Tuesday, April 29, 2008

Review of neo-classical economics

This link has a good review and critique of the neo-classical economics. As you read it, you feel like taking a review course on economics, starting right from the time of Adam Smith. Not a whole lot of new stuff but it is refreshing.

Keynes vs. Friedman:

The greatest challenge was posed by the unprecedentedly severe and long lasting depression in the US economy from 1929 onwards. The laws of Neo-classical Economics required cut in wages to cut costs and create profits, which would stimulate business and raise the economy out of trough. But this did not happen. On the other hand cut in wages reduced demand and deepened depression. Market did not provide an automatic correction and public intervention on a massive scale in the shape of President Roosevelt’s New Deal Programme became necessary.

It is against this background that J.M. Keynes came out in 1936 with his “General Theory of Employment, Interest and Money”. He presented a new theoretical construction. He moved from micro to macro and focused attention on Aggregate Demand and Aggregate Supply. Aggregate Demand and Aggregate Supply could be in equilibrium but at less than full employment level. For the economy to be lifted to equilibrium at full employment level, public authorities would have to stimulate aggregate demand by augmenting investment and consumption. Inducement to invest and propensity to consume are the dynamic elements in the economy which have a multiplier effect. These new concepts and insights came like a breath of fresh air ushering in what came to be known as the “Keynesian Revolution”.

...But World War II intervened and the economic stimulus provided by the war effort absorbed unemployment. On the other hand, demands for war supplies created scarcities and inflationary pressures, which continued even after World War II. Keynesian remedies, that is, fiscal policies in reverse were required to cut public expenditure and curb excessive investment and consumption. Instead, Keynesian economics was held responsible for inflation. The centre of gravity shifted from fiscal to monetary remedies. Under the leadership of Milton Friedman emerged the Chicago School which debunked Keynesian economics and returned to orthodox economics and its remedies and focused on inflation rather than employment.If inflation is curbed through a steady money supply, flexible labour market, cut in wages, control over TU demands and curtailment of social benefits of a welfare state, free market would take care of the economy. The sole function of the Central Bank of a country should be to keep a stable money supply and prevent the emergence of inflationary pressures. If there is still some amount of unemployment, it should be treated as “natural unemployment” which was bound to exist in any economy. Thus, to the old concepts of “frictional unemployment” and “structural unemployment” was added “Natural Rate of Unemployment” (NRU).

Development Economics:

...While economists like Rauel Prebisch of Argentina advocated the strategy of import substitution, which was followed by a country like India, others like South Korea followed the strategy of export promotion.In both models, it was recognised that entrepreneurial activity needs judicious state support. Through a combination of visionary government and entrepreneurial activities, Singapore has risen rapidly to a level higher than that of many European countries.

...A number of textbooks were written—such as W.A. Lewis’s Theory of Economic Growth, or Kindleberger’s “Economic Development”. But orthodox economists like Peter Bauer rejected any special category of “Development Economics”.

...The first amongst the models of development was the “Harrod Domar Model”—investment rate divided by capital-output ratio determines the rate of growth. Robert Solow’s 1956 article emphasised the role of technology for long-term growth. Papers by Robert Lucas (1988) and Paul Romer (1986-1990) focused on human capital (stock of knowledge) and technological innovation respectively. A paper by Arvind Dixit and Joseph Stiglitz (1976) drew attention to the role of differentiated products and increasing returns to scale. Paul Krueger emphasised the role of geographical clusters, education, research and innovation in boosting productivity and growth. In addition to traditional, physical capital of machines and buildings, investment in skills and abilities of work forces were emphasised.

...Development Economics, however, suffered a set- back when as a part of the “Washington Consensus”, the World Bank and International Monetary Fund and later the World Trade Organisation after it was set up in 1995, started insisting that countries approaching them for assistance should strictly follow the Structural Adjustment Programme (SAP) which envisaged marketisation of the economy as against planning, liberalisation as against dirigisme or state control and regulation and privatisation as against the public sector, open economy as against autarky and fiscal discipline implying minimisation of public expenditure and “minimal state”.The programme was uniformly insisted upon irrespective of different socio-economic, geographical and historical background and different problems faced by different counties. The approach was “one size fits all”. The result was hardly beneficial—several countries of Latin America and Africa suffered a set-back after the SAP was imposed as brought out by economists like Jeffrey Scotts and Joseph Stiglitz.

When the poster boys of development, the East Asian countries—like Thailand, Malaysia, Indonesia and South Korea—suddenly suffered an unanticipated economic crisis in 1998, the remedy suggested was also on the lines of the SAP which made for painful recovery. A country like Malaysia, which did not follow the advice, did better.Under the leadership of Milton Friedman and the Chicago boys, a “shock therapy” was imposed by dictator Pinochet’s regime in Chile. A similar strategy was imposed on Russia after the collapse of communism. In both countries it led to the emergence of oligarchies who looted the natural resources of these countries.

What's wrong with neo-classical stuff?

  1. ...the concept of “homo-economics”, the individual economic agent, whether consumer or producer, making choices or taking decisions is a faulty one.
  2. ...the stipulation that an individual makes “rational” choices and takes “rational decisions” in “self-interest” is not valid.
  3. ...the assumptions relating to a perfectly competitive market are inconsistent with the conditions in the real world...As J. K. Galbraith has pointed out, corporations of today are so powerful that with the aid of advertisements and money power they are able to reverse the proposition that supply is according to demand. Corporations manipulate demand to be in accordance with supply.
  4. ...Nor is the assumption of “perfect knowledge” valid.
  5. ...firms in the real world do not take decisions regarding production by equating marginal cost with marginal revenue or by constantly substituting at the “margin” one factor of production for another with a view to optimisation.
  6. ...market as conceived in textbooks of Micro-economics bears no resemblance to the market in the real world.
  7. ...market equilibrium as envisaged by Micro-economics is in “stationary state”.It does not deal with dynamics in the economy. Uncertainty is an integral part of economic life and yet will not be analysed in any rigorous way in the competitive model until the early 1950s when Kenneth Arrow introduced uncertainty in equilibrium analysis, although in a specific and restrictive way.
  8. ...Micro-economics completely overlooks the institutional set-up in the context of which the market functions. The institutional set-up includes the legal framework, educational set-up, cultural institutions etc.
  9. ...Micro-economics confines its attention to economic activity in the “market”, overlooking economic activity conducted in the fold of family, health and educational institutions and government to give a few examples.
  10. ...the record of Micro-economics in understanding and forecasting the economy at macro level is not impressive.

Idealogical Biases

With all its scientific pretensions, Micro-economics claims to be a positive, value-neutral discipline, but its ideological biases are quite apparent. It has provided in recent years intellectual support to a neo-liberal policy, initiated in 1982 by Ronald Reagan in the USA and Margaret Thatcher in the UK and imposed by the “Washington Consensus” on all economies and the world economy. Deregulation of the private sector and minimal government became the key words. This has created acute disparities between countries and people within countries. In neo-liberal Britain, managers of companies draw salaries thousand times more than the wages of its own employees on the ground of efficiency and productivity. The underpaid are asked to improve their own productivity before claiming a better deal.

Farmers in India, who commit suicide, are asked by the Chief Minister not to be lazy. In the home of neo-liberalism, namely, the USA, when Hurricane Katrina wiped out the homes of the poor, the local Republican Senator was cheerful that natural disaster has removed the blot which human agency could not have! The task of rehabilitation of the homeless was entrusted to a private company because the public agency could not be trusted; it made money but made a hash of the job leaving the poor in a miserable state. The task of security in Baghdad was entrusted to a private agency which itself shot dead eleven Iraqis, an act which scandalised even the puppet government.

The reckless lending for sub-prime housing mortgages threatened the banking system not only in the USA but also in Europe and there was run for return of deposits on the North Rock Bank in England forcing Gordon Brown, the PM, to assure the depositors that the government would guarantee the safety of their deposits and yet the run would not stop. Such is the rationality of the market. Some years back, deregulation of financial markets in the USA led to a savings and loan scandal. With her fetish for privatisation, Margaret Thatcher squandered away the precious oil resources discovered in the North Sea, while the Government of Norway used these resources as assets out of whose income the standard of welfare services were improved.

The neo-liberal philosophy downgrades the role of the government in creating the legal framework, regulating the private enterprise so as to ensure that it works within the framework of common good, penalising illegalities and financial scandals, building up essential infrastructure, caring for those whom market does not take care of and using natural resources for social benefit. As Ha-joon Chang of Cambridge University, a teacher of Economic History, has shown, rich countries did not develop on the basis of policies that they now force upon the developing countries.

With the neo-liberal ideology generated by Micro-economics, it can hardly be called “Soul Economics”; rather it is “dismal economics” a title conferred on Economics by Thomas Carlyle. The mainly technical contributions of modern-day economists like the Game Theory or mathematical economics with little empirical base and purely intellectual model building can do little to widen the horizon of Economics. Above all, Economics needs to be “humanised” by restoring the place of value, morality and happiness in economic theory and studies.