Mainstream Economics Has Failed, Part 3

[Full disclosure: this blog is the very first draft - a sketch - of an article submitted to a peer review journal. A reference will be added upon publication.]

In graduate school, most economics students are discouraged from reading anything that is older than five years. The reason for this is that modern-day economics has evolved into a heavily technical profession where methods are more important than methodology, even theory. Applications are often closely limited to what good old Friedrich Engels would refer to as "eclectic flea killing". I emphasize "often", because this is a general trend, not an absolute fact. 

Nevertheless, this general trend has repercussions on the usefulness of economics in modern policy making. The past 20 years of macroeconomic development in the Western world present ample examples of how economics miss the big issues because of its methodical constraints. Among them, the construction of the currency union in Europe stands out as perhaps the worst one. Already from the start the union had an artificial division of policy assignments built into it:

• monetary policy, run by the ECB, was assigned the task of inflation control; 
• fiscal policy was assigned the task of budget balancing; and 
• the labor market was supposed to be the engine for full employment.

The implicit assumption behind this construction is that unemployment - and by consequence job creation - is a matter of equilibrium pricing on the labor market. Economic growth is assumed to be an automatic process that is only hampered by high interest rates, which in turn is the result of excessive deficits. 

In other words, the entire architecture of the European Union rests on the methodological premise of long-term stability or long-term equilibrium as being an automated process inherent to the economic system. This is a serious methodological flaw that, as is evident in national-accounts data for the euro zone over the past 15 years, has only led to stagnation and the withering of prosperity for almost half-a-billion people. This methodological flaw, in turn, could work its way into the currency union's architecture because economists in general are blindly guided by their excessive belief in technical methods which, in turn, cannot work "rigorously" unless the economy over time, by its own volition, drifts back to full-employment equilibrium. 

Again, the construction of the euro zone is one example. It is a compelling one, though, because it allowed mainstream economics to turn an entire continent into a gigantic macroeconomic laboratory. 

The failure of the currency union is, again, evident in national accounts, but it is also evident in the fact that both the monetary authority and the fiscal-policy managers (governments) have chosen to abandon their duties as assigned to them under the original Maastricht Treaty (later Lisbon Treaty). The ECB, which was supposed to run a strictly monetarist regime, has been flooding the euro zone with newly printed money at frightening rates; most governments within the euro zone are having perennial problems balancing their budgets. 

At this point one would expect a flood of economics research examining the fault lines within the euro-zone structure. No such mass movement has taken place, though, and its absence is particularly notable at the methodological and, especially, theoretical level. The reason, again, is the inability of mainstream economics to break out of its inherent-equilibrium paradigm.

The big question, of course, is: how do we as practitioners of economics offer a theoretically and methodologically viable alternative to the increasingly irrelevant mainstream of our profession?

Today, let me offer one step toward that alternative. In 1950 the late Armen Alchian published Uncertainty, Evolution and Economic Theory in Journal of Political Economy. It is perhaps the most stimulating piece of scholarly work in economics in the past century. Alchian's goal with this article is to demonstrate that you can indeed systematically analyze economic behavior even if your analysis does not rely on the mechanics of self-stabilizing long-term equilibrium.

As a methodological framework, Alchian borrows a page from evolutionary biology. Where mainstream economics relies on classical mechanics, a closed system with mathematical precision and predictability, Alchian uses a system that is open and where success is based on trial and error. 

The openness of the system is its permission of failed action. Evolution can spur species or subcategories of a species that is unsuccessful in surviving under the conditions of its natural environment. Mechanics, by contrast, always works and therefore rules out failed action. This difference is crucial, as it is the difference between: 

• an economic system where, as Alchian explains, "incomplete information and uncertain foresight" is permitted as axioms of economic behavior; as opposed to 
• an economic system based on classical mechanics where the economic environment is defined by perfect foresight and uncertainty is absent.

Alchian's first step toward building his open system is the dismissal of the motives of individual action as stipulated in mainstream microeconomics:

Current economic analysis of economic behavior relies heavily on decisions made by rational units customarily assumed to be seeking perfectly optimal situations. Two criteria are well known - profit maximization and utility maximization - According to these criteria, appropriate types of action are indicated by marginal or neighborhood inequalities which, if satisfied, yield an optimum. ... the economist interprets and predicts the decisions of individuals in terms of these diagrams, since it is alleged that individuals use these concepts implicitly, if not explicitly. 

The problem is that the real world does not offer the confinement of foreseeable outcomes needed for individuals to make optimal decisions. Instead, in real-life situations of uncertainty,

by definition, each action that may be chosen is identified with a distribution of potential outcomes, not with a unique outcome. Implicit in uncertainty is the consequence that these distributions of potential outcomes are overlapping. It is worth emphasis that each possible action has a distribution of potential outcomes, only one of which will materialize if the action is taken, and that one outcome cannot be foreseen. [Emphasis in original text]

This is the forecasting problem that Keynes often referred to as "we simply do not know" enough about the possible outcomes. More formally, in his Treatise on Probability Keynes suggested that under uncertainty, we may have a confined set of alternative outcomes, but there is no way for us to put any probability numbers on them. By default, therefore, all outcomes are equally probable - which is the same as saying that probability is a pointless concept, and decisions have to be made on other criteria. 

Keynes and Alchian both refer to the distribution of possible outcomes based on the likelihood of each outcome being the result of a given action. Since the conditions of uncertainty preclude a decision based on verifiable probabilities, some business decision makers rank possible outcomes under uncertainty by worst-case and best-case outcomes. If there is no way to tell the probability of an outcome, this dichotomy offers a method that, as far as possible, protects the business against disastrous consequences.

This business method for managing uncertainty allows decisions and risk-taking even when market conditions are unfavorable. That said, if the difference between best-case and worst-case outcomes is big enough, the lack of outcome probability - which in lieu of other criteria translates into lack of outcome controllability for the decision maker - may lead to a decision to not act at all. If, on the other hand, the business can configure its decision so as to narrow the gap between best-case and worst-case outcomes, its distribution becomes what Alchian calls "preferable" or "optimum distribution" as opposed to the "optimum decision".

In order to be able to navigate an uncertain economic environment and define a preferable or optimal outcome distribution, economic decision makers cannot follow the traditionally stipulated principle of profit or utility maximization. Alchian again:

In the presence of uncertainty - a necessary condition for profits - there is no meaningful criterion for selecting the decision that will "maximize profits." The maximum-profit criterion is not meaningful as a basis for selecting he action which will, in fact, result in an outcome with higher profits than any other action would have, unless one assumes nonoverlapping potential outcome distributions. [Emphasis in original text] 

In other words, under uncertainty it is not possible to distinguish with certainty the specific, individual outcomes within an outcome distribution. If that were possible, decisions under perfect foresight would not only be possible, but guaranteed. Since it is not possible to distinguish individual outcomes from one another, it is not possible to isolate that one outcome that will deliver maximum profits. 

Therefore, under uncertainty it is meaningless to use profit or utility maximization as a criterion for individual action. Alchian instead suggests an "economic natural selection" process. The selection mechanism is the realization of profits, as opposed to maximization of profits. Profit realization is the outcome of a market process; profit maximization, on the other hand, is a criterion of individual action. The market process, Alchian points out, is normally "independent of the decision processes of individual units", i.e., the individual business or household is too small to determine a priori the outcomes of their own actions. 

As an illustration of the importance of this point, consider the amounts of money that corporations spend on legislative lobbying. When government interferes with the market process by taxation and regulation, it steers the market in another direction than the market itself would have gone. The very fact that businesses are willing to influence legislation - or even purchase tailor-made legislation when possible - is a clear indication that the entity that separates successful businesses from unsuccessful ones are the market. 

The criterion used by the individual decision maker is not unimportant, but less important than the market process. More importantly, however: by emphasizing the market as the arbiter of success, as opposed to individual decision criteria, Alchian opens for competition between various criteria. (This has important implications for the evolution of the free market itself. Let us get back to this point later.) It also elevates the market to the status of arbiter of success. Alchian notes that "realized positive profits, not maximum profits, are the mark of success and viability". Realized profits is an ex-post criterion, as opposed to maximum profits which guides decisions ex ante the market process. This difference emphasizes the role that the market plays vs. the individual: if the conditions on the market place are not known - as is the case under uncertainty - then the individual's realized profits depend not on his knowledge of the market, and not on his maximization behavior, but on the actual market process.

This is Alchian's way of showing that the idea of profit maximization only belongs under the special case of perfect foresight. Under all other states of foresight, the motivation of the individual is less important than the realized results. Or, as Alchian so neatly summarizes this point: even in a world of stupid people, profits will exist. 

Since the market is the final arbiter of profits, and since individuals do not have perfect foresight of the market process, it is not known a priori what actions by the individual, in preparation for the market process, that will lead to realized profits. Therefore, the more uncertain the future is, the more of a trial-and-error process will take place as individuals try to survive on the market. 

It is at this point that Alchian's theory significantly departs from mainstream theory. When individuals survive on the market, with survival being defined as realized profits, they will return to the market with experience of past success. This will motivate them to repeat the same behavior that led to success in the first place; repetition and realized profit, rather than profit maximization, is how individuals prevail.

This conclusion is also relevant from a Keynesian viewpoint. Post Keynesian theory prescribes that:

a) uncertainty is the default setting on a market;
b) individuals reduce the impact of uncertainty on their lives by repeating successful behavior; and
c) they build a path into the future, based on the experience of successful behavior, by contracting conditions of trade in advance. 

The most obvious manifestation of point (c) is sticky prices. In other words, sticky prices are good for the individual - not bad as mainstream theory suggests - because they allow firms, households and investors to reduce uncertainty about the future. 

The one important question, though, is what we know about the process that leads to point (c). Again, Alchian has the answer:

In general, uncertainty provides an excellent reason for imitation of observed success. Likewise, it accounts for observed uniformity among the survivors, derived from an evolutionary, adopting, competitive system employing a criterion of survival, which can operate independently of individual motivations. Adapting behavior via imitation and venturesome innovation enlarges the model. Imperfect imitators provide opportunity for innovation, and the survival criterion of the economy determines the successful, possibly because imperfect, imitators. 

Imitation, or the repetition of observed successful behavior, implies formulation of rules for future action. Such rules, in turn, gradually take the form of institutions, either explicitly through enforceable contracts or implicitly through invisible handshakes and habitual economic behavior. For example, I stop at the same grocery store twice a week to buy bottled iced tea in considerable quantities, and in return the store continues to carry the product. We have no written agreement, just their observation of my consumer behavior and my observation of their entrepreneurial decision to keep the product on the shelf.

Institutions then evolve into the bulwark against uncertainty. If these institutions are private and subject to constant challenges from changing market conditions, their sustainability is guaranteed by the impartial arbiter of the free market.

However, not all institutions are, or remain private. Some are taken over by government and become representations of government's permanent presence in our lives. We know that presence as entitlements, regulations and taxes. The problem with these institutions, as opposed to the ones that are subject to constant challenges from the free market, is that their existence is subject to political preferences and legislative decisions. Those are factors that can become far-withdrawn from the free market. As a consequence, decisions to change government-run institutions can also be entirely withdrawn from the free market. 

What does this mean in practice? The answer to this question should bring us to the foundation for an alternative to mainstream economic theory. 

Stay tuned.