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In the introductory note to the book Trade and Market, Polanyi invites the readers to re-examine the notion of the “economy” since many people think that the only way of organizing the livelihoods of men is the market economy. In his own words:

‘What is to be done, though, when it appears that some economies have operated on altogether different principles, showing a widespread use of money, and far-flung trading activities, yet no evidence of markets or gain made on buying or selling? It is then that we must re-examine our notions of the economy.’ (Polanyi et al, 1957: xvii).

In order to develop an alternative notion of the “economy”, Polanyi proposed a new theoretical approach to explain the place and role of human beings in social and economic systems. He addressed that men value those material goods that serve the end to promote protection and social standing. As a result, in his approach, social matters  turn out to be anthropological ones and the role of history is highly relevant. As  Polanyi wrote:

“But a purposeful use of the past may help us to meet our present over concern with economic matters and to achieve a level of human integration, that comprises the economy, without being absorbed in it” (Polanyi et al., 1957: xviii). 

Indeed, while considering different historical references, Polanyi provided a guide to examine the non-market economies and claimed that empirical observations reveal economic life in archaic and primitive economies to be entirely different from that assumed by formal economic analysis (Polanyi et al, 1975: 243-44). Against the methodological approach to economics based on assumptions, premisses and deductive reasoning, Polanyi proposed the method of economic anthropology that depends upon principles of economic behavior that are induced from empirical observation.

From the empirical evidence of economic life in ancient times and primitive economies, Polanyi explained the concepts of reciprocity and redistribution. The reciprocity principle implied that there was an unspoken agreement in society and on its behalf people produced goods and services that could be redistributed according to their needs among all who contributed according to their abilities to the common welfare. Their motivation to produce and share was not the economic motive, but the fear of losing the social status and prestige.

Although Polanyi addressed that ancient and primitive economies had market places, they were not market economies. In this scenario, daily local markets were merely exchange places operating within the broad system of reciprocity. Local craft and provision markets were isolated by the local authorities from the long distance ones (ports of trade) that only sold items which could not be provided within the local system of reciprocity (Polanyi et al., 1957).

In the nineteenth century, however, Polanyi noted that the emergence of a market economy pushed to the side the old economic and social systems based on reciprocity and redistribution.  Since then, the new market economy has been characterized as an economic system controlled by prices that determine what, how and how much is produced and how is distributed.  As Polanyi explained, the decisions about production and distribution are guided by the economic motive and they do not aim at achieving common welfare. Indeed, as he highlighted in The Great Transformation, the process of social change created by the market economy might lead to the emergence of poverty on a large scale.

Karl Polanyi described the desolation, dehumanization and degradation of human lives as necessary steps for the emergence and expansion of the labor market in a market economy:

 “Before the process had advanced very far, the labor­ing people had been crowded together in new places of desolation, the so-called industrial towns of England; the country folk had been de­humanized into slum dwellers; the family was on the road to perdition; and large parts of the country were rapidly disappearing under the slack and scrap heaps vomited forth from the “satanic mills.” Writers of all views and parties, conservatives and liberals, capitalists and social­ists invariably referred to social conditions under the Industrial Revo­lution as a veritable abyss of human degradation” (Polanyi, 1944: 41).

Polanyi’s analysis also enhanced a critique of some well-known economists and public men such as Townsend, Malthus, Ricardo, Bentham and Burke who considered that the provision of extensive relief to the poor by the government (such as the Poor Laws in England) would negatively affect the rate of economic growth.

Polanyi decisively condemned the hunger of workers as the only way to increase the levels of production in a market economy. In fact, Polanyi addressed that the “iron” laws governing a competitive market economy are not human laws.  It is worth recalling his own words:

The true significance of the tormenting problem of poverty now stood revealed: economic society was subjected to laws which were not human laws.” (Polanyi, 1944: 131).

 

References

POLANYI, K. (1944) The Great Transformation: The Political and Economic Origins of Our Time, New York: Rinehart.

 

POLANYI, K. (1977) The Livelihood of Man, New York: Academic Press

 

POLANYI, K., ARENSBERG,. H. and PEARSON, H. W. (eds.) (1957) Trade and Market in the Early Empires: Economies in History and Theory, Glencoe, Illinois: The Free Press.

 

POLANYI-LEVITT, K. (ed.) (1990) The Life and Work of Karl Polanyi, Montreal: Black Rose Books.

 

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My article with the title above is due to be published in the next issue of the American Journal of Economics and Sociology (2019). This was written at the invitation of the editor Clifford Cobb, as an introduction to Islamic Economics for a secular audience. The Paper explains how modern economics is deeply flawed because it ignores the heart and soul of man, and assumes that the best behavior for humans is aligned with short-sighted greed. Islam provides a radically different view, showing how generosity, cooperation, and overcoming the pursuit of desires leads to spiritual progress. Islam seeks to create a society where individuals can make spiritual progress and develop the unique and extraordinary capabilities and potentials which every human being is born with. Pre-print – to appear in American Journal of Economics and Sociology, 2019 – is available for view/download at the bottom of this post.

As an excerpt, I am posting Section 2 of the paper, entitled

The Flawed Foundations of Modern Economics

The defeat of Christianity in a battle with science led to an extraordinary respect and reverence for scientific knowledge, sometimes called the “Deification of Science,” in Europe (Olson 1990; Zaman 2015a).   This had fatal consequences. Even though all scientific knowledge is inherently uncertain, a concerted effort was made to prove the opposite—that scientific knowledge is not only certain, but it is the only source of certain knowledge.  Because of distortions necessary to prove something which was not true, the methodology of science was dramatically misunderstood by the logical positivists. Nonetheless, this philosophy became tremendously popular, because it purported to prove both claims: science is certain, and is the only source of certain knowledge. When this became widely accepted in the early 20th century, modern social sciences were born out of an attempt to gain greater intellectual respectability for the humanities by adopting the methodology of science as it was (mis)understood by the logical positivists. (See “Origins of Western Social Sciences“). This led to a re-formulation of the humanities as “social sciences”—a set of universal laws stripped of their historical, sociological, and institutional context. Eventually, logical positivism collapsed under the weight of mounting evidence of failure on multiple explanatory fronts. However, economists never undertook the exercise of re-building the logical positivist foundations of economic theory. Methodology is treated superficially in textbooks, with the result that most economists continue to believe in the central tenets of logical positivism.

The ideas briefly discussed thus far are strongly in conflict with dominant narratives being told about economics.  I have examined these counter-narratives in more detail in Zaman (2009, 2013, 2015a). We can summarize them as follows:

  1. The dominant understanding of the methodology of science in the early 20th century was based on logical positivism, which became wildly popular for a brief period of glory, before going down in flames in a spectacular crash (see  Rise and Fall of Logical Positivism ).
  2. Modern social sciences were born in early 20th century on the basis of a conscious effort to emulate the methodology of the physical sciences, as mis-understood by the logical positivists. This attempt to mathematicise, quantify, and study general laws of motion in societies, reflected a break from the past, in which the study of social phenomena was more qualitative and historically oriented, aligned with complexities of human behavior. Hodgson (2001: 79-94) discusses the Methodenstreit, or battle of methodologies, in Germany, in which the historical and qualitative school lost to the mathematical and quantitative approach. (see Method or Madness?}
  3. The foundations of modern economics were laid in 1930s by Lionel Robbins as a science of choices subject to scarcity, replacing earlier conceptions based on human welfare. The new foundations were strongly aligned with positivist misconceptions regarding the methodology of science. Cooter and Rappoport (1984) provide an account of how the misconception of that welfare was not observable (and hence not scientific), led to the definition of “scarcity” by Robbins, which replaced earlier conceptions based on human welfare. (see the Methodology of Modern Economics)
  4. The collapse of positivism should have led to radical re-consideration of these foundations. This did occur in other areas in the social sciences. However, economists continue to use the same foundations, and continue to believe in central tenets of logical positivism. [see “Is Scientific Methodology Axiomatic ?A recent survey by Hands (2009) concludes:

So most modern economists generally consider rational choice theory to be a positive, not a normative, theory; endorse the position that normative statements/concepts should be prohibited from scientific economics; and equate normative theories/presuppositions with ethics.

Manicas (1987) and Reuben (1996) provide empirical evidence and arguments for the counter-narrative.  The idea that “science” is a special way of knowing the world, which is radically different from other types of human knowledge, continues to be firmly embedded in the Western intellectual tradition. Manicas (1987) argues that the Western conception of “science” itself is mistaken. Removing misconceptions about the nature of science could lead to a thoroughgoing revolution in received theories. In historical context, Reuben (1996) explains how the internal dynamics of the academia, coupled with the emergence of positivism, led to a re-conceptualization of the nature and function of the humanities, reformulated as the social sciences. In particular, Weber’s ([1918] 1956) influential essay led to the attempt to remove the subjectivity associated with normative and action-oriented elements of the social sciences.

The full article is embedded below

 

 

 

 

 

As I have only recently come to realize, stabilizing the exchange rate at the wrong level can have massively harmful effects. One can trace major economic tragedies to such attempts. The British attempt to go back to the gold standard after post WW1 failed because they set the level too high (as Keynes pointed out). This attempt set of a sequence of events which had far reaching consequences. A similar story is told about Pakistan in “The Rupee is falling; let it crash”. Linked article shows that overvaluation of Pak Rupee de-linked the Pakistan and Indian Economies, which may the economic root of current political hostilities. Current problems of the European Union are a more advanced version of the same problem, where the rate of exchange between European countries cannot be re-aligned according to the gaps between their imports and exports. This is a subject worth exploring further, and if readers have more pointers/articles, I would appreciate learning more about it. The article below deals with the Dutch Disease in Pakistan.

Published as “Burning Billions” in Dawn, on 18th Jan 2019

Today, we can find, fairly cheaply, an amazing variety of imports from all over the world in Pakistan: honey from Germany, vegetables from Brazil, milk from Australia, and clothing from India. The Government of Pakistan subsidizes imports of luxuries for the elites by spending billions in foreign exchange to keep the price of the dollar low. Many different economic indicators show a pattern of consistent and maintained overvaluation of the Rupee over the past several decades. In contrast, many competitors who started out behind us, like India, Bangladesh, and China, have surpassed us in exports by keeping their currencies consistently under-valued.

Long term cheap availability of imports has a well-known effect called the “Dutch Disease”.  Normally, the Dutch Disease strikes countries which are rich in resources (like oil). This makes it possible for them to earn foreign exchange cheaply, without learning how to manufacture world class exports. When the exchange rate is too low, imports are cheap, and prevent the development of local industry. At the same time, exports decline because they are too expensive on the world market. Services sector enjoys a boom because services are locally produced and have no cheap foreign imports to compete with. Over the past few decades, the Pakistan economy shows all the characteristic symptoms of Dutch disease, with deindustrialization, declining exports, increasing imports, and a boom in the service sector.

The proxy war between US and Russia in Afghanistan made massive amounts of dollars available to Pakistan, creating favorable conditions for the Dutch disease. Remittances have also been a significant source of easy foreign exchange earnings. We did not have the wise leadership required to use the availability of foreign exchange to build productive capacity in the domestic economy. Instead, we fell into the trap of building a consumer-oriented economy based on cheap imports, which is attractive in the short-run, but enormously costly in the long run.

An agricultural country imports $6 Billion worth of agricultural products, like food, raw cotton, edible oil, only because over-valuation makes it cheaper to import than to produce. The government must burn billions of dollars to maintain an over-valued rupee, enabling the wealthy to enjoy foreign luxuries.  Unfortunately, the standard sources from which we used to borrow to finance our spending spree have dried up.

The future is in our hands. We can continue to borrow, from other sources, and maintain an economy driven by consumption, and by industries which make profits by using artificially cheap imports. Or we can bite the bullet and go for the structural transformation required to create productivity in the domestic economy, which is the only route to long run sustainable growth. But there are serious obstacles in the path of the needed structural transformation. Currently, when we pump money into the domestic economy, it is channeled into imports because dollars are cheap. If the exchange rate was higher, people would demand domestic products. However, currently, those domestic products do not exist. The industries which could have come into existence had imports been expensive were never born. There is no domestic capacity to fulfill the additional demand, if it is blocked from going into foreign imports. Thus, increased aggregate demand for domestic products will only lead to inflation – increased prices of domestic goods in the desirable sectors. Contrary to common belief, this type of inflation is not harmful. In fact, high prices are required to send a signal to the domestic sectors that extra production is desirable and will be profitable. If we can sustain the policy of keeping aggregate demand in domestic products high, higher prices in the desired sectors will lead to creation of extra productive capacity and stimulate domestic industry, which is exactly what is needed.

However, there are many obstacles in the path. When the subsidy of billions of dollars for imports is withdrawn, there will be a lot of rich and powerful losers. They will demand continuation of the previous policies which created huge profits for them. The potential beneficiaries of the structural change are as yet unborn, and therefore cannot speak in favor of the change.

The challenge facing the current government is to manage the transition in a way which would minimize disturbances to the masses, and provide social support to those who need it the most. The greatest dangers come from the privileged classes, accustomed to extracting revenues without having to work. The billions pumped into supporting the rupees end up, indirectly, in their pockets. Withdrawing this subsidy will lead to loud screams by the rich and powerful, disguised to sound as if they are coming from the people. Whether the present government has the courage t

Good practices for development need leaders who help turning ideas into action. A well-working economy needs leaders who push boundaries, innovate, and make inspirations doable. Any change needs visionaries with strong values and a bold, clear vision of a better world. This applies on both local and global scales. Theories about economy and development are just a part of the bigger scene on which the actors are the actual people with the potential to make things happen. And because people do matter—as agents of change—the contribution of those who plant hope and give inspiration should not be overlooked.

Paweł Adamowicz (1965-2019), the Mayor of Gdańsk city of Poland since 1998, was one of such great leaders. His successful management that turned Gdańsk into an important business centre in the Baltic Sea region, efficacy, passion and the love for people he served granted him popularity. The many accomplishments of his office include the development of a modern transportation and business infrastructure, and civil budget. Adamowicz promoted an economy that protects local business, but is also open to international investors and working force from abroad, welcoming immigrants. He was not shy of bold visions. Before his sixth, and last, reelection as the Mayor of Gdańsk in 2018, he envisioned his city—which he called “the city of freedom and solidarity”—as the most important port in the Baltic Sea, a goal that he wanted to pursue during his most recent post. Adamowicz was also known for his openness and respect for people across divisions and borders such as nationalities and gender. In many ways, this local Pomeranian leader embodied values of global development, global justice, and civil society. These values and visions made liberal Adamowicz also a controversial figure on a strongly divided Polish political scene.

On January 13, 2019, Mayor Adamowicz was stabbed during the finale of the biggest national charity event, The Great Orchestra of Christmas Charity (GOCC).* He was on the scene for the opening of the GOCC’s concert in Gdańsk. The assailant, Stefan W., was a 27 year-old man with a history of instability, violence, and assaults. The motives were, allegedly, a mix of a political vendetta against the Civil Platform party to which Adamowicz once belonged, and personal reasons, which remain unclear. After being stabbed multiple times resulting in serious injuries, Adamowicz underwent 5 hours of surgery. He died on January 14, leaving a mourning family and his people. Gdańsk lost a leader of great charisma and power to make things happen.

To many, the assault on Paweł Adamowicz is not a discreet event. It is more a representation of a deeper friction in society, reflected in hateful attitudes towards different orientations (be it political, sexual, national, or the like), lack of accountability in social media and public space that allows for the language of hate and destruction, and the propagation of vengeance rather than peace. But in the midst of such tragedy, beautiful things happen that give hope and inspire to development–personal and societal alike. The deputy of the Mayor Adamowicz for social affairs, Piotr Kowalczuk, reached out to the mother and family of Stefan W. offering them support. Such a gesture reminds us of the power of humanism and peace that stands with the legacy of the Polish pope Jean Paul II.

In the dawns of such a tragedy like the murder of a great leader, it is necessary to take a stand. And so this is a stand against hatred and ideological divisions that create mindsets capable of unspeakable crime. But more importantly, it is a stand for peace, solidarity, and responsibility. It is also an invitation to cultivate positive leadership, good practices, and bold visions of a better future. There are always plenty of reasons to criticize and improve economic theories and existing practices. But we should not lose from sight all the greatness around us that is nevertheless happening. With this tribute to Paweł Adamowicz, I invite you to acknowledge and share the goodness that comes from, and is inspired by, great leaders and good practices in your region.

The memory of Paweł Adamowicz has also a moral for teaching students. An economy that embodies the values of justice, civil society, and solidarity is a building block of global sustainable development and peace. We tend to look at the bigger picture, a perspective from which we can easily spot flaws. But the local level is the level where things happen on a day-to-day basis. While many of the great actors are not visible or recognized in the bigger picture, local governance, local leaders, and local community is what gives shape to universal, global ideals. Development goes hand in hand with a democratic mindset and institutions, a lesson learned from the real-world example of the work of Paweł Adamowicz in Gdańsk. The assault on these values should not be an excuse for creating more hatred and divisions. It should be an encouragement to carry on the legacy of our great leaders, and to act together for change.

 

 

* The Great Orchestra of Christmas Charity (GOCC) was founded in 1993. The foundation uses the collected donations to purchase the most modern equipment for hospitals that treat children. Over almost a quarter of a decade, the GOCC contributed with modern equipment to all hospitals for children in Poland, and to many other medical facilities. The initiator of this popular and trusted NGO is Jurek Owsiak, who resigned from his function of the Chairman of the GOCC after the attack on the Gdańsk Mayor. Owsiak has just been nominated for the Nobel Peace Prize 2019.

A decade after the 2008 global crisis, some key trends can be highlighted: a) There has been a shift to defined contribution (DC) pension plans, b) The increasing role of alternative assets, such as private equity, among pension assets.

Many governments in OCDE countries have been committed to structural reforms in labour markets and pension plans. As a result, the current era of austerity has deep impacts on the diversification of types of pension plans. According to a 2018 OCDE  report, in a mandatory pension plan, a) employers setup a plan for their employees, b) employees contribute to a state funded pension scheme or c) employees contribute a private pension fund of their choice.  In a quasi-mandatory, employers need to setup a pension plan as a result of labour agreements. In some OCDE countries, there are automatic enrolment programs at the national level where employees have the option to opt out of the plan under certain conditions.

In this setting, a recent PwC report warned that government-incentivized or government-mandated retirement plans turns out to privilege the use of defined contribution (DC) pension plans -such as the United States. In a defined contribution (DC) pension plan the employer, the employee or both make contributions on a regular basis in individual accounts. As  matter of fact, after the global crisis, the traditional occupational defined benefit (DB) pension plans have been losing ground in many countries, such as Australia, Iceland, Israel, the Netherlands, Mexico, New Zealand, Sweden and the United States. Besides, the increase in life expectancy result in longer periods of benefit payments to retirees for DB pension funds for a given retirement age (OECD, 2017).

The shift to occupational defined contribution (DC) plans seemed to be associated with pension underfunding. In this setting, lower discount rates used to value liabilities (as a result of quantitative easing policies) have been important factors to rethink the financial sustainability of pension funds. Indeed, the continuity of liquidity-driven monetary policies and a decline in the long-term interest rates have affected not only the expectations on profitability of pension funds, particularly in those portfolios where income-fixed assets predominate, but also the valuation of liabilities. In this scenario, the portfolio performance has been stimulating the search for alternative assets.

Table 1 shows the evolution of contributions and benefits in DB plans as of 2017. Many factors drove the evolution the funding ration and the asset- liability management of DB pension plans: a) low interest rates, b) composition of assets, c) number of members and wages, d) benefits paid, e) age structure of members, f) aggregate price level.

 

Table 1.  DB pension plans: contributions and benefits in OECD selected countries, 2017, in %

 OECD Countries Contributions Benefits
New Zealand 18.3 -23.3
Iceland 9.6 -13.0
Norway 8.4 -3.6
Switzerland 8.3 -5.0
Germany 7.7 -5.0
Spain 5.6 -7.9
Canada 5.2 -5.4
Portugal 4.6 -3.3
Indonesia 4.6 -8.3
Belgium 4.0 -2.8
Netherlands 3.9 -3.3
Namibia 3.8 -3.0
Guyana 3.3 -2.6
Finland 2.5 -3.5
Denmark 1.6 -3.5
Costa Rica 0.5 -7.4

Source: OECD

Ten years after the global crisis, the funding ratio of occupation defined benefit (DB) pension plans was below their pre-financial crisis levels in most of the OECD reporting countries. However, in Iceland, Indonesia, Mexico, the United Kingdom and the United State the funding ratio had already been below 100% for several years. Therefore, one of the main issue at stake is the path of evolution of benefits and contributions in different types of pension plans and how this evolution may affect the financial sustainability of pension funds.

Considering this background, pension funds´ managers have been searching for alternative investments outside of traditional stocks and bonds. The 2017 Preqin Alternative Assets Performance Monitor also highlights that pension funds (public 30%, private 15%) are increasingly allocating more of their assets to PE today. In truth, between 2008 and 2017, most of pension funds (public and private of all sizes) in developed markets had expanded their allocations to alternative asset classes from 7.2% of assets under management in 2008 to 11.8% in 2017. In emerging markets, on average, pension funds increased their alternative investments from 0.97% in 2008 to 6.6% in 2017. In the past 10 years, pension funds reported median net returns in their private equity allocations ranging between 7.5% and 11.5%. These returns have been above those obtained for fixed income, listed equity, hedge funds and even real estate assets.

Alternative investments like private equity assets might prove to be controversial choices for pension funds because of the PE governance historically focused on the extraction of short-term returns in private companies. At the heart of our argument is that the capital accumulation process involves social relations driven by profit and competition. As the private equity investors´ motive is not growth per se, but value extraction, the social losses in terms of unemployment, working conditions, workers´ rights and income distribution could be relevant.

 

 

 

 

 

 

Let us start with Five Fundamental propositions, which would be startling to the general public, but familiar to my current audience of heterodox economists.

  1. Mainstream modern economic theory is complete garbage. This is true of Micro, Macro, Econometrics, Trade, Monetary, Industrial Organization — EVERYTHING.
  2. It is very EASY to prove this assertion. Fundamental principles on which the entire discipline is built are easily proven to be wrong. The axiomatic theory of human behavior encapsulated in homo economicus has no match to real human behavior. The theory of perfect competition devised to explain prices and markets has no relation to the realities of oligopolies, multinationals, excess production, and shaping of demand by advertisements and culture. The welfare theory implicit in maximization of lifetime utility is exceedingly harmful to our human welfare, which comes from social associations and character traits, rather than excess consumption. The optimization/equilibrium methodology is a complete failure. Humans do not and cannot optimize; they lack the information required to do so. Dynamic systems cannot be understood by looking at their equilibria. Standard econometrics techniques can be used to prove anything at all, given any data. In any place you look, the theory is flawed beyond belief. The young earth theory, as well as the flat earth theory are more defensible, in comparison.
  3. Many leading economists are aware of the astonishing conflicts between economics and simple facts of observation. See Quotes Critical of Economics for a choice collection of quotes to prove this assertion.
  4. The Global Financial Crisis of 2007 created widespread public awareness of this catastrophic failure of Economics. The Queen of England went to London School of Economics to ask why no one saw this coming. The US Congress appointed a commission to study why economists not only did not foresee the crisis, they confidently predicted that such an event could not happen.
  5. What is most amazing is the (lack of) response of the Economics Profession to the Crisis. As documented by many, there has been NO response. The same old theories which failed miserably continue to be taught the world over. Teachers continue to believe in, and preach, the same sermons which led to global disaster. Students continue to be indoctrinated into the same poisonous doctrines which ruin our own personal happiness, and destroy possibilities of building a good society. The same ARCH/GARCH models which failed to predict the volatility of stocks in the GFC continue to be used. The same monetary policies which led to the crisis and could not prevent the Great Recession which followed are lauded and praised, and continue to be practiced. There seems to be increasing general awareness of this failure of the profession as a whole; see, for example,  “Economics: The Profession that Refuses to Change”.

In light of the five propositions listed above, there are two major tasks that emerge as important for the heterodoxy. One of the tasks is to prove the truth of the five propositions. This is generally where most of the effort is being made. The present post also deals with this same issue — how to prove the five propositions listed above. One way to do so is to read the article on “Trouble with Macroeconomics” by Paul Romer, which is summarized below.

However, I believe that the SECOND task, not undertaken here, is much more important, as well as greatly neglected, and not well understood. We must reflect on the nature of a world where lunatic asylum class theories are propounded at leading universities throughout the world, and taught to the brightest (but innocent) students who come to believe them.  What is the nature of knowledge? How do we come to believe in ridiculous theories? How is knowledge transmitted from generation to generation? Very serious meta-questions about all of these issues arise, which must be studied seriously and deeply in order to be able to craft a coherent response to the state of affairs summarized in the five points above. When talking among ourselves, as in this blog and the RWER blog, it is not worth repeatedly re-establishing the five propositions. Rather, we should take these five as axiomatically agreed upon, and proceed to the more difficult tasks that emerge in terms of understanding a world where bright people can be convinced of absurdities, and how we can undo this damage. I will defer this task to a later date (although many of my earlier posts do deal with many different aspects of this issue which require study), and study the article of Paul Romer below.

Paul Romer, recent Nobel Prize winner in economics, wrote “The Trouble with Macroeconomics” which contains a devastating critique of modern macroeconomics.  In particular, Romer writes that modern macro got started when Lucas and Sargent wrote that predictions based on Keynesian economics “were wildly incorrect, and that the doctrine on which they were based is fundamentally flawed”. But after three decades of research, during which the profession has gone backwards, losing hard-won insights into the nature of the economy, exactly the same criticism can be leveled at modern macro theories — they give wildly incorrect predictions and are based on fundamentally flawed doctrines, beyond the possibility of repair. The LAST section of the paper is the most interesting — Romer asks why he is unique in making such a strong critique, basically saying all of modern macro is complete nonsense; others have voiced sharp critiques but stopped short of saying what Romer has said. He says that this is due to the extreme pressure in the profession to conform, and to kow-tow to the mainstream. While others major economists privately agree to his views, they cannot afford to say so in public, because of the serious damage it would do to their careers.  A Video lecture which provides a coherent summary is linked here

Below I pick out some choice quotes from the paper which also provide an outline of the contents of the paper, for those with insufficient time to watch the video-lecture. My own interpolations and explanations are italicised and enclosed in double square brackets [[ ]] below — Other material is direct quotes from the paper itself.

Paul Romer: The Trouble With MacroEconomics

For more than three decades, macroeconomics has gone backwards

Macroeconomic theorists dismiss mere facts by feigning an obtuse ignorance about such simple assertions as “tight monetary policy can cause a recession.” Their models attribute fluctuations in aggregate variables to imaginary causal forces that are not influenced by the action that any person takes

[[Modern macro started with the Lucas critique of incredible identifying assumptions used in econometric models, but, after thirty years of work instead of progress, there has been regress]] Canova and Sala (2009) signal with the title of a recent paper, we are now “Back to Square One.” Macro models now use incredible identifying assumptions to reach bewildering conclusions.

[[Romer finds it incredible that a leading macroeconomist would feign ignorance about effects of monetary policy]] To appreciate how strange these conclusions can be, consider this observation, from a paper published in 2010, by a leading macroeconomist:
… although in the interest of disclosure, I must admit that I am myself less than totally convinced of the importance of money outside the case of large inflations.

Macroeconomists got comfortable with the idea that fluctuations in macroeconomic
aggregates are caused by imaginary shocks, instead of actions that people take, after
Kydland and Prescott (1982) launched the real business cycle (RBC) model.

In this [RBC] model, the effects of monetary policy are so insignificant that, as Prescott taught graduate students at the University of Minnesota “postal economics is more central to understanding the economy than monetary economics” (Chong, La Porta, Lopez-de-Silanes, Shliefer, 2014).

[[After discussing an episode of tightening of monetary policy by the FED]] If the Fed can cause a 500 basis point change in interest rates, it is absurd to wonder if monetary policy is important. Faced with the data in Figure 2, the only way to remain faithful to dogma that monetary policy is not important is to argue that despite what people at the Fed thought, they did not change the Fed funds rate; it was an imaginary shock that increased it at just the right time and by just the right amount to fool people at the Fed into thinking they were the ones who were the ones moving it around.
To my knowledge, no economist will state as fact that it was an imaginary shock
that raised real rates during Volcker’s term, but many endorse models that will say
this for them

Macroeconomists got comfortable with the idea that fluctuations in macroeconomic
aggregates are caused by imaginary shocks, instead of actions that people take, after
Kydland and Prescott (1982) launched the real business cycle (RBC) model. The real business cycle model explains recessions as exogenous decreases in phlogiston (an unexplained residual).

The noncommittal relationship with the truth revealed by these methodological
evasions and the “less than totally convinced …” dismissal of fact goes so far beyond
post-modern irony that it deserves its own label. I suggest “post-real.”

Once macroeconomists concluded that it was reasonable to invoke an imaginary
forcing variables, they added more. The resulting menagerie, together with mysuggested names now includes:
• A general type of phlogiston that increases the quantity of consumption goods
produced by given inputs
• An “investment-specific” type of phlogiston that increases the quantity of
capital goods produced by given inputs
• A troll who makes random changes to the wages paid to all workers
• A gremlin who makes random changes to the price of output
• Aether, which increases the risk preference of investors
• Caloric, which makes people want less leisure
With the possible exception of phlogiston, the modelers assumed that there is
no way to directly measure these forces. Phlogiston can in measured by growth
accounting, at least in principle. In practice, the calculated residual is very sensitive
to mismeasurement of the utilization rate of inputs, so even in this case, direct
measurements are frequently ignored.

To allow for the possibility that monetary policy could matter, empirical DSGE
models put sticky-price lipstick on this RBC pig. The sticky-price extensions allow
for the possibility that monetary policy can affect output, but the reported results
from fitted or calibrated models never stray far from RBC dogma. If monetary policy
matters at all, it matters very little

FWUTV: Facts with unknown truth value [[Romer shows that in order to identify parameters, we feed in lots of arbitrary assumptions — which he calls FWUTVs — into the model. Shows several specific examples of this in action. Lucas critique said that use of arbitrary assumption to identify econometric models made estimates unreliable. However, their techniques introduce even more arbitrary assumptions to identify their models.]] “Post-real macroeconomists have not delivered the careful attention to the identification problem that Lucas and Sargent (1979) promised. They still rely on FWUTV’s. All they seem to have done is find new ways to fed in FWUTV’s ”

[[Romer explains how identification is achieved by hiding the assumption within a maze of mathematics almost impossible to track down, and never made explicit. He provides a specific example where an assumption the E log u = 0, about an unobservable error creates identification. Assumptions on unobservables are hard to spot, and harder to challenge, since they are, after all, unobservable — hence the term FWUTV. Another way to achieve identification is via Bayesian priors. You can put anything you like into the priors, which are arbitrarily chosen, and achieve identification. This section reminds us of the following Keynes quote: Too large a proportion of recent “mathematical” economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols. GT Book 5, Chapter 21,Section 3, p. 298  

Romer shows how members of the Chicago school support each other, even in face of conflicting evidence known to them. He explains the sociology of knowledge, how the publications process ensures loyalty. He explains that he is free of the constraints, and therefore free to express his deep dissent, because he is no longer operating within an Academic environment: “Parenthetically, it is similarly true, that I can make very bold attacks on economics and economists ONLY because my pay, promotions, publications are no longer dependent on how professional economists in the USA evaluate me.” Those operating within the Western academia find that severe penalties are imposed upon them if they dare to step outside the boundaries of permissible dissent. ]]

Back to Square One: I agree with the harsh judgment by Lucas and Sargent (1979) that the large Keynesian macro models of the day relied on identifying assumptions that were not credible. The situation now is worse. Macro models make assumptions that are no more credible and far more opaque.

[[Romer argues that the Chicago School criticized Keynesian harshly for failing to predict stagflation. However, the Lucas prophecy that there would be no more recessions is an even more dramatic prediction failure.]] ” what Lucas and Sargent wrote of Keynesian macro models applies with full force to post-real macro models and the program that generated them: That these predictions were wildly incorrect, and that the doctrine on
which they were based is fundamentally flawed, are now simple matters of fact …
… the task that faces contemporary students of the business cycle is that of sorting through the wreckage …(Lucas and Sargent, 1979, p. 49)”

Some economists counter my concerns by saying that post-real macroeconomics is a
backwater that can safely be ignored; after all, “how many economists really believe
that extremely tight monetary policy will have zero effect on real output?”
To me, this reveals a disturbing blind spot. The trouble is not so much that
macroeconomists say things that are inconsistent with the facts. The real trouble is
that other economists do not care that the macroeconomists do not care about the
facts. An indifferent tolerance of obvious error is even more corrosive to science
than committed advocacy of error.
It is sad to recognize that economists who made such important scientific
contributions in the early stages of their careers followed a trajectory that took them
away from science. It is painful to say this so when they are people I know and like
and when so many other people that I know and like idolize these leaders.

Published in Dawn, 7th Dec 2018 with title: A Lopsided System

SADLY, it is true that ‘money makes the world go round’. But, it is also true that very few people understand how. This article is an attempt at explaining the basics of our global trading system.

A good starting point is the Bretton-Woods conference which took place in 1944, while the Second World War was still raging. The two World Wars had drained the treasuries of the European states, making the gold standard impossible to maintain. An entirely new system had to be created to enable global trade for the post-War era. At the Bretton-Woods conference, the most sensible proposal for the global trading system was created and advocated by John Maynard Keynes. Unfortunately, the political power of the United States enabled it to quash this proposal. Instead, gold was replaced by the dollar standard, with the proviso that dollars could be exchanged for gold.

When the Vietnam War forced the US to print an excessive amount of dollars, president Richard Nixon declared in 1971 that dollars would no longer be backed by gold, creating a brave new world of currencies without any backing. Just like a fixed exchange rate is the natural consequence of pegging currencies to dollar or gold, so too a floating exchange rate system emerges naturally when there are no pegs for any currency

Today, the dollar is at the centre of the global trading system, and is as good as gold once was. Everyone needs dollars as reserves to back up their currencies. To acquire dollars, all countries other than the US, must strive to increase exports — this is how one earns dollars. The US can increase imports just by printing dollars, while the rest of world exports goods and services to earn dollars. Because dollars are the gold of the modern financial system, the US can print money without adverse consequences. For instance, the US printed trillions of dollars to finance the Iraq war, and other trillions to bail out the financial sector from the global financial crisis that was created by it.

If we pause to reflect, the consequences of the dollar-based global trading system are truly breathtaking. Because of mutual dependencies, no one can opt out of the global trading system. Everyone within the system needs dollars, and must strive to increase exports, in order to earn dollars. Net exports cannot increase, and cannot earn dollars, unless the US increases imports. In this financial colonisation of the world, everyone must strive to pay tributes in terms of goods to the US, while the latter country prints dollars to pay for them.

For anyone who falls behind in their payments of tributes, the IMF is there to ‘help out’ by extending a loan, which puts the borrowers deeper in debt enslavement. The results of this system whereby the US prints dollars in return for tributes in real goods provided by the rest of the world are obvious in terms of the immense disparities between American levels of consumption and those of the rest of the world.

A rough measure of how much tribute has been extracted is the current level the US debt, which is $21tr. About $15tr of this total amount has been acquired since 2000. As a benchmark for comparison, note that the world GDP, excluding the US, was around $60tr dollars in 2017. Many more details are required for a more accurate calculation of benefits which accrue to the US due to this dollar-based global trading system, which requires all of us to work hard at increasing exports, while the US printing presses work hard to print dollars to pay for them.

What can be done to replace this immensely lopsided and unjust global trading system, which gives tremendous benefits to the US at the expense of the rest of the world? The first opportunity was lost — rather, suppressed — when Keynes’ proposal for a symmetric trading system was rejected at the Bretton-Woods conference. Keynes’s original proposal continues to be attractive to this day, but many new ideas for how to structure global trading have also emerged over the past few decades.

There are two main concepts at the heart of all such proposals, which differentiate them from the current system. In any fair trading system which treats all countries equally, the target for all countries would be to balance exports and imports. The second concept is to place the burden of adjustment on countries with excess exports as well as those with excess imports. This is more equitable than the current system which places all the burden on the weaker country. With the emergence of China and the European Union as major players, the time is ripe for the demise of the dollar. With multiple centres of economic power, we may hope for a transition to a more equitable global trading system.