28 Neo Classical Economics
The development of neoclassical economics can be read as one long apology for why capitalists deserve their income. Fix (2023) Inflation regulation by wage hikes
Neoclassicism is a religion dressed as a science
Neoclassical economic theory has never resembled a scientific enterprise. It’s simply an ideology presented through an avalanche of mathematics. The underlying assumptions of neoclassical theory all serve to justify the capitalist status quo. When we equate market value with utility, we implicitly assume that individuals’ income indicates their contribution to society.
28.1 General Equilibrium
Ayres
In a closed Walrasian model resources are assumed t o be generated by labor and capital. The neo-classical (Walrasian) equilibrium system does not qualify as a dissipative structure. The neoclassical system is, in effect, a perpetual motion machine.
Ayres (1988) Self-organisation in Biology and Economics (pdf)
28.2 Free Market
Fix
According to neoclassical economics, the most efficient way to organize hu- man activity is to use the free market. By stoking self interest, the theory claims, individuals can benefit society. This idea, however, conflicts with the evolution- ary theory of multilevel selection, which proposes that rather than stoke self interest, successful groups must suppress it. Which theory better describes how human societies develop? I seek to an- swer this question by studying the opposite of the market: namely hierarchy. I find evidence that as human societies develop, they turn increasingly to hier- archical organization. Yet they do so, paradoxically, at the same time that the language of free markets becomes more common, and culture becomes more individualistic. This evidence, I argue, contradicts free-market theory, but only if we treat it as a scientific doctrine. If instead we treat free-market theory as an ideology, the pieces come together. Free-market thinking, I speculate, may stoke the forma- tion of hierarchy by cloaking power in the language of ‘freedom’.
In this evolutionary context, the theory of free markets is an outlier. It posits that, contrary to what we observe among other social organisms, humans need not suppress self-interest to organize in large groups. And we need not use hierarchical organization. We can build complex societies, the theory claims, using decentralized competition.
Treating firms (notindividuals) as the unit of competition legitimizes the firm as an autonomous unit, while leaving the firm’s internal structure as a ‘black box’. By championing firm autonomy, free-market theory may legitimize the firm’s internal chain of command, thereby justifying the accumulation of power.
Neoclassical economics may be best treated as a belief system whose existence should be explained using the tools of cultural evolution.
Neoclassical theory — claims that outcomes from perfectly competitive markets are ‘optimal’, whereas outcomes from centralized control are ‘inefficient’. It is much like if biologists deemed single-celled organisms to be ‘optimal’, but deemed multicellular organisms ‘inefficient’.
Hierarchi - supressing lower-level selection
More complex structure is built from simpler components. Growth of complexity involve the centralization of control. Nested hierarchy occurs through a process of evolutionary problem solving. Structures evolve that solve specific problems. Newly created structure serves as the building block to solve new problems. Large, complex organisms are not composed of autonomous units. The growth of complexity involve gradual loss of autonomy among sub-units and the growth of centralized control. As societies become more populous, they add new layers of administrative hierarchy. Centralized control arise for two (related) reasons. First, assembling a larger system from many smaller components requires coordination. Second, there is the problem of the ‘self-interest’ of sub-units. The major evolutionary transitions happened by merging sub-units that were previously autonomous. According to the theory of multilevel selection, this merger is not possible unless the ‘self-interest’ of sub-units is suppressed.
The key insight of multilevel selection theory is that high-level organization requires high-level selection that suppresses selection at lower levels. Group-level selection suppresses individual-level selection.
Successful groups suppress lower levels of selection by turning to top-down ‘management’. Large-scale organization is accomplished by integrating subunits into a hierarchical control structure.
Whether complex organization requires hierarchy is an open question. But it does seem that complexity and hierarchy go hand in hand.
Free Market - No Hierarki
According to the neoclassical theory of free markets, hierarchy is unnecessary for group organization. Instead, neoclassical theory argues that humans can organize effectively without any form of centralized control. All that is needed is a competitive market.
The ‘first fundamental theorem of welfare economics’claims that under conditions of perfect competition (in which all firms are ‘price takers’), markets will allocate resources in a way that is ‘Pareto efficient’ With their welfare theorem in hand, neoclassical economists look at hierarchical organization and see an ‘inefficient’ system.
The growth of hierarchy with economic development
Fix (2021) Economic Development and the Death of the Free Market (pdf)
28.3 Trade Theory
International trade theory’s prediction of equalization of wages across coun- tries is, in my view, the key terrible simplification that causes world hunger.
Not only are all qualitative diff erences assumed away, the production process itself is also abstracted away. Assuming away unemployment, as the World Bank traditionally does in its models, only adds another dimension to the terrible simplifi cation on which our world economic order is based. In many countries, 80 per cent of the potentially active population are unemployed or underemployed. Assuming that fact away is a terrible simplifi cation.
At the core of our world economic order lie the terrible simplifi cations of international trade theory. Assuming perfect information (i.e. that all know the same) and constant returns to scale for all ranges of output for all goods (i.e. no fi xed costs), and assuming that all goods are private, there is no reason why there should be any trade at all (except in raw materials, for reasons of climate and geography). In its most simple form, the theory that regulates international trade is based on assumptions that mimic conditions which would not produce any division of labour or any trade. It describes a world in which every human being would be a self-suffi cient microcosm. Th e WTO and our world order are based on theories that are, at their very core, fairly simplistic banalities wrapped in an appearance of ‘science’.
Both Mill and Keynes saw that poor countries need an increasing returns sector, i.e. an industrial sector, in order to become wealthy.
What unites the failure to understand that a fi nancial crisis was coming and persistent poverty in the Th ird World is an economic theory at a level of abstraction where production is left out, a theory where the world economy is perceived as stock markets and freight terminals. In reality, markets and trade are mere complements of an incredibly complex global system of production. By focusing on stock exchanges and trade, the complexities of world production have essentially been left out of economic theory.
Why are there so few middle-income countries? Why do countries tend to cluster in two convergence groups, developed and ‘underdeveloped’?
This paper argues that our inability to create middle-income countries is a result of ‘terrible simplifi cations’ resulting from destabilizing stability, as described by Minsky, from ‘theoretical overshooting’ in Hayek’s sense. The policy recommendations resulting from this theoretical overshooting have made the creation of new middle-income countries virtually impossible. A middle-income nation has an increasing returns (industrial) sector which, for a while, is not yet competitive on world markets. Opening to free trade was supposed to even out world incomes. Th e WTO’s fi rst Director-General, Renato Ruggieri, declared that we should unleash ‘the borderless economy’s potential to equalise relations among countries and regions’. Instead, this process ended up killing the incipient industrial sectors in poor countries, lowering real wages. Th e belief that the market, left to itself, guarantees harmony was at the core of the Washington Consensus ideology of the International Monetary Fund (IMF) and the World Bank.
Colonialism
Involves a technology policy preventing increasing returns activities from being established in the colonies.
A poor nation is much better off with a relatively inefficient manufacturing sector than with no manufacturing sector at all.
28.4 Human Capital Theory
The idea of workers as embodied capital
Individual capabilities are fundamentally social
The sentiment behind eugenics (that some people are far more productive than others) lingers on in mainstream academia. It survives – even thrives – in human capital theory.
In the 1950s, economists at the University of Chicago tackled the question of individual income. Why do some people earn more than others? The explanation that these economists settled on was that income resulted from productivity.
The claim that income stems from productivity was not new. It dated back to the 19th-century work of John Bates Clark (1899) and Philip Wicksteed (1894), founders of the neoclassical theory of marginal productivity. Clark and Wicksteed, though, were concerned only with the income of social classes. What the Chicago-school economists did was expand productivist theory to individuals.
Doing so required inventing a new form of capital. The idea was that individuals’ skills and abilities actually constituted a stock of capital – human capital. This stock made individuals more productive, and hence, earn more income.
The idea that skills constituted “human capital” was initially greeted with skepticism. For one thing, the term itself smacked of slavery. (Capital is property, so “human capital” implies human property.) For another, human capital theory overtly justified inequality. It implied that no matter how fat their incomes, the rich always earned what they produced. Any attempt (by the government) to redistribute income would therefore “distort” the natural order. During the 1950s and 1960s, there was little tolerance for such views. It was the era of welfare-state expansion, driven by Keynesian-style thinking. Yes, big government may have been “distorting” the free market – but society seemed all the better for it. Until the 1970s, human capital theory remained obscure.
In the 1990s, a second generation of economists took up the human-capital mantle. By then, neoliberal politics was in full swing. The fact that human capital theory explicitly justified inequality was no longer a liability. Today, the fortunes of human capital theory seem to have peaked.
We can see the scientific flaws by returning to William Muir’s chicken experiment. I have already told you about his psychopathic chickens, created by breeding the most productive hens. But I have not told you about his alternative trial. In it, he bred the most productive group of chickens. The result was an astonishing increase in egg-laying productivity.
The reason this group selection worked is that chickens are social animals. That means productivity is influenced by the social environment. By selecting productive groups, Muir selected for egg-laying ability, but also for sociality. The resulting social hens flourished together.
Human capital theory supposes that income stems from productivity, and that this productivity is an isolated trait of the individual.
When we expose the realities of power (a social trait), we undermine the legitimacy of the social order.
28.5 Efficiency
Klees
Much has been written about the failure of neoclassical economic theory (NCT), so I won’t belabor the point, but I do want to highlight what is too rarely said – that the central concept of NCT, economic (Pareto) efficiency is empty in theory and practice.
The great feat of neoclassical economics has been to convince people that there is a vantage point to view society, separable from concerns with equity and distribution. This vantage point, defined as economic efficiency, supposedly allows one to see if society as a whole is better off, such that decisions to produce a particular array of goods and services could be made in the interests of everybody, irrespective of how little one had, thus separating efficiency decisions from equity ones. However, if prices are not defined according to the exact dictates of what economists call “perfect competition,” then private profitability tells us nothing about the comparative social advantages and the consequent “efficiency” of producing, let’s say, more yachts for rich people instead of more rice and beans for poor people. Similarly, to argue that the allocation of resources can be “efficient” even if half the world is starving to death is ridiculous, but that is exactly what neoclassical economics says.
I find this legerdemain of inventing a concept of efficiency separate from equity, based on a completely unreal, obviously untrue, abstraction, is absurd on the face of it. If the absurdity of this framework is not obvious, one only has to look at what NCT calls “second best theory.” The “first best” world is that of perfect competition; “second best” refers to a world with at least one “imperfection,” say, one monopoly in a world that was otherwise perfectly competitive. Second-best theory essentially asks: “If we don’t live in the first-best world of perfect competition but have, let’s say, only one imperfection in an otherwise perfect world, what are the results?” It turns out, reluctantly admitted by neoclassical economists – second best is their own theory, not a plot by critics – that with just one imperfection, there are ripples so that all market prices become distorted, and Adam Smith’s famous invisible hand is no longer a good guide to the social interest, and the system is no longer efficient — nor is there even any sense of whether it is close to efficiency. In the real world of multiple imperfections – where none of the assumptions of perfect competition hold – even if the neoclassical concept of efficiency had some meaning in theory, in practice, it is an abysmal failure, a completely empty idea.
The implication of my critique of NCT is that if economic efficiency is meaningless, neoclassical economics is useless.
There is no reason to stubbornly hang on to NCT and its justification for capitalism in the way that even critical neoclassical economists like Krugman, Reich, Rodrik, and Stigltiz do.
Klees (2021) Neoclassical Economics is Dead. What Comes Next?
28.7 Production Function
Fix
Friedman’s famous ‘F-twist’, in which he argued that a theory’s assumptions are irrelevant. All that matters, Friedman claimed, is that the theory makes accurate predictions.
Friedman’s F-twist gets dubious assumptions off the hook. But there is still the problem of predictions. How do you ensure that your theory is consistent with the evidence? Here, neoclassical economists have hit upon a tidy trick: frame your theory in terms of an accounting identity. Since the identity is true by definition, any ‘test’ of the theory will come out in your favor.
When neoclassical economists test their theory of income (the theory of marginal productivity), they invoke an accounting identity. They correlate two related forms of income (usually sales and wages) and then call one of the incomes ‘productivity’. Since they always find a correlation, they always ‘confirm’ their theory of income. Nifty!
Then there’s the neoclassical theory of economic growth. The theory assumes that economic output is governed by a ‘production function’ that dictates how inputs of capital, labor and ‘technological progress’ are transformed into economic output. And guess what … this approach seems to have overwhelming empirical support. The problem, pointed out by Anwar Shaikh, is that the production function is actually a re-arrangement of a national-accounting identity. The production function ‘works’ because it is true by definition. Nice!
28.8 Keen Critique
Bichler Nitzan
Neoclassical economics is the of- ficial scientific underpinning of capitalism as well as its main ideological defence, and according to Keen, it fails in both tasks. Contrary to received opinion, neoclassicism cannot explain capi- talism – either in detail or in the aggregate – and the policies it prescribes do not support but undermine the very system it defends.
The book focuses on three key issues:
the bizarre neoclassical perspective that money, credit and debt do not matter for the macroeconomy;
the neoclassical insistence that the economy’s complex, nonlinear turbulences are best explained in linear, self-equilibrating terms; and
the fact that neoclassicists have hijacked the economics of climate change, using patently false assumptions to justify do-nothing policies with untold future consequences.
In the neoclassical universe, government is bad business.
But the book also has one important limitation: it is about economics. Keen offers to replace neoclassical dogma with a new way of thinking, researching and en- gaging with the economy. And while we agree that neoclassicism is a religion dressed as a sci- ence, in our view, what should come in its stead is not a different type of economics, but a new theory of capitalism more broadly. This isn’t semantic nit-picking. All economic theories – including neoclassicism – engage with non-economic entities and forces. They all agree, willingly or reluctantly, that politics, sociology, anthropology, psychology, international relations and other aspects of society affect the economy. But these effects, whether supportive or distortive, are assumed external to the economy proper. And this assumption is pivotal. Although the effects of these so-called external factors alter economic outcomes, they leave the economic categories themselves intact. And this bifurcation, we argue, is the Achilles’ heel of all economic theories, orthodox and heterodox, old and new. In our view, capitalism is not an economic system, but a conflictual mode of power. Those who rule this mode of power – its dominant capitalists, politicians, mainstream academics, opinion makers and the various organizations they control – make every effort to conceal its power features. This is why neoclassical economics, beholden to its masters, can never be a science. But the problem besieges every and any economic theory that keeps power external to its basic categories. In our opinion, it is only when the study of capitalism substitutes for the narrow understanding of its economy that power can assume centre stage to reveal what economics is structured to conceal.
28.6 Socialist Alternative to Human Capital Theory
Mehta
‘THE DEATH OF HUMAN CAPITAL?: Its Failed Promise and How to Renew It in an Age of Disruption’, by Phillip Brown, Hugh Lauder, and Sin Yi Cheung, disputes the theory behind one of the strangest features of the past 40 years of neoliberal economics, one rarely tackled so directly. This is human capital theory (HCT), which tends to shift the responsibility for good jobs and wages from business to higher education.
At one time, a company that laid off hundreds or thousands of workers would be admitting its managerial failure and incompetence; in the 1980s and ’90s, the mass layoff came to signal instead the kind of decisive cost-cutting that would pump up stock price.
Disposing of workers was just the first step. The next was to demand that they embark on a journey of self-improvement. This would make them employable in the “new economy” for the “jobs of the future.”
Public officials stopped expecting that firms maintain employment; they wrote tax law that favored companies that sent union jobs overseas. The once and future worker could only be worthy of new jobs if the country’s colleges — two-year and four-year, assisted by a new collection of for-profit colleges and training companies — acquired the proverbial “laser focus” on job-ready skills.
HCT, which appealed to conservatives and liberals alike, had become the master paradigm of the “information society” and the “knowledge economy” by the early 1960s. Forerunners of the theory had drawn the interest of some 19th-century economic thinkers, such as John Stuart Mill and Alfred Marshall (who identified what he called “personal capital”), and crucial postwar contributions came from a set of Chicago School economists: Milton Friedman, Theodore W. Schultz, Jacob Mincer, and, most insistently, Gary Becker.
HCT was taken up by university presidents like Clark Kerr to explain why universities were at the heart of the postwar economy, where new wealth came from knowledge as human capital and not just physical capital or physical labor. The theory was adopted by New Democrats in the 1980s and ’90s, who liked the claim that knowledge work, in alliance with technology, turbocharged the creation of value and wealth compared to regular industrial labor. In the apparent ebbing of direct colonial extraction, knowledge work was to keep the West on top of the economic food chain, relegating the Global South to manual labor on products conceived and designed in London, Stuttgart, and Cupertino.
In his influential 1991 book The Work of Nations, Robert B. Reich (Bill Clinton’s first secretary of labor) synthesized an evolutionary theory of the economy in which production workers in the United States would (and should) be replaced by that more advanced employee, the “symbolic analyst,” who works with the mind on numbers, words, and ideas. HCT made the collective level of education — defined as its fit with advancing technology — the prime mover of contemporary capitalism. Getting this fit between education and technology became a main objective of public policy.
HCT emerged near the end of a century of high economic growth — a period during which, as Robert J. Gordon documents in his 2016 book, The Rise and Fall of American Growth, productivity and wages grew mostly because of revolutionary inventions — think electric grids, cars, telephones, and elevators — coupled with Fordist and then New Deal approaches to the distribution of the resulting economic gains.
Promoting education principally as human capital is not simply narrow-minded but increasingly dangerous. Using the monetary rewards of education to promote and finance it becomes an increasingly bad idea when those monetary rewards fail to materialize.
Having done serious damage to HCT, the authors offer a new kind of human capital theory. This is somewhat confusing, unless we accept that their progressive educational theory, grounded in John Dewey, among others, seeks to combine educational contributions to production with human development rather than eliminating the productivity dimension.
The emphasis of the new human capital is on education for personal growth, nurturing a holistic relation between knowing and doing.
But if their theory makes personal growth the central goal, it is still a human capital theory, whose focus includes without being limited to the “economic productivity of the human being.” The authors are invoking the capabilities approach rooted in heterodox economics as practiced by Amartya Sen and Martha Nussbaum, and also socially grounded political theory, philosophy, and the psychology of labor and creativity, whose key figures include Hannah Arendt, W. E. B. Du Bois, and C. L. R. James, as well as Aristotle and Karl Marx.
The authors are trying to construct a socialist alternative to human capital theory. Replace HCT with an understanding of education and labor as related but distinct modes of human empowerment.
Education should focus on the full development of all capabilities of each individual in the whole population. Schooling must be universal, and in the 21st century postsecondary education should be too (though modes and structures will vary widely). Education must develop the whole range of capabilities and not just those with manifest relevance to jobs and wages; capabilities go well beyond the life of homo economicus.
Which capabilities to emphasize will vary from person to person: a student who loves history, public policy, or set design should receive systematic education in the deep content and skills of history, journalism, and theater — and not, as now, given a smattering while being advised to be more interested in and better at math, coding, or accounting.
Learning should be seen as central to the individual’s entire life and not mainly as an investment in a wage.
Individual capabilities are fundamentally social, derived from overall social intelligence and embedded in social relations that mix labor and learning on an ongoing basis.
The authors’ new-HCT model would lead to a double transformation. The first is “the liberation of learning from the tyranny of earning.” Business has used HCT to cut education down to its own size, reducing social, cultural, and scientific knowledge that would serve the world in long-range and unpredictable ways.
‘The Death of Human Capital?’ points toward a world beyond human capital theory, which has functioned as a (failed) alternative to industrial policy, impaired equitable social development, and constrained the power of education. Other authors should build on the project under way here.
Mehta (2021) A Socialist Alternative to Human Capital Theory?