Theory vs. Reality: Why Market Absolutism Fails
Ernest Partridge, Co-Editor
The Crisis Papers
December 16, 2008
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"The collapse of market fundamentalism in economies
everywhere is putting the Chicago School theology on trial. Its big
lie has been exposed by facts on two levels. The Chicago Boys' claim
that helping the rich will also help the poor is not only exposed as
not true, it turns out that market fundamentalism hurts not only the
poor and the powerless; it hurts everyone, rich and poor, albeit in
different ways... The fruits of Friedman test are in - and they are
all rotten."
Henry Liu |
An economist and his guide, while hunting in Africa, fall into an elephant trap:
twenty feet deep with vertical walls.
“That does it,” says the guide, “we’re done for. No escape, no food, no chance
of being found in time.”
“Nonsense,” said the economist, “I can get us out of here.”
“And how do you propose to do that?,” the guide asks.
The economist replies: “Well, first we posit a ladder.”
Economists are no more inclined than the rest of us to live in a fantasy world –
not, that is, as they go about the practical business of living their everyday
lives. But when economists write technical papers and teach university courses,
they often enter a theoretical realm of abstract concepts such as “economic man”
(homo economicus) and “perfect markets,” articulated with virtuoso
advanced mathematical manipulations. Very elegant, and very unreal.
Many economists, perhaps most, appreciate the limitations of economic theory in
explaining and predicting social behavior and political trends. Some economists,
however, claim to find in traditional (i.e. “neo-classical”) economic theory,
the key to articulating and proposing public policy. It’s called “market
absolutism,” and it has dominated American politics since the Reagan
administration. It has also led this nation to the brink of economic disaster.
Market absolutism has led us to this crisis because its proponents in academia,
politics and the media have been bewitched by theoretical concepts that apply
imperfectly, if at all, to the real world in which we live and work. In
particular: they posit an imaginary creature (“economic man”) that inhabits a
mythical environment (the “perfect market.”)
Economic Man (Homo Economicus).
In neo-classical economic theory, “economic man” is a
hypothetical individual who is a complete egoist, motivated solely by the
self-interested desire to maximize his “preference satisfaction.” Homo Econ’s
motivation is manifested by his willingness to pay for these satisfactions in a
“free market.” Neo-classical theory also postulates that “all goods that matter
to individuals ... must be capable of being bought and sold in markets” and
“anything that is valued instrumentally ... can be handled by economics, be it
acts of friendship or love.” (Freeman and Edwards. For citation of sources,
follow this link).
“Economic man’s” behavior is described, in neo-classical jargon, as “rational.”
By implication, the self-sacrificing behavior of saints and heroes is
“irrational.”
Clearly, “economic man” exists nowhere outside of Ayn Rand’s novels and,
perchance, on Wall Street. And this is fortunate, for we wouldn’t want him for a
neighbor.
In fact, there is much more to a fulfilled and moral life than self-interested
“preference satisfaction.” Such a life also includes values that can not
be priced in a free market. Among them:
-
Truth. Scientists and scholars offer evidence and
sound arguments, not bids. In courts of law, purchased verdicts are not only
invalid, they are crimes.
-
Civic Values such as justice, due process, civil
rights, and the franchise, are not for sale. The governing impulse of
economic man (qua consumer) is “I want.” The governing impulse of the
citizen is “we need.”
-
Distributive Justice. The economic concepts of
“efficiency” and “utility maximization” do not touch upon the moral issue of
the just distribution of wealth. “Just compensation” and "fair distribution"
are moral, not an economic, concepts. A slave economy can, in classical
economic theory, be perfectly “efficient” (i.e., "Pareto Optimal").
-
Love, friendship and loyalty which is bought is less
valuable than that which is given freely. As philosopher Mark Sagoff reminds
us, “a civilized person might climb the highest mountain, swim this deepest
river, or cross the hottest desert for love, sweet love. He might do
anything, indeed, except be willing to pay for it.”
-
Moral values, which refer to
the worth
of persons, are systematically excluded from neo-classical economic
theory.
A public policy for “economic man,” systematically detached from
criteria of truth, civic value, distributive justice, friendship and loyalty, is
a policy that any civilized person should reject, and reject on non-economic
grounds. (See my
“Why
Economics Fails as a Sole Foundation of Public Policy,” for an elaboration
of these points and a citation of sources).
The Perfect Market.
Neo-classical economists, and their political acolytes, are
convinced that “free markets,” completely undisturbed by government
interference, yield optimum social and economic results. For example:
“In the free market, the individual would have to produce a
good that the other person desired in order to receive a good in return.
Adam Smith's "invisible hand" of the market guides all participants in
society to promote the best wishes of everyone else by pursuing his own
wants and desires.” (Jacob Halbrooks)
“[T]he free market allows more people to satisfy more of their desires, and
ultimately to enjoy a higher standard of living than any other social
system... We need simply to remember to let the market process work in its
apparent magic and not let the government clumsily intervene in it so deeply
that it grinds to a halt." (David Boaz, Libertarianism, a Primer, p.
40, 185.)
"A free market [co-ordinates] the activity of millions of people, each
seeking his own interest, in such a way as to make everyone better off...
Economic order can emerge as the unintended consequence of the actions of
many people, each seeking his own interest." (Milton and Rose Friedman:
Free to Choose, pp 13-14).
History has taught us, time and again, that such assertions are
true only in the purely abstract world of neo-classical economic theory. They
are not true in the real world that we inhabit. To understand why this is so, we
need only list the conditions of “the perfect market” postulated by economic
theory.
-
All participants are “perfectly rational” egoists – i.e.,
are “economic men.”
-
There are many participants in the market.
-
All participants have access to all relevant knowledge.
-
There are no transaction costs.
-
All transactions are mutually beneficial.
-
There are no externalities (i.e., consequences to
non-participating “third parties”).
Clearly, there are no “perfect markets” anywhere on earth, apart
from the imaginations of economists. For consider:
(a) “Economic man” is a myth, or at the very least extremely
rare. As noted above, most individuals engage in economic transactions for
several reasons, some of them non-economic.
(b) Participation in markets is restricted to those with the ability to pay.
Public policy decisions, on the other hand, should involve the rights and
welfare of many who are systematically excluded from market activity; namely,
the very young, the very poor, animals, and future generations. Furthermore,
unregulated markets are self-eliminating, because capitalists detest competition
and strive constantly to eliminate it. The remedy? The enforcement of anti-trust
laws and regulation, which means, of course, “interference” by governments in
the marketplace.
(c) The multi-billion dollar advertising and public relations industries are
devoted to the task of persuading rather than informing. And
persuasion involves the withholding of relevant information (e.g. health risks)
and the dispensing of distorted and false information. Caveat Emptor!
(d) All transactions in the real world exact costs. Among them are the costs of
enforcing the laws required for markets to take place at all (e.g. fair
disclosure, patents and copyrights, contracts, civil and criminal courts, etc.),
and this of course means government, which is so despised by “free marketeers.”
(e) Transactions are frequently not mutually beneficial, due to fraud (i.e.,
violation of “relevant knowledge condition”), the remedy of which is civil
suits, which requires the “transaction costs” of the enforcement of law and the
appeal to courts.
(f) External costs of market transactions are more the rule than the exception.
Innocent, non-consenting parties are routinely impacted by economic activity.
Among these external costs are environmental pollution, urban decay, public
health costs, etc. Third-party “stakeholders” have no say in economic
transactions. Their only recourse for protection and compensation is to the sole
agency legitimately established to represent all citizens: the government. (See
my “Market Failure:
The Back of the Invisible Hand).
Summing up: “Economic man” and “perfect markets” are abstract constructs which,
due to their clarity and simplicity, allow theoretical economists to devise
complex mathematical models. However, they have no counterparts in the real
world, which compromises the application of these concepts in public policy.
Case-In Point: Milton Friedman on Free Trade.
Foreign trade and currency exchange rates provide a vivid
example of the rule, “The theory is beautiful, but reality is baffling.”
According to free market theory, foreign exchange rates should be
self-regulating, negative feedback functions, like house thermostats. The heat
rises, the furnace shuts off, the heat drops, the furnace kicks in, perpetuo
moto.
Similarly with foreign trade. If there is a “trade imbalance,” say between Japan
and the United States, as dollars go to Japan and consumer goods are imported to
the U.S., the Japanese will acquire a surplus of dollars causing the value of
the dollar to fall with respect to the yen. U.S. consumer goods will then be
less expensive than Japanese products, thus encouraging a flow of the yen to the
U.S. to purchase American goods. Then the value of the dollar will rise until
foreign goods once again become competitive. And so on, back and forth, like a
thermostat. It’s all perfectly automatic – a “spontaneous order,” as the
libertarians call it – no governmental interference (e.g. tariffs) required.
This is how Milton Friedman describes it:
If foreign exchange rates are determined in a free market,
they will settle at whatever level will clear the market. The resulting
price of the dollar in terms of the yen, say, may temporarily fall below the
level justified by the cost in dollars and yen respectively of American and
Japanese goods. If so, it will give persons who recognize that situation an
incentive to buy dollars and hold them for a while in order to make a profit
when the price goes up. By lowering the price in yen on American exports to
Japanese, it will stimulate American exports; by raising the price in
dollars of Japanese goods, it will discourage imports from Japan. These
developments will increase the demand for dollars and so correct the
initially low price. (Milton and Rose Friedman, Free to Choose, p.
47).
In theory, it’s all very neat and so simple: “all things being
equal.” But in the real world, “all things” are never equal. Instead, the
ecologist’s rule applies: “you can’t do just one thing.”
What if that flow of dollars abroad is accompanied by a dismantling of the U.S.
industrial base? Then, when the time arrives for U.S. manufacturing goods to be
competitive with foreign goods (due to the weakening of the dollar), there will
be no more American-made goods on the market. Moreover, with the outsourcing of
U.S. jobs overseas and the decline of median disposable income, fewer American
can afford to buy foreign consumer goods. Regressive tax rates cause the
nation’s wealth to flow to the very rich, who send their investments abroad in
outsourced industries. A shrinking tax base results in a disintegrating physical
infrastructure and a decline in higher education, followed by fewer scientists
and engineers, and less basic research and development. Thus today the United
States excels only in military technology, as it needlessly spends more on the
military than all the rest of the world combined, building 3.5 billion dollar
aircraft carriers to fight an “enemy” without an air force, and billion dollar
submarines to fight an “enemy” without a navy.
This is what happens when public economic policy is abandoned to “the will of
the free market” – an abstraction with, we are expected to believe, a benevolent
“mind” of its own. This is what happens when a government puts the fate of the
nation’s economy in the hands of wealthy individuals and corporations;
individual agents without social conscience and with nothing more than their
short-term profits in mind.
In the face of such grim realities, the neat “negative feedback” model of
Friedman’s free-trade theory is irrelevant. It belongs to the abstract world of
“theory,” not to the real world. In the real world, the thermostat is broken,
the furnace will not turn on: down, down, down, goes the temperature.
“Physics Envy:” Formal modeling vs. Empirical Investigation.
Neo-classical economists regard themselves and their discipline
as more “formalist” than “empirical.” “Applied economists” such as John Kenneth
Galbraith, Kenneth Boulding and Herman Daly who study the behavior of markets in
“the real world” and attempt to draw inferences and conclusions from these
studies, are regarded as an inferior caste: they rarely win Nobel Prizes and are
conspicuously absent from the rosters and the publications of right-wing and
libertarian think-tanks. (The remainder of this section is adapted from my
“Beautiful
Theory vs. Baffling Reality”).
Economic formalists are ever-ready to offer explanations of the state of the
nation’s economy, and to issue warnings of dire consequences if their
recommendations are not adopted, a willingness that is compounded as the
economist’s academic training is mixed with his political sentiments and
motives.
Consider, for example, an analysis of the prosperity of the Nineties, the
longest sustained economic boom in our history. Who gets the credit? The
Democrat replies, “Why Bill Clinton, of course!” “Not so fast,” says the
Republican economist. “That prosperity was a time-lagged result of the policies
of Bush I, aided by the wise legislation of the Republican Congress after the
GOP took control in 1995.”
And what caused the stock market bust and recession early in the Bush II
administration, and the humungous deficits that followed? Quoth the Democrat:
“Clearly, those tax breaks to the rich failed to ‘trickle down’ and stimulate
economic growth as the GOP promised.” “Wrong again,” says the GOP apologist.
“The bust and the recession were “time-lag” effects of Clinton’s horrible
economic policies. As for the stimulus from the tax breaks, be patient – just
you wait.”
I trust that you can see where this is going. “Time lag” – the gift to the
economic theorist that keeps on giving -- is just one of several “explain-away”
devices that economists fall back on, when their policies and predictions don’t
quite turn out right.. Whenever “our” policies fail, or “their” policies
succeed, there is always one or another of a myriad of macroeconomic
imponderables to fall back on for an explanation. It’s no wonder that the
disputes that ensue are never definitively resolved.
The problem is not that economic theories explain too little – it's that they
“explain” too much, so that whatever happens, their defenders have an
“explanation,” and likewise, their opponents have a contrary "explanation."
That’s just another way of saying that politically motivated economic
projections and explanations are “non-falsifiable,” and non-falsifiability is
the definitive mark of non-science.
Astronomers can predict within seconds, eclipses hundreds of years into the
future. If economists had a reliable 60% success rate in their macro-economic
predictions, they could all retire at forty on the returns from their stock
market investments. And as we all know, they don’t.
Please understand: I am not "anti-markets." The failed economic experiment in
the Soviet Union proved conclusively that a centralized command economy is
vastly inferior to a market-based system of pricing, distribution, innovation
and quality control. Having "shopped" in both the Soviet Union and the United
States, I know this from personal experience. Furthermore, because human beings
in significant aspects of their lives, do, in fact, act upon economic motives, a
scholarly examination of market behavior has valuable implications for numerous
disciplines, including environmental studies and political science.
In short, I do not assert that a study of markets and economic theory should
count for nothing. Instead, I protest that they should not count for everything.
Homo economicus is an ingredient of our nature that we would be well
advised to study. But our lives consist of much more than buying and selling. We
also love and we sacrifice, and we have goals and concerns that transcend our
self-interest. And we seek, both personally and collectively, truth, justice,
and personal excellence, none of which can appropriately be bought or sold in
markets
With this conviction, I am joined by many esteemed economists, among whom are
some of the severest critics of neoclassical economics. These include Herman
Daly, Nicholas Georgescu-Roegen, Kenneth Boulding, Paul Krugman, James Galbraith
and Amartya Sen, all of whom possess a clear view of the limitations of their
discipline. Indeed, my quarrel is less with economists than with politicians and
policy-makers who have skimmed easy formulas and simplistic generalizations off
the top of the neo-classical economic theory, and put them to work in behalf of
their special political and economic interests.
Even so, the above-listed dissenting economists, whom I admire enormously,
report that there is in fact a dominating "orthodoxy" of neo-classical thought
in the discipline of theoretical economics, and that this orthodoxy has had
enormous influence upon both public policy and politics.
I can validate their report with my own experience. Often, when I have mentioned
the names of these mavericks to economist colleagues, I find that I have evoked
stares of disbelief or even condescension, such as one might expect from a
fundamentalist preacher upon hearing the name of Charles Darwin. I once asked
Herman Daly why he is regarded as an “outsider” by the mainstream of his
profession. He wryly replied that it was probably because he permits the
elegance of formal economic theory to be contaminated by compelling facts of
biology and physics. Meanwhile, the true believers read with admiration the
pronouncements of economists such as Julian Simon, who confidently assert that
the omnipotence of the free-market and the omniscience of future entrepreneurs
can overcome trivial physical constraints such as the second law of
thermodynamics. (See my “Perilous Optimism”). I once heard Paul Ehrlich remark to Johnny Carson that
if an engineer proposed to design an aircraft for an exponentially expanding
crew, he would rightly be regarded as mad. Yet when an economist proposes an
economic model that posits perpetually expanding population and resource
consumption, he is regarded as eligible for the Nobel Prize for economics.
Happily, this era of free-market dogmatism may be coming to an end, as the
dreadful consequences of its application are cascading upon us. Some of the High
Priests are, in the face of stark economic realities, abandoning the cult.
Leading the way is Alan
Greenspan, who told Henry Waxman’s Committee, “those of us who have looked
to the self-interest of lending institutions to protect shareholder’s equity
(myself especially) are in a state of shocked disbelief... I made a
mistake in presuming that they were best capable of protecting their own
shareholders.”
The dogma of market absolutism may, at long last, be replaced by what
James Galbraith calls “a new spirit of pragmatism, “ which, he writes,
“surely requires that we discard the metaphor of market determinism – whole and
entire. No more, let us bow and scrape before that altar. Markets have their
place – they are a reasonably open and orderly way to assure the distribution of
services and goods. They are not a general formula for the expression of social
will and the working out of social problems.”
Thus might the economic strategy of FDR’s New Deal be reinstated: constancy in
ends – national prosperity and economic justice – and flexibility in means.
“Don’t just sit there, do something! If it works, keep it. If it fails, try
something else.” In economics, as with any viable science, theory must be tested
in the real world, whereupon the theory is either validated, modified, or
discarded.
Looking back through history, we might wonder how it is possible that
intelligent and educated people once accepted uncritically such notions as
astrology, judicial trial-by-combat, the demon-possession theory of disease, and
alchemy. Today, more and more sophisticated observers of society and politics
are wondering how homo economicus, a creature bereft of sympathy,
humanity, and noble aspiration, and "the perfect market," a "place" devoid of
any social contacts more elevated than market transactions, ever came to be
regarded by our political elites as the foundation of a just political order.
Copyright 2008 by Ernest Partridge
Ernest Partridge's Internet Publications
Conscience of a Progressive:
A book
in progress.
Partridge's Scholarly Publications. (The Online Gadfly)
Dr. Ernest Partridge is a consultant, writer and lecturer in the field
of Environmental Ethics and Public Policy. He has taught Philosophy at
the University of California, and in Utah, Colorado and Wisconsin. He
publishes the website, "The Online
Gadfly" and co-edits the progressive website,
"The Crisis Papers".
