Foundation for European Economic Development
 

 

What is Wrong with Mainstream Economics?

And How Could Economics be Improved?

 

“... the master-economist must possess a rare combination of gifts. He must reach a high standard in several different directions and must combine talents not often found together. He must be mathematician, historian, statesman, philosopher - in some degree. He must understand symbols and speak in words. He must contemplate the particular in terms of the general, and touch abstract and concrete in the same flight of thought. He must study the present in the light of the past for the purposes of the future. No part of a man’s nature or his institutions must lie entirely outside his regard.”

John Maynard Keynes

 

"The reaction of over-specialism upon the student is closely analogous to its effects upon the industrial worker; by peering incessantly into one little group of facts, he blunts his intelligence and injures the focus of his mental eyesight. His abandonment of the wider survey of knowledge destroys his intellectual judgement. Every bit of new knowledge needs to be assayed by submission to the touchstone of the Universal before its value can be ascertained."

John Atkinson Hobson

The attempt to isolate economics from other disciplines - notably politics, history, philosophy, finance, constitutional theory and sociology - has fatally disabled its power to explain what is happening in the world.”  

Will Hutton

 

The differences between mainstream economics (in all its different ramifactions) and our broad and inclusive alternative approach (which could be described as “political economy” or “institutional and evolutionary economics”) are not always clear-cut and in some cases there are significant intermediate positions. Furthermore, there is significant disagreement among non-mainstream economists on many points. Nevertheless, it is hoped that the schematic presentation in the table below is instructive.

 

Why does all this matter?

 

Economics is the most influential and prestigious discipline in the social sciences. The ideas and advice of leading economists have enormous effects on politicians, journalists and business leaders. But the typical mainstream view of economic agents as amoral and entirely self-interested is both unrealistic and has damaging effects. In the last few decades, while remaining a powerful discipline, economics has narrowed in scope. Heterodox ideas have been pushed off the curriculum, and consequently mainstream economics has almost lost a key reserve of alternative thinking that can help to reinvigorate economics, especially in times of crisis or major institutional change.

 

Mainstream Economics

Our Alternative Stance

What Many Mainstream Economists Believe

Economics from an Alternative Perspective

As a discipline, economics is defined in terms of a set of specific core assumptions and analytical techniques. As the general "science of choice" (Robbins 1932), economics is applied to any living organism, and it is not restricted to human, market, monetary or business phenomena. Economics is defined in terms of the scientific study of a real object – the economy. The economy is that part of human society concerned with the production and distribution of wealth.
Because of the alleged power of these core assumptions and analytical techniques, economists do not need to learn much from other disciplines. Instead they apply these choice-theoretic assumptions and analytical techniques to other zones of enquiry, from rats to religion. Understanding the economy requires an appreciation of the psychological and other mechanisms behind human decision-making. Other disciplines such as sociology, politics and history provide vital insights on how economic institutions work. It is particularly important to understand historically specific economic institutions. Generally, ideas from other disciplines should be adopted if they help our understanding of economic phenomena.
The best way of understanding a phenomenon is to build a model of it, with kosher simplifying assumptions. Models can be useful but their value is limited, especially when the phenomena are highly complex. Appropriate simplification is a matter of critical enquiry and experiment. A rich knowledge and understanding of economic and institutional history is often of greater value than a mathematical model.
The principal purpose of any model is to make correct predictions (Friedman 1953). With complex phenomena and non-linear interactions, the possibilities for prediction are limited. The primary purpose of any science is causal explanation.
Precision in a mathematical sense is a supreme virtue. But precision over central concepts such as “market” and “firm” is inessential. Conceptual precision is no less important than mathematical precision. But no science can be absolutely precise. Being roughly right is better than being precisely wrong.
Economics has established and accepted disciplinary boundaries. Economics is what (good) economists do. After the collapse of the Parsons-Robbins consensus in the 1980s, there is no widely accepted justification for the disciplinary divisions between economics, sociology, economic sociology and economic geography. Either a new and valid justification for their boundaries is found, or these social sciences should be unified in their pursuit of a common object of enquiry, and benefit from ongoing conversation concerning the value of different assumptions or methods.

How Mainstream Economics are Trained

The Need for a Broader Agenda

The training of economists is principally a matter of learning and developing mathematical models and techniques. An understanding of economic history, the history of economics, and the philosophy of economics are essential. There has also to be some appreciation of relevant allied work in other academic disciplines.
The history of economics is regarded as inessential because all valid past theories are incorporated into existing theory. The history of economics adds nothing more than a narrative of mistakes. Without the history of economics we cannot understand the meaning and limitations of existing theory. Much “new” theory replicates past theories without acknowledging them. We can often learn from the errors and critiques of the past.
Despite ritual genuflections to (vaguely and variedly defined*) “methodological individualism”, there is little attention to the ontological and philosophical foundations of analysis. Understanding and questioning of basic assumptions is vital – hence the philosophy and history of economics are essential for the development of the discipline.

The Individual in Mainstream Economics

The Individual in Our Alternative Approach

Rhetorically the individual is taken as the centre of analysis, often with ceremonial declarations of (vaguely and variedly defined*) “methodological individualism”. All analysis in social science must start from individuals and relations between individuals. In practice, even mainstream economists do not start from individuals alone (Arrow 1994).
Rationality is a foundation stone of economics. It is typically defined in terms of consistency of behaviour, and often more narrowly in terms of self-interested behaviour. There is abundant evidence that humans are not entirely self-interested, even in the business sphere. Generally, the rhetoric of rationality is a diversion from the complex analysis of the psychological and other dispositions and mechanisms that drive human behaviour (Sen 1977).
Preferences are often taken as given. Learning is treated as an individual reaction to new information with a given (meta-) preference function. The idea that we are born with a fixed (meta-) preference function at birth, or act as if we had one, is unwarranted. It is difficult to reconcile with the real processes of human development and learning, which always occur through interactions with others.
Despite the rhetorical (and sometimes political) emphasis on individualism, for reasons of mathematical tractability individuals are mostly treated as similar or identical. We cannot understand economic phenomena adequately without taking into account the diversity within populations of human characteristics and dispositions (Kirman 1992).
Information problems are sometimes recognised, but confined to probabilistic risk. Uncertainty (being irreducible to probabilities) is excluded because it does not fit into mathematical models. Many human decisions concern future events for which there are no calculable probabilities – they are thus uncertain by definition (Knight 1921, Keynes 1937). This puts limits on the use of mathematical modelling.
Despite adopting scarcity as a central concept, human decision-making and computational capacities are regarded as massive or infinite. In dealing with the complexity of the world, human decision-making and computational capacities are highly limited. Faced with this complexity, humans use intuition and rules of thumb, and they know that others do likewise (Simon 1957).

Individual decision-makers interpret the same information in a similar or identical manner.

The way individual decision-makers interpret information depends on their cognitive frames, their history and their enculturation in institutional settings. These vary from individual to individual (Veblen 1919).

Institutions, Technology and Markets in Mainstream Economics

Institutions, Technology and Markets in Our Alternative Approach

Institutions are taken as given, or as emerging spontaneously from interactions of rational individuals. Whether spontaneous or designed, the creation or development of institutions is difficult and costly in terms of time and resources.
Technology is typically taken as given. Innovation and the evolution of technology are important drivers of economic change (Veblen 1904, Schumpeter 1934, 1942) and vital matters for investigation by economists.
There is a focus on equilibrium outcomes or on convergences towards equilibrium (involving negative feedback). To model equilibriating processes, diminishing returns are often assumed, irrespective of their frequency in reality. Much greater attention is given to positive feedback, increasing returns, disequilibrium and cumulative causation. Path dependence is possible. Generally, history matters (Myrdal 1957, Kaldor 1985, Arthur 1989, 1990).
The market is the universal context of all human interaction. It has existed at least since humans swapped nuts and berries in the savannah. Markets are historically specific social institutions that organise ongoing exchange. Markets differ in terms of their trading rules and outcomes. Although episodic trade is much older, markets first emerged about 5000 years ago in China and much later (circa 600 BC) elsewhere. Rarely do markets emerge spontaneously in their entirety. Like all institutions they are difficult and costly to create. They require a number of cultural and other major institutional preconditions.
Financial markets are generally self-regulating and efficient. Partly because of problems of uncertainty and bounded rationality, financial markets are prone to instability unless regulated judiciously (Minsky 1985).

Mainstream Welfare and Policy Approaches

Alternative Welfare and Policy Approaches

Free trade is generally beneficial for both developing and developed countries. When the now-developed countries were developing they did not practice free trade (Chang 2002, Reinert 2007). At least without adequate national and market institutions, free trade in practice means the commercial swamping of nascent enterprise by big foreign corporations.
Economic development is principally a consequence of the spread of free markets. Without a robust system of national administration, and without state-backed monetary and legal institutions, no significant market system is possible (Coase 1992). Economic development requires national and other institutions as foundations for economic activity.
The individual is always the best judge of his or her interests. Because of limited access to information, and limited cognitive capacities, the individual is not always the best judge of his or her interests. Furthermore, there is a difference between subjective wants and objective needs (Doyal and Gough 1991), even if needs are often difficult to ascertain. While recognising the value of individual autonomy, other real needs must be taken into account. Neither the individual nor the state should be the uncontested judge of individual welfare. Democratic processes are essential to the ongoing identification and evaluation of real needs (Dewey 1929, 1939).
All welfare recommendations must be Pareto efficient. The Pareto criterion is not the only standard of welfare. Today even some mainstream economists advocate the maximisation of the sum total of human happiness, which would rarely be Pareto efficient. We emphasise the importance of human needs.
All relevant moral issues are reducible to matters of individual preference or utility. Moral judgements differ from matters of individual preference in part because they purport to be universal and are not merely matters of convention or advice. Some morality in this sense is essential for the functioning of institutions and the cohesion of society. In particular, and for good reason, all societies have moral imperatives that limit rampant individualism (Arrow 1987, Etzioni 1988, Schultz 2001, Hodgson 2013).
Utility-based welfare analysis has universal or near-universal applicability. In particular, it applies to matters of ecological stainability, education and health. The limits of utility-based welfare analysis are especially apparent in regard to the natural environment, where utility-based models do not provide adequate evaluations of ecological sustainability (Daly and Townsend 1993, Sagoff 2004). Basic needs, egalitarian concerns and problems of limited information are especially important in areas such as health and education. Such considerations challenge utility-based and Paretian norms.

* For a critical comparison of different proposed definitions of methodological individualism see Hodgson (2007).

Comments on this analysis are welcome.

Geoff Hodgson

Originally drafted December 2008. Table last amended March 2014.


References

Arrow, Kenneth J. (1987) ‘Oral History I: An Interview’, in G. R. Feiwel (ed.) (1987) Arrow and the Ascent of Modern Economic Theory (Basingstoke: Macmillan), pp. 191-242.

Arrow, Kenneth J. (1994) ‘Methodological Individualism and Social Knowledge’, American Economic Review (Papers and Proceedings), 84(2), May, pp. 1-9.

Arthur, W. Brian (1989) ‘Competing Technologies, Increasing Returns, and Lock-in by Historical Events’, Economic Journal, 99(1), March, pp. 116-31.

Arthur, W. Brian (1990) ‘Positive Feedbacks in the Economy’, Scientific American, 262(2), February, pp. 80-5.

Chang, Ha-Joon (2002) Kicking Away the Ladder: Development Strategy in Historical Perspective (Anthem Press: London).

Coase, Ronald H. (1992) ‘The Institutional Structure of Production’, American Economic Review, 82(4), September, pp. 713-9.

Daly, Herman E. and Townsend, Kenneth N. (1993) Valuing the Earth: Economics, Ecology, Ethics (Cambridge, MA: MIT Press).

Dewey, John (1929) The Quest for Certainty: A Study of the Relation of Knowledge and Action (New York: Minton, Balch).

Dewey, John (1939) Theory of Valuation (Chicago: University of Chicago Press).

Doyal, Leonard and Gough, Ian (1991) A Theory of Human Need (London: Macmillan).

Etzioni, Amitai (1988) The Moral Dimension: Toward a New Economics (New York: Free Press).

Friedman, Milton (1953) ‘The Methodology of Positive Economics’, in M. Friedman, Essays in Positive Economics (Chicago: University of Chicago Press), pp. 3-43.

Hodgson, Geoffrey M. (2007) ‘Meanings of Methodological Individualism’, Journal of Economic Methodology 14(2), June, pp. 211-26.

Hodgson, Geoffrey M. (2013) From Pleasure Machines to Moral Communities: An Evolutionary Economics without Homo Economicus (Chicago: University of Chicago Press).

Kaldor, Nicholas (1985) Economics Without Equilibrium (Cardiff: University College Cardiff Press).

Keynes, John Maynard (1937) ‘The General Theory of Employment’, Quarterly Journal of Economics, 51(1), February, pp. 209-23.

Kirman, Alan P. (1992) ‘Whom or What Does the Representative Individual Represent?’, Journal of Economic Perspectives, 6(2), Spring, pp. 117-36.

Knight, Frank H. (1921) Risk, Uncertainty and Profit (New York: Houghton Mifflin).

Myrdal, Gunnar (1957) Economic Theory and Underdeveloped Regions (London: Duckworth).

Reinert, Erik S. (2007) How Rich Countries Got Rich … And Why Poor Countries Stay Poor (London: Constable).

Robbins, Lionel (1932) An Essay on the Nature and Significance of Economic Science, 1st edn. (London: Macmillan).

Sagoff, Mark (2004) Price, Principle and the Environment (Cambridge and New York: Cambridge University Press).

Schultz, Walter J. (2001) The Moral Conditions of Economic Efficiency (Cambridge and New York: Cambridge University Press).

Schumpeter, Joseph A. (1934) The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle (Cambridge, MA: Harvard University Press).

Schumpeter, Joseph A. (1942) Capitalism, Socialism and Democracy (London: George Allen and Unwin).

Sen, Amartya K. (1977) ‘Rational Fools: A Critique of the Behavioral Foundations of Economic Theory’, Philosophy and Public Affairs, 6(4), pp. 317-44.

Simon, Herbert A. (1957) Models of Man: Social and Rational. Mathematical Essays on Rational Human Behavior in a Social Setting (New York: Wiley).

Veblen, Thorstein B. (1904) The Theory of Business Enterprise (New York: Charles Scribners).

Veblen, Thorstein B. (1919) The Place of Science in Modern Civilization and Other Essays (New York: Huebsch).