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Sat

20

Dec

2008

Theory vs. Reality: Why Market Absolutism Fails
Saturday, 20 December 2008 17:06
by Ernest Partridge

"The collapse of market fundamentalism in economies everywhere is putting the Chicago School theology on trial. Its big lie has been exposed by facts on two levels. The Chicago Boys' claim that helping the rich will also help the poor is not only exposed as not true, it turns out that market fundamentalism hurts not only the poor and the powerless; it hurts everyone, rich and poor, albeit in different ways... The fruits of Friedman test are in - and they are all rotten." Henry Liu

An economist and his guide, while hunting in Africa, fall into an elephant trap: twenty feet deep with vertical walls.

“That does it,” says the guide, “we’re done for. No escape, no food, no chance of being found in time.”

“Nonsense,” said the economist, “I can get us out of here.”

“And how do you propose to do that?,” the guide asks.

The economist replies: “Well, first we posit a ladder.”

Economists are no more inclined than the rest of us to live in a fantasy world – not, that is, as they go about the practical business of living their everyday lives. But when economists write technical papers and teach university courses, they often enter a theoretical realm of abstract concepts such as “economic man” (homo economicus) and “perfect markets,” articulated with virtuoso advanced mathematical manipulations. Very elegant, and very unreal.


Many economists, perhaps most, appreciate the limitations of economic theory in explaining and predicting social behavior and political trends. Some economists, however, claim to find in traditional (i.e. “neo-classical”) economic theory, the key to articulating and proposing public policy. It’s called “market absolutism,” and it has dominated American politics since the Reagan administration. It has also led this nation to the brink of economic disaster.

Market absolutism has led us to this crisis because its proponents in academia, politics and the media have been bewitched by theoretical concepts that apply imperfectly, if at all, to the real world in which we live and work. In particular: they posit an imaginary creature (“economic man”) that inhabits a mythical environment (the “perfect market.”)

Economic Man (Homo Economicus).

In neo-classical economic theory, “economic man” is a hypothetical individual who is a complete egoist, motivated solely by the self-interested desire to maximize his “preference satisfaction.” Homo Econ’s motivation is manifested by his willingness to pay for these satisfactions in a “free market.” Neo-classical theory also postulates that “all goods that matter to individuals ... must be capable of being bought and sold in markets” and “anything that is valued instrumentally ... can be handled by economics, be it acts of friendship or love.” (Freeman and Edwards. For citation of sources, follow this link). “Economic man’s” behavior is described, in neo-classical jargon, as “rational.” By implication, the self-sacrificing behavior of saints and heroes is “irrational.”

Clearly, “economic man” exists nowhere outside of Ayn Rand’s novels and, perchance, on Wall Street. And this is fortunate, for we wouldn’t want him for a neighbor.

In fact, there is much more to a fulfilled and moral life than self-interested “preference satisfaction.” Such a life also includes values that can not be priced in a free market. Among them:

  • Truth. Scientists and scholars offer evidence and sound arguments, not bids. In courts of law, purchased verdicts are not only invalid, they are crimes.
  • Civic Values such as justice, due process, civil rights, and the franchise, are not for sale. The governing impulse of economic man (qua consumer) is “I want.” The governing impulse of the citizen is “we need.”
  • Distributive Justice. The economic concepts of “efficiency” and “utility maximization” do not touch upon the moral issue of the just distribution of wealth. “Just compensation” and "fair distribution" are moral, not an economic, concepts. A slave economy can, in classical economic theory, be perfectly “efficient” (i.e., "Pareto Optimal").
  • Love, friendship and loyalty which is bought is less valuable than that which is given freely. As philosopher Mark Sagoff reminds us, “a civilized person might climb the highest mountain, swim this deepest river, or cross the hottest desert for love, sweet love. He might do anything, indeed, except be willing to pay for it.”
  • Moral values, which refer to the worth of persons, are systematically excluded from neo-classical economic theory.
A public policy for “economic man,” systematically detached from criteria of truth, civic value, distributive justice, friendship and loyalty, is a policy that any civilized person should reject, and reject on non-economic grounds. (See my “Why Economics Fails as a Sole Foundation of Public Policy,” for an elaboration of these points and a citation of sources).

The Perfect Market.

Neo-classical economists, and their political acolytes, are convinced that “free markets,” completely undisturbed by government interference, yield optimum social and economic results. For example:

“In the free market, the individual would have to produce a good that the other person desired in order to receive a good in return. Adam Smith's "invisible hand" of the market guides all participants in society to promote the best wishes of everyone else by pursuing his own wants and desires.” (Jacob Halbrooks)

“[T]he free market allows more people to satisfy more of their desires, and ultimately to enjoy a higher standard of living than any other social system... We need simply to remember to let the market process work in its apparent magic and not let the government clumsily intervene in it so deeply that it grinds to a halt." (David Boaz, Libertarianism, a Primer, p. 40, 185.)

"A free market [co-ordinates] the activity of millions of people, each seeking his own interest, in such a way as to make everyone better off... Economic order can emerge as the unintended consequence of the actions of many people, each seeking his own interest." (Milton and Rose Friedman: Free to Choose, pp 13-14).
History has taught us, time and again, that such assertions are true only in the purely abstract world of neo-classical economic theory. They are not true in the real world that we inhabit. To understand why this is so, we need only list the conditions of “the perfect market” postulated by economic theory.

  • All participants are “perfectly rational” egoists – i.e., are “economic men.”
  • There are many participants in the market.
  • All participants have access to all relevant knowledge.
  • There are no transaction costs.
  • All transactions are mutually beneficial.
  • There are no externalities (i.e., consequences to non-participating “third parties”).
Clearly, there are no “perfect markets” anywhere on earth, apart from the imaginations of economists. For consider:

(a) “Economic man” is a myth, or at the very least extremely rare. As noted above, most individuals engage in economic transactions for several reasons, some of them non-economic.

(b) Participation in markets is restricted to those with the ability to pay. Public policy decisions, on the other hand, should involve the rights and welfare of many who are systematically excluded from market activity; namely, the very young, the very poor, animals, and future generations. Furthermore, unregulated markets are self-eliminating, because capitalists detest competition and strive constantly to eliminate it. The remedy? The enforcement of anti-trust laws and regulation, which means, of course, “interference” by governments in the marketplace.

(c) The multi-billion dollar advertising and public relations industries are devoted to the task of persuading rather than informing. And persuasion involves the withholding of relevant information (e.g. health risks) and the dispensing of distorted and false information. Caveat Emptor!

(d) All transactions in the real world exact costs. Among them are the costs of enforcing the laws required for markets to take place at all (e.g. fair disclosure, patents and copyrights, contracts, civil and criminal courts, etc.), and this of course means government, which is so despised by “free marketeers.”

(e) Transactions are frequently not mutually beneficial, due to fraud (i.e., violation of “relevant knowledge condition”), the remedy of which is civil suits, which requires the “transaction costs” of the enforcement of law and the appeal to courts.

(f) External costs of market transactions are more the rule than the exception. Innocent, non-consenting parties are routinely impacted by economic activity. Among these external costs are environmental pollution, urban decay, public health costs, etc. Third-party “stakeholders” have no say in economic transactions. Their only recourse for protection and compensation is to the sole agency legitimately established to represent all citizens: the government. (See my “Market Failure: The Back of the Invisible Hand).

Summing up: “Economic man” and “perfect markets” are abstract constructs which, due to their clarity and simplicity, allow theoretical economists to devise complex mathematical models. However, they have no counterparts in the real world, which compromises the application of these concepts in public policy.

Case-In Point: Milton Friedman on Free Trade.

Foreign trade and currency exchange rates provide a vivid example of the rule, “The theory is beautiful, but reality is baffling.”

According to free market theory, foreign exchange rates should be self-regulating, negative feedback functions, like house thermostats. The heat rises, the furnace shuts off, the heat drops, the furnace kicks in, perpetuo moto.

Similarly with foreign trade. If there is a “trade imbalance,” say between Japan and the United States, as dollars go to Japan and consumer goods are imported to the U.S., the Japanese will acquire a surplus of dollars causing the value of the dollar to fall with respect to the yen. U.S. consumer goods will then be less expensive than Japanese products, thus encouraging a flow of the yen to the U.S. to purchase American goods. Then the value of the dollar will rise until foreign goods once again become competitive. And so on, back and forth, like a thermostat. It’s all perfectly automatic – a “spontaneous order,” as the libertarians call it – no governmental interference (e.g. tariffs) required.

This is how Milton Friedman describes it:

If foreign exchange rates are determined in a free market, they will settle at whatever level will clear the market. The resulting price of the dollar in terms of the yen, say, may temporarily fall below the level justified by the cost in dollars and yen respectively of American and Japanese goods. If so, it will give persons who recognize that situation an incentive to buy dollars and hold them for a while in order to make a profit when the price goes up. By lowering the price in yen on American exports to Japanese, it will stimulate American exports; by raising the price in dollars of Japanese goods, it will discourage imports from Japan. These developments will increase the demand for dollars and so correct the initially low price. (Milton and Rose Friedman, Free to Choose, p. 47).
In theory, it’s all very neat and so simple: “all things being equal.” But in the real world, “all things” are never equal. Instead, the ecologist’s rule applies: “you can’t do just one thing.”

What if that flow of dollars abroad is accompanied by a dismantling of the U.S. industrial base? Then, when the time arrives for U.S. manufacturing goods to be competitive with foreign goods (due to the weakening of the dollar), there will be no more American-made goods on the market. Moreover, with the outsourcing of U.S. jobs overseas and the decline of median disposable income, fewer American can afford to buy foreign consumer goods. Regressive tax rates cause the nation’s wealth to flow to the very rich, who send their investments abroad in outsourced industries. A shrinking tax base results in a disintegrating physical infrastructure and a decline in higher education, followed by fewer scientists and engineers, and less basic research and development. Thus today the United States excels only in military technology, as it needlessly spends more on the military than all the rest of the world combined, building 3.5 billion dollar aircraft carriers to fight an “enemy” without an air force, and billion dollar submarines to fight an “enemy” without a navy.

This is what happens when public economic policy is abandoned to “the will of the free market” – an abstraction with, we are expected to believe, a benevolent “mind” of its own. This is what happens when a government puts the fate of the nation’s economy in the hands of wealthy individuals and corporations; individual agents without social conscience and with nothing more than their short-term profits in mind.

In the face of such grim realities, the neat “negative feedback” model of Friedman’s free-trade theory is irrelevant. It belongs to the abstract world of “theory,” not to the real world. In the real world, the thermostat is broken, the furnace will not turn on: down, down, down, goes the temperature.

“Physics Envy:” Formal modeling vs. Empirical Investigation.

Neo-classical economists regard themselves and their discipline as more “formalist” than “empirical.” “Applied economists” such as John Kenneth Galbraith, Kenneth Boulding and Herman Daly who study the behavior of markets in “the real world” and attempt to draw inferences and conclusions from these studies, are regarded as an inferior caste: they rarely win Nobel Prizes and are conspicuously absent from the rosters and the publications of right-wing and libertarian think-tanks. (The remainder of this section is adapted from my “Beautiful Theory vs. Baffling Reality”).

Economic formalists are ever-ready to offer explanations of the state of the nation’s economy, and to issue warnings of dire consequences if their recommendations are not adopted, a willingness that is compounded as the economist’s academic training is mixed with his political sentiments and motives.

Consider, for example, an analysis of the prosperity of the Nineties, the longest sustained economic boom in our history. Who gets the credit? The Democrat replies, “Why Bill Clinton, of course!” “Not so fast,” says the Republican economist. “That prosperity was a time-lagged result of the policies of Bush I, aided by the wise legislation of the Republican Congress after the GOP took control in 1995.”

And what caused the stock market bust and recession early in the Bush II administration, and the humungous deficits that followed? Quoth the Democrat: “Clearly, those tax breaks to the rich failed to ‘trickle down’ and stimulate economic growth as the GOP promised.” “Wrong again,” says the GOP apologist. “The bust and the recession were “time-lag” effects of Clinton’s horrible economic policies. As for the stimulus from the tax breaks, be patient – just you wait.”

I trust that you can see where this is going. “Time lag” – the gift to the economic theorist that keeps on giving -- is just one of several “explain-away” devices that economists fall back on, when their policies and predictions don’t quite turn out right.. Whenever “our” policies fail, or “their” policies succeed, there is always one or another of a myriad of macroeconomic imponderables to fall back on for an explanation. It’s no wonder that the disputes that ensue are never definitively resolved.

The problem is not that economic theories explain too little – it's that they “explain” too much, so that whatever happens, their defenders have an “explanation,” and likewise, their opponents have a contrary "explanation." That’s just another way of saying that politically motivated economic projections and explanations are “non-falsifiable,” and non-falsifiability is the definitive mark of non-science.

Astronomers can predict within seconds, eclipses hundreds of years into the future. If economists had a reliable 60% success rate in their macro-economic predictions, they could all retire at forty on the returns from their stock market investments. And as we all know, they don’t.

Please understand: I am not "anti-markets." The failed economic experiment in the Soviet Union proved conclusively that a centralized command economy is vastly inferior to a market-based system of pricing, distribution, innovation and quality control. Having "shopped" in both the Soviet Union and the United States, I know this from personal experience. Furthermore, because human beings in significant aspects of their lives, do, in fact, act upon economic motives, a scholarly examination of market behavior has valuable implications for numerous disciplines, including environmental studies and political science.

In short, I do not assert that a study of markets and economic theory should count for nothing. Instead, I protest that they should not count for everything. Homo economicus is an ingredient of our nature that we would be well advised to study. But our lives consist of much more than buying and selling. We also love and we sacrifice, and we have goals and concerns that transcend our self-interest. And we seek, both personally and collectively, truth, justice, and personal excellence, none of which can appropriately be bought or sold in markets

With this conviction, I am joined by many esteemed economists, among whom are some of the severest critics of neoclassical economics. These include Herman Daly, Nicholas Georgescu-Roegen, Kenneth Boulding, Paul Krugman, James Galbraith and Amartya Sen, all of whom possess a clear view of the limitations of their discipline. Indeed, my quarrel is less with economists than with politicians and policy-makers who have skimmed easy formulas and simplistic generalizations off the top of the neo-classical economic theory, and put them to work in behalf of their special political and economic interests.

Even so, the above-listed dissenting economists, whom I admire enormously, report that there is in fact a dominating "orthodoxy" of neo-classical thought in the discipline of theoretical economics, and that this orthodoxy has had enormous influence upon both public policy and politics.

I can validate their report with my own experience. Often, when I have mentioned the names of these mavericks to economist colleagues, I find that I have evoked stares of disbelief or even condescension, such as one might expect from a fundamentalist preacher upon hearing the name of Charles Darwin. I once asked Herman Daly why he is regarded as an “outsider” by the mainstream of his profession. He wryly replied that it was probably because he permits the elegance of formal economic theory to be contaminated by compelling facts of biology and physics. Meanwhile, the true believers read with admiration the pronouncements of economists such as Julian Simon, who confidently assert that the omnipotence of the free-market and the omniscience of future entrepreneurs can overcome trivial physical constraints such as the second law of thermodynamics. (See my “Perilous Optimism”). I once heard Paul Ehrlich remark to Johnny Carson that if an engineer proposed to design an aircraft for an exponentially expanding crew, he would rightly be regarded as mad. Yet when an economist proposes an economic model that posits perpetually expanding population and resource consumption, he is regarded as eligible for the Nobel Prize for economics.

Happily, this era of free-market dogmatism may be coming to an end, as the dreadful consequences of its application are cascading upon us. Some of the High Priests are, in the face of stark economic realities, abandoning the cult. Leading the way is Alan Greenspan, who told Henry Waxman’s Committee, “those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief... I made a mistake in presuming that they were best capable of protecting their own shareholders.”

The dogma of market absolutism may, at long last, be replaced by what James Galbraith calls “a new spirit of pragmatism, “ which, he writes, “surely requires that we discard the metaphor of market determinism – whole and entire. No more, let us bow and scrape before that altar. Markets have their place – they are a reasonably open and orderly way to assure the distribution of services and goods. They are not a general formula for the expression of social will and the working out of social problems.”

Thus might the economic strategy of FDR’s New Deal be reinstated: constancy in ends – national prosperity and economic justice – and flexibility in means. “Don’t just sit there, do something! If it works, keep it. If it fails, try something else.” In economics, as with any viable science, theory must be tested in the real world, whereupon the theory is either validated, modified, or discarded.

Looking back through history, we might wonder how it is possible that intelligent and educated people once accepted uncritically such notions as astrology, judicial trial-by-combat, the demon-possession theory of disease, and alchemy. Today, more and more sophisticated observers of society and politics are wondering how homo economicus, a creature bereft of sympathy, humanity, and noble aspiration, and "the perfect market," a "place" devoid of any social contacts more elevated than market transactions, ever came to be regarded by our political elites as the foundation of a just political order.

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