Economics in Context
Science is the study of Nature from an empirical perspective. Unlike physicists, biologists, and other scientists, economists have not been content to dispassionately comprehend the gyre of their purview and spin theories as to relations and plausible causes. Instead, economists have often acted as intellectual cheerleaders: touting their beliefs through theoretical propaganda that does not fit the facts. To this end, economists have often couched their favored system as representing a physiocracy: a natural order.
“Economics offers a comprehensive doctrine with a moral code promising adherents salvation in this world; an ideology so compelling that the faithful remake whole societies to conform to its demands. It has its gnostics, mystics and magicians who conjure money out of thin air, using spells such as “derivative” or “structured investment vehicle.” Like the old religions it has displaced, it has its prophets, reformists, moralists and above all, its high priests who uphold orthodoxy in the face of heresy.” ~ English sociologist John Rapley
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In the mid-16th century, a group of Englishmen became transfixed on the acquisition of bullion – gold and silver – as the surest route to national power and wealth. Buillionists pointed to the grandeur of Spain, which built its ephemeral prosperity on precious metals looted from its New World colonies.
Mercantilism took bullionism one step further: stressing the value of international trade to amass riches. The mercantilist conception was that wealth was a zero-sum competition of economic winners and losers. Mercantilism inspired nationalist competition.
17th-century English merchant Thomas Mun, a staunch nationalist who was the director of the East India Company, was an enthusiast of mercantilism, and had great influence in promoting the doctrine. Mun advocated the “means to enrich a kingdom” was by achieving a positive balance of trade. The merchant class took to the idea like a fish to water.
“The ordinary means to increase our wealth and treasure is by foreign trade; to sell more to strangers yearly than we consume of theirs in value.” ~ Thomas Mun
More domestically, a group of 18th-century French economists, dominated by François Quesnay and Anne Turgot, believed that the wealth of nations was solely derived from the value of land and its produce. This notion was well-received at the French royal court, and made a splash in academic circles, but its preoccupation with land as the source of wealth ignored manufacture, which was playing an increasingly significant role in commerce.
Economic physiocracy had its strongest formulation with the late-17th-century idea of laissez-faire: that government should not interfere with the forces of the market in determining the allocation of resources. In the 1750s, French economist Vincent de Gournay popularized the term laissez-faire in promoting the free-market system as a natural order.
The promotion of laissez-faire was a direct attack on prevailing mercantilist doctrine, which favored government intervention to restrict free trade, subsidize non-competitive domestic businesses, and bolster monopolies which benefited the state. In contrast, laissez-faire physiocrats believed the government’s role should be restricted to national defense and domestic tranquility: unprofitable roles which nonetheless served business interests.
Adam Smith furthered faith in the physiocracy of laissez-faire. His 1776 Wealth of Nations laid the foundation for classical economics, which shaped economic thinking and public policy in Europe and the Americas for over a century. The American Revolution caused many to question the wisdom of mercantilism, and sparked interest in Smith’s formula to national wealth through free trade.
Some of the most widely read economists were economic classicists. Their moral sentiments were out of step with actual business practices. Classical economics was largely glossy theoretical myths.
One facet of classical economics was considering how economic changes occurred. In this vein, the marginalist school was founded in 1871 by English mathematician-turned-economist William Stanley Jevons, who explored marginal utility in his influential book Theory of Political Economy.
By the turn of the 20th century, marginalists had steeped economics in the fanciful ideas that business decisions were made at the margin, and that the decision-making process on both sides of the market – supply and demand – was rational. Marginalists developed the concept of utility to explain the prices that people were willing to pay for goods and services. Utility is the satisfaction derived from consuming something.
“Capital is that part of wealth which is devoted to obtaining further wealth.” ~ Alfred Marshall
Alfred Marshall became the most influential economist of his time with his book Principles of Economics (1890), which became the dominant textbook on the subject for decades. In it he defined neoclassical economics by coalescing supply and demand, production costs, price, and marginal utility into a conceptual coherency. Much of the success of Marshall’s book owed to its use of explanatory diagrams, which were soon emulated worldwide, and live on in this book in explaining price theory.
“Consumption may be regarded as negative production.” ~ Alfred Marshall
Marx’s stirring socialist sentiments had little effect until Vladimir Lenin used them to spearhead his autocratic takeover of Russia. Politically, socialism amounted to little more than cover for running a command economy by an elitist clique who called themselves communists. Lenin’s ruse was replayed decades later in China by Mao Zedong and his band of rebels.
The failure of neoclassical economics – that economic imbalances were naturally self-correcting – was painfully illustrated by the Great Depression. Global depression inspired John Maynard Keynes to fixate on demand as the wellspring of economic activity.
Keynesian economics was conventional for a few decades, until the gold standard started breaking down. This led Milton Friedman to fixate on money as the lever of economic activity. Unlike Keynes, who thought that government must occasionally act to keep the engine of capitalism running, Friedman’s monetarism did not stray from the religious faith of laissez-faire as a physiocracy, with an accompanying aversion to government interference.
Sensitive to the bilious externalities of free enterprise, John Kenneth Galbraith tried to break the spell of laissez-faire with his economic liberalism, which favored government regulation of capitalism. Galbraith’s sensibility failed to woo the mainstream, which remained in thrall to capitalist plutocracy. As Friedman might have explained: follow the money.
“A society that puts equality before freedom will get neither. A society that puts freedom before equality will get a high degree of both.” ~ Milton Friedman, explaining how American economic freedom delivered equality to the American people.
Economics & Psychology
“Because economics is the science of how resources are allocated by individuals and by collective institutions like firms and markets, the psychology of individual behavior should underlie and inform economics, much as physics informs chemistry.” ~ American economist Colin Camerer
Economic forecasts are regularly way off base, especially when their importance is most critical: in anticipating and curing economic shocks. The unreality of conventional economics models owes to their being based on bogus premises.
Economic theory began with Thomas More and Adam Smith, who examined economic activity in light of man’s moral nature. That holism was lost with the advent of neoclassical economics in the late 19th century, with the atomic calculus that emphasized marginals as the basis of economic decisions.
Psychology and economics both got swept up with the scientific method that had become de rigueur for academic disciplines. Inspired by modeling in physics, economists worked at formalizing economics mathematically. Contrastingly, psychologists became enamored with the experimental tradition, but understandably eschewed mathematical structure to characterize the mind. This divergence in approach broke the natural coupling of psychology and economics.
To a psychologist, a theory is a linguistic construct that organizes regularities in mentation. To an economist, a theory is a body of mathematical models which squirt out predictive variables dependent upon statistical inputs.
Another trend kept the fields apart. In the 1940s, economists took up neopositivism: the philosophical cudgel that crushes, as meaningless, statements not grounded in empirical evidence. While insisting on statistical facts for inputs, economists excused the patently false assumptions behind their models with a special twist, called the F twist, after its vocal proponent, Milton Friedman. The F twist stated that economic models which make accurate predictions are copacetic despite fictional assumptions, such as people being resolutely rational, and being single-mindedly focused on utility or profit. The F twist essentially gave economists license to ignore psychology.
“Economists routinely – and proudly – use models that are grossly inconsistent with findings from psychology.” ~ Colin Camerer
Many economic theorists worried that relaxing rationality assumptions would inevitably lead to models becoming analytically intractable: that reality would ruin the workability of the equations upon which economists relied. Theoretical leaps optimistically suggested that such conceptual stolidity is unwarranted; whence behavioral economics arose.
“Behavioral economics assumes that people are boundedly rational actors with limited cognitive processing power and time, whose choices are influenced by the contexts in which decisions are embedded.” ~ American economist Alain Samson
In trying to rationalize the irrationality of conventional economic models, behavioral economics is still in its infancy. Many of the fundamental drivers behind human behavior remain unincorporated.
“We need to know much more about when, why, and how much people value control.” ~ American legal scholar and behavioral economist Cass Sunstein
Just as in evolutionary biology, altruism and morality are hard to figure, as are other, more picayune peculiarities of the human psyche, such as information avoidance (e.g., the ostrich effect). The conceptual complexity that ensues from accepting that people don’t always look to their own naked self-interest is daunting to model.
“Evolutionary psychologists have challenged assumptions about the rationality that underlies behavioral economics.” ~ Alain Samson
More tellingly, the false idea of economic dynamics tending toward equilibrium has yet to be brought to heel. Predictive models which are predicated upon any degree of aimlessness (such as changing circumstances) presents a conceptual conundrum.
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The ultimate point of economic behavior is survival. Beyond material needs, people often behave economically to satisfy wants: personal desires, many of which are socially derived. From this view, a successful economic system would be where all people might live in a modicum of comfort. Economists have instead typically looked at economics from a more grandiose perspective: of achieving wealth and prosperity.
While acknowledging finite resources, free-market economists seldom suggest husbanding natural resources so that future generations may live as comfortably. A sensible emphasis on sustainable quality of life is disregarded for promotion of unsustainable growth as an economic dictum. Ignoring limits to growth – both in resource extraction and environmental destruction – has been a consistent blind spot for market-loving economists. Some hand-wave that advancing technology will cover for the losses, but that is just another heaping of fantastic whimsy.
The other dereliction of capitalist thought has been to ignore the breakdown in societal harmony that the market system delivers. The psychological and sociological costs of competitive materialism are asides in the theoretical edifices economists build.
“Economists emphasize the benefits of change rather than the injustices and unhappinesses that change brings with it; but even when populations have rising incomes, longer lives, and higher educational standards in total and, on average, many individuals within them may be suffering. Critics who emphasize the miseries of dislocation see matters differently from those who emphasize rising GNP. Even those who prosper may be unhappy if they think they should have done even better.” ~ English political theorist and historian Alan Ryan
Part of the failure of capitalist thought owes to economic models with a time distortion; instead relying the false assumption that everything continually occurs in equilibrium or is mystically moving toward equilibrium. But equilibrium is nothing more than a mathematical fiction that is never attained. Economic activity is an unceasing gyre based upon the current situation as perceived by its participants.
Economists commonly address the problem of abiding poverty under the maxim that “a rising tide lifts all boats”: growth is the recommended solution. As a modern market system relies upon capital allocation (investment) as its wellspring, this perspective has been properly termed trickle-down economics.
“Despite the relatively high average standard of living in the United States, poverty afflicts millions of people. And the particulars of poverty are deeply related to the social structures of class, race, and gender. The vast majority of the poor have always been women and children.” ~ American sociologists Margaret Anderson & Howard Taylor
The tragedy of the commons is the economic observation that natural resources will be depleted in the unfettered pursuit of self-interest. Proven time and again throughout history, this tragedy can be taken as axiomatic.
“The worst error of all is to suppose that capitalism is simply an economic system.” ~ French historian Fernand Braudel
The physical outcome of the commons tragedy – pollution – extends to the basic necessities of life: clean air, pure water, fertile soil. More insidious costs are incurred, most notably societal discord caused by the gross inequities that the market system physiocratically generates. The class struggle that Marx focused on was between the haves and the have-nots that characterizes capitalism; a socioeconomic schism which festers as an economy matures.
Neoclassical economists’ universal prescription for the market system’s inherent flaws, including the inequities, is to impose some limits while not killing the goose laying all the golden eggs. Those less-religious wonder whether the eggs laid are worth the unattributed costs.
An economic system is a commons, as its costs and benefits are shared by all to some extent. The quality of an economic system may be adjudged by the distribution of its outputs. In the case of capitalism, the wealthy reap a disproportionate share of the benefits while the poor are burdened with more of the costs.
Beyond the socioeconomic problems of class stratification, capitalism instills materialism as a metric of the quality of life, fosters a competitive spirit, and strengthens self-interest and a sense of entitlement. In eroding self-esteem, comity, and trust, such social-psychological diseases sicken individual and societal well-being. By succoring suspicion and greed, capitalism is self-defeating, as commerce relies upon confidence in the integrity of strangers.
Capitalism is an ongoing confidence game. Economic cycles are periodic Collective exercises in undue optimism and panic.
Trust is essential to economic activity. Implicit trust is the only reason that anyone conducts an economic transaction besides barter, when the goods exchanged are at hand.
“Virtually every commercial transaction has within itself an element of trust.” ~ American economist Kenneth Arrow
Competition in most every quarter of social life cuts against trust. Morality is readily cast aside when there is something to gain by guile. Such is the state of the world’s societies.
“Competitive markets by their very nature spawn deception and trickery.” ~ American economists George Akerlof & Robert Shiller
The 2008 recession was almost as much a shock to the societal trust system as it was to the economy. Lack of trust retarded recovery.
“The government’s ability to fight the recession was substantially constrained by the fact that its credibility was in tatters.” ~ American economist Justin Wolfers
Beyond blind eyes, a saving grace to capitalism is folks’ short memory; that, and the powerless of most of the population to change their fate. The competition for the future has already been won by those with the wealth to purchase outcomes – in that you can trust.
“It is the loss of social capital at all levels of community that most threatens the world’s stability and future prosperity.” ~ American journalist Roger Cohen
“The value of an item must not be based on price, but rather on the utility it yields.” ~ 18th-century Swiss mathematician and physicist Daniel Bernoulli
People purchase products for their benefits. Accordingly, a key concept in economics is utility: the satisfaction derived from consumption. More broadly, utility is a measure of preferences. Economists myopically consider utility to be revealed by people’s willingness to pay dissimilarly for different goods.
To consume a product or service is to make some use of it. In economics, consumption does not imply using something up, even as that often happens in the act.
The term expected value was coined in 1654 by Blaise Pascal after abstractly examining the probabilities of outcomes. Expected value is the anticipated utility of some specific consumption and is probabilistic; but people value things differently than indifferent mathematics can ascertain, and human decisions are not impartial. Probability applied to human utility is wonky.
“Men of good sense value money in proportion to the usage they may make of it.” ~ Gabriel Cramer
In the mid-18th century, Swiss mathematician Gabriel Cramer attributed limits to human appetite with the concept of a declining marginal utility. The appreciation of growing wealth is never zero, but beyond a threshold of want, each coin added to the pile means a bit less than the one before it.
One implication of a concave utility curve has to do with risk aversion: people prefer to receive a smaller but certain amount rather than gamble with the chance for a larger haul. This explains why investors expect a higher return for risky assets. It is worth noting that risk is entirely within the mind: a psychological attribution of probability with no statistical basis in actuality.
In the early 1950s, French economist Maurice Allais pointed out that utility theory does not always account for people’s behavior. Faced with lopsided choices, people do not necessarily make a rational decision (e.g., the certainty of $1 million versus the chance at either hundreds of millions or nothing at all). This is called the Allais paradox.
A few years later, American sociologist and economist Herbert Simon proposed that people, often unable to gather all relevant information and process it, do not try to maximize utility, but instead set modest goals of what would satisfy them.
In 1979, Israeli American psychologists Daniel Kahneman and Amos Tversky came out with prospect theory, which posits that people make decisions based on the potential of immediate loss or gain rather than a probabilistic final outcome. This explains the commonness of short-sightedness.
Insights from prospect theory include that losses hurt more than gains feel good (loss aversion); decisions depend upon how situations are framed (framing effect); and that probabilities are perceived to be smaller than they actually are, except for quite unlikely probabilities, or those considered certain, which are perceived as larger.
Further, certainty is not as desired as utility theory would have it. Instead, a sense of certainty increases aversion to loss as well as the desirability of gains.
Human heuristics have their own internal, emotively based logic, existing in a conceptual universe parallel to probability.
People often prefer insurance programs that offer limited coverage with low or zero deductible over comparable policies that offer higher maximal coverage with higher deductibles – contrary to risk aversion. Evidently, the intuitive notion of risk is not adequately captured by the assumed concavity of the utility function for wealth. ~ Daniel Kahneman & Amos Tversky
The experimental findings by which prospect theory was developed demonstrate that utility theory, based upon expected values, is inapt, as human rationality is biased.
“Utility theory, as it is commonly interpreted and applied, is not an adequate descriptive model.” ~ Daniel Kahneman & Amos Tversky