Neoclassical Theory under Fire from the Sciences

There is a very good discussion right now on Mark Thoma's Economists View about neoclassical and other economics and linkages to science, theology, ideology, etc. I'll update this post with a bit more in a few hours, but right now I'm just intrigued with the excellent commentary being generated. {Update: I plucked a few comments from Mark's discussion and appended them in the extended portion of this message}

This is Philip Ball, "consultant editor of Nature and the author of Critical Mass," with a criticism of neoclassical theory: Baroque fantasies of a most peculiar science, by Philip Ball, Commentary, Financial Times (free): It is easy to mock economic theory. Any fool can see that the world of neoclassical economics, which dominates the academic field today, is a gross caricature in which every trader or company acts in the same self-interested way – rational, cool, omniscient. The theory has not foreseen a single stock market crash and has evidently failed to make the world any fairer or more pleasant.

The usual defence is that you have to start somewhere. But mainstream economists no longer consider their core theory to be a “start”. The tenets are so firmly embedded that ... it is ... rigid dogma. To challenge these ideas is to invite blank stares of incomprehension – you might as well be telling a physicist that gravity does not exist.

That is disturbing because these things matter. Neoclassical idiocies persuaded many economists that market forces would create a robust post-Soviet economy in Russia (corrupt gangster economies do not exist in neoclassical theory). Neoclassical ideas ... may determine ... how we run our schools, hospitals and welfare system. If mainstream economic theory is fundamentally flawed, we are no better than doctors diagnosing with astrology.

Neoclassical economics asserts two things. First, in a free market, competition establishes a price equilibrium that is perfectly efficient: demand equals supply and no resources are squandered. Second, in equilibrium no one can be made better off without making someone else worse off.

The conclusions are a snug fit with rightwing convictions. So it is tempting to infer that the dominance of neoclassical theory has political origins. But ... the truth goes deeper. Economics arose in the 18th century in a climate of Newtonian mechanistic science, with its belief in forces in balance. And the foundations of neoclassical theory were laid when scientists were exploring the notion of thermodynamic equilibrium. Economics borrowed wrong ideas from physics, and is now reluctant to give them up.

This error does not make neoclassical economic theory simple. Far from it. It is one of the most mathematically complicated subjects among the “sciences”, as difficult as quantum physics. That is part of the problem: it is such an elaborate contrivance that there is too much at stake to abandon it.

It is almost impossible to talk about economics today without endorsing its myths. Take the business cycle: there is no business cycle in any meaningful sense. In every other scientific discipline, a cycle is something that repeats periodically. Yet there is no absolute evidence for periodicity in economic fluctuations. Prices sometimes rise and sometimes fall. That is not a cycle; it is noise. Yet talk of cycles has led economists to hallucinate all kinds of fictitious oscillations in economic markets. Meanwhile, the Nobel-winning neoclassical theory of the so-called business cycle “explains” it by blaming events outside the market. This salvages the precious idea of equilibrium, and thus of market efficiency. Analysts talk of market “corrections”, as though there is some ideal state that it is trying to attain. But in reality the market is intrinsically prone to leap and lurch.

One can go through economic theory systematically demolishing all the cherished principles that students learn... [I]t is abundantly clear that herding – irrational, copycat buying and selling – provokes market fluctuations.

There are ways of dealing with the variety and irrationality of real agents in economic theory. But not in mainstream economics journals, because the models defy neoclassical assumptions.

There is no other “science” in such a peculiar state. A demonstrably false conceptual core is sustained by inertia alone. This core, “the Citadel”, remains impregnable while its adherents fashion an increasingly baroque fantasy. As Alan Kirman, a progressive economist, said: “No amount of attention to the walls will prevent the Citadel from being empty.” ...

T.R. Elliot1: …[H]ere's the problem from my perspective. I'm a physicist as well, with an interest in economics. The heartburn I've encountered when looking at economics from a broad perspective is that the boundary between economics and ideology is not clear. Economists on both sides of the aisle, say left and right, libertarian and statist, love to start any phrase with "as an economist," after which they proceed to explain to the audience why everything everone else thinks is idiotic, why he or she--the economist--can set them straight.

Physicists can't predict earthquakes. And I've not seen many who even pretend that they can. They'd be considered tantamount to astrologers.

In the realm of economics though, I think it much more difficult to tell the astronomers from the astrologers.

I'm sure there are plenty of analogies to be found. The physicist who prescribes a certain defense policy based upon his expertise with nuclear weapons. But I think it still easier to make the following comparison: in days of old, the court would often set policy based upon the court astrologer. These days, we're just as likely to find the policies set by the court economist. Yet the prescriptions provided by the court economist changes from administration to administration, as the ideology of the outgoing and incoming administration changes--bringing with them a willing set of similarly ideologically motivated economists.

Economists take a lot of flack from physicists. But from what I've seen of many economists attitudes, the criticism is deserved at times.
Posted by: T.R. Elliott | Oct 29, 2006 3:16:08 PM

T.R. Elliot2: I suspect Ball's primary complaint is that economic prescriptions that are turned into ideology cause pain in the real world, e.g. the misapplication of free markets principles to Iraq by the Bush administration, not that dissimilar from the application in Russia (as mentioned by Ball). In the case of Iraq, I don't doubt for a second that a bunch of wet-behind-the-ear kids, with the support of a few free market ideologists, decided that wonderous optimality would result once the constraints of the Iraqi state economy were kicked away.

It's was a horrific mistake, on par with the many others made by the administration in their approach to Iraq (before and after the war).

As Hugh Schwartz says in the introduction to "Rationality Gone Awry: Decision making inconsistent with economic and financial theory:" "There does not even appear to be an unequivocal 'best way' of achieving rapid economic growth." He then lists the examples of the US, South Korea, China, Hong Kong, Chile, Brazil, etc.

A basic physics book does not have a warning that says "The physics contained in this book is not sufficient to build a rocket ship that will fly to the moon." Those who do end up building rocket ships that fly to the moon must go through a process that has successfully launched small and then large rockets to increasingly ambitious targets.

In the economics realm, the text is also lacking in a similar warning: "The economics contained in this book is not sufficient to run a real-world economy." Yet those who run real-world economies, including the economists who have passed through the required process, have not passed through any sort of similar process in which small economies are proven successful, then working to larger ones, etc.
I think Ball's primary complaint is that the economics text should have a large warning label on it.

A few notes from Shlomo Maital in the intro to Rationality Gone Awry?:
"In the social sciences, economics reigns supreme--at least, its adherents think it does--because it has a theory."

"Richard Thaler notes 'Most economists believe that their subject is the strongest of the social sciences because it has a theoretical foundation, making it closer to the acknowledged king of sciences, physics. The theory, they believe, is a tool which gives them an inherent advantage in explaining human behavior compared with their weaker social science cousins.'"

"Modern economic theory ls largely derived from Leon Walras' classic Elements of Pure Economics. Walras posited free, opem markets with perfect symmetric information and utility-maximizing or profit-maximizing agents, modelled convergence of prices to equilibrium using the device of an auctioneer, analyzed dynamics using the 'tatonnement' process, and built the foundations of multimarket general equilibrium."

Maital once suggest to Milton Friedman "that the economics profession would today have theories that hold water if it had espoused Marshall's Principles of Economics instead of wholeheartedly embracing Walras' Elements" since Marshall embraced a behavioral view of economics.
Maital then goes on to say economics has been served by following the incorrect and mistaken path set by Walras, it was a path that lead somewhere, but the destination to which it leads is not right and must be amended.

Physics students in quantum mechanics devote inordinate time to the question of meaning. My quantum professor responded that they are interesting question, but (a) progress must be made with what we have and (b) the theory works so well.

I don't think a similar argument can be made with respect to economics. The theory does not work very well, certainly not as well as quantum theory, and more energy should be devoted to the problems of economics. Granted people are focusing on the problems, no doubt, but there is a perception--even if wrong--that economists are like that proverbial drunk, looking for his keys below the lampost, even though he lost them in a dark alley. He's looking where the light is better.
Posted by: T.R. Elliott | Oct 30, 2006 7:51:48 AM

Lee Arnold: [responding to various give and takes w/r/t complex systems]:As to complex systems, I think mathematics is limited in three different ways, possibly four:

(1) WITHIN THE SYSTEM, all the transactions or events at the SAME "logical type" (after Bertrand Russell) are linked in multiple arrays, including circular and more complicated chains. So complicated cause-and-effect sequences are difficult to model. Also, mathematical computation is pairwise and, in practice, is successional. This leads to the "butterfly" effect -- the results swerve wrongly, by compounded error. So both physicists and economists limit the scope of their experiments, for reproducible results.

(2) WITHIN THE SYSTEM, those events at a different, HIGHER logical type are not computable from out of the lower mathematical group. So the "emergence of new properties" is not predicted. In economics there are many examples of these properties, which must be dealt with if there is ever to be a total micro + macro theory: creative ideas, institutional organization, Solow's residual, etc. Macroeconomics, taken separately, works because it starts with whole-systems-level identities -- GDP. unemployment, inflation, etc. -- and more or less stays there.

(3) OUTSIDE OF THE SYSTEM, (since almost all really important systems are "open,") there is a bigger system, which contributes inputs at the periphery of the smaller system. Sometimes this bigger system is not modeled by the same models as the smaller system. And separately, the bigger system has its own prediction problems by (1) and (2) above. So, outside the economic system, we have the "environment," which is now adding, indeed forcing, more complexity into real-world predictions.

(4) There is also the problem of the QUANTITATIVE VALUE OF INFORMATION. Ideas are paramount for economic growth: indeed they may be one-half of the "economic problem." Ideas are meaningful information. BUT information can be created, duplicated, and destroyed -- unlike matter-energy, which is "conserved." So the arithmetic of information is more like Boolean algebra, (a X a = a,) which does not use numerical quantities, and allows no testable numerical predictions for the future that are not tautologous.

Of course, information may a have value in the market; of course, we often pay money for various types of useful information. This perhaps gives hope to some people that ideas, from their monetary valuations, have thereby actually been quantified, to make some sort of predictive hypothesis. But this quantification is not related to any absolute sense of unit weight or measure; and this is quite regardless of the fact that in the real world, information is also incomplete, and markets fail regularly.

A remarkable complication to the problem is that money itself is the only [info + mass-energy] hybrid: it is a type of information (creatable, duplicatable, destroyable) which is ACCOUNTED FOR, by most of its users, in the same way that matter-energy is: money always leaves one person, in order to go to another.

The place where it is created -- i.e., where it does not act like matter-energy -- is at a hierarchical level above common daily experience. Perhaps this gives an inchoate hope that we can grasp, through computations using monetary quantities, the secret of new emergence. More likely that the social sciences, like the physical sciences, are doomed to lack exact predictive ability except in piecemeal, only in this case simply because humans have ideas.
Posted by: Lee A. Arnold | Oct 30, 2006 7:14:53 PM

Dave Iverson:A friend, also then a Dept. Chair for Economics at a local university, used to like to say something like, "Whenever you question an economist, you had better ask, Whose Economics?" You had better inquire as to what school of thought the economist pledges allegiance.

To gain a better understanding of the various schools, I recommend that people study The New School's Schools of [Economic] Thought. Here you can get a glimpse of what my friend was talking about.

And if anyone is interested in knowing more about the decline and fall of the neoclassical mainstream, I highly recommend Goncalo Fonseca's The Walrasaid. An essay that puts the whole tortured history of economic ideas into a newly framed storyline, ancient in style. It's fun, but telling. Here is a snip from "Canto the Fifth" :

...What the new Imperial regime did not notice (and certainly did not anticipate), however, was the slow gathering of the impending clouds of doom. After the disbanding of the Walrasian communes, some of its more puritanical members had gone underground and formed a secret society, the Nash Liberation Front. These, in turn, were joined underground by old dissidents and disaffected members of the new parliament who had grown tired of the edicts of the Emperor's junta. Several of these secret societies were given cover by foreign powers, such as Biology, Mathematics and Psychology, and some of the rebel groups had even set up guerilla camps in their lands. Under the very nose of the Imperial Guards, a Grand Armee of dissidents was being assembled and preparations for an invasion of the Lucasian Empire were being made.

Oh, virtuous reader, your humble storyteller has indeed seen the Grand Armee! Once, when wandering lost through the dark, strange Land of Journals, his faithful goats beside him grazing along those rocky pastures, his Walrasian heart sad, his Keynesian bones exhausted and his Olympian eyes much diminished, he decided to rest upon a hill and await the lifting of the evening mist. And when it arose, what a spectacle unfolded! Your storyteller swears upon all the gods and more that all that is to follow, bar some demon's interference, is what he verily saw.

He spotted a valley wherein were arrayed hundreds of armed men, encamped, sharpening their swords and pikes and cleaning their muskets. Like the great army assembled by Gustavus Adolphus of old in the plains of Saxony, many different flags flew everywhere over the camp of the Grand Armee - and, to the immense joy of this old spirit, they were all tinged with mathematical colors. And institutions and structures - realistic structures - were imprinted on their sabres. And from their eyes blazed forth the fire of determination, a determination to save their discipline from the cold grip of Imperial rot. Their demeanour was brave, as if to announce unto the world "no more unforgivable assumptions, no more shoddy reasoning, no more ambiguity and ideological quibbling!"

But, ah, patient reader of this story, it may seem that your weak storyteller has let his imagination take his senses prisoner. Let him then merely make his report truthfully and soberly of what he saw in the valley.

There were men and women of all lands, speaking many different tongues, arranged by banner colors into separate corners of the camp. ...

So your tired storyteller must end this saga with a word of caution. Perhaps at this point we should lay down our aspirations for a grand system and allow each of the battalions to roam independently for a while, proceeding on their own, examining each other in passing, learning from each other, each taking what is useful to their particular research program and leaving behind what is not. In time, if the gods are kind, there might be some convergence on some principles and possibly even a few conclusions, so that thereupon the discipline may be a bit more honest and maybe even helpful to humanity at large. But if there is not such a convergence, let us not take arms and violently charge each other in the name of ideological purity - for then we might slaughter and bury much of what is insightful and useful. Let us then listen, reflect critically, and proceed with caution. ...Posted by: Dave Iverson | Oct 30, 2006 1:42:03 PM

Comments

[Joshi Chetan Kishor]

Dear Sir,
It is good to criticise the subject you are dealing in. However, it still remains improper to falsify the true fundamentals that we have learned so far. The stock market crash can be easily explained by our laws of demand and supply.

It simple situation of supply exceeding demand resulting fall in prices and fall in trade volume. Even at Macro level the zero sum game of stock exchange has puposes like liquidity to investors and employment to brokers. Ignoring it may not harm a subject called economics. Thanking you.
From
Learner of Economics
Joshi Chetan

[John Konop]

Economists Are Destroying America

Economists, politicians, and executives from both parties have promised American families that “free” trade policies like NAFTA, CAFTA, and WTO/CHINA would accomplish three things:

• Increase wages
• Create trade surpluses (for the US)
• Reduce illegal immigration

Well, their trade policies have been in effect for about 15 years. Let’s review the results:

• Declining real wages for 80% of working Americans (while healthcare, education, and childcare costs skyrocket)
• A record-high 46 million Americans who don’t have health insurance (due in part to declining wages and benefits)
• Illegal immigration out of control
• Soaring trade deficits, much with countries that use slave and child labor
• Personal and national debt both out-of-control
• Global environments threatened by lax trade deal enforcement

Economists Keep Advocating Policies That Aren’t Working

Upon seeing incontrovertible evidence of these negative trade agreement results, economists continue with Pollyannish blather. Some say, “Cheer up! GDP is up and the stock market’s doing fine.” Others say, “Be patient. Stay the course. Free trade will raise all ships.”

Even those economists who acknowledge problems with trade agreements offer us only half-measures—adjusting exchange rates, improving safety nets, and providing better job retraining. None of these will close the wage gap in America—and economists know it.

Why Aren’t American Economists Shouting From Street Corners?

America needs trade deals that support American families and businesses in terms of wage, environmental, and intellectual property abuses. Why aren’t economists demanding renegotiation of our trade deals? There are three primary reasons:

• Economists are too beholden to corporations and special interests that provide them with research grants.
• Economists believe—but refuse to admit—that sacrificing the American middle class is necessary and appropriate to generate gains in third world economies.
• Economists refuse to admit they make mistakes.

Economic Ambulance Chasers

Now more than ever, Americans need their economists to speak truth and stand up to their big business clients. Instead, economists sound like lawyers caught chasing ambulances: they claim they’re “doing it for our benefit”.

[Dave Iverson]

"Beware of Economic Fundamentalism," by Fred Argy, covers the main bases for effective criticism of "economic fundamentalists." And maybe, John, it is these to whom you need to address your criticism. Rather than saying Economists are destroying... maybe you ought to be saying Economist are not working hard enough to counter the chants of "economic fundamentalists" who, along with political ideologues are destroying....

Here's a link to "Beware of Economic Fundamentalism: http://www.australianreview.net/digest/2003/03/argy.html

Question remains open as to "who" are the fundamentalists and who are in other camps.

[c]

You do not seem to know the difference between models and Theory. You really do not have a clue. Maybe you sould really talk to an economist ignore the libertarian and conservatives that also misunderstand general equilbrum to me free markets is the only and best way to go. Most economist are not as conservative as you would think. Also when you talk to an economist make sure you are talking in terms of positive and not normative arguments.