Thursday, November 26, 2009

An Excellent Review of The Failings of Neo-classical Economics

In Reality Base Blog (HERE)a book review by John Gray in the London Review of Books, is reported (25 November):

Animal spirits and what else is wrong with neoclassical economics”

“A much discussed book this year has been Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by George Akerlof and Robert Shiller.

He credits Akerlof and Shiller for their evisceration of neoclassical economics for assuming at its core rational behavior of human beings—conceiving them to be a species, homo economicus, that is not us. Gray goes beyond this and points out that even if we all were homo economicus, important parts of the future are always unknowable and cannot be quantified and factored into market decisions as probabilities. A third theme of the review is the hubris of the neoclassical school in assuming that the magic beans they had discovered would work in any environment and that, indeed, no other doctrine would lead to economic abundance. Unaccountably and regrettably, these ideologues appear not to have noticed in the real world the massive contradictions to that view. A few excerpts:

. . . . The trouble with prevailing theories, in Akerlof and Shiller's view, is that they assume human beings are more rational than they actually are. 'This book, which draws on an emerging field called behavioural economics, describes how the economy really works,' they claim. 'It accounts for how it works when people really are human, that is, possessed of all-too-human animal spirits.' . . . .

. . . . If economists have failed to explain repeated crises, it is because they have interpreted economic activity through an unreal model of rational decision-making. Thinking of human behaviour in this way allows them to claim a high degree of precision for their discipline, which is presented as a kind of applied mathematics. But they have left psychology out of their equations.

. . . . The fact that markets are flawed seems novel only in the context of the economic orthodoxy that prevailed between the wars, and in the run-up to the recent crisis. It is wrong to imply, as Akerlof and Shiller do, that the classical economists believed otherwise. 'Just as Adam Smith's invisible hand is the keynote of classical economics,' they write, 'Keynes's animal spirits are the keynote to a different view of the economy – a view that explains the underlying instabilities of capitalism.' Here they are endorsing the caricature of Smith propagated by neoliberal ideologues anxious to confer a distinguished patrimony on an illegitimate intellectual offspring. . . .

If Akerlof and Shiller's grip on the history of economic thought is shaky, they also fail to grasp why Keynes rejected the idea that markets are self-stabilising. . . .

[I]n his canonical General Theory of Employment, Interest and Money (1936) he concluded that there was no way anyone could make forecasts. Future interest rates and prices, new inventions and the likelihood of a European war cannot be predicted: there is no 'basis on which to form any calculable probability whatever. We simply do not know!' For Keynes, markets are unstable less because they are driven by emotion than because the future is unknowable. To suggest that the source of market volatility is unreason is to imply that if people were fully rational markets could be stable. But even if people were affectless calculating machines they would still be ignorant of the future, and markets would still be volatile. The root cause of market instability is the insuperable limitation of human knowledge. . . . .

The central flaw of the economic orthodoxy against which Keynes fought in the 1930s was to imagine that an insoluble problem – human ignorance of the future – had been solved. The error was repeated in the 1990s, when economists came to believe that complex mathematical formulae could tame uncertainty in the murky world of derivatives. . . .

. . . . Hayek said that governments could never know enough to plan the economy successfully – a claim vindicated by the miserable record of central planning in Communist countries. At the same time, he attributed near omniscience to markets, and never doubted that if left to its own devices the economy would liquidate mistaken investments and return to equilibrium. Against this, Keynes had shown that there is no market mechanism that ensures revival; economic contraction can be self-reinforcing, and only government action can then create a way out

This is more like it. Not having read Akerlof and Shiller’s book, I cannot blindly endorse everything they may have said, but their charge against “Homo economicus”, also made regularly on Lost Legacy, and their objections to mathematical modeling of economics, which precludes humans behaving as they really are, is very welcome.

Nobody actually reading Adam Smith would conclude that humans are, or will become, rational calculating machines, or that economies are closed systems in general equilibrium, and thus predictable, let alone always prone to the working for the public good in a Dr Panglossian “best of all possible worlds”.

That markets are better, in an acceptable sense, than their alternatives is a modest requirement, as the experience of Soviet central planning and the accompanying tyranny, is adequate testimony. But that is where we start from, not where we end.

The hubris of a belief in a predictable world, and events in it, is a serious flaw in the modern “science” of economics. Smith, like the later Keynes, did not endorse the myths of predictability – hence there are few, perhaps only one or two, specific predictions in Wealth Of Nations - one being that the former British colonies in North America would be wealthier (measured by the “annual output of the necessaries, conveniences, and amusements of life” within a century of 1776).

Nor was the 20th-century re-invention of the metaphor of "an invisible hand" as a comforting assurance that whatever the moral failings, or externality-induced misery, that was inflicted by individual "merchants and manufacturers" (to which we can add some governments some of the time, and a few governments all of the time), on the rest of society, was somehow a social benefit.

It wasn't, and economics as a "science" can only delude its practitioners into believing such nonsense by denuding its "models" of human beings. This charge cannot be made against Adam Smith.

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Blogger Luis Enrique said...

"mathematical modeling of economics, which precludes humans behaving as they really are, is very welcome."

no no no no! think about a predator prey model - nothing here has foxes and rabbits "behaving as they really are" but a few simple equations can give us some important insights into population dynamics. It is not a criticism of the model that it is grossly unrealistic, it's actually more like a strength (simplicity, tractability). Think about economics in this way - it depends what the model is there to do.

If you are trying to think about the question of "whether financial markets can ever go wrong", then yes, assuming perfectly rational actors with no information problems etc. is a daft move, but that doesn't mean we cannot get insights about how financial markets work from models with perfectly rational agents with no information problems.

Problems only arise when you take a model that's only suitable for delivering such insights, and treat is as a complete description of reality. Any sensible economist should be able to navigate between the two.

10:02 a.m.  
Blogger Gavin Kennedy said...

Luis Enrique

Thank you for posting your comment.

We'll have to agree to disagree on this issue and I recgonise I am in a minority on such methodological issues.

I have read the standard works and ideas on the need for useful predictions not realism arguments, and that the approach you adopt is not necessarily totally useless.

But I am afraid the limitations of model-building through simplifying are more often left behind in practice. Homo economicus (invented in the post-1870s) leads to utterly misleading notions about how humans behave. Economics has become divorced from its principal subject matter.

What "Any sensible economist should be able to navigate between the two" is what most don't do.

"Insights" are for many economists "a complete description of reality". I have sat through enough seminars and read enough papers to know that your idealised, no doubt sincere beliefs about how economists actually work is not what happens.

For me, I am past the "problems only arise" phase under the evidence of such problems ebing endemic.

Adam Smith had much to teach us about how humans behave in the real world.


5:43 p.m.  

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