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Neoclassical Economics : a Failure of Theory or a Theoretical Failure?

A misrepresentation of Adam Smith

Proponents of neoclassical economics like to refer back to Adam Smith, the eighteenth century Scottish philosopher and author of The Wealth of Nations. Smith, they say, considered freedom to pursue one’s own self-interest to be one of the three things that make us more prosperous, in a general sort of way. (The other two were specialization, which Smith called division of labour; and freedom of trade: Smith was an ardent anti-mercantilist.) Nobel prizewinner Amartya Sen points out “Smith was concerned not only with the sufficiency of self-interest at the moment of exchange but also with the wider moral motivations and institutions required to support economic activity in general.”[1]

When Smith referred to self interest what he meant was that it was a good idea for individuals to try to better themselves: Smith was writing in a time when the overwhelming majority of people were living in extremely poor conditions in almost every way. To give self-interest the emphasis it is given today – a kind of Darwinian survival of the fittest – is to completely ignore the context in which Smith wrote. Smith did not mean to imply an emphasis on the individual to the exclusion of others, he did not mean that competition should be the driving force of the human condition. American writer and satirist, and biographer of Adam Smith, P.J O’Rourke once pointed out, “In the chapter “Of the Wages of Labour,” in book 1 of The Wealth of Nations, Smith remarked in a tone approaching modern irony, “Is this improvement in the circumstances of the lower ranks of the people to be regarded as an advantage or as an inconveniency to the society?”[2]

“Smith wasn’t talking about Gordon Gekko in Wall Street,” laughs O’Rourke.[3] “He was talking about poor crofters in Scotland. At the time he was writing, the majority of people the world over had no capacity to exercise self-interest. They were serfs, slaves, peons working for pitiful wages. All their behaviour was subject to the will of others. By self-interest, Smith saw them as having a chance to better themselves, to jack up their standards a bit, to have the liberty to start a business and not be interfered with by the rich and powerful.”

A Failure of Theory or a Theoretical Failure?

In most European countries governments provide high levels of social welfare without negative consequences for the economy and productivity levels. Interestingly, French people spend more time eating and more time sleeping than the average for people in OECD countries and have amongst the very highest life expectancy.[4] Interestingly there is increasing interest in constructing an index representing many different aspects of life to sit alongside such strictly economic indicators as Gross National Product or GDP which measures only economic performance and that somewhat unreliably.[5]

Recent studies reveal that happiness is not stable over one’s life and is not determined genetically but is a result of choices, choices relating to longer-term relationships and goals.[6] Giving priority to altruistic goals is strongly associated with higher life satisfaction: family goals are also satisfaction enhancing. In southern Africa women participate in trials of chemical gels and their efficacy in preventing contraction of HIV-AIDS even though – in the case of those taking the placebo – they may in fact subject themselves to the likelihood of contracting the virus.[7]

Prioritizing success and material goals is actually harmful to life satisfaction. Yet neoclassical economics consistently emphasises choices relating to material goals and links pursuit of such goals to happiness. Much of the striving for material goods amounts to no more than a seeking of positional goods, things which relate only to attaining status in the eyes of others. Things are acquired to impress others whom one doesn’t know very well and who actually don’t care anyway.

A legion of economic writers, Nobel Prize winning economists and others have filled the pages of scholarly journals, newspapers, magazines and the radio airwaves and television screens with commentary pointing to the failure of the financial system and its ‘economic base’. Paul Krugman, Professor of Economics at Princeton University, 2008 Nobel Prizewinner and New York Times columnist, observes, “the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations.”[8]

On the other hand, as countries have emerged from, or at least coped with, the GFC the action has turned to the defence of existing arrangements by financial company executives and their political supporters against the onslaught of those asserting that the operations of financial enterprises must be subject to much greater regulation. Influential lobbyists work hard to convince governments that government itself should reduce expenditures and reduce its deficits, that excessive control of business enterprises will produce serious distortions and economic hardship.

Senior managers reporting their concerns about the future consequences of sophisticated financial instruments such as mortgage backed securities, credit default swaps and the like can be informed by their executives and boards that their concern is misplaced and not conducive to further employment.[9] Staff of financial entities and officials at the highest levels, as well as academic economists, have failed to consider the possibilities of unlikely events.

A week of intense discussions amongst leading academic economists at a workshop on modelling financial markets[10] in 2008 concluded, “The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold. In our view, this lack of understanding is due to a misallocation of research efforts in economics… The economics profession has failed in communicating the limitations, weaknesses, and even dangers of its preferred models to the public. This state of affairs makes clear the need for a major reorientation of focus in the research economists undertake, as well as for the establishment of an ethical code that would ask economists to understand and communicate the limitations and potential misuses of their models.”

One of the interesting features of those conclusions is how closely it resembles the views of Naseem Tahleb, essayist and mathematical trader and now famous author of The Black Swan.[11] Tahleb says that his central belief is scepticism about the predictability of markets and people’s biases in the attribution of skills, how we are “fooled by randomness”.[12] “Much of what happens in history”, he notes, “comes from ‘Black Swan dynamics’, very large, sudden, and totally unpredictable ‘outliers’, while much of what we usually talk about is almost pure noise. Our track record in predicting those events is dismal; yet by some mechanism called the hindsight bias we think that we understand them. We have a bad habit of finding ‘laws’ in history (by fitting stories to events and detecting false patterns); we are drivers looking through the rear view mirror while convinced we are looking ahead.

“Why are we so bad at understanding this type of uncertainty? It is now the scientific consensus that our risk-avoidance mechanism is not mediated by the cognitive modules of our brain, but rather by the emotional ones. This may have made us fit for the Pleistocene era. Our risk machinery is designed to run away from tigers; it is not designed for the information-laden modern world.” In a later essay[13] Tahleb wrote, “The current subprime crisis has been doing wonders for the reception of any ideas about probability-driven claims in science, particularly in social science, economics, and “econometrics” (quantitative economics).

“Clearly, with current International Monetary Fund estimates of the costs of the 2007-2008 subprime crisis,  the banking system seems to have lost more on risk taking (from the failures of quantitative risk management) than every penny banks ever earned taking risks. But it was easy to see from the past that the pilot did not have the qualifications to fly the plane and was using the wrong navigation tools: The same happened in 1983 with money center banks losing cumulatively every penny ever made, and in 1991-1992 when the Savings and Loans industry became history.”

Much of the reason for the Global Financial Crisis was due to clever salesmanship and development of complicated mathematically based financial instruments sold in complicated ways to other enterprises and eventually to investors who ended up losing their money and their property. This is illustrated by the financing of the sewage system in Jefferson County in Alabama USA, the county seat of which is the city of Birmingham.[14] A project originally estimated to cost around $250 millions ended up costing several billions after complicated interest rate swaps were arranged by corrupt country officials and bank officers. County employees lost their jobs, a number of people were paid ongoing bribes, the banks ended up being fined, sewage rates were increased; at the end the county was left with a debt equal to more than $4,000 per resident. In November 2011 leaders of the Jefferson County voted to file for a $4.1bn bankruptcy, the costliest US municipal failure ever.[15]

Three years on from the depths of the Global Financial Crisis, problems remain though they are not being born by the financial institutions which played so large a part in causing the crisis. The film Inside Job revealed “a political system in paralysis”. Madeleine Bunting writing in The Guardian newspaper proclaims that outrage against the banks is no longer a leftwing hobby as the fact that the greed and irresponsibility of some in the financial community were the cause.[16] Anthony Hilton in the Evening Standard observed, as have many people, “the culture has not changed … What more will it take?” One protest involved people taking over local banks and turning them into hospitals, which highlighted how the future of the National Health Service was in jeopardy because of the actions of the banks! In many cases banks are failing to meet their targets of lending agreed with governments who bailed them out. Bunting observes “.. finance has intertwined itself intimately into the political process in both the US and the UK. Lobbying has ensured some crucial reform initiatives hit the buffers.”[17]

The problems of economics as it influences and describes human life are such that in February 2008, the President of the French Republic, Nicholas Sarkozy, unsatisfied with the present state of statistical information about the economy and the society, asked three leading economists, Joseph Stiglitz, Amartya Sen and Jean Paul Fitoussi to create an investigative Commission, subsequently called “The Commission on the Measurement of Economic Performance and Social Progress” (CMEPSP).[18]

Amongst the Commission’s conclusions was the statement, “there often seems to be a marked distance between standard measures of important socio economic variables like economic growth, inflation, unemployment, etc. and widespread perceptions. The standard measures may suggest, for instance that there is less inflation or more growth than individuals perceive to be the case, and the gap is so large and so universal that it cannot be explained by reference to money illusion or to human psychology. In some countries, this gap has undermined confidence in official statistics.” The OECD “Better Life Index”, already mentioned, is one response to the Commission’s work. (For example, in France and in the United Kingdom, only one third of citizens trust official figures, and these countries are not exceptions.) This has a clear impact on the way in which public discourse about the conditions of the economy and necessary policies takes place.

In November 2011 Nobel prizewinner and Columbia University professor Joseph Stiglitz, noted economic analyist Nouriel Roubini and biographer of J.M. Keynes Robert Skidlesky, writing on the Project Syndicate website, all strongly criticized the increasing inequality brought about by the exercise of political influence and the anti-competitive practices of financial institutions (Stiglitz), strongly urged easing of monetary policy by the European Central Bank to reflate the eurozone periphery and criticised fiscal austerity (Roubini) and urged that a growth strategy be adopted by the Europeans (Skidelsky).

Paul Krugman, writing in the New York Times, has consistently urged similar approaches. All criticized the refusal of the German Government and the European Central Bank to take a more interventionist role. The isolationist position of the UK Government, which amounts to nothing more than playing to their patrons in the City, is potentially destructive. Prime Minister David Cameron’s unmet demands for protocols granting special provisions in a new European Treaty for the UK will surely have ramifications. Instead a treaty between European nations excluding the U.K. was agreed 9 December to impose new rules for the participating nations’ budgets.[19]

Meanwhile Germany continues to refuse to significantly increase expenditure which would likely benefit opportunities for exports from those countries experiencing difficulty whose economies, it is said, need to grow. Nor will it support further lending to those economies in difficulty. But with France Germany supports a tax on financial transactions. Britain opposes it unless every country adopts it. “The city” opposes such a tax. Financial institutions are major donors to the Conservative Party!

We can ask this: what is the future for a country where the unemployment rate for people under 30 is over 30 per cent, as is the case with Spain and Greece? That is the outcome of austerity. The lessons of President F.D. Roosevelt in overcoming the Great Depression of the 1930s in the US have been ignored.[20]

Meanwhile attempts to reform the banking system in the UK – the so-called Vickers Commission – which amongst other things proposed separating retail banking from activities like trading and underwriting – have had a rough ride with financial institutions finding reasons why many of the recommendations ought not to be adopted by the Government.[21] Nevertheless most were!

There are many things yet to be done to fix the system in the US as pointed out by former Chairman of the U.S. Federal Reserve Paul Volcker who has urged minimizing the risk of failure of financial firms and their consequent ‘bailout’ by government, that is taxpayers. Volcker pointed to the destabilizing potential of money market mutual funds and their structural importance in diverting funds from regulated banks.[22]

The failures of neoclassical economics have been addressed by many distinguished economists. University of Queensland Professor John Quiggin’s list of five “zombie ideas that refuse to die” is but one.[23] Quiggin writes, “Two years after the financial crisis, the U.S. economy has steered clear of total disaster, with the Dow Jones industrial average currently near its pre-crash level. But the theories that caused it all are still out there, lurking in the shadows”.

 

 


[1] ‘Adam Smith and the contemporary world’, Erasmus Journal for Philosophy and Economics 3 (1), p 50-67, 2010; Amartya Sen observed, “While some men are born small and some achieve smallness, it is clear that Adam Smith has had much smallness thrust upon him.”.

[2] “Talk of the Nation” on NPR in the USA January 8 2007.

[3] John Walsh, PJ O’Rourke: The original Republican Party Reptile is back’, The Independent 28 July 2007.

[4] In the 2010-2011 global competitiveness ranking compiled by the World Economic Forum France is ranked 15th, having risen 15 places in 5 years, ahead of Australia (which has fallen 5 places in five years), and after Norway which has also risen significantly; the U.S. is now fourth after Switzerland, Sweden and Singapore. The four Scandinavian countries are in the top ten of the Forum’s rankings. The “Economist Intelligence Unit” report on ranking of the most innovative countries gives very similar results.

[5] In ‘There’s so much more to wealth than money’, Sydney Morning Herald December 8, 2011; Ross Gittins and Nicolas Gruen report on the development of an index of social progress for Australia and note that the OECD in 2011 began publishing its “better life index”.

[6] Bruce Heady et al, ‘Long-running German panel survey shows that personal and economic choices, not just genes, matter for happiness, Proceedings of the National Academy of Sciences 107(40), 2010, available at

[7] “Epidemiologist Precious Lunga has been working throughout her career to create microbicides or HIV Prevention Gels which women can apply to help protect them against HIV. She says that these gels could start to make a dent in the HIV epidemic that is hitting large parts of the world.”

[8] Paul Krugman, ‘How Did Economists Get It So Wrong?’ New York Times September 2, 2009

[9] Andrew Kakabadse interviewed by Phillip Adams  on ABC Radio National’s ‘Late Night Live’ on 14 October 2008 about the book The Elephant Hunters: Chronicles of the Moneymen by Amielle Lake, Andrew Kakabadse & Nada Kakabadse (Palgrave Macmillan, 2008)

[10] David Collander et al, ‘The Financial Crisis and the Systemic Failure of Academic Economics’ 98th Dahlem Workshop, 2008.

[11] Taleb, The Black Swan loc.cit

[12] Naseem Taleb, ‘Learning to Expect the Unexpected, The Edge.

[13] Nassim Taleb, ‘The Fourth Quadrant: A Map Of The Limits Of Statistics’, The Edge 15 September 2008.

[14] Matt Taibbi, ‘How the nation’s biggest banks are ripping off American cities with the same predatory deals that brought down Greece’, Global Research, 12 April  2010, Rolling Stone, 31 March 2010; Kathleen Edwards and Martin Z. Braun, ‘Jefferson County’s Insolvent Sewer System to Get Receiver, Judge Says’, Bloomberg Sep 8, 2010,

[15]‘Jefferson County in Alabama faces bankruptcy’ BBCNews 10 November 2011.

[16] ‘Outrage at the banks is everywhere, so why aren’t there riots on the streets?’, The Guardian, 30 May 2011.

[17] In ‘Is the SEC covering up Wall Street crimes?’ (Rolling Stone 17 August 2011), author and ‘polemical journalist Matt Taibbi reports on the revelation to the US Congress by attorney Darcy Flynn that senior managers in the Securities and Exchange Commission in the United States authorising systematic destruction of the records of preliminary investigations of possible crimes by financial institutions, where decisions had been made not to proceed further; information about companies including Deutsches Bank, Goldman Sachs and AIG, and the activities of Bernie Madoff convicted of investor fraud, were destroyed contrary to federal law which authorises National Archives and Records Administration to do so. Senior executives of the SEC are frequently appointed to executive positions in the companies which the SEC had been investigating.

[18] www.stiglitz-sen-fitoussi.fr/

[19] “While Cameron has failed to secure the concessions for Britain’s strong financial services sector, Britain has also forfeited its place at the table where Europe’s future and the new euro regime will be determined. For the first time since Britain joined the European Community in 1973, a treaty that goes to the heart of how the EU works will be struck without a British signature”, Ian Traynor et al. ‘David Cameron blocks EU treaty with veto, casting Britain adrift in Europe’, The Guardian 9 December 2011 (http://www.guardian.co.uk/world/2011/dec/09/david-cameron-blocks-eu-treaty); numerous other stories about the agreement by EU nations appeared in the Guardian for 9 December and all major daily newspapers.

[20] see Martin Bennett and Richard Walker, ‘The Jobs Crisis: What Did Roosevelt Do That Obama Should?’, Truthout 25 November 2011

[21] Patrick Jenkins et al, ‘Vickers plan shakes up City’, Financial Times September 12, 2011

[22] Paul Volcker, ‘Financial Reform: Unfinished Business’, New York Review of Books November 24, 2011

[23] John Quiggin, ‘Five Zombie Economic Ideas That Refuse to Die’, Foreign Affairs October 15, 2010