A Response to Kanbur/Stiglitz: Economics is a Mess, and Economists Need to Fix it. Fast.

This post was basically written to be posted over at Naked Capitalism. It was written as a response to this post: http://www.nakedcapitalism.com/2015/08/kanburstiglitz-rent-seeking-as-a-major-driver-of-wealth-and-income-inequality.html

EDIT(8/20/2015):  Well, Naked Capitalism chose not to publish this.  Perhaps it is a bit frenetic.  I did crank it out in a few hours. As may be.

One possible issue is I did not address 'rent seeking,'  per se. My view on rent seeking is that it is up to the regulators of an economy to minimize and distribute it, and up to economists to provide the best theory for doing so.  Since basically everyone tries to  do it all the time, to address it as original cause would seem not to be a properly economic issue.  However, if the problem is some institutional structure which permits some small slice of society to damage the rest of society with their rent seeking, then that institutional structure is what  you want to address.

Anyway, if you disagree with this post, please comment.  If you agree, feel free to comment, also.  And then you might want to help spread the word. END EDIT.

A Response to Kanbur/Stiglitz:  Economics is a Mess, and Economists Need to Fix it.  Fast.

Recently, Yves crossposted (from VOXEU) an analysis by professors Ravi Kanbur and Joseph Stiglitz.  (Also posted by Mark Thoma at http://economistsview.typepad.com/economistsview/  )This analysis raises the issue that currently fashionable theories in economics may not be able to adequately explain our current, unequal, economy.  While their analysis has value, and admits to serious problems in the study of economics as it is currently understood, the post does not go nearly far enough in acknowledging or addressing the actual problems which may be found in the foundations of the field of economics,. 

As can be shown, these problems rest with some of the fundamental assumptions underlying the practice of economics, and until these errors are addressed, economics will continue to only poorly represent the reality it seeks to describe.

First, regarding the particular issues raised by Profs. Kanbur and Stiglitz.  In the concluding remarks to their post, they propose the following changes to the analysis of the problem of inequality.  They propose these changes as necessary to gain an adequate understanding of the problem: 

“Concluding Remarks

Thus, the new stylised facts of our era demand new theories of income distribution.

• First, we need to break away from competitive marginal productivity theories of factor returns and model mechanisms which generate rents with consequences for wealth inequality.

This will entail a greater focus on the ‘rules of the game.’ (Stiglitz et al 2015).

• Second, we need to focus on the interaction between income from physical and financial capital and income from human capital in determining snapshot inequality, but also in determining the intergenerational transmission of inequality.
• Third, we need to further develop normative theories of equity which can address mechanisms of inequality transmission from generation to generation.”

To be fair, the first item is actually a pretty deep cut.  ‘Marginal productivity theories’ are fundamental, some of their basics taught to budding freshmen in Econ101. For any economist to call these into question is an act, first of all, of intellectual courage. 

However, I think the problem with this formulation runs at once deeper, but is also more shallow, than the real issue.  On the shallow side, models are what economists construct to gain an understanding of a very complex reality.  If in some way, the behavior of the model mirrors the behavior of reality, the model is usually considered a success.  Models can be simple, and based on a few simple assumptions, or like the Kaldor-Kuznets model Profs. Kandur and Stiglitz discuss, more complicated, and based not on just simple assumptions, but some previous body of theory developed from and based on those assumptions.  So questioning such a sophisticated model is only an incidental attack on its underlying assumptions.  And replacing such a model, then, with one based on equally sophisticated theory, does not necessarily address the underlying problem with the assumptions.  And here, Kandur and Stiglitz  seem to be proposing we essentially start with model mechanisms which must ‘generate rents.’  This seems to beg the question, and so such a model will likely be basically useless. 

And on the deep side, are the assumptions underlying ‘marginal productivity theories’ the correct ones to attack?  I am not so proficient at economics that I can determine whether the assumptions underlying ‘marginal productivity theories’ are above reproach.  In my understanding of the theories, however, they seem pretty useful, and generally so.

So I can instead offer alternative assumptions, different from the assumptions I believe economists make, calling them into question. I believe the economics profession should, in any case, examine them.

Now. for item two, however, I think Prof. Stiglitz makes a wrong cut.  He lumps physical and financial capital together, when they are not at all the same thing, and the difference is especially glaring for this problem.  In particular, financial capital feeds off physical capital.   Prof Stiglitz then lumps all human capital together, when the relevant distinction is between labor, in particular labor closely tied to physical production, and management, in particular those who manage financial capital.  Thus the appropriate associations are between physical capital and labor, and between financial capital and (upper) management: The one exploits the other, and indeed, that is how we can define them.    So he puts the lions and the lambs in the same pen.  Twice.

But, let me add that the assertion financial capital and upper management exploit labor and physical capital may be unfair.  The necessary counter claim would be that the benefits to labor and physical capital of the activities of management and financial capital outweigh the costs to labor and physical capital of those activities.  This claim may, in fact, be true.  The claim would seem, however, to be contradicted by the evidence of the combination of increasing inequality, and the decline in the investment in and even maintenance of, society’s real capital. These processes do suggest that ‘exploit’ is indeed the proper word.

In item number three, I believe Prof Stiglitz implies that current normative theories of equity are basically correct, but “further” theories need to be developed, and presumably developed from those basically ‘correct’ theories. 

One of the fundamental and essential assumptions underlying current theories of equity, however, is the standard, textbook definition of money. If this definition of money is in error, then so is our understanding of equity.  So is our understanding of asset. So is our understanding of the nature of investment.  And so would our understanding of the flows and distributions of assets and their distributions. We could not claim to understand either the state of an economy, nor its dynamics.  In all these things we would be no more than part right, and certainly also quite mistaken. So. 

Conventional economics must examine some of its fundamental assumptions.  Here are three corrected assumptions for economists to look at. They need not agree with my assumptions.  But, as Yves said to my earlier post, they need at least to refute them.   As a fourth item, I also bring to attention statistical mechanics.  This is a field whose potential contributions I believe economists fail to appreciate.

1)        The textbook definition of money, which I assume is still relevant to the study     of economics, is wrong:  Money is only incidentally a measure or a store of value.  It is actually a measure and store of *demand* on (things of real) value.  Because money is merely demand, it cannot reliably distinguish between productive assets, and ‘assets’ which are in fact a drain on production and maintenance of real wealth in an economy.  Money, for instance, cannot distinguish between the value of a high school, and the value of a yacht.  In fact, money, especially if badly distributed in an economy, favors the production of yachts over high schools, and in general, the consumption of resources over their production. I argue this point in greater detail at: http://www.nakedcapitalism.com/2015/06/the-standard-definition-of-money-is-in-error.html

2)        While the costs of factors of production are additive, the combination of factors in production is multiplicative.  Labor and capital multiply to create production.  Consider, for starters, how much is *added* to the value of the freight of an empty truck going across country.  And in general, where the cost of an activity exceeds its benefit, it is because the multiplicative factor of that activity is less than one. For example, in the analysis of sectors, finance is multiplicative, as is government.  For another example, academia, and in particular the study of economics itself, is multiplicative. To say that economists add to the value of things produced in an economy is absurd. Economists produce nothing of substance: Nothing that anybody can eat;  Nothing that will heat anybody’s home.  What they do produce, or are supposed to produce, is understanding. This understanding offered by economists can multiply the productive capacity of an economy. Policy adapted from correct theory can increase the productive efficiency and resiliency of an economy.   Efficiency is a multiplicative factor. This factor can be greater than one for sound policy.  Or that productive efficiency can be reduced, the multiplier become less than one, when policy is based on unsound theory.

3)        The motives of capitalists are not the same as the motives of society as a whole.  Therefore, there is no guarantee that the activities of capitalists advance the interests of society.  Indeed, where their motives conflict, where, for example, there is opportunity for capitalists to externalize the costs of their activities, there is every reason to suppose otherwise. 

4)        The study of statistical mechanics is a well developed branch of physics, and one that a few physicists, at least, have been trying to apply to economics.  For statistical mechanics to have application to large systems of ‘particles,’ all that is required is some form of interaction between the particles. One implication of the approach is that there are what might be called ‘natural’ distributions of wealth an income.  Resources must be consumed to maintain distributions of wealth and income which are different from these ‘natural’ distributions.  And indeed, the greater the deviations of these ‘unnatural’ distributions from the natural ones, the more resources which must be consumed merely to maintain them.   There are problems with dimensionality to be worked out, and I have not been following the literature.  However, I can say that I have not heard much about this approach from economists.  I do not access the formal literature all that much, but from the economics blogs I frequent, I have heard nothing.   http://arxiv.org/pdf/cond-mat/0211175v1.pdf

       “Statistical Mechanics of Money, Income, and Wealth: A Short Survey,” from       2002 might be a start for the interested economist.    

Kanbur and Stiglitz are deserving of great respect, They have labored long and hard and produced important results in the difficult and, what also should be, the immensely valuable field of economics.  But, if the assumptions those results are based on are in error, then much of the effort that they and their colleagues have expended have been wasted. And the same can be said of any future investment they, and our society, make, if any errors are not corrected.  Worse, much of those efforts may even have been counterproductive, and this may continue.

To many outside observers, the study of economics seems incoherent. Is it? In many cases, diametrically opposed descriptions and prescriptions can each find support from one or another school of economics. If the study of economics is incoherent, this raises the questions: Is the study of economics incoherent because it is politicized? Or is it politicized because it is incoherent?  If economics is incoherent because it is politicized, then it cannot qualify as a science: It is not the study of, or the theory of, any objective phenomenon. It is, and can be, no more than one or another’s propaganda. 

If instead economics is merely incoherent in the understanding of economists, economics as a science need not be incoherent in principle. For coherent theory to be developed, consistent assumptions need first be discovered.  This failure of understanding then, a failure which is exploited by politicians, is because the assumptions actually used by economists to make and base their theories on cannot be consistent. From inconsistent assumptions, mutually contradictory conclusions can be drawn.  If contradictory conclusions can be drawn, we should not be surprised that the various players should choose from economics those conclusions which favor their own interests, and those economists, who espouse those conclusions. Neither should we be surprised if those players also deny the conclusions which stand in opposition to those interests. After all, they have refutations, and people to argue them.  And so we should also not be surprised if many of the pronouncements of economists are ignored.

Incoherency also implies that any conclusions economics reaches will fail, at least in part, to correspond to reality, where economics is so understood.  This does not necessarily mean here that economics will totally fail to represent reality.  Indeed, microeconomics provides much excellent application. But the true definition of money is not important in microeconomics.  In macroeconomics, however, the definition of money may be very important.  I claim that money, and its flows, impose many significant forces on an economy in the large, with the consequence of many stresses and distortions in that economy.  In this I do not think I am alone. So if the definition of money is in error, then so long as it is in error, explanations for these distortions, if even they are noticed and recognized, will remain mysterious.  The best theories will be no more than ad hoc rationalizations.  Like the Ptolemaic Cosmology, these theories will be bereft of any true insight.  

It is the implicit opinion of some policy makers on the Right that society has no genuine need for economists, or their dubious ‘economics.’  Their claim is that the free markets of unfettered capitalists create the optimum economy, and the optimum society.  To them, the only use for economists is to enable such capitalists to more efficiently exploit these markets, and so enhance their profits. Nowhere for them is there any other role for economists. There is no point to economic analysis, because there is no point to economic governance. To them, there can be no better economy.  There can be no better society.

One final word:

Today’s academic money-centric economics is to very large degree woefully unequipped to handle the analysis of the demands of an increasing population on a diminishing resource base. Most seem to be in denial, their activities increasingly irrelevant to our collective future. What ever else he, or she, may think of this post, every economist, every reader, needs to look at: http://www.overshootday.org/  and the links it points to.

Their analysis concludes that humanity is using the earth’s resources at a rate it takes 1.6 earths to replenish. The other way they put it, for the year up to August 13, humanity consumed the amount of resources it would take the earth one entire year to replace. Simply, we are consuming our children’s future today, and at an ever accelerating rate.

There is a need for a correct understanding of economics. There is a need for economists to clean their house.

It is the case that while we may never run out of money, we may run out of the things that money will buy.  However, if the standard definition of money is correct, we may indeed be fortunate. According to the standard definition of money, $10 of money has the same value as $10 of food.  So if we run out of food, we may yet be able to eat the money.