In the Century of "Black Swans", Modern Economics Deserves "Creative Destruction"

Neoclassical economics must be replaced. Nobody can predict now the full scale of its radical replacement, and how beneficial would that replacement become, but its absence will surely be a tragedy.
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In the 21st century the relentlessly growing humankind would have to fight for its survival, trying to adapt to limited capacity of planet Earth. This would happen against the background of a dysfunctional and disorderly world economy, the prevalence of a productive but amoral and destructive capitalist system of production and distribution of goods and services, and the devastating, incessant battles between Western-style democracies, authoritarian regimes, and militant religious fanatics.

The United States is the largest member of the world economy. It also is the one of the only remaining bulwark of liberal democracies. Accordingly, a disproportionate share of mankind's problems lies on the broad shoulders of this country. But it is not fully prepared for the demanding role of a Great Power. Its political system is archaic, dysfunctional, and geared to inaction; its manufacturing has been largely exported abroad; its financial system is greedy and irresponsible, repeatedly triggering crises; it has more lawyers and financiers than military personnel in armed forces; it has close to 30 million of full and partially unemployed; the U.S. is dead broke and in multi-trillion debt to its most threatening adversaries. Most important, in the last 30 years the country has recklessly destroyed the delicate and beneficial social balance between "countervailing powers" of business, labor, and government, created with enormous difficulties in the past two centuries. The very balance that prevented the social revolution, prophesied by Marx.

The current "mainstream" neoclassical economics supposedly provides solid theoretical support to much of the above calamity. Nothing can be further from truth: neoclassical economics is a pseudo-science, and its recommendations are extremely dangerous. "Voodoo economics" is the right name for the whole discipline, rather than for its napkin variety.

To sum up, the neoclassical economics ("turning back the wheel of history" to the free market) reverses up to 200 years in social progress. Its yearning for autonomous economy, for which its simplistic abstractions may be acceptable, is late by at least one hundred years. Its philosophy is asocial, individualistic self-interest per se, rather as a means of serving the society. It in effect denies the very existence of radical uncertainty, and its current skills of dealing with it are, at best, at a kindergarten level. The discipline is able to address only wrong issues (short-term, "rearranging the chairs on the deck of the Titanic," instead of the crucially important long-term problems of survival, presently facing mankind) and therefore gets wrong answers. It does not take into account externalities and ecological limits. Its major assumptions are mostly non-realistic, often absurd. Moreover, it cannot predict or decide correctly, too, thus not being able to justify by good results its using wrong assumptions. Its tools (maximization models) are wrong, primitive, and absolutely inadequate.

In short, not a single component of the discipline is good, and their aggregating brings no benefits. To the contrary, maximization tends to aggravate the errors. Even worse to come: Nobel prizes in economics have been largely awarded for applied mathematics, rather than for real-world economics. The Nobel prestige of the discipline, thus obtained under somewhat false pretenses, provides a moral umbrella and lulls people to its immense perils. (This year, the Nobel Economics Committee became so afraid of what it had been complicit to, that it switched to pretty small microeconomic fry. And rightly so: a couple of years ago, just before the crisis, I calculated the coefficient of correlation between the number of economic Nobel laureates in a country or a trading bloc, on the one hand, and its trade balance-of-payments, on the other hand. R = -0.87!)

This is a dangerous combination, a gigantic car bomb waiting to explode. A part of it did recently. The result is the current economic condition of the country.

The present economic turmoil makes us, once again, return to Keynes. But it would be primitive and wrong to consider only his currently fashionable deficit financing ideas and similar narrow issues. (Moreover, following only this part of his legacy would be counterproductive.) He was the Einstein of economics, and, like Einstein, he was much broader than his discipline: he was a Thinker.

The most important true philosophical legacy of Keynes can be reduced to three principles, expressed by him explicitly or implicitly.

I. There is no "universal economics": different approaches should be applied under different states of the society and the economy and under different problems facing them.

II. Economics is based on logic of choice, not under scarcity alone, but rather under both uncertainty and scarcity, perhaps with uncertainty playing more important role.

Lower level market activities are beneficial, but -- if the economy is not considered autonomous -- they should be controlled, constrained, and directed, at a higher level, by a non-market entity that pursues broad sociopolitical goals.

There are no absolutes in society, and there exist no timeless rules of behavior or decision-making that can be taken as axioms. Economics cannot be constructed as an axiomatic (deductive) theory. There are only approximate rules of thumb, which sometimes are applicable and sometimes are not. Even the most basic tenets of economics are therefore no more than temporarily acceptable approximations of reality. How acceptable are those approximations? That depends on the then current stage of the society and the economy. What was completely satisfactory yesterday might become unacceptable tomorrow.

Let us then look at the relevant stages of the society and the economy.

From the onset of the First Industrial Revolution, the world economic order has passed through three distinct stages. I propose the following categorization:

Stage 1. (approximately until WWI). Scarcity of goods and resources (including production capacity), needed to satisfy the rising consumption demand.

Stage 2. (from WWI till the end of the 20th century). Excess of goods and resources (including production capacity) over-consumption demand.

Stage 3. (the 21st century, current and expected). Fighting manifold crises and attempting to prevent possible catastrophes in each of them.

At Stage 1, democratization advanced; trade unions gained strength; social and technological progress step-by-step improved material conditions and social standing of labor. Workers gradually became middle class, and that increased political stability. For both Britain and European countries (which dominated the world economy) social costs were also mitigated by possible emigration of the unemployed to America and Australia.

Furthermore, the world was at peace, the general direction and pace of technology advances were sufficiently predictable, and the negative externalities (including the environmental ones) could not lead to a major catastrophe. Consumer demand grew fast and easily absorbed any rise in production of decent goods. Therefore overall uncertainty was tolerable.

Also, since the externalities were small and uncertainty was tolerable, applying the "invisible hand" principle could not cause substantial harm.

Social progress being satisfactory, the economy -- and full utilization of resources in it -- was the most important problem. For the most part, production enterprises were sufficiently small, so that competition could be assumed close to perfect. Also, the gold standard cushioned the possible abuses of international trade. Resources were scarce, and -- with speedily growing consumption demand -- it was very important to use them efficiently. That was achieved by striving to market equilibrium. Also, social pressure on the economy mainly consisted in weakly justified demands of pre-capitalist ruling elites.

Consequently, as a first approximation, the economy could be considered autonomous, and the free market philosophy was a sufficiently good theoretical approach to reality.

At Stage 2, the world economy passed through a turbulent era of products chasing consumers. In the 1920s, the situation already transferred into excess of goods and resources (including production capacity) over effective demand. That led to the Great Depression, which ended only with the start of WWII. The economy could not anymore be considered autonomous.

As pointed out by John Kenneth Galbraith, it was most important that social, technological, and economic progress of the 19th and 20th centuries culminated in a beneficial social balance between "countervailing powers" of business, labor, and government.

Of course, there were troublesome spots in this idyll, too; there never was an Eden without a Serpent. Penny-wise and myopic trade union leaders thought that they were (borrowing from later terminology) Masters of the Universe. They considered their position invulnerable and did not realize that they were just Pawns of a Passing Paradigm. Accordingly, after WWII they missed an opportunity to translate their dominance into political power and strong labor protection. They opted instead to grab unreasonably large wage-and-benefit increases, which, together with the oil shock, created in the 1970s unbearable "stagflation." It could be suppressed by sound, even if difficult and politically unpopular, means. Instead, since 1980, the economic paradigm was changed -- from "full employment" to "maximization of short-term corporate profits."

The new paradigm, blessed by several thousand "mainstream" Anglo-American academic economists, bases the necessary growth of the economy on rising prices of assets (equities and housing). Growth is combined with either increasing debt of private and industrial consumers that use the appreciated assets as a collateral, or sale of these assets. Wage increases are no longer needed, so that offshore workers -- often 30 to 40 times cheaper -- can replace costly American labor. Labor laws are weakened and not followed; membership and influence of trade unions is sharply reduced; government is weakened. Trade deficits balloon.

In a most penetrating and original analysis, "The Crisis of Capitalism: Keynes versus Marx" (2010), Robert Skidelsky points out that the new paradigm was a counter-attack against Keynesian revolution. The latter, in a classical tradition, aimed for full employment, which gave labor -- in its dispute with capital for a share of profits -- a predominant position. The counter-attack considered moving the unemployment rate below its "natural rate" (the concept minted by Milton Friedman) as inflationary and harmful. The counter-attack was politically initiated by Ronald Reagan and Margaret Thatcher; it was to reverse the situation in favor of capital.

The Anglo-American school of economics enthusiastically supported the counter-attack, since it was three-pronged. In addition to the above shift of the upper hand (the first prong), it allowed a return to the beloved philosophy of laissez-faire. No less important, although collateral: shelving Keynes also stood for marginalizing worries about uncertainty. Radical uncertainty -- the field where economics is impotent.

For almost 30 years, the counter-revolution was extremely successful in achieving its profit-increasing goal. It had, however, a crucially important by-product. Just in 30 years, this transformation to wholesale free market orthodoxy destroyed the social progress and the delicate balance (see above) between business, labor, and government. Business becomes the sole prevailing power. A return to laissez-faire is, substantially, a return to social and political conditions of 150-200 years ago, and the more we return to it -- the closer we replicate those conditions. Income inequality widens, the middle class is wrecked, and country is deeply polarized. That creates an additional, critical danger of internal social turmoil to the U.S., which has enough trouble as is. Clearly, the laissez-faire concept is anti-social.

Unbridled globalization serves in this paradigm as a master key, in many functions. It increases corporate profits, reduces prices of consumer goods, makes possible a huge influx of cheap outside money into the country, and lowers inflation. But, most important, it also is used as a bludgeon, to frighten American workers into submission and to eliminate their economic and political power. Globalization puts additional pressure on workers, who are already threatened by reduction of the size of government, increase of labor market flexibility, and retreat from full employment.

As indicated by a Washington economist, Thomas Palley, the end result of that Ponzi process is easily predictable: it is unsustainable. Ceaseless inflation of asset prices is impossible without creating bubbles; by definition, every bubble is due to burst. After savings are spent, bubble-generated profits are exhausted, and assets are sold, creditors tolerate debt only until that suits their interests, and the more they delay the reckoning, the worse is the outcome. Globalization doesn't save; it only amplifies and accelerates the process. Sooner or later, finita la comedia; we have seen the last act recently. A crisis comes.

Throughout Stage 2, because of both economic difficulties and nearly never-ending geopolitical turmoil, including two world wars and a "cold war" with communist countries, uncertainty was pretty high. The "mainstream" Anglo-American economics did not know how to treat uncertainty, and that was not helpful.

Keynesian economics, including governmental intervention -- either satisfying war requests or stimulating consumption demand -- was applied before, during, and after WWII, up to and including the 1970s. Under the circumstances, this theory was a correct first approximation to reality. After that, came the "mainstream" consumption-centric, free-market and free-trade Anglo-American economics, which was not an approximation, but rather a bad mismatch to reality.

At Stage 3, mankind has to deal with a number of crucially important problems. The most serious of them probably is that the human race grows like yeast, in all the wrong places. Everybody wants to live better; nobody wants to live worse. But the planet's capacity is limited, especially when environmental externalities are neglected and the world economy is unbalanced and dysfunctional.

Resources again are insufficient, but they are needed now for solving those survival problems, rather than for satisfying (mostly conspicuous) consumption demands. Even more than at Stage 2, the economy cannot be considered autonomous. The impact of society should be overwhelming. Keynesian intervention is necessary, but not sufficient anymore.

An essentially new approach becomes a must.

The U.S. has much more than a fair share of these survival problems. Accordingly, the country is currently in a precarious position, one of the most dangerous in its history. Simultaneously and immediately, it has to deal with geopolitical threats, environmental dangers, and economic crises. And "the last bulwark" of democracy must have a stable and powerful middle class in a non-polarized society. Otherwise, democracy may veer left or right, to a totalitarian regime.

Again, most important: economics must address these real and crucial problems, rather than secondary issues, such as striving to perfect market efficiency or to increase short-term consumption.

In addition to the difference in problems facing society, uncertainty is the main reason why we need, at this stage, new economics. This is the first time in the history of mankind that the uncertainty external to any serious problem is much more important than the uncertainty internal to the problem. The potential harmful outcomes of the external scenarios dwarf those of internal scenarios, and the likelihood of such outcomes is quite high. This is caused by the combined effect of geopolitical disturbances, including terrorism and the possible use of weapons of mass destruction, deterioration of the planet's environment, and so on. The future may drastically change in a matter of days, hours, and even minutes. We do not know the future, even in the short-term, even in probabilistic sense. We do not know when, where, what might happen, and of what intensity. "Black swans" become a rule rather than exception. It is a situation of radical, un-insurable uncertainty.

Under such conditions, we cannot pretend anymore that "mainstream" economics work. Moreover, it is not harmless: it has exactly the opposite effect to what is needed and is therefore a menace. Both in its recommendations, such as unbridled free trade, and in its anti-social philosophy, taught day by day to impressionable youngsters.

The sad state of economics was amply demonstrated in April, when a large group of economic luminaries, including about half a dozen Nobel laureates, gathered in Cambridge, England, for the inauguration of the Institute of New Economic Thinking. They could not agree on anything, except the obvious notion that the discipline must be changed. They did not see that economics must abandon its focusing on small issues, such as maximizing short-term conspicuous consumption, and instead address the crucially important problems pertaining to the long-term survival of mankind. Moreover, they were not able to propose solutions even for those small problems that they wanted to address. Superficial, clueless, and helpless. I was ashamed for the profession.

As Harvard economist Dani Rodrik says, " ... [E]conomists are an arrogant bunch, with very little to be arrogant about. ... As social scientists, economists have neither the ability of physicists to fully explain the phenomena around us, nor the expertise of physicians to prescribe effective cures when things go wrong."

And yet they still want influence, prestige, and 6- to-7-digit dollar advances for their fancy textbooks. Their self-criticism does not go far enough. Wishing to emulate a natural science, economists try to embed in mathematics their simplistic and, too often, absurd assumptions. That excludes from consideration any social and political implications that -- with no exception -- are too complex for the desired primitivism.

Mathematical modeling, which plays an enormous role in "mainstream" economics, indeed, needs abstraction and simplification. But they should condense reality, not contradict it. We should always remember the best-ever (in my opinion) principle of science, formulated by Albert Einstein: "Make everything as simple as possible, but not simpler." In choosing its assumptions, economics on every step violates that principle.

Here are some data about the economists' opinions of themselves. In March, the Real World Economic Review performed a poll -- which economists were most responsible for the crisis, "for blowing up the global economy." Over 7,500 people voted; many of them were economists. Each participant could cast up to three votes. In total, 18,531 votes were cast.

The vote totals for the first seven "winners" were as follows (the first three won the Dynamite Prize):

  • Alan Greenspan - 5,061

  • Milton Friedman - 3,349
  • Larry Summers - 3,023
  • Fischer Black and Myron Scholes - 2,016
  • Eugene Fama - 1,668
  • Paul Samuelson - 1,291
  • Robert Lucas - 912.
  • Who am I to disagree with this valuation by 7,500 knowledgeable people? I make though one exception: I consider Friedman to have been the most dangerous man in the world in the second half of the 20th century. Greenspan may indeed be the father of the current crisis. But Friedman was its godfather: He generated the ideology that led to it.

    As for the whole "mainstream" part of the profession, I consider it more dangerous than Al Qaeda.

    Well, did Keynes hope in vain that some day economists would be as useful as dentists? I am afraid the economists might be considered that useful only if they turn to using laughing gas, as dentists had been doing at that time. According to the second law of Max Plank, science progresses one funeral at a time. Academics live longer than people of other professions.

    As John Adams remarked more than 200 years ago, "Avarice, ambition would break the strongest cords of our Constitution as a whale goes through a net. Our Constitution is made only for moral and religious people. It is wholly inadequate to the government of any other."

    In the 21st century, we do not have much time left to ponder over this wisdom.

    The same goes for neoclassical economics -- the discipline is wholly inadequate for our very interesting times. Economics must be overhauled from top to bottom. Schumpeter's chickens must come home to roost: the discipline itself deserves a thorough "creative destruction." Neoclassical economics must be replaced. Nobody can predict now the full scale of its radical replacement, and how beneficial would that replacement become, but its absence will surely be a tragedy -- both for this country and for the world. The future would look much bleaker than it does now.

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