Neoclassical economics – a theory based on shaky foundations

30 October, 2012 at 13:16 | Posted in Economics, Theory of Science & Methodology | 6 Comments

To what extent has – or should – the teaching of economics be modified in the light of the current economic crisis? … For macroeconomists in particular, the reaction has been to suggest that modifications of existing models to take account of ‘frictions’ or ‘imperfections’ will be enough to account for the current evolution of the world economy …

However, other economists such as myself feel that we have finally reached the turning point in economics where we have to radically change the way we conceive of and model the economy. The crisis is an opportune occasion to carefully investigate new approaches … Rather than making steady progress towards explaining economic phenomena professional economists have been locked into a narrow vision of the economy. We constantly make more and more sophisticated models within that vision until, as Bob Solow put it, “the uninitiated peasant is left wondering what planet he or she is on” …

The typical attitude of economists is epitomised by Mario Draghi, President of the European Central Bank. Regarding the Eurozone crisis, he said:

“The first thing that came to mind was something that people said many years ago and then stopped saying it: The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does. So the euro was a bumblebee that flew very well for several years. And now – and I think people ask ‘how come?’ – probably there was something in the atmosphere, in the air, that made the bumblebee fly. Now something must have changed in the air, and we know what after the financial crisis. The bumblebee would have to graduate to a real bee. And that’s what it’s doing” …

What Draghi is saying is that, according to our economic models, the Eurozone should not have flown. Entomologists (those who study insects) of old with more simple models came to the conclusion that bumble bees should not be able to fly. Their reaction was to later rethink their models in light of irrefutable evidence. Yet, the economist’s instinct is to attempt to modify reality in order to fit a model that has been built on longstanding theory. Unfortunately, that very theory is itself based on shaky foundations …

Every student in economics is faced with the model of the isolated optimising individual who makes his choices within the constraints imposed by the market. Somehow, the axioms of rationality imposed on this individual are not very convincing, particularly to first time students. But the student is told that the aim of the exercise is to show that there is an equilibrium, there can be prices that will clear all markets simultaneously. And, furthermore, the student is taught that such an equilibrium has desirable welfare properties. Importantly, the student is told that since the 1970s it has been known that whilst such a system of equilibrium prices may exist, we cannot show that the economy would ever reach an equilibrium nor that such an equilibrium is unique.

The student then moves on to macroeconomics and is told that the aggregate economy or market behaves just like the average individual she has just studied. She is not told that these general models in fact poorly reflect reality. For the macroeconomist, this is a boon since he can now analyse the aggregate allocations in an economy as though they were the result of the rational choices made by one individual. The student may find this even more difficult to swallow when she is aware that peoples’ preferences, choices and forecasts are often influenced by those of the other participants in the economy. Students take a long time to accept the idea that the economy’s choices can be assimilated to those of one individual …

Does this mean that we should cease to teach ‘standard’ economic theory to our students? Surely not. If we did so, these students would not be able to follow the current economic debates … But we owe it to our students to point out difficulties with the structure and assumptions of our theory. Although we are still far from a paradigm shift, in the longer run the paradigm will inevitably change. We would all do well to remember that current economic thought will one day be taught as history of economic thought.

Alan Kirman What’s the use of economics?

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  1. Kirman is a cool neoclassicist. Still, he essentially proposes to continue propagating the old theory amongst the students… With the intention that they will understand what main theoretic debates are all about. A very dubious proposition, I’d say.

    I think that all these talks about renewal won’t lead anywhere. New Keynesians won’t abandon the models that feed them, Post-Keynesians won’t come with anything groundbreaking AND accepted, and Austrians are mostly a bunch of science freaks. The most mainstream textbooks are pretty much “worst of the worst” of what neoclassical economics came with, the better made ones are pretty unknown (who reads Marc Lavoie?) and I bet in fifty years there are going to be no radical changes.

    • Roman, you’re actually pointing to THE greatest challenge heterodox economics is facing. As long as one can’t come up with good alternative textbooks (and I mean real good ones, not textbooks for professors à la Eatwell/Robinson) te neoclassical hegemony is perpetuaated. And once young students are fed these thoughts and theories in thir formative years, it’s difficult to get them weaned from Mankiw and company! It’s really sad.
      [RE Kirman, I think he is a perfect example of the fact that even from an unorthodox perspective neoclassical economists CAN come up with really good stuff, even though you, of course, are missing real money, uncertainty etc etc.]

      • I think that the second toughest challenge heterodox researches face is the extreme fragmentation of the economic knowledge. Econophysicists having little awareness of the behavioral school’s breakthroughs and vice versa, that sort of things. The tragedy of the economics, I believe, in the large part also consists in the abandonment of the old research results.
        For example: do you know about the work of Franklin Fisher? He is one of the neoclassicists who were trying to devise disequilibrium foundations of the market process. One of his results (1983) was that when we introduce non-naive expectations of the agents and the possibility that their transactions might not be completed to the GE model than Walras’ Law stops holding: “Instead of the sum of the money value of all excess demands over all agents being zero, it now turned that at any moment of time the same sum (including the demand for shares in firms and for money) equals the difference between the total amount of dividends the households expect to receive at that time and the amount the firms expect to pay”. That’s a pretty interesting result (I guess – I am not an expert in the sphere of the GE models), but 99,99% of even neoclassical economists are not aware of it at all.
        I am not sure what could be realistically done about that. Perhaps, a big collaborative web-project like IEP (Internet Encyclopedia of Philosophy)?

        • Funny you should ask about Fisher. I wrote about him here

          • Haven’t seen that post.
            You’re all the better for the knowledge of him! :)

    • “Austrians are mostly a bunch of science freaks.”

      Sorry could you elaborate on this? I find it a confusing sentence.

      I think the problem with post-Keynesian theories – insofar as there are positive ones – is that they are superficially less elaborate and rigorous, and so seem less ‘professional.’

      The cost plus theory of the firm is incredibly simple: work out costs and add X% The explanation of profit-wage distribution is simply political power (exogenous to the model). Some concepts are borrowed from neoclassicism (the multiplier), but critics seem to have a hard time admitting this. The methodology is indeterminant.

      I’d be interested to see if there is a comprehensive positive case from the post-Keynesian school. Personally I think they need to work with and borrow more heavily from the marxists.

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