Most helpful critical review
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Lots of History of Economic Thought, Presented Nicely
on October 8, 2009
Almost every Ph.D. program in Economics around the world teaches Neoclassical Economics as the correct way to model economic activity. While writing my Ph.D. dissertation in Mathematics at Harvard, I became a anti-Vietnam war/pro-civil rights activist, which led me to embrace Marxism (I didn't know what Marxism was, but I knew the people I hated hated it, so I figured it must be good), and thus to transfer to the Ph.D. in Economics at Harvard, because I was told that "economics determines everything." Naturally, I hated everything about neoclassical economics, and wrote an anti-neoclassical dissertation, which I dedicated to Karl Marx (communist) and Talcott Parsons (sociologist).
Well, that was a long time ago, and in the interim I have come to appreciate neoclassical economics and defend its being taught as the central paradigm in graduate economics programs. Of course, using neoclassical economics to understand the world is fraught with difficulty, because the theory is like a chain saw without a chain guard---if you don't know where to hold it and where to point it, it will carve you up into little pieces. Thus, I spend most of my time critiquing neoclassical economics and proposing additions and emendations that make the theory more useful and insightful.
Lately, I have been very dissatisfied with the main currents in the political economy of social policy. I read the liberal journals, such as Dissent and The American Prospect, but found I could not stomach their platitudes. I read Commentary and the Cato Institute publications, but their knee-jerk love affair with free markets and their lack of concern for the poor and the environment exasperated me. So, I thought I would go back to the classics, rereading Milton Friedman and the other Chicago school policy types, Hayek and the Austrians, and their popularizers. This was very fruitful. Milton Friedman was a deeply insightful genius and in a different way, so was Friedrich Hayek. But their policy positions I found not just incorrect but wildly bizarre and completely out of touch with reality. There are no equally deep popularizers on the liberal side (Galbraith was a great essayist, but had no analytical core, some modern liberal economists like Paul Krugman do brilliant professional work, but their policy positions are puerile). Amartya Sen is a great economist/policy-maker, but his work centers on third-world development. So, before I get to an assessment of Skousen's analysis of the two rival schools of laissez-faire economics, the Chicago school and the Austrian school, let me say what I think the orthodox neoclassical position is---a position that I in fact think is just about completely correct.
The central model of neoclassical theory is the Walrasian general equilibrium model, which portrays consumers/workers/owners earning returns on the labor and capital they supply to firms, which turn labor, capital, and resources into consumer and capital goods. Kenneth Arrow, Gerard Debreu, Frank Hahn, and others showed in the 1950's and early 1960's that when certain provisionally plausible assumptions hold, there always exists a set of prices such that all markets clear, and at such an "equilibrium" the allocation of goods is Pareto-optimal; i.e., you can't rearrange things to make anyone better off without making someone else worse off. This is Adam Smith's famous "Invisible Hand."
It became immediately obvious that several of the assumptions mentioned above sometimes fail. For instance, an industry can produce not only a good x that it sells on the market for price p, but may also produce pollution y, which it "gives away for free" to the community. To restore efficiency, the government must step in and force the industry to pay for its effluents, so that the marginal cost of polluting equals the price the industry must pay. These are called "externalities." Second, there are industries where the efficient scale of production is so large that market competition is precluded (e.g., nuclear energy), or where it is impossible to exclude people from use of the good (e.g., clean air, national defense, epidemic control). These are called "public goods." Third, consumers may have incomplete information as to the quality of goods, so thinks like the Food and Drug Administration are needed to ensure adequate product quality. These are called asymmetric information problems. Fourth, there may be certain things that we, as a moral society, do not wish to permit to be traded on markets. These so-called "merit goods" include body parts, prescription and recreational drugs, votes, and sexual services. Finally, it may be prohibitively costly to enforce certain contracts (e.g., labor and capital) through courts of law, so game theoretic issues involving endogenous enforcement and mutual trust and reciprocity must be added to the general equilibrium system. This is called the problem of "costly enforcement."
This model, with these emendations, I maintain is correct, and if we understand the emendations, we can handle the chain saw that is neoclassical economics without getting hurt. This position was clearly expressed in the dominant public economics text of the post-World-War II period, Richard Musgrave's Public Finance in Theory and Practice (1958). Musgrave was my teacher, and he convinced me that state intervention is appropriate wherever there are "market failures," such as those described above, that prevented the Walrasian general equilibrium system from producing social efficiency.
Now, when I was learning all of this theory from Richard Musgrave, my objections were very simple: why would you believe that the state would actually do these things? Why should the state act in the public interest? I remember once, as a young instructor at Harvard, attending a lecture by the great Keynesian James Tobin, delivered to an audience of thirty or so economics faculty and graduate students. Tobin was telling us that countercyclical fiscal policy could easily hand the current economic downturn. I raised my hand and asked a question. "I understand that the government can do this," I stated, "by why do you think it will do this?" Well, I could have defecated on the buffet table and drawn fewer horrified looks (from both Tobin and the Senior Professors) than I did by asking this simple question. At that time, neoclassical economics simply assumed a Beneficent State. Being a good Marxist, I believed that the state was controlled by the Capitalist Class, who used business cycles to discipline labor and make sure wages did not spiral out of control.
It was not too long after, however, that a group of economists inspired by the Chicago and Austrian Schools mounted a successful attack on the neoclassical model of economic policy, showing that there are forms of "state failure" that are just as pervasive and pernicious as "market failure," because the incentives supplied by market competition were completely missing from the government sector---politicians could make promises to get elected, but there was no way to turn those promises into contractual commitments. James Buchanan and Gordon Tullock's brilliant The Calculus of Consent (1962) was one of the first, and one of the most powerful critiques of this type.
As a result, by 1980 or so, most economists were learning in graduate school that there are important market failures, but because of state failures, in many cases the "cure" of government intervention is as likely to exacerbate as to ameliorate the problem. A proper analysis, therefore, must take into consideration the decision-making structure of the government, and a proposed intervention should prove its incentive compatibility on the governmental level as well as the market level.
The question that I ask, having read Skousen's interesting book, is whether there is anything to be learned from the Austrian and Chicago school economists--- principles that are not represented in the neoclassical public economics model as I have described it above. First, as far as I can see, every deviation from the standard public economics account by the Austrian school is just wrong. Most important, the Austrians hold that economic theory is derived from rational thought and empirical findings are not relevant to the truth value of their assertions. This is just plain wrong. Principles that the Austrians say flow from reason in fact flow from their peculiar, cultish, prejudice.
Second, the Austrians place no value on democracy, recognizing that voters can make choices that undermine their notion of "reason," and therefore a liberal republic should not permit popular sovereignty to override the sanctity of private property and the principles of the minimal state. I recall vividly Hayek (who was a great economist but a poor policy analyst) commenting on the Pinochet overthrow of democratic government in Chile (Pinochet brought a gang of Chicago economists into town to implement the principles of laissez-faire markets, torturing and murdering thousands who had different ideas) commenting that he would prefer a [laissez-faire style] liberal dictatorship to an illiberal democracy.
I am not suggesting that the Austrians are uninteresting; far from it. I love to read their work, and I find their views, bizarre and outlandish they seem to my ear, to be as mind-stimulating as a good fantasy novel, or an ethnographic account of the hunter-gatherer inhabitants of some tropical island. However, in no way are they scientists that deserve to be taken seriously. Of course, when there are Marxists all over the place trying to nationalize everything in sight, the Austrian philosophy might have some popular value as a counterweight. By the way, my reading of Americans who call themselves Austrians is that they are fooling themselves---they are really standard neoclassical public sector economists that have personal values favoring the entrepreneurial spirit.
The Chicago school of public policy inspired by Milton Friedman and George Stigler does not make any of the mistakes of the Austrians. A careful reading of Friedman's most impressive general work, Capitalism and Freedom, shows clearly that Friedman is a thoroughly committed democrat, and he opposes state intervention in regulating markets only on the grounds that the expected state failures will be greater than the market failures they are supposed to solve.
However, I come away of my recent rendezvous with the Austrians and the Chicago school with two bottom-line conclusions. First, these thinkers are often brilliant economists with excellent technical ideas, although these ideas do not imply the policy recommendations they favor. Second, their policy recommendations flow from normative principles that they have the right to hold, but they do not have the right to pass off as "scientific." For instance, their objections to the welfare state are purely ethical, and I find repugnant. Similarly, their objection to anti-trust regulation and the institution of fiat money (not backed by gold) seems to me to lack a scientific basis. I think if we stick to the standard neoclassical model of market-state interaction, and we add the analysis of state failure developed by Buchanan, Tullock, and others, we have the correct system to work with.