RG4: History, Methodology, & Economic Theory

This is the 4th Readers Guide to Goodhart’s book on Evolution of Central Banking. See: Reading Course on Central Banking for more details about this online Reading Course. We have completed Chapter 1, and before beginning Chapter 2, I would like to add some notes on the importance of History for Economic Theory – !4m video is followed by a detailed writeup.

It is an Obvious Truth that economic theories analyze specific historical economic systems.

In nomadic societies, there is no production. Economics would be about finding plants, game, and moving according to seasons.

In agricultural societies, private property becomes important. Those who plant need to have rights to harvest their plantings.

Feudal Societies are mostly self-sufficient in commodities and operate without money. These are barter societies. Money is not a goal, but only a means to get more goods. Karl Marx explained this via the formula: C – M – C’  which means that Commodities are sold for money, which is used to get different commodities.

Market societies: people sell labor for wages to produce commodities. Money is used for purchase. Money is main driver of society. Laborers sell their lives for money. Producers start with money, use money to produce commodities, and sell commodities for more money: M – C – M’  – This inversion of goals is tremendously important in understanding market societies. Both laborers and producers are driven by the desire to make money – not to consume goods. It is important to note the modern economic theory does not recognize this, and treats market societies like barter societies. It is only because of this failure to recognize the motivations that economic theories treat money as a veil, and say that money is neutral.

All of this discussion is to make a very simple point: Economic theories cannot be understood outside their historical context.

To understand Keynes, we must study the Great Depression. What were the theories which failed, and how was Keynes driven to find a new theory? How did his theory explain the Great Depression?

To understand Minsky’s Financial Fragility Theory, we must study the repeated banking crises that occurred since the 1970’s. These led Minsky to think about the causes of these crises, and come up with a theory which explained them.

To understand Mercantilism, we must understand European history driven by wars, and the necessity for accumulating gold to finance them. For modern economies, it make no sense to accumulate gold, but in the 18th Century, gold was of central importance to finance wars.

It is of great interest to understand that the opposite is also true. Just as we cannot understand economic theory without the historical context, so we cannot understand history without understanding economic theory. This is because history is shaped by theories. Economic problems continuously arise, and these problems are solved in light of dominant economic theories – whether they are right or wrong. This makes it important to study wrong economic theories because these theories shape policy, and economic policies shapes history. We give some examples of this process.

When the Great Depression occurred there were two economic theories about what should be done. The free marketeers (Hayek) said that governments should not interfere. Keynes said that free markets can create unemployment, and governments must intervene to create full employment. Following Keynesian theories led to shortening of the Great Depression. Had Hayek been followed, the Great Depression would have lasted much longer, and disastrous effects on millions of live. In the post World War 2 era, rapid growth and full employment was achieved via Keynesian Demand Management Policies based on Keynesian theory. Stagflation caused by oil embargo in the 1970’s led to rejection of Keynesian theories and the rise of Chicago School of free market economics. According to the Chicago school, there was a Natural Rate of Unemployment. Since the 1970’s this theory, which leads to the Expectations Augmented Phillips Curve has dominated policy. This theory is touted as a great success by free market economists, because it has led to control of inflation all over the world. However, they do not mention the enormous cost that has been paid for this low inflation in terms of growth and unemployment.

It is a great puzzle to understand WHY Economists REJECT these Obvious Truths?

This is a long and complicated story. See Emergence of Logical Positivism for a more detailed account. Very briefly, there was a battle of Science and Christianity in Europe. This led to a victory of Science. As a result, Science was accepted as the new religion. The philosophy emerged (and continues to dominate European thought) that SCIENCE is the ONLY source of certain knowledge. The natural methods for humanities are based on qualitative and historical approach. However, because of European worship of science, the Battle of Methodologies (methodenstreit) in 1890’s replaced this natural method by a mathematical, quantitative, scientific approach, applying methods suitable for physics to the study of human beings and societies.

Logical Positivism was a philosophy of science which was based on a deep misunderstanding of the scientific method. This philosophy became wildly popular early in the 20th Century.  The emergence of “Social Science” in early 20th Century. Founded on Logical Positivism, a misunderstanding of scientific method – This misunderstanding was applied to create foundations of economics. Even though Logical Positivism was later rejected by philosophers, economists never went back to correct the foundations on which the discipline is based.

Implications of “Scientific” approach to economics:

The so-called “scientific” approach to economics has led to major problems. Physics works with particles which have the same behavior in all circumstances. Accordingly, economists developed a theory of human behavior which must be the same for all people, regardless of time and place. Another consequence of the rejection of God and Afterlife, was the development of the religion of pleasure-seeking behavior. Utilitarianism was developed by Jeremy Bentham who saw himself as a prophet of a new religion, developed to replace Christianity. The God of this religion is “Rationality” which means rejecting all things for which there is no empirical evidence (like God, Angels, Afterlife). In fact, behavioral economists have learnt that human beings are not pleasure seekers in the way that economists suppose – see “Behavioral Vs. Neoclassical Economics”.

Economists want to look for scientific laws, which are universal invariants. They must hold across time and space, in the same way, in all cultures. The fact that there are no such laws has led to creation of many “ economic laws” which hold only in the imaginary world of economic models, and have no contact with reality. See Quotes Critical of Economics for documentation.  As just one example, the economic theory of International Trade is same for any pair of countries, at any time. It should be obvious that trade of England with China after the opium wars, was of an entirely different nature, and subject to different rules than that of England with France, or that of Pakistan with India. Power, Politics, and Wars, play a tremendous role, which is completely ignored by economists because of their search for pseudo-scientific laws. Geoffrey Hodgson has written a book entitled How Economics Forgot History which discussed the ‘methodenstreit’. Economic methodology consists of the search for universal TRUTHs. Economists do not understand that economic truths keep changing as economic systems evolve in time. This is one of the things that will become clear when we study the evolution of Central Banking system in the present book.

The Global Financial Crisis of 2007 made the complete failure of economic theory plain for all to see – see Romer’s Trouble with Economics for more details about this failure. Because they ignore history, and are based on a misconception regarding scientific methodology, economic theories are disastrous failures. To see just one example of why we must consider history, note that WW1 led to breakdown of Gold Standard, WW2 led to Bretton-Woods and Vietnam War led to the Nixon Shock in 1971. All three wars led to major changes in the international financial system. We cannot understand economics without understand wars and their impact on economies, for starters. History, Culture, Institutions, Environment, and many other factors not part of the “science” of economics, play a very important role in economics.

This creates a Golden Opportunity for us. We must study how economic theory originates from history. We must improve methodology by studying the match between theories and history – this is precisely one of the goals of this study of history of Central Banking. This will allow us to create better theories based on deeper knowledge of history. Because modern economic theory has forgotten history, so this is relatively unexplored territory. Because it is a new area, there are many low hanging fruits – theories we can develop with relatively small amount of effort. There is a problem with this historical approach. These ideas are not acceptable to mainstream  orthodox economists. However, in these times, there are many alternative Journals. Furthermore, the historical approach makes a lot of sense (unlike the equations of economic theory) and this leads to HIGH acceptability by general public as well as by policy makers.

Previous Posts in this sequence: Reading Course: Central Banking, Readers Guide: Goodhart on Central Banks, RG2: Goodhart on Central BanksRG3: Goodhart On Central Banks Next Post RG5 Evolution of Economic Systems.

6 comments
  1. ghholtham said:

    Logical positivism was a very specific philosophical school. Asad Zaman uses the term very freely, when I think he just means empiricism. You can be an empiricist without thinking at ethical discussion is meaningless or simply an expression of personal preference. You can be an empiricist and accept that not all meaningful statements can be reduced to statements about primary sensations – they often depend on logical or metaphysical constructs. A strict logical positivist would reject both propositions. .Most economists, I would guess, would admit to being empiricists; very few would be logical positivists. As Asad says, that school has faded into history. By bandying the term around he is implying guilt by association, which is not a good way to argue.

    Good economic theory is concerned with how people tackle and solve material problems. It often leads to propositions about how problems should be solved in a simple model world. Those propositions will often not have any descriptive validity in the real world for two possible reasons. Important elements of the real world have been omitted in the model or because people do not know enough in the real world for the solution to be obviously applicable. Sometimes the model proposition can be manipulated to be useful in the real world and sometimes not. In general the more abstract a theory, the more situations there are to which it could potentially apply but the more it has to be modified and adapted to work in any situation at all. These theories do not denote “laws” but mechanisms or tendencies that will be at work in a given set of situations. In a real historical situation they will always be overlaid by other influences and things going on.

    There are reasons to do with the sociology of the academic economic profession that lead to a misuse of resources and the production of a lot of useless “theory”. The solution, so far as I can see, is not to tar all economists with the same brush and look for the solution in some methodological fix. It is to tackle real problems as well as we can, do good economics, and trust that the good will slowly push out the bad. In the last century H.A.Simon showed the way in microeconomics and the economics of organisations and Kalecki and Minsky made important contributions in macroeconomics. They have a few active followers. If there were more we would be in a healthier place.

    • It was precisely “logical positivism” which was the dominant force in the re-shaping of social sciences which took place in early 20th Century. Lionel Robbins re-defined economics along lines prescribed by logical positivism as to what a science should be, replacing an approach based on welfare by one based on scarcity. This has been spelled out in my paper on the Normative Foundations of Scarcity, published in RWER and available from SSRN

  2. ghholtham said:

    Understood. But a lot has happened in both philosophy and economics since Lionel Robbins.

    • Yes, philosophers have abandoned logical positivism, but economists have not heard the news. The scarcity definition, based on positivist ideas, continues to be the foundation of modern economics. See my essay on The Normative Foundations of Scarcity

      • ghholtham said:

        What are you saying that the notion of scarcity somehow depends on logical positivism? That is such nonsense you cannot believe it. My local grocer talks about scarcity all the time and he has never heard of logical positivism.

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