Ross Gittins's December 23 article 'Beware of economists wielding simple models' deserves a considered essay, but all I've time for is a yuletide-stream-of-semi-consciousness polemic in the hope of taking Gittins' reservations a step further than he does.
"One conclusion that came to me more forcefully as this year progressed
is the limitation of the economists' favourite analytical workhorse, the
neo-classical model. In recent years, misapplication of that model has
led to a lot of costly cock-ups.
The term "neo-classical" may not be familiar to you but the model
certainly is. It's the one that says the price of a product will be
determined by the interaction of the quantity supplied with the quantity demanded."
The point of the model is that, among all the many factors bearing on a
market, it homes in on just one - price - as having all the power to
explain what's going on. The neo-classicist motto is: prices make the
world go round.
The point is not that this is a lot of hogwash. The model is very
effective in explaining a lot of things that happen in a lot of markets.
It wouldn't have survived and prospered for more than 200 years if it weren't.
No, the problem's more subtle. It's that, precisely because the model is
so effective in certain circumstances, economists face a temptation to
apply it indiscriminately to circumstances it doesn't fit."
Unpopular though this pithy summary might make Ross Gittins among his econopeers (it's largely a resume of Joe Stiglitz's book, and Joe cops heaps from his old mates these days), it still ain't enough. The circumstances in which the demand/supply curve explains nearly enough of what's going on, are much fewer and far further between than Gittins implies here. I do not say it is spurious, just that the model's main shortcoming is that it abstracts from (brackets out) inevitable and decisive circumstances. The dangers Gittins goes on to exemplify concern special cases (eg the murderous economic transformation of the former Soviet Union), but my point is that these dangers are inevitable and decisive everywhere and all the time.
I stress again that all models have such shortcomings - (my model 100-gun 18th-century ship of the line is a wondrous thing, but in all its accuracy, it can only tell me so much about the real Victory, and nothing at all to explain why she should pound the 130-gun behemoth Santissima Trinidad into submission off Cape Trafalgar, or why 27 such ships, whose advance forced them to expose themselves to continual raking fire, should so bloodily best a line of 33) - and I am not mounting an argument for the replacement of one model by another. I am arguing that models entice the analyst to come at a problem through a particular door, and that which doorway is our vantage point dicates much of what we do - and don't - see. In the submission of political economy to the neat numbers of econometric modelling, indeed, we have seen the triumph of rationalism over empiricism. One is not accepted as an economist unless one unproblematically re-aggregates moot aggregates and posits the homo economicus robot in place of real people. The latter point is a significant one, because the whole neo-classical system legitimates itself with appeals to our free will ('freedom to choose' is the public relations vanguard of neo-classical economics), yet its priestly heralds must bracket free will out of their equations (a mathematical representation of free will not being at hand). The observant and unindoctrinated economist (and Australia still boasts a few: by my lights, the likes of Gittins, Martin, and Eslake are inside the neo-classical tent pissing out, and Quiggin, Wheelwright, Stilwell, McFarlane and Brain have long stood outside pissing in) must perform these strange rites to gain acceptance, and then undermine the whole methodology (indeed, the whoile epistemology) by factoring in the inevitable gap between their scientistic calculations and the dynamics the real world actually evinces. Erstwhile econometrician Frank Shostak sums up his former occupation thusly:
" ... the predictive capability of each equation in the model is checked against actual data and the
difference between the actual data and the data obtained from the equations, also known as the add factor, is extrapolated forward and incorporated into models equations. In many instances the forecast produced by an econometric model is heavily influenced by the add factor which allows the model builder to force the outcome of the forecast in line with his "gut feelings". Most people however, are not aware of these tricks and believe that the outcome was generated by the model alone. All that of course casts shadow on the scientific procedures employed by econometric
modelling. Further one should not forget the shaky quality of the data out of which econometric models are constructed.
Rather than viewing econometric models as some kind of sophisticated technique that can discover the hidden truth about the economy, we should regard them as just clumsy and expensive extrapolative devices which have nothing in common with real economies. Anyone who decides to use models as
an analytical tool or a forecasting device runs the risk of seriously confusing himself."
Shostak dams the whole business, for mine, but let's get back to that fulcral model of the neo-classicist, the supply/demand curve.
The 'price mechanism' as neo-classical economics tendentiously call their baby envisages a world of equally powerful (or, rather, powerless) rationally optimising individuals (I was actually going to talk about methodological individualism last month, and still might, if there's any expression of interest at all) and is wont not to notice that
(a) the rationally optimising individual seeks to control as much as possible the price it can exact for what it sells,
(b) that, whilst corporations, workers and consumers are all individuals (equally powerless and rationally optimising) in neoclassical theory, they are not in reality (an example even from the world of real individuals makes the point: I don't have the control over my remuneration that, say, a politician does, and s/he doesn't have the control a CEO does); and
(c) that when the concomitant differentials in power are thrown into the theory, what we're effectively throwing in is differential capacities to CONTROL PRICE. The goal of the rationally optimising actor is not the freedom of the market at all, but rather freedom FROM the market. The commanding heights of capitalism are definitively occupied by the profit motive, but that can play out in a variety of ways, depending on whether the state has the power to mediate, coordinate, stabilise and ameliorate (as was the case during the post-war long boom, when JK Galbraith developed his theory) or the corporations rule more directly (as, relative to the Australian state, is the case now). In the latter scenario, capitalism can do okay (which does not have to mean the people do okay, of course) as long as capital behaves on behalf of capital AS A WHOLE. If the corporations are in the genuine cut-throat competition that so excites neo-classicists, then, contrary to our neo-classical priests, we're in trouble - of which, more below.
Whilst the law and the neo-classical model might see the corporation as just another individual actor, the corporation itself knows full well (or, rather, the suits in the boardroom know it) its size and significance (it'd be a monopoly or a major oligopolist) affords it more price-controlling power than is enjoyed by most workers (whose organisations are under an assault redolent of Pitt's ill-fated Combination Acts of 1799), most would-be-competitive market entrants (take on Microsoft and see what happens to you - and witness Murdoch's deliberate loss-making pricing in his attempts to wipe out The Age back in '89 or all competitors in Britain in '95), most suppliers (Toyota no longer makes its own parts, but those to whom it 'out-sources' remain completely under Toyota's control as to what they may charge for their wares and to whom they may sell), and most consumers (where marketing, the dictates of concpicuous consumption, and the incapacity of so differentiated a mass to organise are decisive).
One question on which this corporation would agree with all other corporations is that of the necessity of 'free markets'. Just as the lion would benefit more than the zebra if all cages were removed from the zoo, so would the corporation benefit more than the worker if all government regulation of wages and conditions were removed. But, just as all the yummy herbivores would eventually run out at the zoo, so would the effective demand of consumers run out if in their role as workers they could not elicit from their paymasters enough to fund their consumption. Whilst it would make sense for the class of capitalists to pay their workers well and sell their commodities cheaply (as Henry Ford did whilst he enjoyed monopoly market power in mass-produced cars) it does not suit the truly competitive individual corporate entity to pay its workers over the odds or sell its goods under the odds. The shareholders would take their funds elsewhere.
The corporate entity either pays low and charges high, or it does what JK Galbraith noticed them doing many decades ago: oligopolists compete only where they must, and effectively collude where they can (as Adam Smith, in a passage never quoted by market economists, had always maintained they would), and the record tells us oligopoly produces much the same price behaviour as does monopoly. Schumpeter thought this a good thing on balance, as monopoly pricing proffered the system stability (conservative investment decisions and a decisive certainty regarding prices) where untrammelled competition inevitably brought with it the Bacillus Of The Bust (profit-busting competitive investment and uncertain price projections, especially where fixed costs are high and marginal cost low, as in transport, electricity and telecommunications [take a look at those sectors, post-privatisation, and then tell me you can't see Schumpeter's point).
Ross Gittins again:
"It's the general economists - those outside their area of
specialisation - who're most prone to this error. Whereas the specialist
health economist, for instance, is very conscious of the peculiarities
and "imperfections" of the health market, the general economist will
come along, whip out his pocket neo-classical model, and have the
industry's problems (wrongly) diagnosed in no time flat.
It was the Keynesian economists who first objected to the assumption
that an appropriate change in prices could easily fix all problems. They
argued that, in practice, the demand for many things is too inelastic
(unresponsive) for plausible price changes to ensure that markets clear."
It's important to resist the temptation to assume that the 'problem' with the health 'market' is merely 'sticky prices' (I've posted on the health insurance sector already). Which is not to say sticky prices aren't a profound problem for market economists in any dynamic economy - after all, if prices don't rise or fall on cue how are supply and demand supposed to produce this fabled equilibrium upon which the neo-classical economists so much depend? Or what is it then, we might ask the neo-Austrians, that prices communicate to market actors? 'Market imperfections' implies a state of perfection from which markets can deviate. There are in fact only ever imperfect markets, and all that's at issue is the degree to which each sector deviates from the idealised norm. Health is one, by its very definition, that deviates so far that the idealised norm is a dangerous nonsense. Same with the even more crucial 'market' for labour.
But back to Ross Gittins:
"Take the common neo-classical argument that unemployment among unskilled
workers is caused by excessive minimum wage rates. The Keynesian
counter-argument is that minimum wages might have to fall a mighty long
way to induce firms to employ just a few extra workers."
Keynes also suspected effective demand had a decisive role in promoting investment. The supply-side micro-economism of today kinda ignores that, so it forgets that most stuff is bought by wage-earners. And, whilst Keynes thought (unlike yours dismally) that things might turn out okay in the long run, he reminded the neoclassicl types that 'in the long run we're all dead', and that any economist prepared to destroy a generation's lives in order to get things right (as their theory always predicts it would) a generation later was setting herself too easy a task. Yeah, and much too low an ethical hurdle, too.
"In recent years, however, the neo-classicists' preoccupation with the wonders of the price mechanism has blinded them to the importance of the institutions in which markets operate. (The model simply abstracts from the complication of institutional arrangements.)"
Ross Gittins again:
"It was this model-induced blindness that led the International Monetary
Fund and some very big-name US economists to give the Russians and East
Europeans such disastrous advice on how to manage the transition from
planned to market economies.
The advice was to privatise all the national monopoly industries at
once. It didn't really matter how you did it, just as long as you
shifted to full reliance on the price mechanism ASAP.
This advice was oblivious to the multitude of legal, commercial and
attitudinal institutions that surround and bolster the price mechanism
in market economies - institutions that have built up over centuries in
industrialised market economies."
Good points. Fair dinkum. if you're drowning and the IMF offers you a hand, just drown. At least then there'll still be a wallet and a nice watch for your loved ones to mine from your bloated corpse when it washes up on the beach.
"Quite frankly," wrote ex-World Bank Chief Economist Joe Stiglitz, "a student
who turned in the IMF’s answer to the test question 'What should be the fiscal stance of Thailand, facing an economic downturn?’ would have gotten an F ... [they're] third rate students from first rate universities". He reckons it's because the IMF's models are 'flawed or out-of-date', "critics accuse the institution of taking a cookie-cutter approach to economics, and they’re right ... the calamity in Russia shared key characteristics with the calamity in East Asia – not least among them the role that the IMF and US Treasury policies played in abetting it.’’
The IMF's advice was blind, too, to the fact that public monopolies are a better idea than private ones (Australian users of electricty are getting a clue). Oh, and dispossessing a hundred million Russians is murder on effective demand, too. As it turned out, it was just murder, of course. Life expectancy has plunged a decade in Russia - in a decade.
Ross Gittins again:
"The bitter truth is that satisfactorily functioning market economies
just can't be established overnight by the making of a handful of
politically courageous decisions. In the absence of all the institutions
you and I (and, we now discover, the neo-classical geniuses) take for
granted, the move from a planned to a market economy has to be made
slowly and carefully, with great attention to the "timing and
sequencing" of each step."
Fair enough. But just how problematic the whole deal is becomes apparent when you remember that it took 'the west' centuries to get to where they are, and used a lot of gun powder and chains (at home and abroad) to make the journey, too. The US also defaulted on debt when it suited 'em and the whole west has been corporatist and mercantilist a lot longer than it has not been so (and we should remember that classical economics' annointed founding-father Adam Smith's *Wealth Of Nations* was a polemic against mercantilism, not government, not regulation, and not public works). I'd also quibble with the blithely presumed polarity of 'planned' and 'market' economies in these days of transnational corporatist capitalism. JK Galbraith has been on about that for forty years at least.
Ross Gittins again:
"But so great is the grip of their model that the neo-classical
economists were slow to learn the lesson from the huge economic damage
they wreaked on the Russians and East Europeans. Certainly, it didn't
stop them offering the myopic advice that led to the Asian crisis.
The Asian emerging market economies hit major financial difficulties
because they didn't have the sophisticated Western financial
institutions - arms-length banking relationships, prudential
supervision, effective commercial law, believable financial accounts,
etc - needed to withstand the stresses and strains of volatile foreign
A decade earlier, the same flows had caused great disruption even within
the developed economies (including ours). But this wasn't sufficient to
prompt the IMF and other alleged experts to exercise caution in urging
the emerging economies to open up their balance-of-payments capital
accounts and give the global price mechanism free rein."
Morgan and Stanley's Asia Watcher (although I just like to read him becaused he's Wall Street's uberbear) Stephen Roach, reminds us that the Tiger Economies' strengths also lay in their institutional arrangements. He points us to Robert Wade's *Governing The Market*, which showed that
the regime of Asian "Alliance Capitalism" with its high household savings and "deep" banking intermediation was the mix that achieved one of history's most impressive leaps up the economic hierarchy of nations. Wade effectively repudiates the quasi-Rayndian neoliberal arguments of
the likes of Greenspan, who dismiss the East Asian model, with its government intervention and corporatist alliances between business, labour, and government, as a failure relative to the ascendant unfettered free market capitalism of America. Wade praises the competitive advantage of co-operation and applauds the synergistic manner in which decisions have historically been allocated between markets and public administration.
Whatever were the Tigers' problems in '97/'98 (and core-economy currency/equity manipulations has to be at the top of the suspects' list - Mahathir accused, inter alia, George Soros, and Soros himself has written his like need close watching and controlling), they got an awful lot worse when the pimpled suits of the IMF came in mob-handed and started ripping apart the institutional ties responsible for the greatest economic miracle of the last forty years.
'Crony capitalism' it might have been, but capitalism is always a set of relations between state and corporations and the economic historian would have her job cut out looking for a capitalist arrangement that didn't meet the definition of 'crony'. It's a tautology. I mean, weren't these sagacious suits the product of the economy that has brought us the likes of Carlyle - indeed the whole military-industrial complex Eisenhower warned us against half a century ago?
But, bleat these self-styled saviours, crony capitalism leads to inefficient investment and poor returns on capital! Yep, like the trillions that were being 'invested' in US internet start-ups at that very moment Oh, and 90% excess capacity in US telecommunications, acres of empty US office blocks, flat US profits since '97, yadda, blah, groan ...
What the Tigers had been doing was identifying major world industries as priority targets and coordinating huge investments accordingly. This was only possible through borrowings---neither equity markets nor retained corporate earnings were up to the sheer scale. Large-scale lending by banks to deeply indebted firms---both of whom require state support---allowed the state to effectively implement its industrial strategy. That's what happened when the bankers took over New York in '75 (see Doug Henwood's *Wall Street*). I reckon it happened again when the Fortune 1000 took over the world in the eighties. So the suits don't have a point there either.
And, as Roach concludes, "for all the white elephants and corruption, the system has yielded an unprecedented quantum leap in technology and scale and dramatic improvements in living conditions."
Oh, well, too late now.
"More recently, Professor Paul Krugman has been arguing that the dishonest behaviour of so many US listed corporations is the product of changed "social norms"."
Bollocks. Thorstein Veblen was describing the same behaviour a century ago (in his Theory of Business Enterprise, which he wrote around the same time he nailed that little upstart 'marginalism' to the wall with his equally timeless reflections on 'the leisure class' and their 'conspicuous consumption'). Regulation is the decisive variable, not social norms. Insufficiently regulated corporate capitalism does not merely allow dodgy practices, it ultimately necessitates them. Competition is not, and can not be, the sole regulator that neo-classical theory holds it is.
" ... you could wait an eternity for the neo-classical model to alert
you to that development because the model assumes away such things as social norms."
It has to. Because it does away with society itself. We're all rational, competitive, egoistic acquisitive and equally powerless autonomatons, y'see. No society to change and no change to make.
No sociology, no history.
And no bloody use as anything but an ideological bulwark for a world-historical grab-fest.