Naive Experts: Economists and the Real WorldBy John Médaille for FRONT PORCH REPUBLIC
A review of Robert E. Prasch, How Markets Work: Supply, Demand, and the ‘Real World’ (Edward Elgar: Northhampton, MA, 2009).
It is considered something of a rude question, nevertheless I think it fair to ask why 90% of all economists missed the coming of the current disaster. One doesn’t wish to judge too harshly. After all, everyone makes mistakes, even scientists. And if economic science missed this one, it wouldn’t be fair to use such a mistake to call into question the whole science. None of us would wish to be judged by one mistake. Should we not extend the same courtesy to economic scientists?
The problem, however, is that the same 90% of all economists also missed the last crises, and the one before that as well, and before that, and so on. In fact, their record of being able to diagnose and treat economic problems is about zero. And their prescriptions always seem to be counterproductive: the recommendations to limit government always make it grow, their advice on limiting taxation always makes it more, their prescriptions on growing the economy only leads to the illusory growth of bubbles, etc. Put it this way: If your doctor had this same track record of diagnosing and treating disease, you’d be dead by now.
Obviously, there is some deep problem at the heart of economic science which prevents it from being a useful analytic or prescriptive tool. Let me suggest that the problem lies in the very name of that discipline, which is a new name, only about 100 years old. The study of economic systems is as old as Aristotle, but this study was always considered to be a branch of ethics, and the proper functioning of any economic system was believed to be dependent upon proper ethical arrangements. Adam Smith, for example, was himself a professor of Moral Theology. Through most of the 19th century, the science was known as political economy. As the name implies, an economic system was always viewed as something embedded within—and dependent upon—particular political and social institutions, and could not be studied apart from them. Further, political systems cannot be viewed apart from ethics. It was this connection with ethics that made the new “economists” uneasy. As one wag put it, they suffered from “physics envy,” and wanted to divorce their “science” from any moral considerations, making it solely a matter of pure calculation (as with the neoclassicals) or of pure deduction (the Austrians.) By the start of the 20th century, the term political economy disappeared from common usage and was replaced by the new “science” of economics, a “science” divorced from the moral world.
However, the elimination of ethics could only be accomplished by a ruthless reductionism: man was reduced to an “economic calculator” capable of acting only in self-interest, while all markets were reduced to a single model of supply and demand curves with a single, well-defined equilibrium points. The new homo oeconomicus was conceived as a pure individual with no natural ties and was no more than a collection of unfulfilled desires, always waiting for the entrepreneur to fill them up, while creating new wants. Thus, it is an economics designed for an alien race, built on markets of a single type. But are all men like this new creation, and are all markets like the one they modeled? In other words, does current economic theory bear any relationship to the real world?
These questions are at the heart of Robert Prasch’s book, How Markets Work: Supply, Demand, and the ‘Real World’. This book is comprised of nine brief lectures that challenge the market fundamentalism which has come to dominate the economics profession, whether of the Austrian or more mainstream neoclassical economists. Dr. Prasch first deals with property, contract law, and a theory of exchange, which is the proper place to begin any study of the markets. He concludes that, “[T]he social institution that we term ‘the market’ is a complex construction, based on an evolving system of rights, property law, and contract law,” all of which depend on the political and social environment. Hence,
[T]he social scientific and policy question is not whether the law or the state is involved in the market. Rather the correct question is just how it should be involved, and what laws and regulations make the most sense. In short, “regulation” is not necessarily in conflict with “the market.” On the contrary, the social arrangement that is conventionally called a “free market” has been built upon a long and evolving tradition of legally framed rights, distinctions, and prohibitions that is continually interacting with an equally long history of evolving ideas, legislation, and court rulings on property and contract law (27).
Prasch next turns his attention to commodity markets, which form the model for standard economic theory. The problem with this theory is not that it doesn’t work, but that it does work, and works rather well, but only for certain kinds of commodities under certain conditions. This model works for non-status, man-made, reproducible, highly elastic commodities for which many substitutes and complete information is available and which are supplied by a vast number of firms such that no firm has any pricing power; they are all price-takers rather than price-makers. Such “spot markets” can easily be modeled on relatively simple supply and demand curves with a single equilibrium point. This is the “self-correcting” market model which requires little government regulation.
Nearly everyone is familiar with the operation of markets of this type because it is the market model deployed in arguments about government regulation of credit and asset markets, labor markets, environmental and safety standards, etc. But these other markets do not look at all like the simplified commodity market model. They have completely different supply and demand curves. At this point, economics and reality go their separate ways. Prasch takes us on a journey through markets which have completely different characteristics, specifically credit, asset, and labor markets. These markets have complex supply and demand curves which are completely different from simple commodity markets.
Credit market, for example, exhibit “backward-bending” supply curves. As interest rates rise, the quality of borrowers falls, and banks are less willing to provide the loans. The good borrowers get out of the market when the rates rise; they defer their plans or seek other sources of credit. So as demand rises, the interest rate rises, but so do the risks. As Adam Smith noted, with high rates, “the greater part of the money…would be lent to prodigals and projectors, who alone would be willing to give this high interest.”
Asset markets are peculiar in that while a commodity price is based on the “history” of a product, an asset price is based on its future. That is, the price of a commodity must in general recover the costs of that commodity, or it will cease to be produced. But costs have little to do with asset prices; they are based solely on the expected revenue stream of the equity. But a history can be known, the future cannot; it can only be discovered. These markets are highly emotional and are subject to all sorts of information asymmetries (where one party knows more about the asset than the other), speculation, arbitrage, uncertainty, etc. There is simply no simple model of their behavior.
Prasch’s most interesting work concerns labor markets, and here he parts company with the standard theory in the most radical way. The standard theory treats labor as just another commodity with a “normal” supply and demand curve. Looked at in this way, all government interference in such a market, such as minimum wage laws, would be counterproductive. But labor is not a commodity manufactured for the market. Labor, of course, is human beings, and since most people must live from their labor, they cannot substitute some other “commodity”; this is a market which is driven by necessity rather than choice.
Standard theory contrasts “work” with “leisure,” and all that is not (paid) work is leisure. But it is a travesty of language to say that people living on the streets are enjoying leisure. Further, much of the time spent apart from paid work is given to other kinds of work, such as that necessary to maintain a family and a household. Leisure, properly considered, is a joint product of free time and purchasing power, and only those with sufficient purchasing power can “substitute” leisure for work. Therefore paid work is balanced against leisure and other forms of work. This gives the supply curve for labor a serpentine form with four equilibrium points, two of which are stable and two unstable. The stable points occur near subsistence,where people must give more hours just to live or to maintain an acceptable lifestyle, and at a higher point where work may be freely traded for leisure. The result is a dual labor market, one which is low wage-high hours, and the other high wage-low hours.
Although standard theory denies the possibility of multiple equilibrium points in one market, Prasch’s description matches more closely the labor markets we actually see in the real world. The problem with the standard theory is that it doesn’t account for the dual market (“work” and “leisure”) represented as one supply curve. In such a case, a supply curve can be serpentine with multiple equilibria.
Is the existence of a low-wage equilibrium point a problem? Yes, and for several reasons. The first is that people who must work at low wages can only get out of poverty by giving more hours to work. But as they give more hours, thereby increasing the supply, they further lower the wage. Thus low wages lead to even lower wages if a significant number of people try to escape from poverty. This is called a “poverty trap,” where any attempt by a group to escape poverty leads to more poverty. But this is just the beginning of the problems. The next difficulty is that low wage workers have less time to devote to family work, to the serious job of raising families and maintaining homes. Thus family structures are weakened, often fatally. But the whole point of a sane economy is to strengthen the family and provide the material basis for the stable family structures upon which any stable society must rest.
We can expand on Prasch’s analysis by pointing out that as bad as the low-wage market is for workers and their families, it also posses a dilemma to investors. The entrepreneur may believe that he is being clever by depressing wages and increasing profits. However, the wage bill for one firm is also the primary component of the demand curve for every other firm. By depressing wages, the entrepreneur lowers demand in every other sector. If this is widespread (e.g., when there is a lot of outsourcing) consumer markets are under-supplied with purchasing power, while capital markets are over-supplied. The entrepreneur makes more money, but he finds there is less opportunity to invest it, because the very success of his strategy has narrowed demand. Since the productive economy offers less opportunity for the excess capital, the investor turns to purely speculative gambling instruments such as the synthetic CDOs and CDSs with which we have become all too familiar.
Understanding the labor market leads to better policies. For example, a minimum wage set below the low-wage equilibrium point will have little effect on the market, but one set above it will tend to drive the market towards the higher equilibrium point. Workers with some excess over their perceived needs will be freer to enter the “leisure” market and thus give more time to family work and actual leisure.
Prasch also analyzes the social effects of markets. Standard theory proposes that the market by itself, and without the aid of government rules, is capable of solving social problems such as discrimination. Prasch shows why this is naïve, and why such problems can persist no matter how free the market.
These nine lectures are easy to read yet not lacking in sophisticated analysis. Both the amateur who wants an introduction to the laws of supply and demand and the economist looking for better analytic tools will find this text useful. But most importantly, Prasch provides a technical analysis of ethical issues in economics. Too often, those who wish to re-establish the ethical pole of the debate cannot do so in technical terms. Thus their arguments come off as mere bromides or preaching and fail to persuade the economist. It is not enough to merely insist on a connection between ethics and economics; one must demonstrate the connection at a technical level, or the two sides will simply be talking past each other.
It should be clear by now why economists have failed, by and large, to anticipate the recurring disasters or to proscribe effective remedies. You cannot predict the course of a system if you cannot accurately describe it, and the simple models simply fail to account for the realities. Unless and until economists get better models, they will continue to be naïve experts, skilled at discussing highly artificial systems that have little real world applications.