I want to understand the big relationships in our world. I want to learn the reasons of unemployment and inequality; how to design successfull economies and how to prevent financial crises.
I am as passionate about economic issues as one can be and this is why I have been studying economics for the last 5 years.
Unfortunately, to say that I am a little unsatisfied with my major would be a strong understatement - I am deeply frustrated.
In this post, I'll try to explain why that is and what's wrong with the current state of economics.
It might all have began with physics envy:
In the history of the discipline, the early economists tried to follow the approach of physics in describing the world through mathematical equations to depict economic behavior. This approach seemed so precise, so objective, so scientific. Therefore, the most common tool of the contemporary economist are mathematical-theoretical models. And this is how it works:
First, assume that everyone is homo oeconomicus - perfectly rational, future-knowing, completely egoistic, emotionsless and constantly trying to maximise one's "utility" (usually that is to maximise consumption and minimize the amount of work).
Second, assume that all goods are identical, markets are in equilibrium and that there is perfect competition between profit-maximising firms.
Third, assume that money doesn't have any effect on the "real" economy so you can neglect banks and financial markets.
And voilà - you have a foundation to begin your economic analysis!
Starting with this "foundation", economists feel free to assume more just as they please. The motto is: The more advanced, the more ridiculous the assumptions.
This is a list of additional assumptions of typical economic trade theory, here analyzing two countries with two different commodities:
- The only inputs for production are labor and capital and these inputs are homogenous that is, there is no differentiation between capital as a factory, a street or IT systems, the only thing of interest is total capital and total labor.
- Both countries have identical production technology, something like: Output of food equals amount of capital squared + amount of labor squared
- Production is assumed to exhibit constant returns to scale (that is if you double inputs, you double outputs)
- Labor and capital move freely within countries but can't move at all between countries
- Commodity prices are the same everywhere
- Perfect competition, full employment (no corruption, monopolies, unions, politics)
- No transport costs or trade barriers
- All consumers are identical, have the same income and have constant preferences (that is there is a constant ratio of how much of each good they want to consume).
Now of course one needs to make some simplifications to model reality. But economic models are not simplifications of reality, they are build on top of reality, trying to squeeze it into a mathematical formula.
And then, as if there were no assumptions at all, as if reality and the model were the same, economists feel free to transfer all insights from their model to reality. This leads them to conclude with strong certainty that free trade is good for everyone and that taxes and tariffs are usually harmful.
To illustrate the way how economists use to think, following is a typical exercise from my advanced microeconomics class:
I have calculated hundreds and hundreds of these kind of tasks in all thinkable variations but we rarely leave our models behind to look at real firms, institutions or distribution.
At the beginning of the economics education at the university we usually prove that markets are "efficient". This we call the "Fundamental theorem of welfare economics".
If you wonder about the meaning of "efficient", you need some background information:
Any analysis that includes value judgements, so called normative analysis, is considered as not being scientific and therefore taboo. To circumvent the problem of not being able to make any judgement at all, economists invented the concept of "pareto-efficiency": A situation is defined as pareto efficient if no one can be made better off without making someone else worse off. It doesn't matter if the cake is shared equally or one get's it all, as long as no piece goes to waste (that means a situation where one dictator owns everything is still pareto-efficient!).
The economists next trick is to use the concept of "welfare", which is defined as the sum of all the "utility" of all the homi oeconomici in a model. So if some policy can increase overall "welfare" (i.e. by somehow increasing production/consumption) or bring about pareto-efficiency, economists will usually call for this policy to be implemented. As an example, here is a paper that calculated (using a model of course) a 4,7% "welfare" increase for Germany if the TTIP trade agreement would become real.
Distribution, justice or any of those things not included in the "utility function" are completely neglected, they are pretty much invisible to the contemporary economist. "Efficiency" is all the contemporary economist can see.
Further, while mathematicians are well-respected by economists, other social sciences such as sociology, politics or history are generally looked down on as they lack the "scientific" language of mathematics. What these do is just blabla, definitely nothing scientific.
For me it is incredibly frustrating if I sit in the lectures and all they teach me are horribly complicated mathematical models with ridiculous assumptions, which we use to precisely calculate some "welfare" gains and then find some neoliberal policy recommendations (financial deregulation, free markets, low taxes) to increase pareto-efficiency.
I remember how in earlier semesters (when I was less critical) I often left lectures puzzled, why those stupid politicians didn't listen to the economists good advice?!
Take minimum wage, the economics demand and supply curves seem to prove that a wage above equlibrium leads to unemployment (nice graphical illustration here). However, leaving the world of theoretical modelling behind and looking at the real world, empirical studies couldn't prove this effect. Instead the effect of a minimum wage on employment seems highly ambiguous because there might be macroeconomic effects the model couldn't grasp. Still, at the university we only focus on those supply/demand graphs and get indoctrinated that minimium wage leads to unemployment. Is that scientific?
And it's not that using those mathematical models is the easier way to approach reality. It rather seems that the most ridiculously complex models bring the smallest insights (if you can derive any insight regarding reality at all). To illustrate this, here you can have a look at a basic set up of a modern macroeconomic model (the equations start at slide 7).
I remember how confronted with all those complicated equations and graphs that grew in complexity with every passing semester, I started to think that economic relationships are just too damn difficult to understand. I felt like the more I learn, the more I know not to understand.
Now, given this frustrating situation, imagine that at some point, rather incidentally you find out that there are actually many better and much more promising ways to do economics. Schools of thought that go much deeper, don't rely on those ridicouls assumptions and seem to examine the real world. They just don't teach you those at the university!
The following picture gives an excellent overview of the many different schools of economics. However, at universities 95% of economics classes are only based on the second school, neoclassical economics. And that is the status quo pretty much everywhere in the world!
One final example regarding money and banks to illustrate what's going on:
The common view among mainstream economists on banks is that banks collect savings and then lend them on to those people that need credit.
The problem with this view is that it is just plain wrong.
Private banks actually do create new money every time they extend a credit and if you look at the institutions and bank balance sheets you CAN'T come to a different conclusion (here is an excellent description of the process by the Bank of England).
What's especially interesting here is that about 100 years ago, this was a known fact by economists. Over the last century though, the truth has been unlearned by a whole discipline! (a recent study brilliantly illustrates this phenomenon). Absorbed in their models, assuming that banks are mere intermediaries, economists have managed to turn away from reality. That is as if contemporary astronomists would unlearn that the earth is round and again start believing in the flat earth model again!
Additional fun fact: Before the financial crisis hit, banks and financial markets were pretty much completely excluded from economic mainstream models. They were seen as mere intermediaries, not affecting the "real" economy.
Recently, even the queen wondered why no one saw the crisis coming...
The way the discipline has taken, as described in this essay has arrived at a point that is unacceptable to the critical mind. If some of the old great economists knew what has been made from their ideas, they wouldn't just turn over in their grave, they would rotate (as a friend of mine used to say). Therefore, a broad coalition of students has emerged in the last years, demanding change at their universities. Last year this has culminated in a global call for more pluralism (here the open letter). So finally there is a bit of hope.
Still, one might wonder how this state could emerge and why it doesn't happen that better ideas flow in to defeat the old ones. As you can imagine, I have long wondered about that. It seems a part of the answer is rather profane and has to do with the way academic achievement is measured:
To become a professor, you need publications in top journals. And if you want to publish in a contemporary journal you need to follow the rules: build a mainstream model, use assumptions (it is actually a quality criterion to use all those strange assumptions mentioned above, this is called being microfounded). But if you come from a different school of thought, forget it. This is the story I heard from the "outsiders" again and again.
And perversely, as the study "The Superiority of Economists" describes, criticising (and thereby citing) a mainstream article actually strengthens the author as this improves his citation-ranking. As a matter of fact, heterodox (=non-mainstream) economists and other social-sciences cite the mainstream but the mainstream doesn't cite they them back. It is a closed society and the syscitation tem is cementing the status quo - once a particular path has been taken, it's hard to go back.
There is the famous analogy of scientists sitting in their ivory tower, secluded from the real world.
If philosophers or mathematicians sit up there, it sucks.
But if economists are settled up there, disconnected from reality, but nevertheless advise politicians, then financial crises break out, nations fail and ultimately people suffer.