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New Economic Thinking - Turning Away from the Market Fetish
by Ronald Schettkat
Monday Jul 16th, 2012 6:19 AM
"New economic thinking" rejects the view of the person as "homo oeconomicus" reduced to maximization of individual benefits and offers a more comprehensive and realistic concept in which justice, norms, routines and emotions flow into decision-making. Theory must adjust to reality, not vice versa. "Homo recipocans" better reflects our inter-dependent nature.
TURNING AWAY FROM THE MARKET FETISH – NEW ECONOMIC THINKING

By Ronald Schettkat [1]

[This article published in: WISO direct, June 2012, is translated from the German on the Internet, http://library.fes.de/pdf-files/wiso/09179.pdf. Ronald Schettkat is a professor of economics at the Schumpeter School of Economics, University of Wuppertal, Germany.]

SUMMARY

With the financial- and economic crisis, the promises of a stable market-guided economic development of political neoliberalism and its theoretical-economic basis, neoclassical economics, have burst. Superficially it seems to be a failure of macro-economic models. However criticism of the extreme assumptions and the axiomatic inductive methods of neoclassical economics long fermented in economics. Trifling deviations from the referential model of the perfect market lead to completely different economic-political conclusions. “New economic thinking” rejects the view of the person of the “homo oeconomicus” reduced to maximization of individual benefits and offers a more comprehensive realistic concept in which justice, norms, routines and emotions flow into decision-making. New economic thinking is based on inductive empirical economics whose effect now shakes the foundations of doctrinaire economics.

CRISIS IN ECONOMIC THINKING

Queen Elizabeth was amazed that economists did not warn of the banking crisis and was astonished about the justification for the economics Nobel Prize winner Robert Lucas. Economic theory assumes that such events are not foreseeable but are exogenous shocks of otherwise stable markets. Lucas holds to the hypothesis of efficient markets (HEM) that markets always tend to balance and represents the collapse of Lehmann Brothers (September 15, 2008) as an exogenous shock rather than a result of excessive financial markets. The big investor, speculator and philanthropist George Soros was dismayed by Lucas’ answer. He gained his considerable assets [2] with an interpretation of market events contrary to HEM. Instead of relying on the constant tendency to balance (HEM), Soros emphasized reflexivity and interdependent acts since the market can drift away from balance. Soros now uses part of his assets to support “new economic thinking” and promotes the “Institute for New Economic Thinking.” He also organized the much-discussed conference “Paradigm Lost: Rethinking Economics and Politics” in Berlin (April 12-15, 2012). [3]

NOT ONLY A CRISIS OF THE MACRO-ECONOMY

Superficially only the macro-economic models seem to have failed. However the crisis of economic thinking concerns above all the extremely unrealistic assumptions. The “homo oeconomicus” orders a myriad of action alternatives according to a use-function (which must satisfy mathematical demands), considers the consequences of its actions and chooses the maximum benefit combination by including price- and income conditions. The “homo oeconomicus” has “rational” expectations, operates on perfect capital markets with the markets tending to general balance in a “natural” unemployment rate. Ideas of justice, fairness and relative income are unimportant. The aggregation problem from individual- to market-conduct is defined away and macro-economic results are projected from the assumed macro-economic conduct.

Agreement with axioms is more important than realistic empirically validated conduct. Discrepancies between assumptions and actual behavior are irrelevant. The logical consistency of the models is crucial, not the reality-content of the assumptions. Adjusting reality to the model (deregulation) is recommended. Markets are stable without regulations and state incursions. They always tend to balance; they are efficient and lead to maximum welfare. The state and politics only disturb this balance and cause inefficiencies. That is why state activity should be limited and its functions replaced by private arrangements (privatization) as much as possible. “Rigidities” can delay price adjustments. However the dominance of market forces in the long-term is assumed that leads back again to balance as if nothing happened (comparative statistics). Economics is even reduced to the analysis of balances.

ADJUSTING REALITY TO THEORY

A fundamental methodical criticism criticizes the formal deductive procedures of a neoclassical model world. This method does not contribute to more knowledge but blocks the way to a profound empirically-oriented development of theory. The “new thinkers” – including many Nobel Prize winners – argue that theory must adjust to reality, not vice versa. Prognoses based on false assumptions could accidentally be right. Understanding the conduct of individuals depends on the context and interactions on markets. Motivations, structures and processes must be considered to identify the causal connections.

“Super-rationality,” systematically alternating individual conduct may not be dismissed as a special case (anomaly) or irrationality because ideas of justice, routines, norms and emotions influence conduct. Studies on the behavioral axioms of neoclassical economics also show a systematically different conduct than assumed. If individuals feel they are treated unfairly, they refuse advantageous gratifications – against their “rational” monetary interests.

EFFECTIVE MACRO-ECONOMIC POLICY

Markets are stable and always tend to optimum welfare and general balance. That is why macro-economic stabilization policy can only have a disturbing effect. This theoretical conclusion of “neoclassical theory” rests on a whole bundle of dubious assumptions: (1) balance in the initial situation; (2) a-historical analysis; (3) rational expectations; (4) consumption determined by long-range instead of current incomes; (5) “Ricardian equivalence” that explains the debts of today as the taxes of tomorrow; (6) there are no credit restrictions on the assumed perfect capital market (!); (7) risk instead of uncertainty guides the assessment of future events and (8) the “natural” unemployment rate.

“New economic thinking” regards these assumptions as theoretically and empirically refuted and criticizes the political recommendations based on the neoclassical immunization strategy. Right at the front, effective analyses of expansive economic policy consider the initial situation. The mere assumption of balance and full employment (1) is inadequate and misleading. In reality, expansive macro-economic fiscal- or monetary policy is used to gain balance and full employment, not to produce inflation-driving over-employment.

National economies carry out adjustment processes that substantially influence the path of development. “Neoclassical theory” only allows short-term quantitative reactions (“straw-fires”) that are quickly compensated by price reactions. Interim inflation occurs. The economy levels out at a higher price level with the original quantities. Expansive macro-policy leads to wrongly understood signals. “Rational” expectations (3) fade out such errors from the start. They anticipate the model-immanent effects. For that reason, systematic influences on politics are impossible. Unexpected and surprising policies could induce economic agents to act. This a-historical analysis of “old economic thinking” should be replaced by a sequential analysis (2) which is especially relevant when the restriction to negative feedbacks is abandoned and positive feedbacks are allowed. Economic decisions are made outside balance situations. When businesses invest in reaction to expansive political-economic impulses, then the production possibilities of the economy (the potential) are changed. New balances result that are crucial for long-term price reactions. The long-term balance cannot be equated with the short-term balance of a fictional frictionless economy. Through their actions, investors and other market actors influence the development. Therefore development is characterized by insecurity and risk (7).

The thesis of “long-term income” (4) includes the effect of fiscal impulses (tax allowances and premiums) on consumer conduct (consumers make their buying decisions based on long-term available income, not on current income) and the “Ricardian equivalence” (5) according to which the state debts of today are the taxes of tomorrow. State spending neutralizes – doesn’t influence – growth or crowds out private investments. If the economy is really used to capacity, then the neoclassical reflections are right. If there is under-employment, the impulse to balance will lead us out. The focus of public spending is decisive: consumption or investment. The public sector brings important benefits for the private economy and is not inefficient per se. Public payments have great importance for income distribution in reducing the inequality in all OECD countries. In other words, lower income groups are disproportionally burdened by cancellation of public benefits.

PERFECT FINANCIAL MARKETS?

Credit restrictions are eliminated in the neoclassical model by the assumption of perfect capital markets (6). Businesses can finance their investments and households their education spending (human capital investments) at any time with foreign capital. Credit restrictions, uncertainty and asymmetrical information do not exist. Future profits are foreseeable (risk). The assumption of perfect capital markets seduces to the thesis that high and increasing wage inequality is conducive for education investments since education profit increases with them. Here is one fallacy or non sequitor: the share of successful bachelor degrees increases with the socio-economic status of the parents. Inequality reproduces inequality across generations the more intense is the inequality of a society. In the US with the greatest income inequalities, there is the strongest inter-generational bond while the bond is nearly outgrown in Norway – the country with the least income inequality and high public engagement in education. A broad access to education, equal opportunities, is essential for knowledge-societies. There is a “great goal conflict” when taxes reduce performance –readiness and flow into an inefficient public sector. On the other hand, technical progress and the growth potential are promoted if taxes flow into efficient areas like education.

INSTITUTIONS RELEVANT FOR JUSTICE AND INCOME DISTRIBUTION

Wages should correspond to individual production contributions. That is another firmly anchored assumption of “old economic thinking.” Every person receives what he or she earns. There is a quasi “natural” income distribution whose correction (through taxes or minimum wages) leads to efficiency- losses. The increasing wage spread in nearly all OECD countries is interpreted as a “natural” market reaction to technical progress or as a consequence of globalization. But market forces are no longer plausible as an explanation when income growth increasingly concentrates with the top one percent of income recipients and great wage-differences appear in narrowly limited groups. Institutional explanations like the decline of union organizations, trifling or missing minimum wages, taxes (the top tax rate in OECD countries fell 20 percent on average; capital incomes are taxed less than work incomes) gain more and more plausibility. However such regulations were condemned in “old economic thinking” as efficiency-reducing and disturbing the “natural” distribution. Still the same efficiency seems attainable with very different income distributions.

In the neoclassical model, minimum wages inevitably lead to redundancies of employees previously paid below the minimum wage. But individual production contributions are not observable and comparable. Therefore one easily falls to a circular reasoning in which one deduces from wage to individual production contribution. “New economic thinking” recognizes that wages are negotiated and the balance of power plays an essential role on the labor market. The pay of different activities is always subject to value judgments.

UNEMPLOYMENT IS NOT OPTIMIZING CONDUCT!

Institutional incentives (above all wage compensations) determine the general balance, the “natural” unemployment rate to which the economy should always return. This unemployment rate can only be reduced through structural reforms, not through macro-economic policy. If the “homo oeconomicus” is jobless, this is a benefit-maximizing weighing of freedom, work suffering and income in a given institutional environment. What a contrast to the findings of modern research in which unemployment is established as the crucial event drastically reducing well-being – comparable with divorce. In “new economic thinking,” adjustment processes on the labor market are very relevant because long recessions lead to fortified long-term unemployment. If this occurs, the costs of unemployment will be very high. That is why timely counter-measures are efficient.

“New economic thinking” is based on empirical inductive analysis and considers actual human conduct. Turning away from the extreme assumptions of the “homo oeconomicus” overcomes the immunization of neoclassical economics and gives an active role to economic policy. The division of labor according to which only the central bank is competent for price stability and structural reforms and the demand-side of the economy is ignored cannot be maintained.

NOTES

1 The author is a professor of economics at the Schumpeter School of Economics, University of Wuppertal, Germany.

2 With $22 billion in net assets, Soros is nr. 22 on the Forbes list of billionaires.

3 http://www.ineteconomics.org
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RELATED LINKS:

Schettkat, Ronald, “Will Only an Earthquake Shake Up Economics?
http://www.ilo.org/public/english/revue/download/pdf/s3schettkat.pdf

A Manifesto for Economic Sense July 2012 http://www.manifestoforeconomicsense.org/

More than four years after the financial crisis began, the world’s major advanced economies remain deeply depressed, in a scene all too reminiscent of the 1930s. And the reason is simple: we are relying on the same ideas that governed policy in the 1930s. These ideas, long since disproved, involve profound errors both about the causes of the crisis, its nature, and the appropriate response.
These errors have taken deep root in public consciousness and provide the public support for the excessive austerity of current fiscal policies in many countries. So the time is ripe for a Manifesto in which mainstream economists offer the public a more evidence-based analysis of our problems.
• The causes. Many policy makers insist that the crisis was caused by irresponsible public borrowing. With very few exceptions - other than Greece - this is false. Instead, the conditions for crisis were created by excessive private sector borrowing and lending, including by over-leveraged banks. The collapse of this bubble led to massive falls in output and thus in tax revenue. So the large government deficits we see today are a consequence of the crisis, not its cause.
• The nature of the crisis. When real estate bubbles on both sides of the Atlantic burst, many parts of the private sector slashed spending in an attempt to pay down past debts. This was a rational response on the part of individuals, but - just like the similar response of debtors in the 1930s - it has proved collectively self-defeating, because one person’s spending is another person’s income. The result of the spending collapse has been an economic depression that has worsened the public debt.
• The appropriate response. At a time when the private sector is engaged in a collective effort to spend less, public policy should act as a stabilizing force, attempting to sustain spending. At the very least we should not be making things worse by big cuts in government spending or big increases in tax rates on ordinary people. Unfortunately, that’s exactly what many governments are now doing.
• The big mistake. After responding well in the first, acute phase of the economic crisis, conventional policy wisdom took a wrong turn - focusing on government deficits, which are mainly the result of a crisis-induced plunge in revenue, and arguing that the public sector should attempt to reduce its debts in tandem with the private sector. As a result, instead of playing a stabilizing role, fiscal policy has ended up reinforcing and exacerbating the dampening effects of private-sector spending cuts.
In the face of a less severe shock, monetary policy could take up the slack. But with interest rates close to zero, monetary policy - while it should do all it can - cannot do the whole job. There must of course be a medium-term plan for reducing the government deficit. But if this is too front-loaded it can easily be self-defeating by aborting the recovery. A key priority now is to reduce unemployment, before it becomes endemic, making recovery and future deficit reduction even more difficult.
How do those who support present policies answer the argument we have just made? They use two quite different arguments in support of their case.
The confidence argument. Their first argument is that government deficits will raise interest rates and thus prevent recovery. By contrast, they argue, austerity will increase confidence and thus encourage recovery.
But there is no evidence at all in favour of this argument. First, despite exceptionally high deficits, interest rates today are unprecedentedly low in all major countries where there is a normally functioning central bank. This is true even in Japan where the government debt now exceeds 200% of annual GDP; and past downgrades by the rating agencies here have had no effect on Japanese interest rates. Interest rates are only high in some Euro countries, because the ECB is not allowed to act as lender of last resort to the government. Elsewhere the central bank can always, if needed, fund the deficit, leaving the bond market unaffected.
Moreover past experience includes no relevant case where budget cuts have actually generated increased economic activity. The IMF has studied 173 cases of budget cuts in individual countries and found that the consistent result is economic contraction. In the handful of cases in which fiscal consolidation was followed by growth, the main channels were a currency depreciation against a strong world market, not a current possibility. The lesson of the IMF’s study is clear - budget cuts retard recovery. And that is what is happening now - the countries with the biggest budget cuts have experienced the biggest falls in output.
For the truth is, as we can now see, that budget cuts do not inspire business confidence. Companies will only invest when they can foresee enough customers with enough income to spend. Austerity discourages investment.
So there is massive evidence against the confidence argument; all the alleged evidence in favor of the doctrine has evaporated on closer examination.
The structural argument. A second argument against expanding demand is that output is in fact constrained on the supply side - by structural imbalances. If this theory were right, however, at least some parts of our economies ought to be at full stretch, and so should some occupations. But in most countries that is just not the case. Every major sector of our economies is struggling, and every occupation has higher unemployment than usual. So the problem must be a general lack of spending and demand.
In the 1930s the same structural argument was used against proactive spending policies in the U.S. But as spending rose between 1940 and 1942, output rose by 20%. So the problem in the 1930s, as now, was a shortage of demand not of supply.
As a result of their mistaken ideas, many Western policy-makers are inflicting massive suffering on their peoples. But the ideas they espouse about how to handle recessions were rejected by nearly all economists after the disasters of the 1930s, and for the following forty years or so the West enjoyed an unparalleled period of economic stability and low unemployment. It is tragic that in recent years the old ideas have again taken root. But we can no longer accept a situation where mistaken fears of higher interest rates weigh more highly with policy-makers than the horrors of mass unemployment.
Better policies will differ between countries and need detailed debate. But they must be based on a correct analysis of the problem. We therefore urge all economists and others who agree with the broad thrust of this Manifesto to register their agreement at http://www.manifestoforeconomicsense.org, and to publically argue the case for a sounder approach. The whole world suffers when men and women are silent about what they know is wrong.

http://www.storyofstuff.com
http://www.steadystate.org
http://www.whatawaytogomovie.com/watch-the-movie/ 2-hr video “What a Way to Go: Life at the End of Empire”