Tag Archives: reforming economics

threebooksIn our PhD Economics program at Stanford, we learnt nothing about the history of major economic events of the twentieth century. Instead, we were taught the rather arcane and difficult skill of building models. In order to analyse what would happen in an economy, we learnt that you have to construct an artificial economy, populated by rational robots called homo economicus, who behave according to strict mathematical laws. At no point in our studies were we asked to match what happens in our models with any events in the real world; it was assumed that the two always matched. This process of economic modelling permits us to provide exact mathematical answers to a vast range of questions one might ask about the economy. This is undoubtedly a powerful technique, which has earned economics the name “Queen of the Social Sciences”. Our poor cousins in political science, psychology, sociology, geography, and so on, have to study the more complex real world, and cannot offer anything comparable. Nonetheless, the power of mathematical modelling derives from the extremely unrealistic assumption that real world events and human behaviour can be predicted by mathematical formulae. Thus, the precise predictions of economists are often dramatically contradicted by real world outcomes. As Nobel Laureate Paul Krugman remarked after the global financial crisis took economists by surprise: “the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.”

My own education in economics began many years after graduate school, when I chanced across a copy of Economics and World History: Myths and Paradoxesby Paul Bairoch. Bairoch’s book challenged one of the holy cows of economic theory, that free trade is always a superior policy for all parties. Believing in free trade is a hallmark of economists — a recent survey showed that 90 per cent of economists believe in it, while only 20 per cent of the general public believe that free trade is always optimal. So it came as a shock to me when Bairoch discussed many historical episodes to show that free trade had caused harm to the less developed nations, by preventing development of industries, and also by creating unemployment. Many nations with strong industries had built them up under the umbrella of protection, contrary to free trade principles. This historical evidence was strongly in conflict with the mathematical demonstrations of superiority of free trade that I had learnt in graduate school. In bewilderment, I asked several of my mentors, very senior and respected economists, about this. I was even more surprised by the responses I received. None of them were familiar with the historical evidence, and furthermore, they did not find it relevant. They argued that if protection provided good results, then free trade would have provided even better results. The mathematical proofs were impervious to empirical evidence.

Economists do not study history because it is a record of particular events, while they search for universal scientific laws, which would be equally valid among the Aztecs and the Zulu, in the nineteenth century and in the twenty-first. I realised that the laws of economics hold only in an imaginary world populated by robots, and that to learn real economics, it was necessary to study history, which I had bypassed in graduate school. It was only after many years of detailed historical studies of real world economic events that I came to realise that nearly everything I had been taught in graduate school was wrong.

Recent historical events have shaken the faith of many true believers in free market economics. A landmark 2013 study by Autor, Dorn and Hanson, found that competition from China has destroyed jobs and lowered wages in many US industries, especially manufacturing. Contrary to economic theory, which states that the displaced labourers will find better jobs in different sectors, workers displaced by Chinese competition often went on the government dole. A large group of heterodox economists, students and laymen are becoming increasingly aware of the lack of realism, ideological bias, and lack of concern with poverty and inequality, which are hallmarks of modern economic theory. However, dissent is weak and dis-united, while orthodoxy is firmly entrenched in the halls of power. The task of creating a new economics remains as essential as it is undone. 

Newspaper article published in Express Tribune, on 25th May, 2015 Pakistan. It explains the defects of the fractional reserve banking system, and suggest switching to 100% reserve banking.

A long time ago, Ibn-e-Khaldoon noted the tendency of conquered nations to unthinkingly imitate the conquerors in all dimensions of life. After achieving freedom from colonization, the former colonies have tended to imitate or retain the colonial institutions, without reflecting on whether or not these institutions are suitable for them. In his classic, “Small is Beautiful,” Schumacher showed that appropriate technology for developing countries was often small and low-tech production techniques which empowered the people. Imitating the highly capital intensive and large scale industries of labor short capitalist countries is like trying to run before learning to walk. Today, large dams are being built all over the world at enormous financial and environmental costs, while smaller scale agile energy producing technologies which deliver quick results cheaply are being ignored. Similarly, we have retained colonial institutions which were designed to be top-down, hierarchical, and non-democratic; people being heavily taxed and exploited cannot be allowed to have a vote in the matter. Transiting to democratic institutions requires many reforms. For instance, the “police force” which maintains order by force, needs to be re-conceptualized as the police service, responsible for the security and protection of citizens.

Banking is another institution that has been copied without a cost benefit analysis. The Great Depression of 1929 was caused by a banking crisis which wiped out lifetime earnings and led to prolonged misery for millions. Stringent banking regulations prevented major crises for fifty years. Financial liberalization in the 1980’s led to the Savings and Loan crises; the bailout was more than the profits of banks for the entire century. Since the 1980’s financial de-regulation has been extended and globalized, resulting in more than 200 banking crises globally, with huge economic costs. The latest and greatest is the Global Financial Crisis of 2008, which cost trillions of dollars, and led to the highest levels of homelessness and hunger seen in the USA since World War 2. Overall, when we add up the benefits and subtract the costs of current banking systems, the net result is tremendously negative.

Many have analyzed the reasons for repeated banking crises, and found that the root cause is the fractional reserve banking system. In this system, banks holding a billion Rupees can freely create a large multiple – like five or ten billion Rupees – from nowhere. They only need to have a small fraction of the money that they create to give to lenders. The inherent injustice of a system which allows certain wealthy private parties to create money at will is hidden from public view. Henry Ford said that “It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” An inherent feature of the system is that the claims on banks are far greater than their assets. When too many depositors wish to withdraw money, there is bound to be a crisis. In the words of Lord Mervyn King, the former Governor of the Bank of England “Of all the many ways of organizing banking, the worst is the one we have today – change is I believe inevitable. The question is only whether we can think our way through to a better outcome before the next generation is damaged by a future and bigger crises.”

The excellent documentary “Inside Job” shows that Iceland was badly mauled in the GFC 2008. Financial de-regulation crashed a small stable and robust economy, due to wild and excessive lending. Iceland Bankers, utilizing their powers of money creation, expanded the money supply by a factor of twenty over the decade leading upto the GFC 2008. The bloated money supply led to soaring prices of stocks and lands, and ultimately crashed the economy. The Central Bank of Iceland found that, contrary to what is written in monetary theory textbooks, it was completely unable to control the money supply. It utilized all the tools at its disposal, including raising the discount rates to extremely high levels, but could not prevent the private banks from creating excessive money.

Chastened by the experience of helplessness, watching an impending crisis without being able to do anything about it, the Iceland government has recently formulated a plan for monetary reform. The key ingredient of the plan is that the power to create money is taken away from the private banks. The proposed system of “Sovereign Money” puts the power of money creation in the hands of a panel of specialists at the Central Bank. They would use economic theory to create money in quantities which would allow for full employment without creating inflation. Specialists can download and read the Iceland proposal for monetary reform, full of fascinating details and information about the defects of our current banking system. The question of ‘why only Iceland?” when this reform is needed everywhere was addressed briefly in my previous article on The Shifting Battleground. A much more detailed historical explanation of the power and craftiness of the financial lobby is given in the writings of Ellen Brown.

The main problems of current banking system are that it is unjust, crisis prone, and anti-growth. Private money creation leads to a rentier economy, where the largest profits are made by owners of wealth, who invest in stocks and land, and earn interest on bonds. The producers, laborers, and farmers who make up the real economy, get very little reward for their labors. Instead, rewards accrue to the financiers who provide money – created from nothing – to all the real sectors. Not only is this unjust, but it causes growth prospects to shrivel, since all investment is directed towards financial sectors, and away from the productive sectors. Studies show that growth of GDP is very strongly correlated with the amount of investment in the real sector, and in human beings. This is only natural: growth is directly tied to how much we invest in our future. Although it is radical, the Iceland Plan for monetary reform offers the possibility of a dramatic increase in real investment and real growth, very much needed today in Pakistan.

1. See also an intelligent critique of the Iceland Proposal at Re-inventing Money

2. See also my paper on “An Islamic Version of the Iceland Plan for Monetary Reform” — this extends the plan by adding the elimination of interest from the banking system.

There is widespread agreement on the proposition that people act according to their self-interest. Marx went further to suggest that people subscribe to ideologies conforming to their class interests. For example, agricultural laborers would believe in land reforms, while big landlords would believe that small farms are inefficient. Gradually the weight of strong empirical evidence has led me to understanding that this proposition is false. Large segments of the population can be brought to believe in, and act according to, ideologies extremely harmful to their self interest. As Dani Rodrik has written in How the Rich Rule, political scientists Gilens & Page found that on issues where there was a conflict between the interest of the elite and that of the public, Congress voted in favor of the elite and against the public interest. In the past, the elites have enforced their interests by the use of power. In a democratic age, the same effect is achieved by the use of propaganda. This is striking because the propaganda must convince the public to act against their own self-interest, in favor of the ruling elites. It would seem that you can fool most of the people most of the time. Here is some empirical evidence for my thesis: Read More

The Great Depression of 1929, and now the Great Recession following the Global Financial Crisis, poses several puzzles for economists. One is them is the sudden and severe drop in aggregate demand. This leads firms to curtail production, and therefore reduces demand for factors of production, most importantly labor. Why does aggregate demand fall, and why do not the price adjustment mechanisms restore equilibrium? The outstanding contribution of Atif Mian and Amir Sufi in House of Debt (see my Review & Summary) is to explain both why aggregate demand fell and also why the standard price adjustment mechanisms fail to restore equilibrium. The correct explanations have eluded famous economists like Keynes, Friedman, Lucas and many others . Only after understanding the reason for the shortfall in aggregate demand does it become possible to prescribe a remedy.

(see also discussion following repost on RWER Blog)
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{Short Link for THIS post: ;  Published in Express Tribune on 27 April 2015}. Summary below has been updated to include an additional point — the double movement of Polanyi — on 3 September 2016

An earlier post by Madi provided an introduction to Polanyi’s classic work The Great Transformation. This book is crucial to understanding both HOW and WHY we need to re-structure economic education today. Unfortunately, the book is quite complex, a bit dry and technical at times, and consequently hard to follow. Although many leading economists have praised it, I did not see any glimmer of understanding of its central arguments anywhere in orthodox arena. Even among heterodox economists, it is not frequently mentioned or cited.

Mostly for the purposes of understanding it for myself, I set out to write a compact summary of the key arguments in the book. The central theme of the book is a historical description of the emergence of the market economy as a competitor to the traditional economy. The market economy won this battle, and ideologies supporting the market economy won the corresponding battle in the marketplace of ideas. I quote from the introduction of my article:

The market economy has become so widespread that it has become difficult for us to imagine societies where the market does not play a central role. Yet, for reasons to be clarified in this article, this is the need of the hour. The unregulated market has done tremendous damage to man, society and nature. Bold, imaginative steps to find alternative ways of organizing economic affairs in a society are essential to our collective survival.

Below is a revised and updated version of the ORIGINAL POST. This revision below include some new information, and also provides some clarification of some common confusions related to original post:
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Karl Paul Polanyi (1886 – 1964)  is known for his opposition to traditional economic thought and his book, The Great Transformation.  The Great Transformation was written in the interwar years but not published until 1944. Polanyi is known for his opposition to the emerging Austrian school of formal economic method. Methodologically, the Austrian free-market group of economists, that included Ludwig von Mises, defended abstract quantitative economic models based on the assumption of Homo oeconomicus.  The associated policy recommendation fosters market liberalism. The “natural” free markets without state intervention would function efficiently.

Polanyi’s critic is oriented to the Homo oeconomicus – all-knowing self-interested decision maker that maximizes choices combining considerations of opportunity cost, marginal utility and price. His critique is also oriented to the free markets as a “natural” setting.

Indeed, Polanyi is remembered today on behalf of his cultural approach to economics which emphasized the way economies are historically embedded in society and culture. This view ran counter to mainstream economics but has been popular in anthropology, economic history, economic sociology and political science.

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from Jack Reardon

A spirited debate on the reformation of economics education is welcomed and necessary. I am thrilled to participate in it. The key word is education: we need to educate our students and the public, rather than proselytize, which unfortunately is too often the modus operandi of neoclassical economics. Proselytization is little different from bullying and no better example of this was written by Edward Fullbrook as a chapter in my book (Handbook of Pluralist Economics Education) and has circulated on the internet. Education is our most important endeavor as human beings: t is absolutely necessary for ourselves, our planet and the future generation.

While I think we are agree on the need to educate rather than proselytize, a much more difficult question is what is education and what does it mean to educate? And a related question is what should we be teaching our students. To answer the first question, I believe the key to education is to foster doubt about existing institutions- why are they structured as is? Who benefits? Where is the locus of power? Can the existing situation be improved for all rather than the select few? Another key in education is to foster humility and respect for other views. This doesn’t mean we must agree with everyone; on the contrary, disagreement (and doubt) is necessary for the advancement of knowledge.

The goal of reforming economics education is too important to exclude either specific beliefs or a specific modus operandi. We should welcome all suggestions, and all blueprints for change, from the barely nudging to the radical reformation. A pluralist tent for reforming economics education should be broad enough to harbor all views. To exclude any one view is to mirror the myopic and self-defeating practice of neoclassical economics.

We have much to learn from each other and I don’t want to limit my own learning by restricting who I can dialogue with. I view the above distinction as artificial and counter-productive. Instead I view the comments as different degrees of the same objective: the reformation of economics education.