“For a successful technology, reality must take precedence over public relations, for Nature cannot be fooled.”

Richard Feynman


Dangerous Currents by Lester Thurow

Get the book Dangerous Currents by Lester Thurow Random, 1983

Dangerous Currents is 200 pages poking fun at economists and micro-economic theory by someone who teaches it. Here is some of Thurow’s brilliance:

I am convinced that accepting the conventional supply-demand model of the economy is rather like believing that the world is flat, or that the sun revolves around the earth — you can make a rigorous case, on paper, for both propositions, but hard evidence is more than a bit scarce. Moreover, if you choose to act on either belief, you can get into a lot of trouble. [p. xvii]

…the profession, the discipline of economics, is on its way to becoming a guild. Members of a guild, as we know, tend to preserve and advance traditional theories rather than try to develop new ways of thinking and doing things to solve new problems. The equilibrium price-auction view of the world is a traditional view with a history as old as that of economies itself: the individual is asserted to be a maximizing consumer or producer within free supply-demand markets that establish an equilibrium price for any kind of goods or service. This is an economies blessed with an intellectual consistency, and one having implications that extend far beyond the realm of conventional economic theory. It is, in short, also a political philosophy, often becoming something approaching a religion.

Price-auction economics is further blessed because it can assume mathematical form it can work hand in glove with calculus. Expression in mathematics imparts to the theory a seeming rigor and internal strength. But that rigor easily degenerates into scholarly rigor mortis, as mathematical facility becomes more important to the profession than a substantive understanding of the economy itself. To express an idea mathematically gives it the illusion of unassailable truth and also makes it utterly incomprehensible to anyone untutored in mathematics. Then, too, young scholars aspiring to the profession are required to demonstrate a technical virtuosity in math before they are even considered eligible. By analogy, once the Confucian scholars of ancient China passed a very complicated set of entrance examinations, they used the same examinations to keep others out. Both then and now, all honor is reserved for those who can explain current events in terms of “The Theory,” while anyone trying to develop new theories to explain recent developments is regarded with suspicion at best. In economics today, “The Theory” has become an ideology rather than a set of working hypotheses used to understand the behavior of the economy found in the real world. [pp. xviii-xix]

All over the globe, we have recently witnessed a return to religious fundamentalism. In my view, the return to the equilibrium price-auction model in economics represents a parallel development — a desire for psychological certainty in a world that is, in the last instance, uncertain. [p. xix ]

If you were to ask the average economist what was wrong with his discipline, he would no doubt tell you that something was really wrong with macro-economics: the profession has lost its ability to understand or control the aggregate economic problems of inflation, unemployment, and low productivity growth. But the same person would probably also say that micro-economics is fundamentally sound, that the profession fully understands the behavior of individual economic actors. He would probably then say that though he wasn’t sure exactly how the issues in macro-economic theory should be resolved, the source of the difficulty is clear; namely, that macro-economics is not securely grounded in micro-economic theory — the equilibrium price — auction (supply and demand) view of the world.

The perceptions here are accurate, except for one. Microeconomic theory is not fundamentally sound, and the real problems in economics are to be found in a micro-economic theory that is unsatisfactory. Too much of real individual behavior, as I will try to show in this book, is unexplained or explained away by the equilibrium price-auction view of behavior. Macro-problems do exist, but they will not be solved until some fundamental reform occurs in micro-economic theory. [p. 3]

Economists can, for example, always retreat to unobservable variables to explain unwelcome facts. The price-auction model, for example, calls for equal wages for those with identical skills, but it is very difficult to find those predicted homogeneous wage groups. No matter how fine the background classifications, the job descriptions, and other explanatory variables, the variance in earnings within each group in the United States is almost as large as the variance in earnings for the population as a whole. But economists can claim that unobservable variables are at work. In this case the most frequently used is the “willingness to take risks.” Seemingly equal workers earn different wages because some are more willing to take risks than others. But since no one knows how to measure the “willingness to take risks,” this is an explanation that cannot be definitively proven or refuted. Either one believes it or one doesn’t.

Or it may be said that identical workers are getting different amounts of psychic income (nonmonetary benefits such as pleasant working conditions) from their jobs. These nonmonetary benefits lead money incomes to differ but leave total incomes, money plus psychic, identical. Here again the explanation may be true, but there is no way to prove it.

Or the observation can be dismissed as a “market imperfection” — something that exists but should be eliminated to bring the real economy into conformity with price-auction theory. Union induced seniority wages might, for example, be preventing homogeneous wages from developing. The solution for those who see a “market imperfection” is to eliminate the problem — unions. If the economic actors are not doing what they are supposed to be doing, something is wrong with either the actors or the market. In short, the theory is always right. [pp. 16-17]

So, in general, an economist’s prior beliefs about what is true play a very important role in the way he sees economic evidence. Once their beliefs are formed, it is difficult to prove any economist’s priors wrong so convincingly that he will change his beliefs about the way the world works. And because of its seemingly comprehensive answers to all economic questions, the price-auction model creates a very strong set of prior beliefs. [p. 18]

Economics is like other disciplines in that it attempts to deduce theories that allow it to describe and predict reality, but it differs from all other fields because it also has a theory of what “ought” to be. This explains why economists are always recommending the elimination of this or that “market imperfection,” like the unions mentioned earlier. In fact, any unpopular regulation is denounced by those not liking it as a market imperfection. In contrast, no astrophysicist recommends the elimination of planets (observations) that he does not like as “market imperfections.”

Here the economists’ recommendations flow from the peculiar role that the concept of a free market plays in economic theory. The equilibrium price-auction model is not just a tool used by economists to describe and predict events. The particular economic game called free competitive markets is regarded as the best economic game. It is assumed to produce the highest possible welfare, and at best, other economic games can only equal its performance. As a result, economists feel at liberty to recommend the “free market” to society and to recommend that actual economic games be made to conform with the free-market game.

Think the academic division between economies departments and business schools. While economics departments work out ever more sophisticated versions of the free-market game and watch for market imperfections imposed by government or monopolies, business schools teach students how to become better maximizers within the constraints of the free market. If economists successfully get their point across in business schools, they guarantee that at least part of their economic theory — the existence of profit maximizing producers — will come into being. No other discipline attempts to make the world act as it thinks the world should act. But of course what Homo sapiens does and what Homo economicus should do are often quite different. That, however, does not make the basic model wrong, as it would in every other discipline. It just means that actions must be taken to bend Homo sapiens into conformity with Homo economicus. So, instead of adjusting theory to reality, reality is adjusted to theory.

What this creates, however, is a lot of confusion both among economists and the public as to whether economists are speaking as predictors or as prescribers. Suppose some economist says that energy price increases cannot cause inflation. Is he saying that higher energy prices do not cause inflation in the real-world economy, or is he saying that higher energy prices would not cause inflation in a perfectly competitive free market where any price increase must be balanced with price decreases somewhere else in the system? The belief that competitive free markets constitute the best possible economic game also rests on a highly restrictive set of assumptions. The conclusions are technically correct only in a static world of fixed tastes and static technology where the basic economic problem is one of exchange. Every economist knows the dozens of restrictive assumptions (perfect knowledge, ease of entry, exogenous independent preferences) that are necessary to “prove” that a free market is the best possible economic game, but they tend to be forgotten in the play of events. If tastes are endogenous (created in the process of conducting economic activities), it is not obvious, for example, that a free market leads to the highest possible welfare. If tastes differ depending on what economic game is actually being played, competitive markets with their opportunities for invidious comparisons might make people more unhappy with their standard of living than some other economic game where the “winner” is not the one with the most goods and services. The perverse preference of envy (my welfare goes down when your income goes up), for example, destroys the nice utility maximizing outcome of any free-market economic game where everyone is supposed to look at his own income and only his own income when judging his welfare. The economic game played by Homo economicus may or may not be the best economic game for Homo sapiens, but it is almost always so advocated by economists. [pp. 21-22]

Given a clever economist armed with a concept that can’t measure anything in the real world, any activity can be described and organized as if it were the outcome of a freemarket maximization process. All consumption purchases represent utility maximization; all job choices represent income (psychic plus money) maximization. There is nothing wrong with formulating models with unknown and in principle unknowable variables if everyone is clear that the result is merely a descriptive model that might help us catalogue activities. The capacity to provide such descriptions, however, does not mean that the model is an economic model in any of the other four senses. To be that, the model must be capable of being proved wrong.

Because economists cannot measure nonobservable variables such as psychic income, they cannot make predictions from a model based upon them. And if you don’t understand how these unobservable variables are created, you can’t understand economic activity in the real world. But without that, influence or control over the economy is impossible. Yet economists often talk as if they can do all of these things simply because they can build a descriptive model.

Economists who hold this view in its most extreme form cling to the following syllogism: (1) The price-auction market is the most efficient economic game that man can play. (2) More efficient economic games drive less efficient economic games out of business. (3) Therefore the real economic game must be an equilibrium price-auction game. [pp. 23-24]

In late 1973 the first OPEC oil shock struck, as oil prices quadrupled and the general inflation indexes shot up to 11 percent. More important, gasoline lines appeared. Waiting in line to buy a basic commodity like gasoline is something that no American had ever experienced. Shock and irritation were high, but those lines were like the first small heart attack — an indication of mortality. Maybe the American economy was growing old and becoming vulnerable. Maybe the American economic dream of an ever rising standard of living was over. Small may be beautiful, but if that phrase meant a lower standard of living, then the average American considered it a nightmare.

The Nixon-Ford Administration responded with oil and gas price controls. As a vehicle for holding down prices, controls were bound to fail. For one thing, world prices would have to be paid on that part of consumption imported from abroad; for another, controls make it too easy for oil companies to hold oil in the ground or not to look for new supplies oil until prices rose. When controls did fail, the public’s feeling that the federal government and its economists were incapable of managing anything efficiently was further reinforced.

What was worse, economists could pose no solution to the energy problem. Influential professionals, such as Milton Friedman, predicted that the oil cartel would quickly fall apart. It didn’t. Other economists recommended that prices be allowed to climb to world levels, but that wasn’t a solution to the problem faced by the average American. Higher prices would force him to change his life style. He might respond to higher prices with smaller cars and colder houses as economists predicted, but he liked doing neither and he could vote. No one considered a forced change in life style a solution.

Once again, falling back on the principle that higher unemployment would produce lower inflation, monetary authorities tightened the rate of growth of the money supply in an effort to slow the economy, raise unemployment, and push inflation out of the economy. This time the policies produced a credit crunch. For six months in late 1974 and early 1975 the GNP fell at the fastest rate ever recorded. Even the rates of decline in the Great Depression had been less precipitous — although of course longer and deeper. Anxieties quickly shifted from an unacceptable inflation rate to an unacceptable unemployment rate, and the term “stagflation” was born.

Stagflation was both a term and an indictment, since economists had taught that the phenomena — slow growth, rising unemployment, and rising inflation — could not all exist at the same time. Yet they did. [pp. 34-36]

While the macro-economic failures of the public policy makers appear in the headlines every day, the micro-economic failures in prediction and control are equally large and just as corrosive to public confidence in the economics profession. In fact, much of what is perceived as a macro-failure is a failure in microeconomics. If success or failure in predicting and controlling events determines whether an economic theory is solid and deserves respect, then micro-theory is in as bad a shape as macro-theory.

Unforeseen and uncontrollable price shocks in energy and grain markets are failures-in micro-economic prediction – not macro-failures. And micro-economic efforts to control food or energy prices were no more successful than macro-economic efforts to control inflation in general. Those analyzing investment decisions, human and physical, should have foreseen the slowdown in productivity and recommended policies to stop it. If wages are rising faster than productivity and causing inflation, that is a micro-economic phenomenon. If macro-economic failures are shaking the foundations of macro-economic theory, micro-economic failures should be similarly shaking the foundations of micro-economic theory, but the latter failures have no such effect.

Consider the standard economic recommendation of the 1950s and early 1960s for protecting oneself from inflation. Conventional wisdom had it that to preserve wealth, one had merely to invest in corporate stocks. According to the verbal traditions of the staff of the President’s Council of Economic Advisers, Paul Samuelson is supposed to have said in the early 1960s that anyone who did not protect himself from inflation by buying corporate equities was so stupid that he deserved to lose his wealth. Prices could rise only if corporations were raising prices, and therefore corporate stocks had to be a hedge against inflation. In fact, corporate equities were the worst possible inflation hedge. From 1968 to August 1982 the real value of common stocks fell 54 percent as measured by the New York Stock Exchange Index, and 65 percent as measured by the Dow Jones industrial average.

Economists could come up with many possible after-the-fact explanations for the poor performance of corporate equities. Some pointed out that since oil prices were set not by American corporations but by foreign governments, prices could rise without corresponding increases in American incomes. Others asserted that because taxes were not indexed, the tax collector was taking a larger bite of real profits. Still others said that inflation produced greater variance in prices and hence more risk and uncertainty that had to be compensated for in the form of lower prices. With an unhappy electorate, economic risks were compounded by the political risks of government interventions designed to hold prices (and hence profits) down. Both events increase the risk premium used to evaluate future earnings streams and net present values decline. Another group pointed out that investors might be discounting future earnings for the under depreciation of plant and equipment, but failing to correct their balance sheets to reflect the lower real value of corporate debt. Future earnings might be discounted with interest rates that reflect inflation, but those same inflationary expectations might not be embedded in the estimated future earnings streams as they ought to be. Alternatively, public subsidies for housing might be so large that they were similarly attracting funds out of the equity markets.

All of these explanations were offered. Some or all of them may even be true. But regardless of the persuasiveness of these explanations, the fact remains that economists’ standard remedy for protecting capital values in a period of inflation failed — the bottom line being that the best micro-economic wisdom was no better than its macro-economic counterpart. [pp. 38-39]

Meanwhile, unemployment cannot exist in an equilibrium price-auction market. Yet unemployment does exist. Why is it ignored? The answer is simple. No alternative theory was developed to challenge the price-auction model’s explanation of individual economic behavior. So it was almost inevitable that the dominant view of the 1920s would reassert itself when immediate memories of the suffering produced by the Great Depression passed. Today’s measured unemployment is defined away as “voluntary” unemployment, and therefore not “real” unemployment. [p. 132]

According to Reagan economists, social insurance also creates free-riders: knowing that others will work to provide the resources necessary to insure you against the hazards of life, you reduce your work effort and let others carry the load. But when everyone makes what is individually a rational decision to work less, the result is a collective irrationality — an economy with too little work and output.

An extreme form of this contention is advanced by George Gilder, who argues that both welfare payments and working wives sap male initiative. “The man’s earnings, unlike the woman’s, will determine not only his standard of living but also his possibilities for marriage and children — whether he can be a sexual man. The man’s work thus finds its deepest source in love.” “Under guaranteed-income plans … marriages dissolve not because the rules dictate it but because the benefit levels destroy the father’s key role and authority. He can no longer feel manly in his own home.” “When the wives earn less, the men tend to work more and are far more likely to reach the pinnacles of achievement.” “Material progress is ineluctably elitists: It makes the rich richer and increases their numbers, exalting the few extraordinary men who can produce wealth over the democratic masses who consume it.” [p. 138]

According to Reagan’s version of supply-side economics, if the economy is not working, something must be wrong with government’s place in the economy. This has not been proved by empirical analysis but is known so because a priori it is impossible for an undisturbed free-market competitive economy to perform badly. If the economy is performing badly, government, the great distorter in a free-market economy, has to be the culprit.

Whatever the validity of the supply-side argument, there is no question that it is a logical product of an equilibrium price-auction view of the world. The supply-siders merely make explicit what is implicit in that model. Mainstream economists may say that supply-siders exaggerate the “truth” to be found in the model, but it is the “truth” nonetheless.

In any case, supply-side economics represents the triumph of literal and unqualified equilibrium price-auction economics. Supply-siders are to that model what religious fundamentalists are to biblical interpretation. No deviations from the revealed truth are possible or allowed. [pp. 140-141]

If Newton and his contemporaries had behaved as the economics profession is now behaving and had access to the modern computer, it is likely that the law of gravity would never have been discovered. In Newton’s day, deviant celestial observations were made that did not fit into the existing epicycle theory of heavenly motion, but each such observation could be and was explained with an addition of another epicycle to the system. Given enough epicycles, all patterns were theoretically explainable. Eventually, however, the computational difficulties forced Newton to rethink the existing theory to obtain a simpler set of results based on gravity. But with the modern computer Newton would never have been forced to look for anything new. The computer would have made short work of the necessary geometric computations, making a new theoretical approach seemingly unnecessary.

Like “deviant” celestial motion at the time of Newton, deviant observations in the labor market keep being reported. But each was and still can be made consistent with the orthodox theory. Usually some market imperfection is hypothesized, and as we shall see, each is posited ad hoc and after the fact. At some point it becomes necessary to examine the weight of the evidence to see the extent to which the labor market is or is not working in accordance with the theories of the equilibrium price-auction model. And if it is not, to develop new micro-economic approaches. [pp. 184-185]

According to the price-auction model, anyone can get a job by knocking on the door of some employer and offering to work for less than those already employed. Anyone who has actually looked for work knows this approach is not viable. [p. 187]

Economists often blame unions for economic effects that extend well beyond the direct effects on their own membership. It is asserted, for example, that employers have to meet union wages in order to keep unions out. This may be true, but if so, the economy is not the competitive economy prescribed by the price-auction model. In a free market, employers cannot meet union wages to keep unions out. They have to pay market, not union, wage rates to keep other nonunion employers from driving them out of business. [p. 193]

One of the peculiarities of economics is that it still rests on a behavioral assumption — rational utility maximization — that has long since been rejected by sociologists and psychologists who specialize in studying human behavior. Rational individual utility (income) maximization was the common assumption of all social science in the nineteenth century, but only economics continues to use it.

Contrary behavioral evidence has had little impact on economics because having a theory of how the world “ought” to act, economists can reject all manner of evidence showing that individuals are not rational utility maximizers. Actions that are not rational maximizations exist, but they are labeled “market imperfections” that “ought” to be eliminated. Individual economic actors “ought” to be rational utility maximizers and they can be taught to do what they “ought” to do. Prescription dominates description in economics, while the reverse is true in the other social sciences that study real human behavior. [p. 216]