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Critiques of Economic Theories

After the 1920s, the theoretical and methodological approach to economics deeply changed. Based on a criticism of Marshall’s work and legacy, a new generation of American and European economists developed Walras’ and Pareto’s mathematical economics. As a result of this trend, the Econometric Society was founded in 1930.

The constitutional assembly was held in  Cleveland, Ohio, during the annual joint meeting of the American Economic Association and the American Statistical Association. The Norwegian economist Ragnar Frisch played an important role in the Econometric Society that was founded to enhance studies based on the theoretical-quantitative and the empirical-quantitative approach to economic problems. In this way, the  founding fathers believed that  economic thinking could be as rigorous as the one that dominates the natural sciences.

At the 5th European Meeting of the Econometric Society, in 1935, Jan Tinbergen presented a paper on ‘A mathematical theory of business cycle policy’ that followed the Econometric Society’s guidelines. His causal explanation of the business cycle began with a priori economic-theoretical considerations about explanatory variables and then he proceeded to test a model.

In the late 1930s, John Maynard Keynes and other economists objected to this recent “mathematizing” approach. Keynes, as editor of the Economic Journal, wrote  a negative review of Tinbergen’s 1939 book A Method and its Application to Investment Activity. This book  presented an statistical testing of business cycle theories based on the application of the method of  multiple regression and  mathematical framing in the form of a specified model. At the core of Keynes’ concern lied the question of methodology. Recalling his own words:

Am I right in thinking that the method of multiple correlation analysis essentially depends on the economist having furnished, not merely a list of the significant causes, which is correct so far as it goes, but a complete list? For example, suppose three factors are taken into account, it is not enough that these should be in fact veræ causæ; there must be no other significant factor. If there is a further factor, not taken account of, then the method is not able to discover the relative quantitative importance of the first three. If so, this means that the method is only applicable where the economist is able to provide beforehand a correct and indubitably complete analysis of the significant factors. The method is one neither of discovery nor of criticism. It is a means of giving quantitative precision to what, in qualitative terms, we know already as the result of a complete theoretical analysis. (Keynes 1939: 560)

In this paragraph, it is clear that Keynes doubted the use of inductive methods of generalization and statistiicial inference to build economic theories because of the peculiarity of the economic systems characterized by:

  • a low degree of homogeneity,
  • a high degree of complexity
  • the lack of stability through time.

Indeed, on behalf of the peculiarities of the economic systems, Keynes highlighted that econometrics turns out to be a method not of testing or of discovery, but of measurement of selected variables.

 

refeences

Keynes, J. M.,  Professor Tinbergen’s Method, The Economic Journal, Vol. 49, No. 195 (Sep., 1939), pp. 558-577. Published by: Blackwell Publishing for the Royal Economic Society. Stable URL: http://www.jstor.org/stable/2224838

Tinbergen, J. A Method and its Application to Investment Activity. Geneva: League of Nations, 1939.

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1000 word summary of Quaid-e-Azam Lecture at PSDE 33rd AGM held on 14th Dec, 2017 at Islamabad. Published in Express Tribunethe Nation 13th Jan 2018. 43m Video Lecture on YouTube:

The main thesis of our lecture is that our quest for prosperity has failed to deliver the sought-after goals because we have misunderstood the meaning of prosperity , and looked for it where it cannot be found. We base our economic policies on modern economic theory, which is based on the amazing assumption that human beings act to maximize lifetime consumption, since this is the sole source of human welfare. Human beings are far more generous and cooperative than the assumptions of economic theory allow for. Even more important is Richard Easterlin’s discovery that enormously increased levels of consumption do not bring about corresponding increases in happiness. Consumption only brings short-run happiness; long-run happiness has no correlation with consumption, and is far better correlated with character traits like generosity and gratitude. Mindless pursuit of wealth, implemented by policies to maximize growth, has led to increasing misery, instead of prosperity . Growth-oriented policies have destroyed family lives, engaging all members in production of wealth, and they have damaged our environment, destroying the future of our species for short run gains. Can this damage be reversed? Can we improve human lives and welfare, and also stave off the impending environmental crisis? At the core of the crisis we face is the prioritization of wealth over human beings. A market economy cheapens human beings because it is based on the idea that human lives are commodities for sale in the labor market. Reversing these priorities requires the recognition that all human lives are infinitely precious, with amazing potentials and capabilities for growth in dimensions unknown. Taking this principle seriously would require re-writing all economics textbooks, and radically re-organizing our economic, political and social institutions. Taking collective responsibility to ensure that all members of a society get the chance to develop their capabilities would be a new definition of prosperity , very different from GNP per capita, which is the current focus of policy makers across the globe.

Modern economic theory makes accumulation of wealth the goal of economic activity, and values human lives only to the extent that they contribute to production. How can we reverse these priorities, putting the enrichment and empowerment of human lives at the center, and valuing wealth only to the extent that it is helpful in achieving this goal? The first requirement is to win the battle of ideas, creating consensus on the prioritization of human beings over material wealth. To do this, we need to recognize modern economic theory for what it is, instead of what it claims to be. To accomplish this goal, it is useful to label modern economic theory as Economic Theory of the Top 1% — or ET1% — and explain how all aspects of this theory are designed to portray increasing wealth of the top 1% as the goal of society, and also to show that this serves to benefit the entire society. For example, use of GNP per capita as a yardstick of social welfare exactly fits this description, since gains to the top 1% are first divided over the entire population and then measured, thus appearing to be generally beneficial, when in fact they are not. Overcoming this deception will involve replacing ET1% by ET90% — a new economic theory for the bottom 90%.

Karl Marx clearly recognized the deceptive nature of economic theory, and stated that functioning of capitalism requires convincing the laborers of the necessity and fairness of their own exploitation. ET1% does this by arguing the growth is the best policy to pursue for all, since benefits which obviously accrue to the rich will eventually trickle down to the poor. In contrast, Marx offered us ET90% by asking for a shift from each according to his abilities (to gather wealth) to “each according to his needs”, thereby prioritizing the needs of the poor over growth to provide more wealth to the already wealthy.

As a prescription for change, Marx urged the laborers of the bottom 90% to unite, and throw off their chains.  Experience shows that we can successfully unite laborers to revolt against the capitalists, but after the revolution, control necessarily remains in the hand of a small minority. The nature of power is such that this small minority is likely to be corrupted by it, and use it for personal gains, and to oppress the majority. Just like democracy has failed to give ‘power to the people’, so alternative systems of government also fail.

The Islamic solution works along different dimensions. It seeks to co-opt the rich and powerful, instead of killing them off, and replacing by another set of rich and powerful. This is done by creating social norms of generosity and social responsibility. Fourteen centuries ago, the revolutionary teachings of Islam led backwards and ignorant Arabs to world leadership. These teachings include the ideas that the best leader is the servant of the people, that power is given to us in order to protect the weak, and wealth is meant to be given to the needy. Widespread acceptance of these ideas created a society which provided basic needs, health care, and education to all members using the institutions of Waqf, and the norms of collective social responsibility and brotherhood. Because these ideas have been forgotten, they continue to have the same revolutionary potential today, as they did 1400 years ago. The most important first step in this revolution is sensitizing our hearts to feel compassion for sufferings of all mankind. The feeling that all of the creation is the family of God, and service to humanity, and all living creatures, is the highest form of worship, is essential motivation for the Herculean efforts required to create revolutionary changes required to reverse the increasing concentration of wealth at the top and misery at the bottom.

huntergatherer

As a preliminary demonstration, and an explanation of the “Three Methodologies“, we assess how they work in primitive hunter-gatherer societies.

A hunter-gatherer is a human living in a society in which most or all food is obtained by foraging (collecting wild plants and pursuing wild animals), in contrast to agricultural societies, which rely mainly on domesticated species.

There are many characteristics of such societies forced by the material conditions of production. Since existing food supplies in any one location are soon exhausted, such societies are generally nomadic. Here are some philosophies, and political and social structures that would naturally arise in hunter-gatherer nomadic societies.

Philosophy: Since human beings are directly dependent on the environment, the idea of “Mother Earth” and a close relationship with nature can be expected to develop. This stands in contrast with urban lifestyles which are remote from nature; it is this detachment from nature which has permitted the widespread environmental destruction which is currently taking place.

Politics: Typical Hunter-Gatherer societies are egalitarian. This is because everyone derives a living directly from nature, and is mobile. If one subgroup is oppressed, they can simply leave, so there is not much room for powerful groups to exercise large amounts of power and control over other groups. Furthermore, in subsistence economies, one cannot afford slaves because there is generally not enough surplus food to feed them. So economic conditions favor egalitarian political structures; nonetheless, human ingenuity can sometimes overcome such obstacles.

Property: Since property of nomads is confined to what they can carry with them, it is necessarily limited. Illustrative of hunter-gatherer attitudes towards property is the Cherokee Constitution of 1839, which states: “The lands of the Cherokee Nation shall remain common property”.

We now consider insights yielded into the study of such societies by the three methodologies discussed in the previous post

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'Are you sure this isn't the point in which we should stop following the invisible hand of the marketplace?'

Rafi Amir-ud-Din and Asad Zaman “Failures of the ‘Invisible Hand
Forum for Social Economics Vol. 45, Iss. 1, 2016 pp 41-60.

Textbooks, like Mankiw, state that the four claims listed below are at the center of modern economics. Our goal in this paper is to show that all four of these claims are wrong.

1.      Participants in market economies are motivated by self-interest. (SI) – In fact, cooperation, service, recognition and status in community, and reciprocity are very strong motivators of human behavior.

2.      Decentralized market economies work very well, and maximize the welfare of society as a whole. (FM:  free markets). As illustrated by the Global Financial Crisis, unregulated markets lead with regularity to disasters and crises.

3.      The reason for excellent functioning of decentralized market economies is that all participants are motivated by self-interest. This self-interest works better than love and kindness in terms of promoting social welfare.  (GG:  greed is good). This is absolutely false, and the opposite of the truth – love and kindness work much better at promoting social welfare.

4.      The principles listed above were summarized in the concept of the “Invisible Hand” by Adam Smith. (AS). Adam Smith can be blamed for many wrong ideas, but this is not one of them. In fact, free market economists attribute this theory to Adam Smith to create legitimacy for their ideas. 

Detailed presentation of the paper is available in the following 1 hr. video.

Because of Western dominance, brilliant thinkers from the East get very little attention in global media. Even though brilliant economists from East Asia and China have created globally acknowledged economic miracles in their countries, none of them have received a Nobel Prize. On the other hand, Western economists whose theories were demonstrably in conflict with the events that took place in the global financial crisis — like Lucas, and Fama — have received Nobels. One of our greatest un-sung Eastern Heroes is Mahbubul Haq. My recently published article describes the revolution he created in economic thought:
HDI

Goethe starts his famous East-West Divan with a poem about the journey (Hegire), both physical and spiritual, from the West to the East. In this essay, we consider the analogous journey from Western to Eastern conceptions of development. This involves switching from viewing humans as producers of wealth, to viewing wealth as a producer of human development. To start with the Western conceptions, both Adam Smith and Karl Marx defined economic growth as the process of accumulation of wealth. The range of diversity of Western thought is bounded by the Left-Right spectrum. Ideas on which both extremes agree command widespread consensus in the West. Consequently, a core concept of modern economic theory is that wealth is the means and ends of the process of economic development. Unfortunately, due to the dominance and influence of Western paradigms, this concept has been widely accepted and adopted in the East today.

Mahbubul Haq was indoctrinated into the Western development paradigm which gives primacy to wealth at leading universities, Yale and Harvard. He got the chance to apply these economic models as the chief economist in Pakistan during the ’60s. However, because of his Eastern upbringing and heritage, he was able to see the murderous message at the heart of the cold mathematics of the Solow-Swan growth models. These models focus on savings, created by reducing present levels of consumption, as the only route to the accumulation of greater future wealth.

Mahbubul Haq realised what is not mentioned in the economics textbooks: obsession with production of wealth requires us to use the sordid and cruel tactic of making workers produce wealth, and refusing to allow them to consume it, in order to buy machines and raw materials. He was clear-sighted enough to see the consequences of these policies: wealth did indeed accumulate, but it went into the pockets of the 22 families, without providing relief to the misery of the masses. Today the global application of capitalist growth strategies has led to a dramatic increase in inequalities both inside nations and across nations. Just one among many horrifying inequality statistics is that the top 13 individuals now have more wealth than the bottom 3.5 billion on the planet.

Dissatisfaction with state-of-the-art Western growth theories led Mahbubul Haq to a revolutionary insight, taken from the heart of the traditions of the East, and having no parallels in current Western economic theories. Instead of capital, Mahbubul Haq placed human beings at the centre of the process of economic growth, returning to the ancient wisdom that “human beings are the means and ends of development”. Even though he was called a heretic for going outside the boundaries of contemporary economic thought, the pragmatic genius of Mahbubul Haq sought to minimise differences and create bridges to conventional thinking in order to achieve acceptance for his radically different approach to development.

His Human Development Index (HDI) was a master stroke, combining two inherently incompatible conceptions of development in a compromise which ceded ground to wealth in order to create international visibility for poverty. His friend and classmate Amartya Sen was reluctant to accept the HDI because of certain inherent flaws in this marriage of fire and water, but eventually agreed to its practical necessity. The pragmatic approach of Mahbubul Haq paid off handsomely when the HDI measure achieved global recognition as rectifying major defects in the standard GDP per capita. Widespread acceptance and use of HDI has led to a radical change in the discourse on development, by adding poverty, health, education and other soft social goals to the pure and simple-minded pursuit of wealth. The revolutionary ideas of Mahbubul Haq have led to improvements in the lives of millions, as global consensus developed on the social goals embodied in the MDGs and SDGs.

The Human Development approach of Mahbubul Haq was carried further by Amartya Sen, who defined development as the freedom to develop human capabilities. This notion, closely aligned with Eastern thought, was so alien to orthodox economists that they rejected it. Consequently, a new human-centred field of development studies emerged, which combined many streams of dissent from orthodoxy. Unfortunately, leaders at the helm of policymaking in the poor countries of the world are trained in orthodox economic theories, and have not assimilated the radical lessons of Mahbubul Haq, acquired from bitter experience. The paths to genuine development lie open, but with their backs to the doors, they are unable to see them.

Conventional growth theories create the mindset that the game is all about wealth creation. We will worry about our poor population only after we acquire sufficient wealth to feed them. The poor are a burden on the development process because providing for them takes away from money desperately needed to finance development of infrastructure, purchase of machinery and raw material, and industrialisation. We cannot afford to feed the poor, if we want to grow rapidly. The human development paradigm stands in dramatic contrast to this currently common mindset among planners. Instead of utilising humans to produce wealth, we utilize wealth to develop human capabilities. Our human population, our poor, are our most precious resource. This point of view receives strong support in the empirical findings of a recent World Bank study entitled “Where is the Wealth of Nations?” The study finds that the wealthiest nations are rich because they spend money to develop their human resources, and not because of natural resources.

Thus, instead of being a burden, our poor are our most efficient means to development. If we use available wealth to improve their lives, to empower them, to educate them, and to provide them with the support they need, they can rapidly change the fate of the nation. Furthermore, they are also the end of the development process — that our goal is NOT to produce more and more wealth, a la Adam Smith and Karl Marx — but to ensure that our people lead rich and fulfilling lives. If we use our energies to achieve this goal, we have already arrived at the destination — we do not need to wait for a distant future where sufficient wealth will accumulate to enable us to take good care of our people.

Published in The Express Tribune, May 20th, 2017.

Currently, I am teaching a course in Advanced Microeconomics where I have started with the premise that conventional economic theory, both Micro and Macro are fundamentally wrong. The number of ways in which they are wrong cannot even be counted. Instead of enumerating errors, the course is devoted to providing a constructive alternative. A lot of the early lectures deal with the basic concepts of optimization and equilibrium, the fundamental building blocks of conventional courses, and explain how these are wrong. I also explain how economists are using a wrong methodology, and how they misunderstand the concept of a theoretical model, and the relations between models and reality. The video-taped lectures, PPT slides, and some supporting materials, are available from my website: https://sites.google.com/site/az4math/

Originally, I had not planned to teach Karl Polanyi because his theories are significantly more complex than those of Karl Marx and Adam Smith. However, because the class has been very receptive, and has understood the what I have been teaching, I have decided to explain his ideas. We have already started discussing his ideas starting from Lecture 13, and have finished Part I of the Great Transformation in Lecture 16. In order to prepare for the complexities of Part II, I have distributed the following handout to the class, to explain the complex general methodological framework which underlies Polanyi’s analysis.

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A relevant feature of the current crisis in economic knowledge is the recurrence of the  Ricardian Vice. Joseph A. Schumpeter coined this term in his book History of Economic Analysis when he criticized the habit assigned to Ricardo to represent the economy by a set of simplified assumptions and to use tautologies to develop practical economic solutions. Indeed, Schumpeter rejected the kind of economic thought that mainly favours deductive methods of inquiry – based on mathematical reasoning- because the  habit  known as the Ricardian Vice generates analytical unrealistic results that are irrelevant to solve the real-world economic problems.

Also Keynes warned that the understanding of the economic phenomena demands not only purely deductive reasoning, but also other methods of inquiry along with the  study of other fields of knowledge- such as History and Philosophy. In his own words:

The study of economics does not seem to require any specialised gifts of an unusually high order. Is it not, intellectually regarded, a very easy subject compared with the higher branches of philosophy and pure science? Yet good, or even competent, economists are the rarest of birds. An easy subject at which very few excel! The paradox finds its explanation, perhaps, in that the master-economist must possess a rare combination of gifts. He must reach a high standard in several different directions and must combine talents not often found together. He must be mathematician, historian, statesman, philosopher – in some degree. He must understand symbols and speak in words. He must contemplate the particular in terms of the general, and touch abstract and concrete in the same flight of thought. He must study the present in the light of the past for the purposes of the future. No part of man’s nature or his institutions must lie entirely outside his regard. He must be purposeful and disinterested in a simultaneous mood; as aloof and incorruptible as an artist, yet sometimes as near the earth as a politician.” (Keynes, Collected Writings, vol. X: Essays in Biography)

Today, Schumpeter’s and Keynes’s criticism could be certainly addressed to those economists whose beliefs ultimately privilege the deductive method of inquiry in Economics. Due to these beliefs,  mainstream economists favour the adoption of a nominalist bias. And as a consequence, the trouble is that the dialogue between economic theories and the economic reality turns out to be abandoned not only in academic research but also in the policy making process.

This dialogue is complex and should be considered in any attempt to build realistic economic theories, as Keynes warned. Indeed, the changing environment of real-world markets through time -that is irreversible-  refers to a certain degree of ontological indeterminacy that should be considered in realistic economic theories and in the study of Economics.