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This is the second part of Lecture 9 in Advanced Macro II, Spring 2019, at PIDE by Dr. Asad Zaman. The first part (L09A: Why Minsky Matters) covers the first 27m of the YouTube lecture linked below. The second part, L09B, starts 27:22m is about 1hr long:

 

A 1500 word summary/outline of the key points covered in L09B is given below:

Krugman fails to understand Minsky

On the one hand, Minsky has been transformed from an eclectic outcast to a darling of the mainstream after the crisis. On the other hand, Krugman and others have failed to appreciate the central insights of Minsky, just as they did with Keynes. While Keynes had completely rejected mainstream theories on solid grounds, Hicks and Samuelson constructed a neoclassical synthesis which conceded the short-run to Keynes on the basis of short run wage rigidities, but kept the fundamentals of mainstream theories intact. Similarly, today mainstream economists like Krugman admit to being at fault in not predicting the GFC, but blame it on external factors, rather than central weaknesses in mainstream theories. Three external factors which account for the failure of economists to “see it coming” are:

  1. The GFC was Black Swan Event. A period of stability led to under-estimation of risks and a discounting of the probabilities of crisis.
  2. The Fed kept interest rates low for too long. This allowed massive credit creation, which led to bubbles
  3. Rise of Shadow Banking Industry went un-noticed. The unregulated financial sector created a crisis by making high leverage gambles, using derivatives as insurance.

Accordingly, mainstream economists propose three solutions, none of which require re-thinking traditional Macroeconomics.

  1. We should pay more attention to the possibility of black swan events, and allow for distributions with fat tails in our stock market models.
  2. We should pay more attention to monetary policy
  3. We should do more regulation of shadow banking (Macro-Prudential Regulations)

In fact, this analysis fails to understand the central insights of Minsky. The mainstream, deluded by theories of intermediation, does not understand the central role of private sector credit creation in generating crises. Even more important, Minsky attacks the central religious belief in “equilibrium”. While Krugman believes that market forces are stabilizing, Minsky promotes the heresy that “equilibria” are inherently unstable. In modern financial economies, the very stability of the equilibria generates the forces which de-stabilize the economy.  Very briefly, stability encourages risk taking behavior, which increases until a crisis occurs. This view is truly deeply heretical because it attacks the founding pillars (optimization/equilibrium) of mainstream orthodoxy.

Mainstream Views on Money

The standard story of money, taught worldwide in conventional textbooks, is that the Central Bank controls the High Powered Reserves, and the total money supply is determined as a simple multiple – M = kR, where M is money supply, k is the money multiplier, and R is the High Powered Reserves. Monetarists argue that the Money supply has no effect on the real economy except for determining prices. Accordingly, Friedman recommended the simple monetary policy rule that the Central Bank should aim for 6% per annum growth in the money supply. Setting a fixed target, and achieving it would anchor expectations about future money and prices, allowing inter-temporal trade without frictions created by uncertainty. Attempt by Central Banks to follow this policy proved to be a complete failure. The reason is that the process of credit creation by private banks is not under the control of the Central Bank. This depends on the investment climate and business expectations. Central Banks would routinely fail to meet announced policy targets, since the money supply depended on factors outside their control. This failure would damage credibility of the central bank, further weakening the impact of monetary policy.

This failure of the Friedman rule led to the use of Minsky’s preferred and recommended policy: the use of the overnite discount rate (and not reserves) for monetary policy. In addition, Minsky recommended the elimination of the interbank borrowing of reserves. The theory behind the creation of the inter-bank market was that this allows extra liquidity to the banks. However, Minsky thought that reserves should only be borrowed from the Central Bank, because this will allow the Central Bank to monitor the quality of loans being offered as collateral. The inter-bank borrowing market allows a general decline in quality of loans, as occurred prior to the GFC. Had Minsky’s idea been implemented, it would have been possible for the Central Bank to forestall the crisis by refusing to accept high risk mortagages as collateral for borrowing of reserves. The Fed would have been aware of risky debt portfolios accumulating in the Private Banks, because that is used as collateral for reserves.

The Financial Instability Hypothesis

One of the key contributions of Minsky, which advances on Keynes, is the recognition that the Business Cycle is caused by Pro-cyclical Credit Creation. In booming economy, there is a huge demand for credit, and everybody is lending, substantially expanding the supply of credit to the economy. Financial assets are used as basis for loans, and easy availability of credit can lead to rise in the prices of these assets, creating a bubble. When all banks are lending, accepting high-risk assets as collateral, no one bank can afford to get left behind, because they would lose market shares. When the music is playing, everyone must dance. BUT, when music stops, you are caught holding assets no one wants. In more prosaic terms, pro-cyclical lending exacerbates the cycle.

To explain the business cycle, Minsky offers us a pair of related theories. The first is the Keynesian theory of Investment as the driver of the business cycle. The second is Minsky’s contribution, the Financial Theory of Investment. These are explained further below.

Keynesian Theory of Investment: What differentiates Keynesian views from modern macro is the idea that investment is driven by “animal spirits” – expectations about the future which are not ‘anchored’ by any past events (and hence not ‘rational’).  This corresponds to the Keynesian view that the future is DEEPLY and INHERENTLY uncertain. Because it is COMPLETELY unpredictable – rational expectations cannot exist. If all investors are optimistic, this will create a self-fulfilling prophecy, and similarly for pessimism. Random fluctuations in investor sentiments can lead to an upswing maintained for sufficiently long to lead to creation of extra credit. Now the pro-cyclical behavior of financial institutions further fuels the fire, providing extra credit with high leverage, high risk, weak collaterals. Then the Central Bank Responds to the increasing aggregate demand by raising interest rates. In the expansion phase, firms have short term debt which is to be rolled over. Now this becomes more costly than anticipated and creates losses, possibly bankruptcies. This leads to a minor downswing which is further exacerbated by financial response created by tightening credit, and reducing money supply.

Minsky’s Typology of Finance: In this context, it is useful to learn the Minsky Classification of financing:

  1. Hedge Finance (not related to Hedge Funds): earnings enough to repay interest and principal.
  2. Speculative Finance (earnings sufficient for interest payments, but not for principal)
  3. Ponzi Finance (earnings not even sufficient for interest – more borrowing to pay off interest)

Speculative Finance is based on the speculation that asset values will increase in the future, allowing repayment of the principal – for example, this could happen in market where property values are rising rapidly. However, if incomes decrease or interest rates increase, then speculative finance can turn into Ponzi finance, where one has to borrow to make interest payments. This is problematic because loans may not be available, leading to bankruptcies. Many households took Ponzi financing to purchase houses in 2000-2007, speculating that rising house prices would cover their costs. To some extent, Lenders lend to protect past loan, but they will cut losses at some point by going for loan default and collecting collateral.

Causes of Crisis: As the expansion continues, financial fragility continues to increase, as riskier loans are extended, with more leveraging. There are multiple sources which can create a crisis which bursts the bubble:

  • income flows turn out to be lower than expected,
  • interest rates rise,
  • lenders curtail lending,
  • prominent firm or bank defaults on payment commitments.

When leveraging is high, then one failed payment has a multiplied impact on contraction of credit, and this can rapidly multiply defaults throughout the system, leading to a financial crisis. A financial crisis collapses the economy via the following mechanisms:

  1. Debtors cut back spending to make payments
  2. This leads to fall in Aggregated Demand, hence fall in income, jobs, wages
  3. To make loan payments,Asset are sold, which leads to fall in asset prices.

In extreme cases, this can lead to the Debt-Deflation seen by Irving Fisher in the aftermath of the Great Depression. Because of asset price collapse, and defaults by financial institutions, wealth is wiped out. Inability to make payments leads to widespread bankruptcies. Output and employment collapse. Debt increases further from efforts to pay it off.

Minsky’s Policy Recommendation: It was thought that the development of the inter-bank Funds market would facilitate credit creation. Minsky argued AGAINST this. It is not true that banks first acquire reserves and then they make loans. Rather, Banks make loans and then borrow reserves to meet reserve requirements. The Inter-bank market weakens the REGULATORY capacity of the central bank, it does not create additional capacity for lending. If the Central Bank is the sole source for reserve funds, it can monitor the quality of assets being used for collateral throughout the system, and thereby control systemic risks much more efficiently.

Course Website: bit.do/az4macro – contains lectures for both Adv Macro I and II.

Advanced Macroeconomics II – Spring 2019 – PIDE – Dr. Asad Zaman. Course Website: https://bit.do/az4macro . Lecture 9 is provides an introduction to L Randall Wray “Why Minsky Matters”. This post [L09A] covers the first portion (00-27:22m) of the lecture linked in the YouTube Video Below:

AM2 L09A – first half of lecture 9 compares the Global Financial Crisis to the Great Depression, similarities in origins and differences in responses.

  1. Why did No One See It Coming?

We start by posing the question “Why did no one see it coming?” which the Queen of England asked at the London School of Economics. To answer, we must consider the evolution of macroeconomic thought. This involves the rejection of Keynes, the rise of monetarism of Friedman, the extremism of Lucas, New Monetary Consensus of Bernanke, Efficient Markets of Fama, Laissez-Faire approach to financial regulation. The book starts with a beautiful description of the problem, eminently worth adding to my collection of “Quotes Critical of Economics”:

What passed for macroeconomics on the verge of the global financial collapse had little to do with reality. The world modeled by mainstream economics bore no relation to our economy. It was based on rational expectations in which everyone bets right, at least within a random error, and maximizes anything and everything while living in a world without financial institutions. There are no bubbles, no speculation, no crashes, and no crises in these models. And everyone always pays all debts due on time.

In short, expecting the queen’s economists to foresee the crisis would be like putting flat-earthers in charge of navigation for NASA and expecting them to accurately predict points of reentry and landing of the space shuttle. The same can be said of the U.S. president’s Council of Economic Advisers (CEA)—who actually had served as little more than cheerleaders for the theory that so ill-served policy makers.

  1. Minsky: Stability is De-Stabilizing!

According to Minsky, the degree that the economy achieves what looks to be robust and stable growth, this is setting up the conditions in which a crash becomes ever more likely. It is the stability that changes behaviors, policy making, and business opportunities so that the instability results. Examining the history of financial crises furnishes empirical evidence for this thesis: Crashes are often preceded by long period of stability.

The Great Depression: Back in 1929, the most famous American economist, Irving Fisher, announced that the stock market had achieved a “permanent plateau,” having banished the possibility of a market crash. In the late 1960s, Keynesian economists such as Paul Samuelson announced that policy makers had learned how to “fine-tune” the economy so that neither inflation nor recession would ever again rear their ugly heads. In the mid-1990s, Chairman Greenspan argued that the “new economy” reflected in the NASDAQ equities boom had created conditions conducive to high growth without inflation. In 2004, Chairman Bernanke announced that the era of “the Great Moderation” had arrived so that recessions would be mild and financial fluctuations attenuated.

In every case, there was ample evidence to support the belief that the economy and financial markets were more stable, that the “good times” would continue indefinitely, and that economists had finally gotten it right. In every case, the prognostications were completely wrong. In every case, the “stability is destabilizing” view had it right. In every case, Minsky was vindicated.

Minsky not only saw it coming, but all along the way he warned that “it” (another Great Depression) could happen again. In retrospect, he had identified in “real time” those financial innovations that would eventually create the conditions that led to the GFC—such as securitization, rising debt ratios, layering debts on debts, and leveraged buyouts

  1. Financial Crisis Inquiry Report

The crisis was foreseeable and avoidable. It did not “just happen,” and it had nothing to do with “black swans with fat tails.” It was created by the biggest banks under the noses of our regulators.  This contrasts with what economists at LSE told the Queen – that these things just happen and no one can foresee them – like earthquakes.

According to the report, the GFC represents a dramatic failure of corporate governance and risk management, in large part a result of an unwarranted and unwise focus on trading (actually, gambling) and rapid growth (a good indication of fraud, as William Black argues). Indeed, the biggest banks were aided and abetted by government overseers who not only refused to do their jobs but also continually pushed for deregulation and de-supervision in favor of self-regulation and self-supervision

  1. Dynamite Prize: Friedman, Greenspan, Summers

Instead of helping, economists  (armed with defective economic theories), actually pushed for OPPOSITE policies to those required for stabilization. President Clinton’s Secretary of the Treasury Larry Summers—a nephew of Paul Samuelson and the most prominent Harvard Keynesian of today—famously pushed for deregulation of “derivatives” that played a critical enabling role in creating the financial tsunami that sank the economy. One of the key contributions of Minsky lies in identifying the sources which make the economic system prone to crises. This diagnosis permits the design of appropriate remedies.

  1. Response to GFC 2007 different from response to GD 1929

Monetary and Fiscal Stimulus: Both crises were created by similar kinds of irresponsible behavior by unregulated financial institutions. However, the response to both was dramatically different. A $29 Trillion package was used to bail-out bankrupt financial institutions, and a $1 Trillion government deficit was incurred to pursue expansionary fiscal and monetary policy. This change in response also led to a change in outcomes. Financial collapse of the system was avoided. Although huge numbers became homeless and hungry, the social security programs enacted in the New Deal prevented the worst scenarios of deep massive social misery which followed the Great Depression. HOWEVER, a terrible Recession did follow, where unemployment reached double digit figures, around 25 million.

Recovery? It is claimed that there has been a recovery. Although official unemployment rates came down, much of the improvement is illusory—millions of workers have given up all hope and left the labor force. Even after years of “recovery,” both the homeownership rate (percentage of Americans who own their homes) and the employment rate (percentage of the adult population with jobs) are stuck well below where they were before the GFC. Inequality has actually increased, and all of the gains in the recovery have gone to the very top of the income and wealth distribution.

No Post-Crisis Financial Reforms:  The federal government in Washington did not follow Roosevelt’s example in undertaking a thorough reform of the financial system after GD ’29. The biggest banks are actually even bigger and more dangerous than they were on the eve of the GFC. They’ve resumed many of the same practices that created the GFC. Our public stewards are again allowing this to happen. We didn’t seem to learn much from the GFC. Not only is it true that banking practices have not changed, but is also true that mainstream economics has not changed. Examination of syllabi of universities after the GFC does not reveal any significant changes in terms addition of readings on Minsky, Keynes, and others, who offer deeper insights into the crisis. The same ARCH/GARCH models that failed miserably to assess volatility in the GFC continue to be used. The same DSGE/RBS models in use to make monetary policy continue to be used all over the world.

It seems that we have not learned much from the Global Financial Crisis!

CONTINUED in L09B: Mainstream VS Minsky — goes from 27m to end of lecture (1 hr) — explains how the mainstream misunderstands Minsky, just like they misunderstook Keynes, whose work Minsky builds upon.

Something for PhD Students and early-career researchers thirsty of pluralistic education:

 

CALL FOR APPLICATIONS

Poznań Summer School in Heterodox Economics

3rd edition

12.09.2018-16.09.2018

Poznań University of Economics and Business

 

The School is intended for PhD Students and early-career researchers interested in heterodox approaches to studying complex economic phenomena. We provide an international learning environment for those interested in deepening their knowledge in heterodox economics or considering applying it to their own research area. Over five days, participants will have an opportunity of attending lectures, presenting their findings and ideas, as well as discussing them with highly competent faculty. They will also take part in workshops and seminars that will improve their analytical skills.

 

Confirmed speakers:

– MACIEJ GRODZICKI (Jagiellonian University, PL),

– PAOLO RAMAZZOTTI (University of Macerata, IT),

– LOUIS-PHILIPPE ROCHON (Laurentian University, CA),

– MARC LAVOIE (University of Ottawa, CA, University of Paris 13, FR),

– HANNA SZYMBORSKA (The Open University, UK)

– ANNA ZACHOROWSKA-MAZURKIEWICZ (Jagiellonian University, PL).

 

The School is organized by the Poznań University of Economics and Business in cooperation with Wydawnictwo Ekonomiczne “Heterodox”.

The event is supported by the European Association for Evolutionary Political Economy, the Review of Political Economy and the Forum for Social Economics.

 

For more information, please contact the Organizing Committee through email: heterodox.school@projekty.ue.poznan.pl or facebook.

Ongoing Recruitment – please send us an email to check if places are still available.

 

Please send your application to: heterodox.school@projekty.ue.poznan.pl

School fee: 120 euro/500 zł

Fees include lunches and coffee breaks. Budget accommodation can be provided by organizers upon request.

Deadline for payment: 15 August 2018.

 

The Organizing Committe:

Krzysztof Czarnecki (Poznań University of Economics and Business),

Marcin Czachor (Wydawnictwo Ekonomiczne „Heterodox” – Publishing House „Heterodox”),

Anna Piekarska (Praktyka Teoretyczna; Wydawnictwo Ekonomiczne „Heterodox” – Publishing House „Heterodox”)

Agnieszka Ziomek (Poznań University of Economics and Business).

[bit.do/azifa] Lecture 1 on Rise and Fall of the Gold Standard, on Friday 4th May 2018 in AR Kemal Rm at PIDE, by Dr. Asad Zaman, VC PIDE. 1hr 20m Video Lecture. Shortlink for Lecture 2: bit.do/azifa3

3100 word summary of lecture:

Read More

[[bit.do/weafm]] In “The Trouble with Macro”, Romer writes that macro-economists casually dismiss facts, and the profession as a whole has gone backwards over the past few decades, losing precious and hard-won knowledge. He does not consider WHY this happened. What are the methodological flaws that create the possibility of moving backwards, losing knowledge, affirming theories known to be in conflict with facts. How is it that leading economists can confidently assert theories which border on lunacy, and receive Nobel Prizes instead of psychiatric treatment?

This is due to the famous AS-IF methodology of Friedman, which gave economists a license for lunacy.  Friedman came up with this defense of orthodoxy when numerous emprical investigation revealed clearly that firms did not maximize profits, did not know their marginal costs, typically used mark-up pricing, and did other things which did not square with neo-classical theories.  Friedman argued that the validity of the axioms of a theory was not relevant; all that mattered was the ability to derive true conclusions from them. This has been called the F-twist:  “Truly important and significant hypotheses will be found to have “assumptions” that are wildly inaccurate descriptive representations of reality, and, in general, the more significant the theory, the more unrealistic the assumptions.” Friedman’s fallacious argument satisfied a deep-seated need — since the daily bread and butter of economics is ‘wildly inaccurate descriptive representations’ — and hence it became wildly popular and widely accepted throughout the economics profession. Now one can, without any embarrassment, make bizarre assumptions worthy of the lunatic asylum, and this is indeed the daily occupation of leading economists.

Friedman’s argument has been universally condemned by logicians and philosophers as an instance of the logical fallacy of “Affirming the consequent” – the use of modus ponens in reverse. That is, Friedman says, in effect, that theory T implies observable consequence C. We observe C, and therefore we can affirm that T holds. This is obviously fallacious since many different theories, inconsistent with T, may also imply consequence C. Even more importantly, a false theory T will always imply consequences C* which are not observed — since the theory is false, it will have consequences which are false. Ignoring all of these problems,  Boland uses an instrumentalist interpretation to defend Friedman, just like all economics textbooks. He writes that even though critics universally condemn his logic, Friedman is right, and ALL the critics are wrong.

In my lecture on  AM2L07 (code for Advanced Micro II: Lecture 7) Methodological Mistakes: Prospect Theory and Psychology Protocols, I explain why Friedman is wrong and his critics are right by discussing this methodological debate within the concrete context of trying to understand search theory. Consider a hypothetical problem where a person is searching for the highest wage. He goes from one firm to next. At each point he is offered a job at a certain wage W. He can accept and quit searching, or reject the offer and go on searching. We want to find a theory which explains search behavior that we observe in lab experiments designed to emulate this situation.

In simple models, it is easy to show that optimal search sets a reservation wage W* and the laborer searches until he/she finds the first offer above this value. The Economist is committed to the assumption that humans are hyper-rational, and they maximize. ONLY theories satisfying these assumptions will be examined for validity. This means that there is NO QUESTION of looking at human behavior itself to see whether or not this hypothesis about behavior holds. Rather, the ONLY problem is to find the FUNCTION which is being maximized.  Economists start by using Expected Utility theory. A rather large number of empirical examples show that this theory does not match human behavior. Nonetheless, this continues to be the dominant theory of decision making under uncertainty and continues to be taught in textbooks, even though the theory is KNOWN to be wrong.

An improvement upon this is PROSPECT theory. By making ad-hoc modifications to probabilities, utilities, and FRAMING the problem in a suitable way, this theory can achieve a MUCH BETTER match to observed behavior than Utility theory. This theory preserves MAXIMIZATION – humans maximize something. However it abandons rationality — why should humans treat probabilities INCORRECTLY. Economists cannot stomach this observed failure of rationality and so AFFIRM theories solidly in conflict with observed facts about human behavior.

NEITHER of these approaches is scientific, since both dogmatically assert allegiance to the maximization principle regardless of observation. The articles by John Hey show how one can move beyond this to a genuinely scientific methodology. He explains how many researchers have investigated search behavior, but have only been concerned with whether or not it matched ASSUMED theories of behavior. INSTEAD he proposes to investigate how humans ACTUALLY behave, without imposing any assumptions about behavior in advance. He used psychological protocols, asking subject to think out loud about the process with which they arrive at the decision on whether to accept an offer or to go on to search for the next one. As can be expected, humans cannot make complex calculations that theory requires of them, and instead they use various heuristics and rules of thumb. These heuristic work fairly well, and get them reasonable close to what someone with full information and infinite computational capabilities could achieve. Nonetheless, the use of heuristics gives radically different results about what we could expect to see in markets where these behaviors, rather than the hypothesized AS-IF behavior is used. The full lecture is linked below

For lecture slides and reference materials, links to related articles, as well as the whole sequence of lectures, see the course website: Advanced Micro II (shortlink: bit.do/ee2018)

POSTSCRIPT: The process of lecturing, trying to explain to my students how their fellow students are being duped by economic textbook, always give me greater clarity. In this lecture, I examine three approaches to understanding human behavior in the process of searching for the best wage (or searching for the best price).

1: AXIOMATIC — represented by Expected Utility. Here we know in advance what human behavior is. We do not need to look at human behavior at all. If someone ELSE studies this behavior and finds that our theories do not match actual behavior, we say that the experiment must be wrong.

2: DESCRIPTIVE — represented by Prospect Theory. Unlike economists, experimentalists and behaviorists study actual behavior. When it fails to match Expected Utility, they came up with a new theory — prospect theory — which summarizes and encapsulates a description of how humans behave in decisions under uncertainty. Economists REJECT this picture because it shows how human behavior is IRRATIONAL – and this conflicts with their FUNDAMENTAL assumptions of rationality, which must be maintained regardless of any inconvenient facts or observations or introspection.

3: SCIENTIFIC: An accurate description permits us to proceed to the next stage, which is to try to understand the REASONS for this behavior. For example, we observe that most people are risk-averse. They prefer the certain outcome of $50 to a gamble with offers $0 and $100 with equal probabilty. Now we can ask why — this is with regards to unobservable, hidden motivations, about which we can never be certain. A good explanation for this is REGRET. Because of our psychological makeup, the flatness of the utility function in gains, a win of 100 does not feel vastly superior to a win of 50. But the real kicker is the feat that if I take a gamble and lose, I will feel so stupid. Avoiding the regret that might occur when I say I should have taken that certain $50 might be the explanation for risk aversion.

Actually, even “reverse Modus Ponens” is not a good description of Friedman’s methodology — there is an added F-Twist: If we can FIND some observations C such that theory T implies them, then we affirm theory T, and IGNORE any other implications of T which actually conflict with observations.

The METHODOLOGICAL point is the Friedman, like all nominalists and instrumentalists, GIVES up on the possibility of understanding human behavior. All he wants is a model which provides a SUPERFICIAL match to some observations. However, many many real life situations show that this is NOT ENOUGH — we need to have a deeper understanding, in order to be able to explain economic and social phenomena.

See also previous related post on Economists Confuse Greek Methodology with ScienceA more recent related post is: The Methodology of Modern Economics.

This is a summary of the introduction/motivation part of href=”https://sites.google.com/site/az4math/ll15europe19th”>Lecture 15 on Advanced Microeconomics II, delivered at PIDE in Spring Semester 2017.  The lecture is about 19th Century European History, and how it is deeply entangled with Modern Economic Theory. We cannot understand one without the other.

19th Century European Economic Ideas In Historical Context.

“… the race is not always to the swift, nor the battle to the strong …” Ecclesiastes 9:11

In the late 19th century, a battle of methodologies (“Methodenstreit”) took place, which shaped the future of economics. The German Historical School lost out to the newly emergent, quantitative, mathematical and scientific approach. This led to a re-conceptualization of economics as a science similar to physics, which studies the economic laws of motion of societies. For a detailed account of this battle, and its effects, see “How Economics Forgot History,” by Geoffrey Hodgson.

1. Contemporary Methodology:[humans are predictable robots] The idea that economic theory is a science like physics has extremely unpleasant and counterintuitive consequences. We look for universal laws of economics, which apply equally well to Pakistan, France, Brazil, Russia and Nigeria. Furthermore, they apply equally well in the seventeenth, nineteenth, and twenty-first century. The trade theory of economists must apply equally to trade between Ghana and England, India and Pakistan, and the Huron and Iroquois tribes. Since the ability of human beings to shape their destiny in accordance with visions cannot be fit into a scientific framework, human behavior is reduced to that of a robotic pleasure machine, which follows precise mathematical laws.

2. Marxist Methodology:[social and political structures are determined by economic structures] A key element of Marxist methodology is that economic relations of production are fundamental. These determine the political and social superstructures. Marxist methodology is far richer than current methodology, which removes history, and human beings, from economics. Nonetheless, Marxist methodology gives primacy to materialistic conditions of productions, and considers society and politics as important secondary consequences.

3. (Polanyi’s Methodology):[material circumstance shape human societies, but also human vision and ideas shape material circumstances] Whereas conventional methodology restricts attention to the material circumstance, and Marx considers material circumstances as primary, Polanyi uses a bi-directional causality. Human ideas and visions can shape history, and conversely, the economic relation of production shape human ideas and visions. For more discussion of the radical implications of this entanglement of ideas and materials, see my earlier post on “Meta-Theory and Pluralism in Polanyi’s Methodology“.

These are three distinctly different methodological principles.  In the rest of this lecture, we will look at nineteenth century European history through these three different colored glasses and see how they help us understand the economic, social and political changes which occurred during this period. Our goal will be to establish that “entanglement” occurs – that human ideas are both shaped by, and shape, history. In particular, economic theories are used by humans to understand historical experience, and also to guide social responses to this experience, and attempt to mold history in favorable directions. An extremely important consequence of this entanglements is that economic theories cannot be understood when detached from the historical context in which they were born. As Polanyi explains clearly, modern economic theories were produced in nineteenth century England, and to understand these theories, it is necessary to understand European history of that era.

The failure to see the impact of ideas on history was due to the overwhelming influence of a materialist view of the world, which had come into existence following the success of Newton’s laws in explaining diverse phenomena. Since material substances follow laws, they could not be affected by ideas. This duality and divide between spirit and matter has been influential in shaping Western epistemology, and in making it difficult to see the influence of spirit on matter, due to ideological preconceptions.

Before proceeding to the complexities of European history, we will do a dry-run of the conceptual framework we are using within the simpler context of hunter-gatherer as well as feudal societies. The 90m Video-Lecture linked below, discusses the co-evolution of economic theories along with the historical context in 19th century Europe:

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

[bit.do/azfiv] 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.