Debunking Economics The Naked Emperor of the Social Sciences Steve Keen University of Western Sydney, Australia Copyright held by Steve Keen First published in 2001 by Pluto Press Australia Limited Locked Bag 199, AnnandaleNSW 2038 www.plutoaustralia.com Reprinted 2002 First published in Great Britain and the United States of America by Zed Books 7, Cynthia St, LondonN1 9JF, UK Room 400, 175 Fifth Avenue, New YorkNY10010, USA and St Martin’s Press Inc 175 Fifth Avenue, New YorkNY10010, USA Copyright © Dr Steve Keen, 2001 Cover design by Wendy Farley and Justin Archer Cover illustration by Michael Fitzjames Edited by Michael Wall Index by Tonia Johansen Typesetting by Bookhouse, Sydney Printed and bound by Hyde Park Press Australian Cataloguing in Publication Data Keen, Steve. Debunking economics : the naked emperor of the social sciences. Bibliography. Includes index. ISBN 1 86403 070 4. 1. Economics. 2. Economic policy. 3. Social policy. I. Title. 330 UK Cataloguing in Publication Data A catalogue record for this book is available from the British Library. 1 85649 991 X (cased) 1 85649 992 8 (softcover) Table of Contents 1. No more Mr Nice Guy. 1 2. The calculus of hedonism.. 23 3. The price of everything and the value of nothing. 57 4. Size does matter 91 5. To each according to his contribution. 125 6. The holy war over capital 146 7. There is madness in their method. 166 8. Let’s do the Time Warp again. 184 9. The sum of the parts. 209 10. The price is not right 237 11. Finance and economic breakdown. 267 12. Don’t shoot me, I’m only the piano. 283 13. Nothing to lose but their minds. 294 14. There are alternatives. 328 http://avaxho.me/blogs/ChrisRedfield Preface In the preface to the General Theory, Keynes commented that its writing had involved a long process of escape from “habitual modes of thought and expression”. He implored his audience of professional economists to likewise escape the confines of conventional economic thought, and observed that The ideas which are here expressed so labouriously are extremely simple and should be obvious. The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds. (Keynes 1936) This statement was unfortunately prophetic. Keynes’s own escape was incomplete, and the residue of traditional thought the General Theory contained obscured many of its most innovative aspects. Faced with a melange of the new and unfamiliar with the old and familiar, the bulk of his audience found it easier to interpret his new ideas as no more than embellishments to the old. The Keynesian Revolution died, slowly but surely, as economists reconstructed the “habitual modes of thought and expression” around the inconvenient intrusions Keynes had made into economic dogma. Economics failed to make the escape which Keynes had implored it to do, and as time went on, ‘modern’ economics began to resemble more and more closely the ‘old ideas’ which Keynes had hoped economics would abandon. I was initially educated in this resurgent tradition – known as the Keynesian-Neoclassical synthesis – some thirty years ago. The catalyst for my escape from this dogma was extremely simple: my first-year microeconomics lecturer pointed out a simple but glaring flaw in the application of conventional theory. The economic theory of markets argues that combinations of any sort, whether by workers into unions or manufacturers into monopolies, reduce social welfare. The theory therefore leads to the conclusion that the world would be better off without monopolies and unions. If we were rid of both, then the economic theory of income distribution argues that, effectively, people’s incomes would be determined solely by their contribution to society. The world would be both efficient and fair. But what if you have both monopolies and unions? Will getting rid of just one make the world a better place? The answer is categorically no. If you abolish just unions, then according to ‘conservative’ economic theory, workers will be exploited: they will get substantially less than their contribution to society (equally, if you abolish just monopolies, then workers will exploit companies). If you have one, then you are better off to have the other too, and a single step towards the [1] economist’s Nirvana takes you not closer to Heaven but towards Hell. I was struck by how fragile the outwardly impregnable theory of economics was. What seemed self-evident at a superficial level – that social welfare would rise if unions or monopolies were abolished – became problematic, and even contradictory, at a deeper level. Had I come across that fragility in my honours or postgraduate education, which is when students of economics normally learn of such things, I would quite possibly have been willing to gloss over it, as most economists do. Instead, because I learnt it ‘out of sequence’, I was immediately suspicious of the simplistic statements of economic principle. If the pivotal concepts of competition and income distribution could be so easily overturned, what else was rotten in the House of Economics? That scepticism initiated a gradual process of discovery, which made me realise that what I had initially thought was an education in economics was in fact little better than an indoctrination. More than a decade before I became an undergraduate, a major theoretical battle had broken out over the validity of economic theory. Yet none of this turned up in the standard undergraduate or honours curriculum – unless it was raised by some dissident instructor. There were also entire schools of thought which were antithetical to conventional economics, which again were ignored unless there was a dissident on staff. Thirty years after starting my sceptics’ intellectual tour, I am completely free of the “habitual modes of thought and expression” which so troubled Keynes. There are many non-orthodox economists like me, who are all trying to contribute to a new, deeper approach to economics. But still the world’s universities churn out economists who believe, for example, that the world would be a better place if we could just get rid of unions, or monopolies. Worse still, over the last thirty years, politicians and bureaucrats the world over have come to regard economic theory as the sole source of wisdom about the manner in which a modern society should be governed. The world has been remade in the economist’s image. This ascendancy of economic theory has not made the world a better place. Instead, it has made an already troubled society worse: more unequal, more unstable, and less ‘efficient’. Why has economics persisted with a theory which has been comprehensively shown to be unsound? Why, despite the destructive impact of economic policies, does economics continue to be the toolkit which politicians and bureaucrats apply to almost all social and economic issues? The answer lies in the way economics is taught in the world’s universities. When I became an academic economist, I realised that very few of my colleagues had any knowledge of the turbulent streams in economics. Most were simply dismissive of any attempt to criticise orthodox thinking, and equally dismissive of any of their peers who showed tendencies towards unconventional thought. This was not because these conventional economists were anti- intellectual – far from it. Even though conventional economics is flawed, it still takes intellectual muscle to master its principles – as you will soon discover. Yet still economists refused to consider any criticisms of economic theory, even when they emanated from other economists, and met rigorous intellectual standards. Nor were they ill-intentioned – most of them sincerely believed that, if only people followed the principles of economic theory, the world would be a better place. For a group of people who espoused a philosophy of individualistic hedonism, they were remarkably altruistic in their commitment to what they saw as the common good. Yet the policies they promoted often seem to non-economists to damage the fabric of human society, rather than to enhance it. They also rejected out of hand any suggestion that they were ideologically motivated. They were scientists, not political activists. They recommended market solutions, not because they were personally pro- capitalist, but because economic theory proved that the market was the best mechanism by which to determine economic issues. Yet virtually everything they recommended at least appeared to favour rich over poor, capitalist over worker, privileged over dispossessed. I came to the conclusion that the reason they displayed such anti- intellectual, apparently socially destructive, and apparently ideological behaviour lay deeper than any superficial personal pathologies. Instead, the way in which they had been educated had given them the behavioural traits of zealots rather than of dispassionate intellectuals. As anyone who has tried to banter with an advocate of some esoteric religion knows, there is no point trying to debate fundamental beliefs with a zealot. After many similar experiences with economists, I abandoned any delusion that I might be able to persuade committed economists to see reason (though there has been the odd exception to this rule). Instead, I prefer to spend my time developing an alternative approach to economics, while persuading others not to fall for the superficially persuasive but fundamentally flawed arguments of conventional theory. Hence this book, which is aimed at a broader audience than Keynes’s target of his fellow economists. Instead, my primary target market is those people who feel that they have been effectively silenced by economists. One of the many reasons why economists have succeeded in taking over social policy is that they have claimed the high intellectual ground against anyone who opposed their recommendations. The object of this book is to show that this claim is spurious. Though I am the sole author, and thus responsible for all its errors and omissions, I cannot claim sole credit for what is good in it. In particular, I owe an enormous debt to the pioneers of critical thinking in economics. Pre-eminent amongst these is Piero Sraffa – a name which is known to almost no non-economists, and very few economists. There are many others whose names turn up in subsequent pages – Blatt, Garengani, Goodwin, Kalecki, Kaldor, Keynes, Minsky, Veblen, to name a few. But none has had quite the impact of Sraffa. I owe a more personal debt to those few teachers who were, as I am now, dissidents in a sea of believers. Pre-eminent here is Frank Stilwell – the first year lecturer who, many years ago, introduced me to the first of many flaws in conventional economics. I also gratefully acknowledge the influence which Ted Wheelwright’s panoptic knowledge of the many currents in economic thought had upon my intellectual development. My colleagues in HETSA, the History of Economic Thought Society of Australia, have also enriched my appreciation of the many ‘roads not taken’ by mainstream economics. Colleagues around the world have provided feedback on the arguments presented here. None can be held liable for what follows, but all influenced it, either directly, in debate, or by providing a forum in which heterodox views could flourish. My thanks go to Trond Andresen, George Argyrous, Tony Aspromorgous, Joanne Averill, Aldo Balardini, Bill Barnett, James Dick, Marchessa Dy, Geoff Fishburn, John Gelles, Ric Holt, Julio Huato, Alan Isaac, James Juniper, Gert Kohler, John Legge, Jerry Levy, Henry Liu, Basil Moore, Marc-Andre Pigeon, Clifford Poirot, Jason Potts, Barkley Rosser, Gunnar Tomasson, Sean Toohey, Robert Vienneau, Graham White, and Karl Widerquist, for reading and commenting upon drafts of this book. I Karl Widerquist, for reading and commenting upon drafts of this book. I would especially like to thank Karl Widerquist for detailed suggestions on content and the flow of arguments, John Legge for assistance with the proofs of some propositions, Alan Isaac for providing a testing foil to many propositions in the early chapters, and Geoff Fishburn for many years of intelligent and critical discussion of economic theory. Joyce Hitchings provided valuable feedback on how to make the book’s arguments and counter-arguments more accessible to readers with no prior training in economics. I have also received great encouragement and feedback from my publishers Tony Moore of Pluto Press, and Robert Molteno of Zed Books. My editor, Michael Wall, did a sterling job of making the final product more concise and accessible than the original manuscript. Sabbatical leave granted by the University of Western Sydney gave me the time away from the everyday demands of an academic life needed to complete a book. The Jerome Levy Institute of Bard College, New York and the NorwegianUniversity of Science and Technology in Trondheim, Norway, kindly accommodated me while the finishing touches were applied to the manuscript. And so to battle. Preface to the e-Book Edition The print edition of Debunking Economics is still in print, courtesy of Zed Books UK. But the fact that is was printed back in 2001 makes it a back- order item for most bookshops, which has made access for many would-be purchasers problematic. Since the financial crisis began in 2007, I have been receiving ever more regular requests to produce an e-Book version. I have therefore taken time out from my analysis of the crisis to produce a slightly updated version of the book for e-Book distribution. There are only minor alterations to this edition over the print version—a [2] major revision will have to wait until I finish my book on the financial crisis. The specific changes include an extension of the critique of the theory of the firm—the one original critique of economics developed in the book—and a correction to the discussion of Lorenz’s model of the weather. The reception of the book has been both gratifying and predictable. The gratifying side has been the public reception: sales have far exceeded the norm for this type of book, and the public response has been almost universally positive. The predictable side has been the reaction from neoclassical economists. They have disparaged the book in much the way they have treated all critics—as Keynes once remarked, he expected his work to be treated as being both “quite wrong and nothing new”. And they have been incensed by the critique of the theory of the firm. Their rejoinders to that critique have led me to develop it far beyond the version published here, and in ways that are very difficult to convey other than with mathematics. For those who can cope with the odd—or rather frequent!—equation, the most accessible papers are in the journals Utilities Policy (2004, Vol 12, pp. 109-125) and Physica A (2006, Volume 370, pp. 81-85), while the most comprehensive expression of the argument, covering both Marshallian and Cournot-Nash approaches, is forthcoming in the free access online journal The American Review of Political Economy (http://www.arpejournal.com/). A forthcoming book on teaching heterodox economics, edited by Jack Reardon, A Handbook for Heterodox Economics Education (to be published by Routledge), covers the critique of the Marshallian model of the firm. Sydney, November 23rd 2008 1. No more Mr Nice Guy Why the public needs to know that economics is intellectually unsound Why have we handed over the running of the world to economists? It is hardly because economics has won the intellectual equivalent of a popularity poll or election. In fact, if anything, economics is deeply unpopular, and its unpopularity spans all social spectra. The demonstrations against the IMF and other institutions in Seattle, Washington, Davos, Melbourne and Prague were fundamentally demonstrations against the proposition that the world should be reshaped in accordance with economic theory. Those events were simply the most dramatic of many protests which have frequently cut across the standard Left–Right divide of political debate, uniting the most unlikely of bedfellows against the policy recommendations of economists. Only parties of the middle – the Democrats and Republicans of America, the Social Democrats or Christian Democrats of Europe, England’s Conservative Party and ’New Labour’, Australia’s Liberal and Labor Parties – espouse the policies of economics. Parties which are more avowedly Left and Right often express economic attitudes which are diametrically opposed to policies of centrist parties, but are remarkably similar to each other – with their similarity derived from a shared disdain for conventional economic thought. However, because centrist parties have almost always been in power, the economic policies they champion have shaped the modern world. At the level of ’grassroot’ politics, in countless disputes around the world, social groups which normally oppose each other have also found themselves united by a common opposition to economic policy. Unionists opposing how economics treats labour as a mere commodity have found themselves standing, figuratively or actually, shoulder to shoulder with businessmen chafing against its anti-monopoly dogma. Farmers bemoaning the decline of rural communities have found themselves united with ecologists denying that a dollar value can be placed on nature. Feminists decrying its lack of respect for household labour have found themselves allied with Christians fuming at its portrayal of people as innately hedonistic. And yet economics has swept all these opponents aside. Nor is the political success of economics explicable because, though its message may occasionally be unpalatable, its opponents have to concede that it works: that the world has become a clearly better place because of the policies followed by governments that have followed the advice of economists. The global economy of the early 21st century looks a lot more like the economic textbook ideal than did the world of the 1950s. Barriers to trade have been abolished or dramatically reduced, regulations controlling the flow of capital have been liberalised, currencies are now valued by the market rather than being set by governments; in so many spheres of economic interaction, the government’s role has been substantially reduced. All these changes have followed the advice of economists that the unfettered market is the best way to allocate resources, and that well- intentioned interventions which oppose market forces will actually do more harm than good. With the market so much more in control of the global economy now than fifty years ago, then if economists are right, the world should be a manifestly better place: it should be growing faster, with more stability, and income should go to those who deserve it. Unfortunately, the world refuses to dance the expected tune. In particular, the final ten years of the 20th century were marked, not by tranquil growth, but by crises: the Japanese economic meltdown, the Long Term Capital Management crisis, the Russian crisis, the Mexican crisis, the Asian crisis, and many more. Economists are prone to ’point the finger’ and blame these crises on particular economic policy failings by the relevant governments – closed capital markets in Japan, fixed exchange rate shenanigans by the Thai government prior to the collapse of the baht, and so on. Yet many non- economists harbour the suspicion that perhaps these crises were in some sense caused by following the advice of economists. This perspective was recently supported by none other than Joseph Stiglitz, a renowned economist who has had an intimate involvement in public policy via his roles as Chief Economist and Vice-President of the World Bank. Speaking as an insider and an economist, he asserted that these crises were indeed often precipitated by economists. The most extreme case Stiglitz discusses was the collapse of the Russian economy, as Russia attempted to move from a command economy to a market economy in a timescale measured in days rather than years. While he notes that there was a group of eminent economists, including himself and Kenneth Arrow, who favoured a slow transition with an emphasis upon institutional reform, he says that the day was won by another group whose faith in the market was unmatched by an appreciation of the subtleties of its underpinnings. These economists typically had little knowledge of the history or details of the Russian economy and didn’t believe they needed any. The great strength, and the ultimate weakness, of the economic doctrines on which they relied is that the doctrines are – or are supposed to be – universal. Institutions, history, or even the distribution of income simply do not matter. Good economists know the universal truths and can look beyond the array of facts and details that obscure these truths. (Stiglitz 2000) The outcome, as Stiglitz details, was far different from the expectations held by these economists. Rather than enabling Russia to rapidly transmute from moribund socialism to dynamic capitalism, The rapid privatization urged upon Moscow by the IMF and the [United States] Treasury Department had allowed a small group of oligarchs to gain control of state assets. While the government lacked the money to pay pensioners, the oligarchs were sending money obtained by stripping assets and selling the country’s precious national resources into Cypriot and Swiss bank accounts. (Stiglitz 2000) In other words, the end result of the IMF’s Russian ’capitalist revolution’ was not a vibrant, efficient market economy, but a capitalism of crooks – and a drastically impoverished nation. As Stiglitz observes, “standards of living remain far below what they were at the start of the transition. The nation is beset by enormous inequality, and most Russians, embittered by experience, have lost confidence in the free market.” Indeed, this free market experiment may have done more to rehabilitate Karl Marx – and even Joseph Stalin – in the eyes of the average Russian, than anything positive done by Russia’s socialist rump. Stiglitz tells a similar tale of the impact economists had on the Asian crisis, where the IMF’s enforcement of austerity seriously worsened a crisis which had been initiated by the international capital markets (Stiglitz 1998 and 2000). Where I and a significant minority of economists part company with Stiglitz is on the explanation he gives to the question he was often asked, of “how smart – even brilliant – people could have created such bad policies”. Part of Stiglitz’s answer is that “these smart people were not using smart economics”. This book puts the case that even the best, latest version of the type of economics Stiglitz describes as smart is not smart, but [3] fundamentally unsound. Unsmart economics The belief that economic theory is sound, and that it alone considers ’the big picture’, is the major reason why economics has gained such an ascendancy over public policy. Economists, we are told, know what is best for society because economic theory knows how a market economy works, and how it can be made to work better, to everyone’s ultimate benefit. Its critics are simply special interest groups, at best misunderstanding the mechanisms of a market economy, at worst pleading their own special case to the detriment of the larger good. If we simply ignore the criticisms, and follow the guidelines of economic policy, ultimately everybody will be better off. The occasional failures of economies to respond as economic theory predicts occur because the relevant policy-makers either applied the theory badly, or were using out-of-date economics. Bunkum. If this proposition were true, then economic theory would be clear, unequivocal, unsullied, and empirically verified. It is nothing of the sort. Though economists have long believed that their theory constitutes “a body of generalisations whose substantial accuracy and importance are open to question only by the ignorant or the perverse” (Robbins 1932), for over a century economists have shown that economic theory is replete with logical inconsistencies, specious assumptions, errant notions, and predictions contrary to empirical data. These critical economists are neither ’ignorant’ of economic theory, nor ’perverse’ in their motives. As this book shows, they have a far more profound understanding of economic theory than those economists who refuse to peer too deeply into the foundations of their dogma. Far from being driven by perversity, they hoped to improve economics by eliminating notions which were illogical, internally inconsistent, or irrelevant to the actual economies in which we live. When their critiques are collated, little if anything of conventional economic theory remains standing. Virtually every aspect of conventional economic theory is intellectually unsound; virtually every economic policy recommendation is just as likely to do general harm as it is to lead to the general good. Far from holding the intellectual high ground, economics rests on foundations of quicksand. If economics were truly a science, then the dominant school of thought in economics would long ago have disappeared from view. Instead it has been preserved, not via greater knowledge, as its advocates might believe, but by ignorance. Many economists are simply unaware that the foundations of economics have even been disputed, let alone that these critiques have motivated prominent economists to profoundly change their views, and to consequently themselves become, to some extent, critics of economic orthodoxy. Names such as Irving Fisher, John Hicks, Paul Samuelson, Robert Solow, Alan Kirman and Joseph Stiglitz are famous within economics because they made major contributions to modern economic theory. Yet to varying degrees, these and other prominent economists have distanced themselves from conventional economics, after coming to believe, for a range of reasons, that the theory harboured fundamental flaws. Unfortunately, in a classic illustration of the cliche that ’a little knowledge is a dangerous thing’, lesser intellects continue to build the economic edifice atop foundations which many of its architects long ago declared suspect. There are many reasons for this failure of economics to accept fundamental criticism, and to evolve into a different but richer theory. As I discuss later, these include the undeniable complexity of economic phenomena, and the impossibility of conducting crucial experiments to decide between competing theories. But a key reason – the one which motivated me to write this book – is the manner in which economics is taught. Educated into ignorance Most introductory economics textbooks present a sanitised, uncritical rendition of conventional economic theory, and the courses in which these textbooks are used do little to counter this mendacious presentation. Students might learn, for example, that ’externalities’ reduce the efficiency of the market mechanism. However, they will not learn that the ’proof’ that markets are efficient is itself flawed. Since this textbook rendition of economics is also profoundly boring, many students do no more than an introductory course in economics, and instead go on to careers in accountancy, finance or management – in which, nonetheless, many continue to harbour the simplistic notions they were taught many years earlier. The minority which continues on to further academic training is taught the complicated techniques of economic analysis, with little to no discussion of whether these techniques are actually intellectually valid. The enormous critical literature is simply left out of advanced courses, while glaring logical shortcomings are glossed over with specious assumptions. However, most students accept these assumptions because their training leaves them both insufficiently literate and insufficiently numerate. Modern-day economics students are insufficiently literate because economic education eschews the study of the history of economic thought. Even a passing acquaintance with this literature exposes the reader to critical perspectives on conventional economic theory – but students today receive no such exposure. They are insufficiently numerate because the material which establishes the intellectual weaknesses of economics is complex. Understanding this literature in its raw form requires an appreciation of some quite difficult areas of mathematics– concepts which require up to two years of undergraduate mathematical training to understand. Curiously, though economists like to intimidate other social scientists with the mathematical rigour of their discipline, most economists do not have this level of mathematical education. Instead, most economists learn their mathematics by attending courses in mathematics given by other economists. The argument for this approach – the partially sighted leading the partially sighted – is that generalist mathematics courses don’t teach the concepts needed to understand mathematical economics (or the economic version of statistics, known as econometrics). This is quite often true. However, this has the side-effect that economics has produced its own peculiar versions of mathematics and statistics, and has persevered with mathematical methods which professional mathematicians have long ago transcended. This dated version of mathematics shields students from new developments in mathematics that, incidentally, undermine much of economic theory. One example of this is the way economists have reacted to ’chaos theory’ (discussed in Chapter 8). Most economists think that chaos theory has had little or no impact – which is generally true in economics, but not at all true in most other sciences. This is partially because, to understand chaos theory, you have to understand an area of mathematics known as [4] ’ordinary differential equations’. Yet this topic is taught in very few courses on mathematical economics – and where it is taught, it is not covered in sufficient depth. Students may learn some of the basic techniques for handling what are known as ’second-order linear differential equations’, but chaos and complexity only begin to manifest themselves in ’third order