Thursday, October 21, 2010

Early Thoughts On Neoliberal Economics

When I started out to develop my new business model, I wanted to develop universal, cross-cultural themes, which led me to study up on philosophy, religion, and mythology.  Somehow, this led me to start digging into economics (it was probably Marx that led me there).  As a result, my wife claims that I've achieved the equivalent of a graduate degree in the philosophy of economics.

As you'll see from the below post, I started off thinking that neoliberal economics (what I called neoclassical economics at the time) were the result of a mistake, the compounding of intergenerational translation errors.  While I think the politics that have grown up around neoliberal policy certainly displays the tendency of "temporal telephone" described below, I've come to the conclusion that neoliberal economics were the result not of a mistake but of a carefully calculated fraud.

J.S. Kim seems to have reached similar conclusion here.  There are a lot of things that I've heard from J.S. that I don't agree with, and I actually think that the depth of his skepticism may have taken him to the point of paralysis, but he makes a lot of valid points about economics and the reality of our financial system.

Temporal Telephone and Neoclassical Economics
One thesis that I am continue to flesh out is that neoclassical economics (including the Chicago School and Friedman) as well as its close relatives (e.g., the Austrian school of economics and Ayn Rand's Objectivism) all arose in response to the threat to capitalism posed by socialism and communism in the early twentieth century. Now that the threat of socialism no longer exists, we should really take a hard look at neoclassical economics and ask ourselves whether it remains a Useful Fiction or whether it has outlived its usefulness (i.e., whether it has become a Debilitating Fiction that leads to Unknown Knowns).
Now, some will argue that socialism is still a threat, and didn't Newsweek just tell us that "We're All Socialists Now?"

To paraphrase the brave and wise Inigo Montoya, "You keep using the word 'socialism.' I do not think it means what you think it means. "

The term "socialism" is used very haphazardly these days to refer to any action whereby the government gets directly involved in helping people (as opposed to corporations). For example, some libertarians refer to public education as a form of socialism.

This incorrect understanding of socialism was not promulgated by the founders of neoclassical economics, who understood what socialism was and were very careful to define it (see, e.g. , Hayek's The Road to Serfdom, Friedman's Capitalism and Freedom, and Von Mises' Socialism). I'll update this post to provide pin-point cites and perhaps even quotes.

Rather, this incorrect understanding of socialism arises from a compounding of "translation errors" that happens whenever you unwhittingly play "temporal telephone." Everybody has heard of the game of telephone, in which one person is given a message to pass on to one other person in the room, and the process continues until everybody in the room has received "the" message. What typically happens, given a large enough number of people, is that the final message differs substantially from the original message. I coined the term "temporal telephone" in recognition of the fact that even if the words of the message are passed on accurately from person to person, if enough time passes, the context of the original message is lost and the meaning of those words often changes (e.g., the words can become iconic, as I discussed in a prior post). Thus, due to the passage of time, even a message that has been dutifully passed on precisely as it was originally dictated will have a substantially different meaning.

What were the errors that led us to this point?

First, the founders of neoclassical economics embraced the non-interventionist aspect of Adam Smith's laissez-faire economics but studiously ignored Smith's recognition that the government has a larger role than just being policeman (indeed, Smith recognized the need for welfare and public education, for example). In view of the existential threat that radical socialism and communism posed to capitalism, it is to be expected that some capitalists would respond by being radical themselves, and how could die-hard capitalists embrace a broader role for the state when that would appear to legitimize the aims of socialism. [NOTE: the first sentence is factual and can be substantiated with citations, which I will provide in an update; the second sentence is a theory based on a brief review of a number of articles and books and my own experience, which I will explain further in an update.]

Second, the founders of neoclassical economics did not understand that Smith's laissez-faire economics arose from a very different time and context than what existed at the beginning of the twentieth century. In particular, Smith assumed that the individual was the engine for progress and that the ethics of that individual in pursuing his own self interest acted as an invisible hand that promoted the greater good of society. [cites will be forthcoming] Corporations in Smith's time were somewhat rare and very different than what they had become by the late nineteenth century, and Smith actually heaped as much (if not more) scorn on corporations as he did on the state. [cites will be forthcoming] Today, corporations are the rule, not the exception, and they have replaced the individual as the engine for progress.

Third, this failure to distinguish between the individual-driven economy of Smith's time and the corporate-driven economy of the early twentieth century led to an overestimation of the efficiency of the markets. The most significant difference between corporations and individuals is the legal consequences for their actions. If an individual engages directly in an activity that goes wrong, the individual can lose everything. If an individual engages indirectly in the same activity undertaken by a corporation, he can at most lose his investment, the rest of his fortune remains safe. Because the individual's risk is reduced, the guidance of the invisible hand lessens. Because the managers of corporations are not putting their own money at risk and may have interests that conflict with the individual shareholders, it is an open question whether the inivisble hand disappears completely. [this section will most likely be removed and form part of a separate post]

Finally and somewhat predictably, the political rhetoric that has flowed from neoclassical economics has become categorical: government action is always bad. Again, however, Smith never said that; in fact, he took the opposite position. Yet, the neoclassical school's version of laissez-faire economics does not allow for any positive role for government.

Where we find ourselves today is that socialism and communism are no longer threats to capitalism, the clear winner of the "-ism" wars. Given this fact and the horrible economic situation that we find ourselves in-- which is the result of the wholesale adoption of neoclassical economics, including monetarism-- doesn't it make sense to go back and test the assumptions of neoclassical economics to see they remain viable and, more importantly, operative? If we do put neoclassical economics under a "stress test," I am pretty certain we will agree that this byproduct of the Cold War is no longer operative and that it vastly overestimates the efficiency of the markets in view of the corporation's impact on the risk-reward analysis. While I am not advocating a move away from corporate capitalism, I do believe more government regulation is required to ensure that corporations have the same invisible hand guiding them as does the individual.