goes up, people buy fewer apples, and “…apple orchard owners decide to hire more workers and harvest more apples.” Supply and demand are the direct result of incentives. Taxes can be used as incentives. If the gasoline tax goes up, people drive smaller cars, switch to public transport and buy hybrids. If the price goes high enough, they might even switch to electric cars. Incentives can have unintended consequences. Seat belt laws led to a higher number of accidents, and more accidents involving pedestrians. There are two longer examples, one on changes resulting from the gas price hikes from 2005 to 2008, and one on the way bus drivers are paid in Chile.
It’s no doubt true that generally as prices rise, the amount purchased falls. It’s probably the case that the relationship isn’t continuous. People don’t watch the price of apples at all. When they are at the store or the market to buy they don’t say to themselves “prices are up a penny a pound, so I’ll just buy a bit less.” Instead, they compare apples to other fruits and even vegetables and as long as the prices seem about right, they buy. It takes a pretty good price jump foror people to notice the exact price per pound. On the other hand, maybe people think Fuji’s are about as good as Gala’s, so if one is cheaper, they buy them. Or if one set looks tastier for some reason, they buy those.
The idea that the orchard owners harvest more or less depending on the price seems equally inadequate. Of course, once harvest season is over, there won’t be any more harvesting, so all decisions have to be made during the short season when the apples are at the proper stage of ripeness. If owners think the prices will be higher, maybe they will harvest more. Or, maybe they harvest all they can to protect the trees and the fields, and only sell if the price is right, and feed the rest to the cows. I don’t know enough about running an orchard to have an opinion, but apparently Mankiw does.
The second example, gasoline taxes, supports the idea that demand can be manipulated by society for its own good. I don’t think that was Mankiw’s point though. We return to this idea in Principle 8.
The discussion of seat belt changes shows typical short-term thinking. Assuming that the study Mankiw cites is accurate, and I note he describes it as controversial, in the short term, people acted in a more risky way after the passage of seat belt laws. Here’s a chart from the Statistical Abstract produced by the Census Bureau in 2012 with more recent statistics.
Those statistics tell a different story. They say that the incentive created by one set of changes can be changed once the actual outcomes are known. Cars have become more and more safe, and with the recognition that some of the changes produced bad driving, people were able to find ways of making cars safer in ways that defeated the original incentives.
You’ll note that the deaths of pedestrians were down, too, but that doesn’t tell us much. The number of pedestrians overall may be down.
Finally we have the bus driver example in Chile. It comes from Austan Goolsbee, and explains that drivers paid by the passenger work harder than drivers paid by the hour, including taking the shortest routes between two points when there is a lot of traffic. It doesn’t tell us anything about the response of bus riders who don’t get picked up, oe of other people trying to drive on the same streets as racing bus drivers.
So, everyone agrees that people respond to incentives. The question is how people respond to incentives. Mankiw tells us that economists are social scientists, and their field is centered on understanding human behavior. If these examples are typical of economic thinking, the understanding of behavior is rudimentary and reductive. It’s fair to assume that models built on rudimentary and reductive ideas may produce strange and untrustworthy results.
Mankiw’s third principle: Rational People Think At The Margin. His definition is:
Rational people systematically and purposefully do the best they can to achieve their objectives, given the available opportunities.” Principles of Macroeconomics 6th Ed. at 6
He defines marginal change: a small incremental adjustment to a plan of action. He teaches that rational people often compare the results of marginal changes to make decisions. Finally we get to his major premise:
A rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost.
The first example is dinner. The choice, Mankiw says, is not between fasting and eating like a pig, but whether to eat another spoonful of mashed potatoes. At exam time, the choice is not blowing them off versus pulling all-nighters, but whether to put in an hour on your notes or goof off for that hour. His next example is seat prices for airplanes. The airline should sell seats at the price above the marginal cost of flying the passenger. Then we get the water/diamonds example. Water is essential for life, but it’s cheap. Diamonds are an extravagance, but they are very expensive.
All of this is in support of a central element of neoliberal and mainstream economics, that economies can be modeled by treating them as made up of rational agents. This idea fits neatly into Mirowski’s commandments of neoliberalism, specifically number 6: Thou Shalt Become The Manager Of Thyself. This means that individuals must learn to act rationally to decide upon a set of investments in themselves and changes in their behavior that will improve your appeal to people with money so they will give you money to work for them.
The food example is straight-forward enough, but how is the choice made? Some people are raised to clean their plates, and they do even if they could have skipped the last few forkfuls. Some people feel differently about meat than about French fries or carrots. Some people are abstemious, and always leave food. Others make the choice at the outset, by serving themselves a fixed amount and then eating all of it. Suppose the person would prefer to eat the last few bites of pork chop and skip dessert? If all these are rational choices for individuals, what possible generalization about eating is there? What, if anything, can this principle predict? How would Mankiw use that idea to model eating dinner?
The study example is fascinating. I remember my college days, and I ‘m sure I didn’t rationally choose whether to goof off with my friends or to study for finals. I chose, but it was random. And how would you calculate the benefit of one hour of study versus one hour of relaxing? Is that a real possibility?
The airline example is obvious to anyone familiar with basic business principles. It certainly isn’t an indication of “rationality” in the sense Mankiw is using the term. It merely requires an understanding of the difference between fixed costs and variable costs.
Then there’s the water/diamonds example. Here’s Mankiw’s explanation, so you won’t think I’m being snarky:
The reason is that a person’s willingness to pay for a good is based on the marginal benefit that an extra unit of the good would yield. The marginal benefit, in turn, depends on how many units a person already has. Water is essential, but the marginal benefit of an extra cup is small because water is plentiful. By contrast, no one needs diamonds to survive, but because diamonds are so rare, people consider the marginal benefit of an extra diamond to be large.
So water is cheap because people have a lot of it? Of course, there is plenty of water in most parts of the country, in our commonly held lakes, rivers, underground acquifers, and water run-off. As a commonly-owned asset, it’s free, if you could get it. But it has to be cleaned, delivered, and disposed of. That means the real question is why do we have a lot of clean water at the tap and few diamonds? The real reason is that our ancestors decided to make sure we all had clean water to drink, and explicitly chose to keep the “free market” out of it.
There are plenty of diamonds, though they are hard to find and dig up. The diamond business is controlled by a monopoly that artificially restricts the supply. Our ancestors made sure that didn’t happen to water. To see this clearly, think about the price of a bottle of water at the movies. There we have artificial scarcity, produced by the theater’s policy against bringing in snacks. Just ask yourself whether you want to buy your water from a profit-maximizing monopoly, say the Comcast or the DeBeers of water. Maybe you’d like to buy your water from the private company that didn’t have a system in place to detect the foul chemicals in the water supply of Charleston, WV?
So now let’s see how this rationality principle works in practice. Consider retirement savings. What would it mean operationally to say that people act rationally when making decisions about saving and preparing for retirement? What does this principle tell them to do? How should they invest? What should they do to protect themselves against losing big in those investments? What happens if they are hurt and can’t work, or if their spouse gets hurt and they need to quit work to take care of them? How do you calculate the value of a dollar today against the value of that dollar in retirement? For a short lesson in the prevalence of financial literacy, look at this paper, or this site.
Finally, it isn’t just one choice. There is a chain of choices in life, each one eliminates other choices and creates new choices and possibilities, each with its own probability of success. In the retirement example, you might have a 75% chance of correctly guessing at how much to save, a 95% chance of getting an honest financial adviser, a 60% chance that the investments will be very successful, and related chances of less good outcomes. Your chances of getting the best result are about 43%, and that’s before you consider the general state of the economy when you need money, continued good health, unexpected possible current uses for your money, good relations with your partner and your partner’s success in contributing, and all the other variables. That tells you that most people will be somewhat successful, a few will be wildly successful, and a fair number will crash and burn. The reality is that most families have very little success, and are dependent on Social Security and Medicare for a decent retirement. Even people who do reasonably well need those social arrangements to secure a good retirement.
This analysis shows that the margin plays little or no role in the lives of ordinary humans. It’s just a construct used to simplify human life in a way that permits economists to justify their use of calculus.
Here are some possible conclusions:
1. This principle makes sense when considered in the very short run, like the mashed potatoes example. For any longer term, it feels more or less random, mostly because there is no way to determine the probabilitiies. Some people get lucky and win the game of life. Others don’t get lucky. The number of things that seem perfectly rational at a point in time either work, or they don’t, and the results are unpredictable. That accords with my understanding of markets as minute by minute affairs. In the longer run, investment and housing markets are a real threat to the marginal thinking of Mankiw’s rational people.
2. We all want to think we are pursuing their goals systematically and purposefully, Mankiw’s definition of rational people. We want to believe our success is the result of their personal skill, and many people apparently feel justified in looking down on, and even punishing, the losers. I’d say the reality is that it’s better to be lucky than rational.
2. By deciding that the economy is full of rational people, the door opens to armchair speculation. Hmmm, says Mankiw, if I were faced with a bowl of mashed potatoes, here’s how I’d decide how much to take. I’m rational, so that means everyone would act that way. So, I’ll model mashed potato eating based on purely rational me. In exactly the same way, they figure out how they prepare for retirement, and draw conclusions about the way rational people act and build that into their models. No.
3. I do not think this is the definitive discussion of the role of rationality in human decision making. The entire subject of rational agents has been subjected to criticism on philosophical and practical grounds, and I hope to get to it at some point.
Mankiw’s second principle is The Cost of Something Is What You Give Up To Get It. Mankiw explains that you have to include opportunity costs in your calculations. His example is college: the actual cost of going to college includes tuition, but not necessarily all of the costs of room and board, because you need food and a place to sleep whether or not you go to college. It also includes the money you didn’t earn by going to work instead of going to college.
Before I read Mankiw’s explanation, I thought we were going to get a discussion of the way an economist might calculate costs. That was not to be. Maybe I have to buy his Principles of Microeconomics. In the express language Mankiw chooses, you are the sole standard for calculating costs. That kind of calculation fits perfectly with the neoliberal canon of Philip Mirowski. It’s part of Number 6: Thou Shalt Become The Manager Of Thyself for sure, and it complements Number 3: Thou Shalt Worship “Spontaneous Order”, meaning the market.
Again, non-specialist students will likely remember the principle, and will repeat it mindlessly when talking about value and cost, even though this discussion doesn’t include value or even price. This is a license to ignore all the costs that are not visited upon the neoliberal You. Smoking may not make you sick, but smoking makes some people sick directly and others indirectly. The neoliberal You hopefully doesn’t pay those costs, so they aren’t included in the calculations of the neoliberal You. Computers have a number of components that are dangerous to the health of people. Those costs aren’t paid by the neoliberal You, so they aren’t included in the calculation of costs. Coal burning is a major contributor to climate change, but maybe those costs won’t be paid by the neoliberal You, so they don’t count.
Well, perhaps that wasn’t Mankiw’s intent. He does discuss externalities as something government can correct maybe, sometimes, after a fashion, and at a cost to efficiency. The notion of opportunity costs arises directly from Principle 1: People Face Trade-offs. Most likely the only point of the second principle is to make sure there a nice round ten.
The first of the Ten Principles of Economics laid down by N. Gregory Mankiw is “People Face Trade-Offs”. Principles of Macroeconomics, 6th Ed. 2012, p. 4. In language more suited to a high school textbook than a best-selling college textbook, he provides several examples. If you study economics for five hours, then you can’t spend that time studying something useful, like welding or English Literature. If parents have a certain amount of money, every dollar they spend on rent can’t be saved, or used to buy food. Then, as if society were a person, and faced trade-offs in exactly the same way (government is just like a household) he gives two macro examples. First:
The more a society spends on national defense (guns) to protect its shores from foreign aggressors, the less it can spend on consumer goods (butter) to raise the standard of living at home.
There is also a trade-off between a clean environment and a high level of income. If companies have to pay for environmental contamination, they make smaller profits, pay lower wages, or raise prices or some combination. This is the last example:
Another trade-off society faces is between efficiency and equality. Efficiency means that society is getting the maximum benefits from its scarce resources. Equality means that those benefits are distributed uniformly among society’s members. Emphasis in original.
Mankiw explains this by saying that government policies that help those in need, like unemployment insurance or welfare reduce efficiency, because, and I quote because otherwise you’ll think I’m being snarky:
When the government redistributes income from the rich to the poor, it reduces the reward for working hard; as a result, people work less and produce fewer goods and services. In other words, when the government tries to cut the economic pie into more equal slices, the pie gets smaller.
The statement that individuals face trade-offs in consumption of goods and services as well as every other human activity is vacuously true. We get one life, and at any point in time can only do one thing. If we do one thing we cannot do another. So what’s the point of this principle? I think it’s not the principle itself, but the examples. Each supports the principles of neoliberalism, as described by Philip Mirowski in this article.
Mankiw’s first two examples are folksy and disarming. Let’s try a similar version:
Angela has a problem: should she summer with her mom on Martha’s Vineyard, or should she summer with her dad on their ranch in Montana? Jane has a problem: should she pay her utility bill, or should she buy the drugs she needs to control her Parkinson’s Disease? Since these are two individuals, you can see that the problems they face are identical. Both will suffer if they make the wrong decision, and both will suffer anyway because of the knowledge they could have chosen otherwise. The rich and the poor are just the same: people struggling with trade-offs. Or, from Mirowski on neoliberalism:  Thou Shalt Know That Inequality Is Natural.
Things get more complicated at the macro level. The third example, guns or butter, is as abstract as the first two are concrete. Mankiw makes it seem that “defense” is a consumer good, like Hummel Figurines or orange marmalade. The government just goes down to the defense store and buys as much as it wants. He doesn’t talk about how those decisions get made at the social level, and doesn’t talk about who gets the benefits of those guns and who pays the costs of the foregone butter, or whether there are better ways to keep aggressors away than bombing their countries. He turns the example into a concrete fact, with no context. The choices made in the US and other countries about how much “defense” to “buy” would make a really interesting case study in macroeconomic behavior, and just defining terms would be really helpful to public discourse. That’s certainly not the point of the Mankiw textbook.
One of the goals of neoliberalism, Mirowski’s Number 5, is to change the idea of democracy from one of participation by citizens in determination of social policy to one of consuming state services, like defense. Guns v. butter shows how that notion gets into people’s heads. Given the level of corruption in the system, in the broad sense of Zephyr Teachout in her excellent book, Corruption in America, it’s also an example of crony capitalism, part of Number 8. There’s a lot more to unpack in the guns and butter example, but let’s move on.
The environmental example is fascinating. From the very beginning of this country, companies polluted lakes, rivers and the air, to keep costs low and prices down. No one did anything. Then when citizens started complaining about their ability to breathe the air and drink the water, and the rich people and their corporations act all outraged, like they have a right to pollute. Mankiw ignores this history, and ignores the obvious fact that dumping pollutants everywhere hurts everyone in general, and some people dramatically; and profits only a few. Again, the entire issue of pollution and environmental destruction would make fascinating case studies in economics. Mankiw’s discussion supports Mirowski number 10: Thou Shalt Not Blame Monopolies and Corporations.
Finally, there is the trade-off between equality and efficiency. Mankiw’s explanation about the negative effects of a progressive income tax on economic efficiency is flatly wrong. For my explanation, see this and this and this. For a short view, does Mankiw think the economy in the 50s was less efficient strictly because of high income and estate taxes on the rich? I’d love to see a paper showing how that happened. Piketty and Saez suggest a top tax rate of 80%. Here’s a short article explaining their thinking, and here’s an impenetrable paper that lies below it.
I assume Mankiw was referencing Arthur Okun’s 1975 book Equality and Efficiency: The Big Trade-Off. Okun postulated that there was a trade-off between equality and economic efficiency from his armchair, and he discusses the implications for policy in this excellent piece. By 1995, it was clear that the facts did not support his speculation. This paper is a review of literature and discussion of exactly how wrong Okun was: Lars Osburg, The Equity/Efficiency Trade-off in Retrospect. Subsequent work has made this even more clear. Mankiw ignores all the evidence and new theory to the contrary, choosing to continue to support an unmeasured armchair theory Mirowski number 9: Thou Shalt know that Inequality is Natural.
The point of this discussion is that textbooks have an outsized influence on people, particularly on non-specialists. They may not recall the argument, but they will recall the examples and the general approach, especially when those are common in discourse, and not contravened by other authorities. I know this from my own college education. It has taken years for me to shed the parts that don’t conform to the reality of life as I have lived it and seen it.
UAL also briefly grounded flights on June 2nd, due to “automation issues.”
Now the New York Stock Exchange has halted all trading shortly before noon, cancelling all open orders, due to “technical difficulties.”
There are reports that CNBC and WSJ websites are down, but they could simply be swamped by traffic.
Who’s or what’s next?
UPDATE — 12:55 pm EDT —
Looks like CNBC may only have had a brief burp due to high traffic as there are no further complaints about service interruption. WSJ’s website has been slowly working its way back to normal service; the media outlet posted an abbreviated versionfor 15-20 minutes once its technical problems had been resolved. No indication yet that anything apart from high traffic volume may have spiked the site.
UPDATE — 1:35 pm EDT —
You know what cracks me up, in a ha-ha-ouch kind of way? FBI Director Jim Comey puling about the need for back doors into technology in front of Congress today, while a major airline and the most important stock market in the world demonstrate exactly how ugly it could get if hackers with malicious intent used the back doors he demands for evil rather than good. The “technical difficulties” both UAL and NYSE experienced today could be duplicated by hackers using back doors.
The U.S. Government is an aircraft carrier, very slow to turn even when under fire. Hackers are speedboats. Asking for back doors across all technology while facing myriad fleet-footed nemesis is like chasing 38-foot Cigarette Top Gun speedboats with a carrier. Unless the carrier can see Cigarettes coming from a distance and train gun on them, Cigarettes will fly up its backside. The U.S. Government has already proven it can’t see very far ahead, stuck in a defensive posture while using its offense in ways that only ensure more attacks.
UPDATE — 2:20 pm EDT —
Fortune reports the NYSE halt was due to a “failed systems upgrade.”
Right. Upgrade. Let’s roll out an upgrade in the middle of the week, in the middle of the month, when both China’s stock market and Europe’s banksters are freaking out. Let’s not manage traders expectations in advance of the day’s trading, either.
Somebody needs to retake a course in Change Management 101 — or there’s some additional explaining required.
Reuters assures us, too:
The U.S. Department of Homeland Security said there were no signs” that the problems at NYSE and United Airlines stemmed from “malicious activity,” CNN reported.
Good to know, huh? Can’t believe they went to CNN for that.
UPDATE — 3:30 pm EDT —
The buzz since 2:00-ish pm is that Anonymous *might* be to blame for the NYSE “glitch.” The Hill, Salon, and a few other outlets reported about a cryptic tweet from @YourAnonNews late last evening:
But another Anonymous affiliate laughed it off, saying:
Timing is incredible, though; the NYSE, WSJ, and UAL outages all happened concurrent with a Congressional hearing at which FBI Director Jim Comey discussed the need for back doors into everything. What an incredible series of coincidences today.
UPDATE — 3:55 pm EDT —
Best take by far on today’s NYSE “technical difficulties”, gonzo reporting with a feminine touch from Molly Crabapple:
UPDATE — 5:00 pm EDT —
NYSE re-opened again around 3:00 pm EDT, with trading a bit jittery. Financial news outlets speculated the market closed at 17,515.42, down -261.49 (-1.47%) due to concerns over China’s tanked stock market and Greece’s EU debt woes. The Shanghai market had closed the previous day at 3,507.19 down -219.93 (-5.90%).
Feeling iffy over the Shanghai index, Hong Kong’s Hang Seng Index closed at 23,516.56 down -1,458.75 (-5.84%); Japan’s Nikkei 225 closed at 19,737.64 down -638.95 (-3.14%).
But these Asian markets weren’t affected by the NYSE’s technical difficulties today. Wonder how they will open on July 9th their local time — flat or down? I wouldn’t put my money on an uptick, but I’m not a financial adviser, either.
I imagine the bars and pubs around Wall Street saw greater-than-average action. I might put money on that.
In this series, I tried to learn what Thomas Kuhn’s The Structure of Scientific Revolutions meant for economics. In this post, I suggested a possible paradigm for neoliberal economic theory. It uses the Ten Principles of Economics preached by N. Gregory Mankiw in his best-selling economics textbook, the general principle of maximization of economic efficiency, and a method suggested by David Andolfatto of the St. Louis Fed. Let’s assume the goals of neoliberalism fit the parameters described by Philip Mirowski in this article. I think my proposed paradigm can be used to generate the economic theory those parameters require, and I think that suits the goals of the people who fund academic neoliberalism just fine.
As Kuhn describes them, scientific revolutions take the form of a wholly new way to look at things, like an optical illusion. Where once our eyes told us that the sun revolves around the earth, now we know that it’s just the opposite. Not just is the earth not the center of the universe, we are on a small planet on the outskirts of a small galaxy, whirling around in a monstrously large physical space until entropy ends it. Since publication of Kuhn’s essay in 1962, there has been some discussion of such paradigm changes in economics, but as the series shows, I think old ideas do not die, but come back to haunt us, just as John Maynard Keynes said:
… the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. Not, indeed, immediately, but after a certain interval; for in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil. Chap. 24 Sect. 5, The General Theory of Employment, Interest and Money.
I don’t know where Keynes got the optimism in the second half of that quote, any more than his seeming optimism about the end of laissez-faire theories. The ideas of Hayek and Friedman and their laissez-faire government-hating chest-beating right wing capitalism-worshipping true believers are still dominant nearly a century later. It just goes to show that if you capture the minds of the young, especially the young elites with textbooks like Mankiw’s, it’s mostly impossible to change their minds with mere facts and natural experiments from the real world.
Still, I think it’s quite possible to change some minds, or I wouldn’t bother with this. And there are new ideas, ideas just as revolutionary as any that Kuhn describes. One example is taxation. For centuries, people believed that the function of taxes was to provide the revenues to run the government. That may have been true in an age of gold. But in an age of fiat money, it’s just not true. Here’s a 1946 discussion by Beardsley Ruml, head of the New York Fed, explicitly stating this truth, and then offering justifications for taxation:
1. As an instrument of fiscal policy to help stabilize the purchasing power of the dollar;
2. To express public policy in the distribution of wealth and of income, as in the case of the progressive income and estate taxes;
3. To express public policy in subsidizing or in penalizing various industries and economic groups;
4. To isolate and assess directly the costs of certain national benefits, such as highways and social security.
This, of course, is the basis of Modern Money Theory. Here’s a quote from a readable and cogent explanation from L. Randall Wray:
But in the case of a government that issues its own sovereign currency without a promise to convert at a fixed value to gold or foreign currency (that is, the government “floats” its currency), we need to think about the role of taxes in an entirely different way. Taxes are not needed to “pay for” government spending. Further, the logic is reversed: government must spend (or lend) the currency into the economy before taxpayers can pay taxes in the form of the currency. Spend first, tax later is the logical sequence.
In the same way, most of us were taught that banks and other savings institutions were intermediaries between savers/depositors, and borrowers/investors. The role of the banks was to direct the accumulated assets of a society into their most profitable uses. No. Banks don’t need deposits to make loans. That idea, which I remember learning in Econ 101 at Notre Dame a very long time ago, is false. The bank merely makes book entries, one set to loans receivable, and one to deposits. This model is called finance and money creation in this 2014 paper by Zoltan jakab and Michael Kuhof of the IMF. Here’s the abstract:
In the loanable funds model of banking, banks accept deposits of resources from savers and then lend them to borrowers. In the real world, banks provide financing, that is they create deposits of new money through lending, and in doing so are mainly constrained by expectations of profitability and solvency. This paper presents and contrasts simple loanable funds and financing models of banking. Compared to otherwise identical loanable funds models, and following identical shocks, financing models predict changes in bank lending that are far larger, happen much faster, and have much larger effects on the real economy.
I remember learning about bank multiplier effects and the importance of reserves in determining the amount of money in circulation. It was one of those bizarre things that seemed logical until you realized that there was no particular reason to think any bank could or would actually lend all that money sensibly. Yet, as Jakob and Kuhof say, that is the theory incorporated into standard models of the economy. They create a new model using the financing theory, and get completely different predictions. These graphs are from the paper. The dotted lines are the predictions under the loanable funds model, and the solid lines are from the financing and money creation model.
At one level, this is just another reason to distrust economic models, because their basic assumptions are simply wrong. At another, it demonstrates that the standard paradigm is useless, because it treats the finance sector are irrelevant. And at another level, the new model demolishes the idea that the role of the bank is to intermediate savings. Savings are irrelevant to the main role of the bank, which is not to insure that savings are rewarded, but to make sure banks are rewarded.
Of course, such revolutionary changes won’t affect anyone not exposed to them and to their basis. And the wrong ideas will stay in textbooks for decades, insuring that generations will have them imprinted. No wonder nothing changes.
The proposed paradigm is set out here. In future posts in this series, I’ll attempt to show how each element contributes to the neoliberal economic theory that dominates the national discourse, and see whether I can find an optical illusion in each, leading to a better although not revolutionary understanding.
In a series of posts which you can find here, I have been trying to formulate an answer to the question why has neoliberal economics not been tossed out in the wake of its total failure as demonstrated by the Great Crash. I’ve used as a lens Thomas Kuhn’s seminal essay: The Structure of Scientific Revolutions. I am totally dissatisfied with the usual progressive explanations of bad faith, whether in the form of the ubiquitous quote from Upton Sinclair: “It is difficult to get a man to understand something, when his salary depends on his not understanding it;” or direct or indirect accusations of intellectual dishonesty or corruption. The world is more complex, and we need to think more deeply, especially if we want to change things. Here is a list of the most important things I think I learned from the exercise.
1. Kuhn argues that science cannot proceed without a paradigm. That seems true in the hard sciences, but it seems inadequate as a description of the social sciences. Even so, there it remains an important insight. This series offered insights because I used the paradigm paradigm to examine a specific problem.
2. Following Mark Blyth, it seems that there are a number of schools of economics. These include neoliberals, post-Keynesians, Austrians, rational expectations theorists, and real business cycle theorists; to which we can add Modern Money Theorists, Marxians, and perhaps Piketty and his colleagues. Each of these has a paradigm through which it tries to organize the vast amount of data and theory we have accumulated over the centuries. Each has its own incommensurate ideas about what counts as data and about how to interpret the data. In other words, they each have a definition of truth, and their truth claims cannot be settled inside their paradigms, as Kuhn tells us is true about the hard sciences.
That means that the decisions about which, if any, of these schools dominates at any point in time has nothing to do with some transcendent truth, but rather with a struggle over politics.
3. This view was reinforced by a reading of Keynes’ delightful essay The Death of Laissez-Faire, which actually didn’t die despite Keynes best efforts, but lives on in the grifter stylings of Grover Norquist and the rest of the zombie right wing. If Keynes caouldn’t kill it, it is permanent.
4. It is further reinforced by Bronfenbrenner’s suggestion that paradigms in the social sciences are not replaced outright as Kuhn argues, but are met by an antithesis, and eventually fall into a new synthesis. I suggest that Paul Samuelson follows this approach in his textbook, based on the back inside cover. In a Hegelian or Marxian world, this is supposed to represent progress, but I’ve always thought of it a just something different that might or might not be useful in a specific social situation.
5. I laid out the seeds of a paradigm for neoliberal economics in this post. In passing I pointed out that Mankiw’s principles are couched in bland language, but they can easily be interpreted to carry out the neoliberal program. See 8. below. Again in passing, I note that tweaking them, and setting up a slightly different paradigm can produce a better solution to the problems our economy faces. That is an exercise for another day.
6. One crucial problem that arises from the existence of many schools of economics is that each can claim that there are no tests that disprove it. As Kuhn and others point out, that’s because the meaning of facts and truth is determined by the paradigm, and neither facts nor truths are commensurate across paradigms. That’s why the likes of Gary Becker and N. Gregory Mankiw can claim that the Great Crash was not a problem for neoliberal economics. What looks like a failure to a person who got hammered looks like the normal course of events to an ideologue married to a paradigm.
7. The neoliberals recognized the importance of politics in economics long before the liberals. They wrote their views into textbooks, which have a thin veneer of science and a thick veneer of authority, and used them to indoctrinate generations of college grads who only took one or two economics classes. They also arranged to have the basic tenets taught in high school classes mandated in many states on the wonders of capitalism. As Kuhn explains, the textbook is the authoritative teaching tool for creating new scientists and presumably new followers of the dominant school of economics. The tenets of neoliberal economics are taught as if they were the only way to understand capitalism, and any other set of ideas are communist or socialist, by which we are to understand they are evil.
8. One factor Blyth doesn’t discuss is why neoliberal economics has such a hold on the populace. Certainly a big part of that is the domination of authoritative discourse through the textbook process in point 7. Another crucial point is that without quite saying so, Mankiw’s principles of economics play directly to the prejudices of the a large segment of the voting public. Take the first one as an example: People face trade-offs. Some people face the trade-off between summering in the Hamptons or on Martha’s Vineyard. Others face trade-offs between rent and food. These are the same thing to neoliberals, who sneak in a bunch of outmoded Benthamite utility. And these are also the same for a huge number of conservatives. Suck it up and pick. It’s your fault for not being rich.
The rich people who dominate elections and the public discourse in general can rely on those principles in anodyne form to pacify the liberals while dog-whistling to their base of conservatives.
9. As a result, the voices of authority on economic matters don’t have to listen to anyone who disagrees with them. They have a base of voters who think it’s great to screw the poor and don’t even necessarily want to accept anything that comes from the government.
10. We need to focus attention on the political nature of economic paradigms. Neoliberal economics failed. We need to hammer home the failure, to undermine the authority of neoliberals on economic matters.
Here are links to the posts in this series with a note about each.
1. The Two Prongs of the Neoliberal Project. This is a justification of the inclusion of economics at this blog. It is also a general introduction to neoliberal economic theory.
2. Paradigms in Economics. This is an introduction to Kuhn’s theory of scientific revolutions and an introduction to a theory of paradigms in economics.
4. Paradigm Change in Science and Economics. This is a discussion of Kuhn’s explanation for paradigm change in science, and begins the discussion of the comparable problem in economics.
5. A Possible Paradigm for Neoliberal Economics. N. Gregory Mankiw’s textbook lists 10 principles of economics. This post takes those and a simple methodology as a possible paradigm for neoliberal economics. In passing, I discuss an actual paradigm change that seems to meet the requirements of Kuhn’s analysis.
6. Pragmatic Aspects of Paradigm Change According to Kuhn. This addresses Kuhn’s argument that even in the hard sciences, paradigm change requires persuasion, because the superiority of an alternative paradigm cannot be tested inside a different paradigm. This idea is applied to economics, and specifically to textbooks.
7. Keynes on Paradigm Change. John Maynard Keynes calls for the death of laissez-faire, especially in its virulent form of demanding that government do nothing. Economic ideas don’t die.
8. Paradigm Change Through Authority and Arguments about Truth. This is a discussion of a more sophisticated approach to changes in economics paradigms through a paper by Mark Blyth. Blyth offers a grounded approach to the problem of change as a result of authority and persuasion.
So far in this series, we have encountered a number of answers to my central questions: why hasn’t neoliberal economic theory been thrown out as a result of its horrifying failure? Why hasn’t the paradigm change theory of Thomas Kuhn’s The Structure of Scientific Revolution worked? If Kuhn were right, then the utter failure of the neoliberals would lead to its rejection and replacement by a new paradigm.
Most of the people who followed Kuhn pointed to differences between the natural sciences and the social sciences as part of the reason. That led to explanations like the dialectic, in which an idea is met with an antithesis and eventually a synthesis emerges which solves the tension, but it then attracts its own antithesis, and so on. Another possibility is that bad ideas don’t ever die. We saw that with Keynes’ discussion of the end of the silly ideas of laissez-faire; he points to a number of reasons for its long life.
We might next look at the pendulum idea of intellectual history. There’s an excellent example of this in a paper by Ravi Kanbur of Cornell, The End Of Laissez-Faire, The End Of History, And The Structure Of Scientific Revolutions I’m going to skip that one, though, because I don’t think much of pendulum theories. They don’t help us see the forces that drive the swings. Instead, I’ll look at this paper by Mark Blyth, Paradigms and Paradox: The Politics of Economic Ideas in Two Moments of Crisis. Unfortunately, this excellent paper was published by Wiley, which is trying to screw money out of people, so perhaps you could find it through your library. Here’s the abstract.
This article argues that there is a paradox at the heart of Hall’s “Policy Paradigms” framework stemming from the desire to see both state and society as generative of social learning while employing two different logics to explain how such learning takes place: what I term the “Bayesian” and “constructivist” versions of the policy paradigms causal story. This creates a paradox as both logics cannot be simultaneously true. However, it is a generative paradox insofar as the power of the policy paradigms framework emerges, in part, from this attempt to straddle these distinct positions, producing an argument that is greater than the sum of its parts. In the second part of the article, I discuss the recent global financial crisis, an area where we should see third-order change, but we do no not. That we do not strengthens the case for the constructivist causal story.
This article starts as a discussion of a paper by Peter Hall on the shift of ecocnomic paradigm by the Thatcher government from Keynesian to neoliberal. The “Bayesian” story mentioned in the abstract is the standard version of Kuhn’s theory. It says that the normal process of change in institutional governance is cumulative: “an additive function of policy errors that begin with settings, moves to instruments, and then leads to goals as a function of environmental pressures.” Suppose a policy and a paradigm are accepted by the institutions of government and the private sector as controlling in a certain area. As things change and evolve, the institutions first change the settings, hiking or lowering interest rates or taxes, for example. Then they add or delete the instruments through which the policy is put into practice, perhaps adding a new tax or a new deduction. Only if these fail do questions about the paradigm itself come to the fore. These are the three orders of change in this discussion. Paradigm change only comes in the third order.
The alternative is the “constructivist” view. Blyth isn’t as direct in the definition of this idea, but here’s the general idea. The Bayesian view is that there are “transcendent, objective, and empirical standards through which observations of events and other ‘facts’ can be judged.” In the constructivist view, “Truth is a series of intersubjectively held conventions regarding “the way the world works” among a given community at a given moment.” The Bayesian view is probably eventually true in the natural sciences, even if new data or events can be interpreted in several ways under different paradigms that might exist at some point in time. It is much less true in the social sciences. There, different paradigms produce different facts. As an example, Blyth points to the claim of the monetarists (the sheep’s clothing of the neoliberals) that Keynesianism failed in the 1970s in a way that monetarism didn’t. Within the Keynesian paradigm, that wasn’t so, but the monetarists seized control of the narrative, and the bad performance of the economy was taken as evidence of failure of Keynesianism. Blyth says that the key step was the construction of the evidence of the performance of the economy by the monetarists as failure.
Blyth claims that the 70s did not constitute a natural test of Keynesianism, for reasons he discusses in footnote 8 and are beyond my power to assess. I’ll add that the solution of the monetarists was to hike interest rates and hike unemployment to ridiculous levels to stamp out inflation. The result was a catastrophe for the middle class and the working class, and it made life even more miserable for the poor. There was no reason to stomp on workers to end inflation, but there was a determination to protect the interests of the rich. This, I think, is the direct opposite of any policy Keynes would support.
In the constructivist view, then, truth is a matter for contest among the people allowed to participate in the discourse. Blyth quotes Hall:
Politicians, officials, the spokesmen for social interests, and policy experts all operate within the terms of political discourse that are operative within the nation at a given time, and the terms of political discourse generally have a specific configuration that lends representative legitimacy to some social interests more than others . . . and defines the context in which many issues will be understood (Hall 1993, 289).
This analysis focuses our attention on the actual decision-makers, not just the economists themselves, but the group with authority in any given setting to determine the bounds of discourse. Blyth points out that each of the schools of economics, rational expectations theorists, real business cycle theorists, post-Keynesians and Austrians, along with the neoliberals and the outright laissez-faire school of political economics, have explanations for the Great Crash, but they are all incommensurate, totally different paradigms. The argument, the social argument, is over which will dominate the discourse. That is a sociological problem, not a problem of economics.
Blyth uses this framework to analyze the persistence of neoliberal economics. I’ll summarize them
1. It takes time to work out a new system.
2. After Kuhn, people expect an all or nothing change. It’s quite possible that we have a failure of a paradigm, but no new paradigm to replace it.
3. Economics professors have tenure, and a huge stake in preserving their status.
4. Institutions like the World Bank, the IMF, the European Community Bank and others are slow to change for the same reasons economics professors won’t change.
5. The neoliberal consensus had taken such deep root and its adherents were in control of so many institutions that there was no way to get the public involved in demanding change. The few prominent economists calling the neoliberals out had to spread their attacks over such a huge area that there was insufficient firepower.
… the singular lesson of the recent crisis for the policy paradigms model is that the sociological can trump the scientific precisely because the locus [of] authority did not shift despite the facts. Mere facts will (sometimes) not be allowed to get in the way of a good ideology. Being seen to fail, Obama’s stimulus, for example, can trump actual failure, such as Eurozone austerity packages. In such a world, the “truth” about the crisis and the ideas that made it possible really does depend upon what the most powerful members of a group (or society) consent to believe.
This explains why nothing changed: the people who define the policy also define the evidence and the tests that might question the policy. But there’s more, for another day.
John Maynard Keynes wrote about paradigm change long before Thomas Kuhn’s The Structure of Scientific Revolutions. In a 1926 essay, The End of Laissez-Faire Keynes discusses the lingering doctrines of Laissez-Faire economics well into the period economists were for the most part persuaded by the examples of Alfred Marshall, and the proponents of the marginal utility school that the main ideas of laissez-faire were wrong. Keynes was a brilliant writer, witty and insightful, but he was also a fine scholar. This isn’t a long essay, and it is certainly worth reading, for the giraffe analysis if nothing else. I am going to pick out a few points that show why Keynes thought old and strange ideas cannot be rooted out of economics. Here’s the laissez-faire he is talking about:
Finally, in the works of Bastiat we reach the most extravagant and rhapsodical expression of the political economist’s religion. In his Harmonies Économiques, [he writes]
I undertake [he says] to demonstrate the Harmony of those laws of Providence which govern human society. What makes these laws harmonious and not discordant is, that all principles, all motives, all springs of action, all interests, co-operate towards a grand final result … And that result is, the indefinite approximation of all classes towards a level, which is always rising; in other words, the equalisation of individuals in the general amelioration.
That sure sounds like any Republican or corporatist Democrat, any TV economist or any person who plays economist on TV, and it’s just a shade riper than the average commenter on an article in which Bernie Sanders is identified as a Social Democrat.
Keynes identifies several social and political issues which led to this florid statement. There was struggle against monarchy, which led Locke and others to fetishize private property and the freedom to do as one will with that property. There was a philosophical basis in the Social Contract ideas and the theories of the Utilitarians. There was Darwin and his scientific colleagues who seemed to argue for the necessity of competition for evolution. There was the “corruption and incompetence of eighteenth-century government”, coupled with the successes of the early industrialists. There was the support of the economists of that time, a new group, but once seemingly versed in science, saying that government interference with private property would be bad.
He explains that although economists of the day generally supported laissez-faire, it wasn’t they who preached the gospel as laid out by Bastiat. Instead, it was the “popularisers and the vulgarisers”, who pushed the doctrine into the public mind, and it was the philosophers, not the economists, whose views it fit best. He quotes the popularisers, including the fabulous Mrs. Marcet, and I can’t resist:
CAROLINE. The more I learn upon this subject, the more I feel convinced that the interests of nations, as well as those of individuals, so far from being opposed to each other, are in the most perfect unison.
MRS B. Liberal and enlarged views will always lead to similar conclusions, and teach us to cherish sentiments of universal benevolence towards each other; hence the superiority of science over mere practical knowledge.
The economists turned away from this stuff immediately, Keynes says, treating it as a useful idea but hardly one with evidentiary or theoretical support. But the idea remains fixed in the public mind. To be clear, Keynes agrees that government should be limited, but he firmly believes that limits on the use of private property of various kinds and a sensible government are both crucial to controlling the practice of capitalism. The idea that the government could do nothing useful, which underlies laissez-faire as taught by the likes of Mrs. Marcet, is foreign to Keynes, as he shows in Part IV of the essay.
In Part III, Keynes dismantles this analysis. Here’s a taste:
This assumption, however, of conditions where unhindered natural selection leads to progress, is only one of the two provisional assumptions which, taken as literal truth, have become the twin buttresses of laissez-faire. The other one is the efficacy, and indeed the necessity, of the opportunity for unlimited private money-making as an incentive to maximum effort. Profit accrues, under laissez-faire, to the individual who, whether by skill or good fortune, is found with his productive resources in the right place at the right time. A system which allows the skilful or fortunate individual to reap the whole fruits of this conjuncture evidently offers an immense incentive to the practice of the art of being in the right place at the right time. Thus one of the most powerful of human motives, namely the love of money, is harnessed to the task of distributing economic resources in the way best calculated to increase wealth.
Shades of Thomas Piketty. Keynes’ primary target is professors of economics who teach the the simplest and most reductive assumptions as the norm, with all of the messy complications of reality excised. “They regard the simplified hypothesis as health, and the further complications as disease.” He says that the alternatives, Marxian socialism and protectionism, are terrible themselves. Third, there’s this:
Finally, individualism and laissez-faire could not, in spite of their deep roots in the political and moral philosophies of the late eighteenth and early nineteenth centuries, have secured their lasting hold over the conduct of public affairs, if it had not been for their conformity with the needs and wishes of the business world of the day.
And in conclusion to that analysis, he writes in Part IV:
Let us clear from the ground the metaphysical or general principles upon which, from time to time, laissez-faire has been founded. It is not true that individuals possess a prescriptive ‘natural liberty’ in their economic activities. There is no ‘compact’ conferring perpetual rights on those who Have or on those who Acquire. The world is not so governed from above that private and social interest always coincide. It is not so managed here below that in practice they coincide. It is not a correct deduction from the principles of economics that enlightened self-interest always operates in the public interest. Nor is it true that self-interest generally is enlightened; more often individuals acting separately to promote their own ends are too ignorant or too weak to attain even these. Experience does not show that individuals, when they make up a social unit, are always less clear-sighted than when they act separately.
Keynes believed that a capitalist economy could be made to work better through government actions as the situation demanded. “Our problem is to work out a social organization which shall be as efficient as possible without offending our notions of a satisfactory way of life.” I would have written that we should have a satisfactory way of life, made as efficient as possible, but maybe that’s what Keynes meant.
Given these forces, it’s hard to see the basis for Keynes’ hope that the principles of laissez-faire might be eradicated, and, of course, they weren’t. They govern the economic thinking of the Republicans and the corporatist Democrats even today, as the vote on the TPP indicates. They are people who ignorantly repeat the tropes of laissez-faire without reading their original proponents: “… we should consider their arguments preposterous if they were to fall into our hands.“
That’s certainly true, more so today than ever. It points to the central reason why stupid economic ideas cannot be vanquished:
To suggest social action for the public good to the City of London is like discussing the Origin of Species with a bishop sixty years ago. The first reaction is not intellectual, but moral. An orthodoxy is in question, and the more persuasive the arguments the graver the offence.
In this post I ask what the paradigm of economics might be, and if there is one. I did not address the question of the exact nature of the paradigm as discussed by Kuhn, leaving it at the broadest possible level: the theories, instruments, methods, prejudices and so on common to a community of scholars working in a fairly specific area of human knowledge. The general question of the nature of the paradigm is the subject of a number of papers, most concluding that the concept is too unclear to support careful analysis. That’s the position taken by George Stigler in a remarkable paper, Does Economics Have a Useful Past? 1 Hist. of Pol. Econ. 225 (1969). Stigler dismisses Kuhn because he can’t find an example of a paradigm that completely defeats a prior paradigm.
To be concrete, the marginal utility revolution of the 1870s replaced the individual economic agent as a sociological or historical datum by the utility-maximizing individual. The essential elements of the classical theory were affected in no respect. (A possible, but uncertain, aftereffect in twenty years was the development of the marginal productivity theory.) Until Kuhn gives us criteria of a revolution (or a paradigm) which have direct empirical content, it will not be possible to submit his fascinating hypotheses to test.
I assume Stigler means that Kuhn’s ideas aren’t applicable to economics. Certainly the book is full of examples from physics and chemistry of theories that completely replace older theories, leaving the old to as nothing more than objects of interest. Let me propose one such idea for economics. It is a certainty of economics that taxes exist for the purpose of raising revenue for the government. That was probably true before the advent of fiat money. When nations left the gold standard, it became untrue, as the Chairman of the Federal Reserve Bank of New York, Beardsley Ruml, wrote in 1946 in a paper titled Taxes For Revenue Are Obsolete. This idea is as revolutionary as the Copernican Revolution. It forms the basis of Modern Money Theory, and both the idea and the elaboration into a coherent theory are fiercely ignored or fiercely fought by the dominant economists. As it happens, this idea is leaking into public discussion despite their best efforts.
I have little else to add to this discussion about the nature of paradigms. I’ll follow Stigler in accepting that there are communities of scholars engaged in the same general areas of study, and in these communities, there is a mutual agreement on theories, instruments, methods, measurements, and even prejudices, and these guide the thinkers in their day to day efforts. Stigler considers this a good picture of economics, and for my purposes, it serves to connect Kuhn’s ideas to economics.
The neoclassical school dominates economic discourse and is widely taught as authoritative at every level in the US. N. Gregory Mankiw, Harvard professor and author of the leading economics textbook, wrote this in a New York Times column in May 2009:
Despite the enormity of recent events [meaning the Great Crash], the principles of economics are largely unchanged. Students still need to learn about the gains from trade, supply and demand, the efficiency properties of market outcomes, and so on. These topics will remain the bread-and-butter of introductory courses.
Let’s try to tease out the paradigmatic points of the neoliberal school. Mankiw’s best-selling economics textbook contains these 10 principles of economics:
The primary method of this school is mathematical modeling, which adds at least two covert assumptions, that collective and individual human behavior is continuous enough so that it’s reasonable to use college calculus, and that aggregate behavior is nothing but the sum of individual behaviors which exist independently of each other at all times. The theory is premised on the idea that the motivation of all people is efficiency, and that economic efficiency is the most prized value in a society, with all other goals held as secondary. The models are used to give normative policy advice.
This school of thought, to follow Stigler, replaced Keynesianism. P. 228. Why? Stigler suggests that a school of thought cannot survive the life of its leader. That seems very odd, because many of the ideas of the neoliberals are taken from the past. As Stigler says:
The young theorist, working with an increasingly formal, abstract, and systematic corpus of knowledge, will seldom find it necessary to consult even a late-nineteenth-century economist. He will assume, just as the mathematician or chemist assumes, that all that is useful and valid in earlier work is present — in purer and more elegant form — in the modern theory. P. 217-8
I won’t belabor the obvious point that every element of the neoliberal school is contested. Instead, I continue to focus on this question. The canonical explanation of the rise of neoliberalism is that Keynesianism failed in the 1970s, and was replaced by neoliberal economics which offered a better solution to the problem that Keynesianism stumbled over. That explanation leaves a bunch of questions. Not the least is exactly why the events of the 1970s were somehow a failure of economic theory. The solution offered by neoliberalism was the traditional conservative solution: hammer the workers and coddle the capitalists. Why is that a better solution? Remember, Keynes believed that the goal of economic recovery was to give people useful work to do [see paragraph 5], not to help the rich. And why isn’t neoliberalism facing extinction in the wake of its disastrous failure? Both Kuhn and Keynes have something to offer on this question, and I’ll take that up next.