Back to your classics

August 6, 2009

While many economists are on holiday, the debate rages on over the future of the profession.

In today’s FT, Robert Skidelsky contributes with a classic theme: the aloofness of perfect-equilibrium mathematical economics and all those models it produced. These model’s assumptions have led, for example, banks straight into bankruptcy, or laissez-faire-minded central banks into thinking we are living in a perfect world where businesses regulate themselves. This approach has, to put it mildly, shown its limits. Each time, financial crises are deemed a crisis of capitalism. As we shall see, they simply are. But these are the moments where social conservative/religiously-minded and/or socialist-minded get a hearing on the failures of the neo-liberal economic model and of the Devilish Market Economy per se.

But let’s go back to the roots, so that we get a better understanding of what this is all about. To start with, here a few quotes from Skidelsky’s article, who comments on the ongoing debate stirred by the Queen in the UK:

[…] the Queen’s question […] accepted at face value the predictive claim of economics – a feature that has distinguished it from all other social sciences. Karl Popper produced a famous argument against the possibility of prediction in human affairs: one cannot anticipate a new invention because, if one could, one would already have invented it. However, this objection can be overcome if one assumes a stable and repetitive universe in which rational actors make efficient use of the information available to them. In this environment, uncertainty disappears to be replaced by calculable risk. Shocks and mistakes may occur but these will cancel each other out, so that, on average, people get what they expect.

“An important implication of this view is that shares are always correctly priced. This is the basis of the so-called efficient market hypothesis that has dominated financial economics”.

[…] It has also led to the discrediting of mainstream macroeconomics. The efficient market hypothesis is simply an application of the recently triumphant New Classical school, which preaches that a decentralised market system is always at full employment. In their obsession with getting government out of economic life, Chicago economists claimed that any consistent set of policies will be learnt and anticipated by a population, and will therefore be ineffective.”

This article strikes at the heart of the distinction between “classic” and so-called “neo-classic” approaches in economics. Unfortunately “classic liberal” economists have indeed become marginalised eccentric mavericks in universities and public debate. Classic liberals are generally only supported by social conservatives as long as the “natural liberty” they advocate remains strictly circumscribed to the economic field, and are despised by the Left for being part of those “right-wing” “neo-liberals” who really-don’t-get-that-markets-don’t-work. In fact, they are generally simply misunderstood.

 I am currently reading a brilliant book by one of those (truly) maverick classic liberals, UCLA Development Economist Deepak Lal, whose book, published in 2006, “Reviving the Invisible Hand, The Case of Classical Liberal Liberalism in the Twenty-First Century” is, as one can imagine, not currently an international best-seller. Yet he raises a few points that are quite useful in the current discussion:

 “The laissez-faire doctrine has been caricatured as “the night watchman state” as assuming “a harmony of interests” and as assuming utility-maximizing rational actors. But all these are alien to the thought of the fathers of classical liberalism – Hume and Smith. They do not look upon man as a rational utility maximizer with perfect knowledge. Hume talks of “the imperfections and narrow limits of human understanding” and that “reason is, and ought only to be the slave of the passions and can never pretend to any office other than to serve and obey them”. Their central claim is that, a free market economy, by promoting the division of labour, and by coordinationg the division of knowledge (which necessarily exists in any society) through the price mechanism can goad individuals to become more rational. The specialization that then ensues allows a better allocation of a society’s resources and leads to greater national wealth. But, the free market is not considered to be one which has perfect competition as defined by modern-day economists.”

 “Moreover, instead of there being harmony of interests, a legal framework is needed to mediate between clashing interests and reconcile individual self-interest with the public good. Classical liberals strongly believe in “liberty under the law” and therefore a qualified, not an absolutist laissez-faire”. [see too Razeen Sally]

 “The classical liberals were not hostile to the state, nor did they believe that governments had only a minor role in economic life. Their view of the state was positive (…).  Adam Smith’s famous statement of the three functions of the state, viz. (i) to protect society from foreign invaders, and (ii) every member, as far as feasible, from oppression and injustice by other members of society, and (iii) provide and maintain various public works and public institutions which provided public goods, is almost identical with Keynes famous formulation in “The End of Laissez Faire”: “the important thing for government is not to do things which individuals are doing already, but to do those things which at present are not done at all”.

 Another crucial distinction between classic and neo-classic economics is the conception of competition.

“The modern concept of perfect competition, conceived as a market structure in which all producers are price takers and face perfectly elastic curves for their outputs […] is foreign to the classical conception of competition as a process of rivalry in search for the unrealized profit opportunities, whose outcome is uniformity in both the rate of return on capital invested and the prices of identical goods and services, but not because producers are incapable of making prices.”

Furthermore, Lal points to Joseph Schumpeter, who sees capitalist progression as driven by recurrent, crisis prone and destabilising, innovative competition: what he called “creative destruction”.

 So. Classic liberal economic thinking is very well capable of capturing what is at work in this capitalist crisis. Just a few obvious examples:

  •  many governments that during a boom have not done “what individuals [were] not doing”, e.g. curb the bubble that came home to … burst; through, for example, sounder monetary policies;
  • regulators that have not been able to create institutions that regulate diverging interests. One thinks of the “clash of interest” problems between banks and ratings agencies. These have led to what Adam Smith has coined their “combination”, to the detriment of your average saver, investor, and, ultimately, tax payer.
  • innovative competition, i.e. the one that has led to the creation and overselling of complex financial derivatives, now sitting in banks’ balance sheets as “toxic assets”;
  • insufficient “reason” and understanding. For example “irrational exuberance”, and other market dysfunctionalities picked up by behavioural economists recently, and the simple and plain fact that the new financial products were practically impossible to understand.

Back to Skidelsky – who obviously can’t help being a Britisher:

“The reconstruction of economics needs to start with the universities. First, degrees in the subject should be broadly based. They should take as their motto Keynes’s dictum that “economics is a moral and not a natural science”. They should contain not just the standard courses in elementary microeconomics and macroeconomics but economic and political history, the history of economic thought, moral and political philosophy, and sociology. Though some specialisation would be allowed in the final year, the mathematical component in the weighting of the degree should be sharply reduced. This is a return to the tradition of the Oxford Politics, Philosophy and Economics (PPE) degree and Cambridge Moral Sciences.”

What Skidelsky forgets to say is that Adam Smith, founder of classic liberalism, understood indeed very well that economics is a moral science. Smith is also the author of a lovely “Theory of Moral Sentiments”. Smith’s view of why humans strive, work hard and take risks to get rich is, to put it simply, their vanity, their desire to be recognised and admired in society. Because being wealthy and happy is one of the ways of attracting public admiration and social recognition. Skidelsky is right in wanting to put economics into its wider context and in pointing to the world’s most excellent universities. However, he also omits to mention that the City of London, its regulatory bodies, and the list of economists that have written their mea culpa to the Queen, are themselves full of people who come out of Oxbridge. Driven – probably even more than any other less ambitious person in the Kingdom – by Smith-style vainglory. Despite their brainpower and ability to think more broadly than by numbers and econometric models, they too have failed to see the crisis coming, because they too have benefited from the unprecedented financial bubble that has burst spectacularly. The problem is we now also need these peoples’ brains to clean up this mess. Let’s hope that in the process they won’t throw away the babies with the bath: a capitalist market system that has proven to be the least inefficient in creating and spreading wealth in all human history, as well as the occasional usefulness of a mathemical model to help investors take risks.


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