Thursday, June 23, 2011

A Serious Scholar Disagrees

Over at the excellent Anti-Dismal Blog, Paul Walker raises important criticisms of my Monday post this week on Lost Legacy, (HERE):

“The neoclassical model”

‘When discussing The Emergence of Capitalist Economics II at the Adam Smith's Lost Legacy blog, Gavin Kennedy writes
[...] we are treated to an account of the usual Ricardian corn model, regarded by some economists as illustrative of the inner workings of a capitalist economy, upon which the seeds of the profession’s love affair with models were planted in 1817.

YHT also link Adam Smith to the problems with which the corn model is lined up to discuss and which the late 19th-century mathematical school went on to separate economics even further from the real world, leading to the fantasies of General Equilibrium and much of microeconomics as we know it today.’

Paul Walker: I find myself asking, if GE and much of microeconomics is just a bunch of fantasies, how did we come to these fantasies? If we assume, as economists normally do, that those like Ricardo, J S Mill, Marshall, Jevons, Menger, Walras, Knight and many others, who developed the neoclassical model were not stupid, then why does neoclassical economics look the way it does, there has to be a reason. Ether I'm wrong and all these economists were just morons as many critics seems to suggest or they were rationally attempting to answer some question. So, if neoclassical economics is the answer, what was the question? This is something those who just want to complain about microeconomics don’t ever seem to ask. And even less answer.


Comment
Fair enough, but I would suggest, humbly, that Paul misses my point (I cannot speak for other critics of neoclassical economics).

It is not that the neoclassical models were wrong, given their assumptions, or that their designers were ‘just morons’. Far from it; they were among the brightest minds of their respective generations. It’s just that they were asking the wrong questions. Their work (and it was hard work) was to ask how a perfectly competitive economy worked abstracted from all human distractions that could not be incorporated in the models.

This was the reverse error that shaped the thinking of the old classical mercantile political economists, whom Smith severely criticised in WN. Specifically, they ignored in their speculations about the damaging roles of imports, that the common politics of all of Britain’s nation state trading partners was one imbued by the existence of ‘jealousy of trade’, linked to the dynastic insecurities of the monarchical governments in Europe (within which primogeniture both fed and projected their insecurities).

Monarch’s proved title to their vast properties and income by primogeniture and others challenged their title through normal changing events in passing generations. Mercantile political economy did not create jealousy of trade; it was jealousy of trade (for all its reasons) that created mercantile political economy. Each nation was ‘threatened’ by every other nation, and the mercantile state threatened ever other nation, forming and dissolving temporary alliances to suit events.

Here the search for proofs of perfect competition reached their final success in the proof of General Equilibrium; but the mathematical world it identified corresponded to no known – or knowable –world in which human beings did or could exist.

‘Paul Walker’: 'I would argue there are two possible answers to my question: one theoretical, the other empirical.'

‘From the theoretical side as has been pointed out by Demsetz (1982, 1988a and 1995) the fundamental preoccupation of neoclassical economists is with the market and the price system and hence little, or no, attention gets paid to either the firm or the consumer as separate, significant, economic entities. Firms and consumers existed as handmaidens to the price system.’

In Demsetz's view the interest in the price system, culminating in the "perfect competition" model, has its intellectual origins in the eighteenth-century debate between free traders and mercantilists. Butler (2007: 25-6) briefly sums up mercantilism in the following way:

[...] it measured national wealth in terms of a country's stock of gold and silver. Importing goods from abroad was seen as damaging because it meant that this supposed wealth must be given up to pay for them; exporting goods was seen as good because these precious metals came back. Trade benefited only the seller, not the buyer; and one nation could get richer only if others got poorer. On the basis of this view, a vast edifice of controls was erected in order to prevent the nation's wealth draining away - taxes on imports, subsidies to exporters and protection for domestic industries. [...] Indeed, all commerce was looked upon with suspicion and the culture of protectionism pervaded the domestic economy too. Cities prevented artisans from other towns moving in to ply their trade; manufacturers and merchants petitioned the king for protective monopolies; labour saving devices such as the new stocking-frame were banned as a threat to existing producers.

The free trade versus mercantilism debate was, to a large degree, about the proper scope of government in the economy and the model it gave rise to reflects this. The question implicitly at the centre of the debate was, Is central planning necessary to avoid the problems of a chaotic economic system? The mercantilists would (surely) answer "yes" but Adam Smith famously answered "no".

‘Smith [ ... ] realised that social harmony would emerge naturally as human beings struggled to find ways to live and work with each other. Freedom and self-interest need not lead to chaos, but - as if guided by an 'invisible hand' [GK: Smith never used the IH as a simile] - would produce order and concord. They would also bring about the most efficient possible use of resources. As free people struck bargains with others - solely in order to better their own condition - the nation's land, capital, skills, knowledge, time, enterprise and inventiveness would be drawn automatically and inevitably to the ends and purposes that people valued most highly. Thus the maintenance of a prospering social order did not require the continued supervision of kings and ministers. It would grow organically as a product of human nature.
(Butler 2007: 27-8.)'

GK Comments: Butler imposes a somewhat idealist gloss on Smith’s more down-to-earth realism about the ‘prospering social order’. Sure, the social order did not require ‘the continued supervision of kings and ministers’ and noted that their ‘continued supervision’ was a drag on prosperity, but neither did he consider that ‘natural liberty’ was necessary or sufficient for progress towards opulence (as he told Dr. Quesnay in WN); in fact the saw the reforms he recommended on their own merits and not as some sort of economy-wide imperative.

I would also suggest that the sentence: ‘As free people struck bargains with others - solely in order to better their own condition - the nation's land, capital, skills, knowledge, time, enterprise and inventiveness would be drawn automatically and inevitably to the ends and purposes that people valued most highly’ puts a modern gloss on Smith’s thinking; his objectives were much more localised to the world as he knew it. He was not in the prophesising business. And ‘the ends and purposes that people valued most highly’ leaves much scope for modern market distortions (Bubbles, False Accounting, Cartels, Scarcity Manipulations, Pollution, etc.) that may also serve private-ends intentionally, but may also have unintentional social disbenefits.

Paul Walker:

For Smith, markets are the most prominent mechanism for solving the problems of coordination and motivation that arise with interdependencies of specialisation and the division of labour. Market institutions leave individuals free to pursue self-interested behaviour, but guide their choices by the prices they pay and receive. For economists, the 200 years following Smith involved a search for conditions under which the price system would not descend into chaos.

[GK Comments: Smith also recognised that other factors guided individuals; indeed, that was the actual point that he made about the ‘invisible hand’: some but not all merchants were led (‘by an invisible hand’) in the form of their insecurity about the evident risks of foreign trade to invest in ‘domestick industry’ and suggested, but did not identify, many other examples of similar non-price driven behaviour (WN Book IV.ii. 1-9).] Smith was no single-track ideologue.]

'The formal (neoclassical) model that arose from this search abstracts completely from any form of centralised control in the economy. [For Adam Smith this would be an abstraction too far. Smith knew of the importance of institutions to the proper functioning of the market economy.] It is a model delineated by "perfect decentralisation". Decentralised insomuch as authority plays no role in coordinating resources, the price system does the work. Note that the neoclassical model is often described as one of "perfect competition" and one reason that the emphasis on the firm and the household diminished as the model developed was that the neoclassicals placed a growing emphases on the concept of market competition and thus less emphases was given to firms and households. As McNulty (1984: 240) explains "[t]he 'perfection' of the concept of competition, beginning with the work of A. A. Cournot and ending with that of Frank Knight, which was at the heart of the development of economics as a science during the nineteenth and early twentieth centuries, led on the one hand to an increasingly rigorous analytical treatment of market processes and on the other hand to an increasingly passive role for the firm." For Knight "[p]erfect competition is conditioned by the existence of a set of assumptions, the most important of which are the following: (1) "a perfect market for productive services [ ... ], that is, uniform prices over the whole field" (1921[a], 316); (2) complete rationality and perfect knowledge by free and independent individuals; (3) "perfect mobility in all economic adjustments, no cost involved in movements or changes" (1921[b], 77); (4) "virtually instantaneous and costless" exchange of commodities (1921[b],78); (5) "perfect, continuous, costless intercommunication between all individual members of the society" (1921[b], 78); (6) perfect divisibility of commodities; and (7) "an indefinitely large number of competing organizations, each of the most efficient size" (1921[a], 316)." (Marchionatti 2003: 58)'.

[GK Comments: agreed. Paul deploys and ample illustration of the neoclassical abstraction. A step forward for the perfection of the model and a clear step away from reality.]

Paul Walker comments:
Again, authority, be it in the form of a government or a firm or a household, plays no role in coordinating resources. The only parameters guiding decision making are those given within the model - tastes and technologies - and those determined impersonally on markets - prices. All parameters are outside the control of any of the economic agents and this effectively deprives all forms of authority a role in allocation. Thus the neoclassical model gives a set of sufficient conditions under which the price system alone can achieve equilibrium.

Foss and Klein (2005: 6-7) argue that there is the possibility of an empirical reason for the way the neoclassical model considers the production side of the economy, at least. In short, the relative unimportance of the firm. Until relatively recently firms were simply not a large part of the economy. So treating firms as if they were all small may have been a reasonable approximation to a large section of the economy of the time. But they also point out that such an explanation is not wholly convincing. Large firms have existed since at least the time of Adam Smith and the classical economists knew this. Mokyr (2002: 122-3) summarises manufacturing in the U.K. before the Industrial Revolution by noting that,

[...] large plants were not entirely unknown before the Industrial Revolution. For instance, Pollard (1968) in his classic work on the rise of the factory, mentions three large British plants, each employing more than 500 employees before 1750. Perhaps the most ``modern" of all industries was silk throwing. The silk mills in Derby built by Thomas Lombe in 1718 employed 300 workers and were located in a five-story building. After Lombe's patent expired, large mills patterned after his were built in other places as well. Equally famous was the Crowley ironworks, established in 1682 in Stourbridge in the Midlands (not far from Birmingham), which at its peak employed 800 employees. [...] In textiles, supervised workshops production could be found before 1770 in the Devon woollen industry and in calico printing (Chapman 1974).

Also chartered companies were well known as witnessed by Adam Smith's negative assessment of chartered companies in general and the East India Company in particular, contained in the Wealth of Nations.
'

[GK Comments: agreed. (Caveat: Smith did not condemn all ‘joint-stock companies; he found them workable when they operated in ordered sectors, such as banking and insurance, but he did object to those founded by Royal Charter for foreign trade, especially in India where the London directors’ control was week to non-existent, mostly because of the distance – a year or more each way by sea).

Paul Walker:
A more precise, and more defendable, version of the argument would be that the large, vertically integrated and diversified firm was not empirically important until recently. Thus analysing anonymous "firms" may not have been a bad approximation to the empirical realities of the time. As an approximation to "anonymous firm" production - that is, fully price-decentralised production - consider the case of rife manufacture in Birmingham, England in the 1860s,

[o]f the 5800 people engaged in this manufacture within the borough's boundaries in 1861 the majority worked within a small district round St Mary's Church. [...] The reason for the high degree of localization is not difficult to discover. The manufacture of guns, as of jewellery, was carried on by a large number of makers who specialized on particular processes, and this method of organization involved the frequent transport of parts from one workshop to another.

The master gun-maker-the entrepreneur-seldom possessed a factory or workshop. [...] Usually he owned merely a warehouse in the gun quarter, and his function was to acquire semi-finished parts and to give these out to specialized craftsmen, who undertook the assembly and finishing of the gun. He purchased materials from the barrel-makers, lock-makers, sight-stampers, trigger-makers, ramrod-forgers, gun-furniture makers, and, if he were engaged in the military branch, from bayonet-forgers. All of these were independent manufacturers executing the orders of several master gun- makers. [...] Once the parts had been purchased from the "material-makers," as they were called, the next task was to hand them out to a long succession of "setters-up," each of whom performed a specific operation in connection with the assembly and finishing of the gun. To name only a few, there were those who pre-pared the front sight and lump end of the barrels; the jiggers, who attended to the breech end; the stockers, who let in the barrel and lock and shaped the stock; the barrel-strippers, who prepared the gun for rifling and proof; the hardeners, polishers, borers and riflers, engravers, browners, and finally the lock-freers, who adjusted the working parts. (Allen (1929: 56-7 and 116-7), quoted in Stigler (1951: 192-3).)
Such a method of production would be a guide to the way production would take place under a functioning version the neoclassical model of the "firm"
.

[GK Comments: agreed.]

Paul Walker:
‘Thus whether we see the neoclassical model as a set of conditions under which the price system alone can prevent decent into chaos, more formally conditions under which equilibrium can be achieved, or as an approximation to a large section of the economy of the time, the neoclassical model makes more sense than many of its detractors would permit.’

GK Comments: To paraphrase Smith: there is a ‘lot of ruin’ possible in a market system (and long before it ceases to function effectively) which does not require to be in equilibrium to avoid ‘chaos’ because ‘chaos’ is not the opposite of equilibrium, nor a necessary consequence. Degrees of imperfection are tolerable in real world markets; they characterise them. In fact, also, given the world we live in, they are normal.

Demanding perfection in markets is an act of faith, not an assurance of science. The study of real-world markets, and the politics of societies that impinge on markets and non-market provision, is more required than class-room illusions of perfectionism, and worse, that new scores of students leave believing that the perfection-paradigm has value as policy, even though it applies nowhere and never has.

The details that Paul provides in the course of his rebuttal are infinitely more interesting and relevant to the real world than the equilibrium models developed since Smith.

Mercantile political economy persisted in basic forms long after Wealth Of Nations. Having lost one empire after 1776-83, Britain continued its mercantile policies in a second empire in India, Caribbean, Canada, Africa, Australasia, and the Pacific (until after the second world war) and its mercantile instincts continue, post-colonialism, in the protectionism in the EU and WTO. The state’s role Britain, and all other major economies, shows that all countries are more state capitalist than they are anywhere near perfectly competitive.

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5 Comments:

Blogger Tom Hickey said...

Physicist Joseph L. McCauley,'s "The Futility of Utility: how market dynamics marginalize Adam Smith" is a mathematical deconstruction of neoliberalism's interpretation of the so-called invisible hand "of Adam Smith" in terns of utility and equilibrium models.

From the abstract: "Econometrics is based on the nonempiric notion of utility. Prices, dynamics, and market equilibria are supposed to be derived from utility..... To emphasize the inconsistency of the economists' notion of 'equilibrium', I discuss both deterministic and stochastic dynamics of excess demand and observe that Adam Smith's stabilizing hand is not to be found either in deterministic or stochastic dynamical models of markets, nor in the observed motions of asset prices. Evidence for stability of prices of assets in free markets simply has not been found."

From the conclusion: "I have shown that utility generally does not exist as a function, that utility maximization is not an equilibrium condition, and therefore that price generally cannot be expected to be defined as a function of demand variables. This means that standard econometrics is wrong, inapplicable (no great surprise to anyone, presumably) and cannot form the basis for intelligently-made socio-economic policy decisions. I point out further that market models are not equilibrium models, that there is no stability either in the models nor in asset price data. The entropy can be defined, but it is never maximized in an unregulated free market. Equilibrium does not prevail, and is not a useful idea for understanding real markets.... The fact that markets operate on the basis of noise and complexity rather than on the basis of Adam Smith’s controlling/stabilizing hand means that anything can happen, including long runs of either pleasant or unpleasant events."

3:20 p.m.  
Blogger Gavin Kennedy said...

Tom

Thanks for this. The neo-classical scholars who took up mathematics Walras, Jevons were innovative, but it does not follow that they shined in the field. Maths teachers in other subjects have commented to me to the effect that the economists' 19th-century maths are primitive compared to where physics is now at.

Neo-classical economics are more ideological (even theological) than they are scientific.

Of course, Smith was not of the view that economies were necessarily in equilibrium- there was, and is, far too much noise in real world markets. He never saw the IH metaphor as extra controlling influence as modern economists have alleged - he used the metaphor to show unintended consequences were present in human society. He explained the IH metaphor's object on both occasions that he used it.

Gavin

4:31 p.m.  
Blogger Gavin Kennedy said...

Please Note: two comments from 'cuauti' posted on this topic were accidentally deleted, but I recovered them and they are posted on Friday's Blog with my comments.

Gavin

4:34 p.m.  
Blogger jcb said...

John Maynard Keynes thought that the origins of the divergence between general equilibrium theory and other approaches to economics could be traced to the debate between Ricardo and T.R. Malthus. (They were intellectual opponents and warm friends.) Keynes was sympathetic to Malthus, whom he called "The First Cambridge Economist" (Essays in Biography, 1933). Of their correspondence he wrote, in that essay:

"Here indeed, are to be found the seeds of economic theory, and also the divergent lines so divergent at the outset that the destination can scarcely be recognised as the same until it is reached along which the subject can be developed. Ricardo is investigating the theory of the distribution of the product in conditions of equilibrium, and Malthus is concerned with what determines the volume of output day by day In the real world. Malthus is dealing with the monetary economy In which we happen to live; Ricardo with the abstraction of a neutral money economy...

One cannot rise from a perusal of this correspondence without a feeling that the almost total obliteration of Malthus's line of approach and the complete domination of Ricardo's for a period of a hundred years has been a disaster to the progress of economics. Time after time in these letters Malthus is talking plain sense, the force of which Ricardo with his head in the clouds wholly fails to comprehend. Time after time a crushing refutation by Malthus is met by a mind so completely closed that Ricardo does not even see what Malthus is saying."

Malthus' developed views are expounded in his "Principles of Political Economy with a View toward Considering their Practical Application" (1820, 1836). It can be read on Google Scholar.

The success of general equilibrium theory marked the triumph of a model-based approach to economics, and a turning away from the highly empirical, comparative, evolutionary-historical approach of Adam Smith, Malthus, and other political economists. The debate over the IH is, as you say, an anachronistic reading of Smith as a believer in economic equilibrium. Incidentally, the same anachronism is perpetuated in the common reading of Malthus' theory of population as resulting in some sort of "malthusian equilibrium." As Keynes saw, the concept of equilibrium was foreign to him.

The modern origins of equilibrium theory in economics are discussed in Philip Mirowski, "More Heat than Light" (Cambridge, 1989), which I've just started.

6:58 p.m.  
Blogger Gavin Kennedy said...

JCB

Thank you for your information on Malthus, Ricardo, Keynes and Philip Mirowski. These are most helpful to myself and, I am sure, to readers.

That's the most important aspect of continuing my interest in economics without access to the daily discourses with faculty, which since I retired in 2005, I only manage to enjoy at academic conferences and in occasional correspondence with colleagues.

So, I shall order Mirowski's book and McCauleiy's (thanks to Tom Hickey's comments) and Malthus's 1820 essay, when I return to Edinburgh a week today (or read them in Edinburgh University's library).

Meanwhile, I am reading YHT's critique (its analysing the film, the Matrix ...). Its main concern at present is the theory of 'value'. I ma not sure about its focus, but there is a long way.
Gavin

8:42 a.m.  

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