What is (wrong with) mainstream economics?

28 Nov, 2019 at 21:15 | Posted in Economics | 13 Comments

If you want to know what is neoclassical economics — or mainstream economics as we call it nowadays — and turn to Wikipedia you are told that

fund neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits by cost-constrained firms employing available information and factors of production, in accordance with rational choice theory.

The basic problem with this definition of neoclassical (mainstream) economics — arguing that its differentia specifica is its use of demand and supply, utility maximization and rational choice — is that it doesn’t get things quite right. As we all know, there is an endless list of mainstream models that more or less distance themselves from one or the other of these characteristics. So the heart of mainstream economic theory lies elsewhere.

The essence of mainstream economic theory is its almost exclusive use of a deductivist methodology. A methodology that is more or less used without a smack of argument to justify its relevance.

The theories and models that mainstream economists construct describe imaginary worlds using a combination of formal sign systems such as mathematics and ordinary language. The descriptions made are extremely thin and to a large degree disconnected to the specific contexts of the targeted system than one (usually) wants to (partially) represent. This is not by chance. These closed formalistic-mathematical theories and models are constructed for the purpose of being able to deliver purportedly rigorous deductions that may somehow be exportable to the target system. By analyzing a few causal factors in their “laboratories” they hope they can perform “thought experiments” and observe how these factors operate on their own and without impediments or confounders.

Unfortunately, this is not so. The reason for this is that economic causes never act in a socio-economic vacuum. Causes have to be set in a contextual structure to be able to operate. This structure has to take some form or other, but instead of incorporating structures that are true to the target system, the settings made in economic models are rather based on formalistic mathematical tractability. In the models they appear as unrealistic assumptions, usually playing a decisive role in getting the deductive machinery to deliver “precise” and “rigorous” results. This, of course, makes exporting to real-world target systems problematic, since these models – as part of a deductivist covering-law tradition in economics – are thought to deliver general and far-reaching conclusions that are externally valid. But how can we be sure the lessons learned in these theories and models have external validity when based on highly specific unrealistic assumptions? As a rule, the more specific and concrete the structures, the less generalizable the results. Admitting that we can move from (partial) falsehoods in theories and models to truth in real-world target systems does not take us very far unless a thorough explication of the relation between theory, model and the real world target system is made. If models assume representative actors, rational expectations, market clearing and equilibrium, and we know that real people and markets cannot be expected to obey these assumptions, the warrants for supposing that conclusions or hypothesis of causally relevant mechanisms or regularities can be bridged, are obviously non-justifiable. To have a deductive warrant for things happening in a closed model is no guarantee for them being preserved when applied to an open real-world target system.

Henry Louis Mencken once wrote that “there is always an easy solution to every human problem – neat, plausible and wrong.” And mainstream economics has indeed been wrong. Its main result, so far, has been to demonstrate the futility of trying to build a satisfactory bridge between formalistic-axiomatic deductivist models and real-world target systems. Assuming, for example, perfect knowledge, instant market clearing and approximating aggregate behaviour with unrealistically heroic assumptions of representative actors, just will not do. The assumptions made, surreptitiously eliminate the very phenomena we want to study: uncertainty, disequilibrium, structural instability and problems of aggregation and coordination between different individuals and groups.

The punch line is that most of the problems that mainstream economics is wrestling with, issues from its attempts at formalistic modelling per se of social phenomena. Reducing microeconomics to refinements of hyper-rational Bayesian deductivist models is not a viable way forward. It will only sentence to irrelevance the most interesting real-world economic problems.

If the ultimate criterion of success of a deductivist system is to what extent it predicts and coheres with (parts of) reality, modern mainstream economics seems to be a hopeless misallocation of scientific resources. To focus scientific endeavours on proving things in models is a gross misapprehension of what an economic theory ought to be about. Deductivist models and methods disconnected from reality are not relevant to predict, explain or understand real-world economic target systems. These systems do not conform to the restricted closed-system structure the mainstream modelling strategy presupposes.

Mainstream economic theory still today consists mainly of investigating economic models. It has since long given up on the real world and contents itself with proving things about thought up worlds. Empirical evidence only plays a minor role in mainstream economic theory, where models largely function as substitutes for empirical evidence.

What is wrong with mainstream economics is not that it employs models per se, but that it employs poor models. They are poor because they do not bridge to the real-world target systems in which we live. Hopefully humbled by the manifest failure of its theoretical pretences, the one-sided, almost religious, insistence on mathematical deductivist modelling as the only scientific activity worthy of pursuing in economics will give way to methodological pluralism based on ontological considerations rather than formalistic tractability.

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  1. I cannot say that I object to deductive reasoning in theoretical analysis; I object to stopping there and I object to claiming a purely analytic model is ever anything but a priori. I object to methodology-free handwaving at the real world and the absence of observation and measurement of the actual institutions of the existing political economy. (And, no, econometrics that just continues the deductivist analysis by rebranded means is no real empiricism.)
    .
    Uncertainty is everywhere the issue. The “tractability” issues are most often just an excuse for refusing to deal in theory with the implications of uncertainty, just as the refusal to study the actual working of institutions is a refusal to acknowledge the ways in which economies are everywhere structured around coping with uncertainty, including the pervasiveness of sunk-cost investment.

    • How can you be so certain that “uncertainty is everywhere the issue”?
      .
      To me, it seems like your model assumes uncertainty, and dismisses financial innovation that can eliminate financial uncertainty. Real disruptions occur but you should not have to add to that by imposing needless financial uncertainty …

    • Robert,
      .
      There is no financial innovation that deals with uncertainty other than the central bank acting as saviour of last resort.
      .
      Spreading risk does not eliminate risk.
      .
      And please do not repeat the claims about Goldman Sachs and their putative magnificent derivatives record during the GFC. I’d say they got lucky or used their market power to get lucky.
      .
      I would have more confidence in your confidence in derivatives if you could demonstrate personal experience with successfully trading derivatives over a long period of time.

      • I’m petitioning local and state governments to charter a public hedge fund. It should borrow at below-market costs and crowdsource trades from the general public through an open website. Professional traders could be incentivized to submit and peer-review trade proposals, by pledging that a percentage (say 20%) of the public hedge fund’s profits (like the “management fee” of a private hedge fund) would go towards reducing property taxes. The idea is to find trades that are guaranteed to return higher than the borrowing costs. After giving the “management fee” to property tax reduction, the rest of the profits could be used for a basic income pilot or to provide free garbage pickup at homeless camps …

      • “the central bank acting as saviour of last resort.”
        .
        “Spreading risk does not eliminate risk.”
        .
        With one bank at the top, there need be no runs. The world central bank currency swap network serves as a proxy for a world central bank.

      • “The idea is to find trades that are guaranteed to return higher than the borrowing costs.”
        .
        Guaranteed?!?!

        • Here’s one trade I would run past a peer-review process: buy the S&P 500 index, and also buy long options in the $VIX. $VIX goes up when the S&P 500 goes down, so you can figure out how to insure your S&P 500 index investment so that if it goes up, you get enough profit to pay back the borrowing costs, and if the S&P 500 goes down, you cash in the $VIX options for enough net profit to do the same.
          .
          I need to do some more work to figure out the amounts of each to buy. You also need to monitor the $VIX daily to get the maximum insurance value. You might need to rebalance every day. But a hedge fund should have low-cost access to trading platforms …

        • Robert,
          .
          Why don’t YOU do the trade? (it’s guaranteed, right?)

        • Robert,
          .
          Why don’t YOU take the trade. (It’s guaranteed, right?)

          • I might get to the point where I can try a proof-of-concept. I’m studying …

            • Good luck Robert, but in my opinion your financially risk free world for everyone is doomed unless the finance (as in money) is completely separated from production and distribution of goods and services. Which means money would be worthless.

          • Robert
            .
            You can intellectualize all you like.
            .
            There is only one way to learn and that is to trade.
            .
            These days you don’t even have to play with real money – there are plenty of trading platforms with demo accounts.
            .
            However, they don’ t come close to the real thing – when you have you own money on the line a whole new world of fear opens up. 🙂

    • I mean that uncertainty is a common issue in most if not all the ways mainstream economics theory goes wrong.


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