The dominant paradigm
In
the 1980s and 1990s a school of thought reached the zenith of its
power.
Its
influence had become pervasive. Having been the view of only a
minority
little more than 20 years earlier, this approach had succeeded in
dominating
its
discipline at all leading universities in the world. Academics that did
not
adhere to it found it hard to make a career: obtaining jobs or
moving up the
ladder depended on publications in leading journals â which had
been
usurped by this particular school of
thought.
But
dominance in academia was merely the foundation of a much
widerreaching
influence. A large number of prominent national and
international
bureaucrats, journalists, politicians and other âopinion-makersâ
had either
been
trained in the discipline or had otherwise become its followers. As
a
result, the views proposed by it came to dominate public policy
debate by
the
mid-1980s, permeating the discussion of issues affecting
individuals,
communities, companies, the nation and the international
community.
This
school of thought is better known by its key tenets than by its
name.
Its
key beliefs are that the pursuit of individual self-interest will lead to
a
better society, that government intervention beyond the narrow
maintenance
of
law and order should be minimized if not eliminated and that
the
powers of unfettered markets should be unleashed in virtually every
part of
society, at home and abroad. For this purpose, structural reforms
are recommended
to
deregulate, liberalize, privatize and open up as many
industries
and
aspects of the economy as possible, as the beneficial forces of the
invisible
hand, if only allowed to operate freely, would improve peopleâs
lives, create
wealth, produce prosperity and lead to maximum
happiness.
The
name of this school is less well-known: neoclassical economics.
This
may
have to do with its somewhat obscure or technical ring. It is also
testimony
to
the extent of its dominance: proponents are often no longer
aware
that
there could be alternative schools of thought. To them,
neoclassical
economics is synonymous with modern economics per se. Most
economics
Prologue: Searching for a New Kind of
Economics
programmes at universities consist entirely of neoclassical
economics, and
students can spend years studying for their degrees without
becoming aware
that
they may have been studying just one particular branch, one of
many
schools of thought in the discipline of
economics.
The
financial press cites neoclassical ideas on a daily basis and its
followers
have
entered highest public office. Central bankers are among the
first
profession to have been closely associated with neoclassical
economics. This
was
followed by financial journalists and civil servants. As a result, the
tune
of
deregulation, liberalization and privatization is being played daily
and
offered almost as the panacea to many of the worldâs ills. For
instance, in
July
2003 we were warned in the Financial Times that the German
âeconomy
will
stagnateâ, unless the country does what neoclassical economics
recommends,
namely to âaccelerate the pace of the economyâs structural change
ââ
What
is needed, we are told, is âprivatization, deregulation and
liberalizationâ.
1
State-dominated firms need to be sold off. The labour market
needs
to
become âmore flexibleâ. This means that employment protection must
be
abandoned and staff should be laid off, while the remaining ones
are made
to
feel they might be next. âReforms of the social security and
healthcare
systems to reduce ballooning costsâ are needed, which often is to
say that
the
lifelong contributors to these systems should be denied the
agreed
payouts. If such deep structural reforms are not implemented, we
are
warned, Germany will not be âfit for
the futureâ.2 The story is familiar in
other countries. In July 2003, neoclassical economist Paul
Samuelson, whose
textbooks have contributed to the advancement of his school of
thought,
reaffirmed that âFree markets [are the] key to prosperity.â Turning
to Japan,
Samuelson has little trouble identifying the solution to its
problems: a recovery
is
only possible âby turning away from the old Japanese modelâ
and
implementing deep structural reform.3
Samuelsonâs nephew, Lawrence Summers, is another example of a
successful
neoclassical economist who made it into highest government
office.
Neoclassical economists have moved beyond being appointed central
bank
governors, ministers of the economy or treasury secretaries. They
have even
become prime ministers (such as Spainâs
former prime minister Aznar) or
Presidents (such as Peruâs Toledo). In these positions of influence
they have
done
much to advance the policy programme of the neoclassical school
of
thought.
Anyone who has lived in one of the worldâs less developed countries
â in
other words, the vast majority of the worldâs population â also has
ample
opportunity to experience the neoclassical policy agenda.
Neoclassical economics
has
dominated the decisions of the large international
organizations
that
deal with economic policy. Among them, regional development
banks,
the
IMF, the World Bank, the BIS, the WTO (and its predecessor),
as
well
as the OECD stand out. Early on, these institutions had focused on
hiring
and
advancing the careers of adherents of the neoclassical school
of
thought. Already by the late 1970s, they had become bastions of
neoclassical
4
New Paradigm in Macroeconomics
Prologue
5
economics. Their policy advice duly reflected this. Thanks to the
legal,
financial and political muscle of these institutions, especially
the IMF
and
the World Bank, the neoclassical free market economics was
projected
beyond the limitations of a small number of industrialized
countries where
it
had been developed and made its mark on the world by affecting the
lives
of
millions of people in the most far-flung corners of the earth. In
over
100
countries, central bank policies, IMF-led structural adjustment
programmes
and
development bank-led reform packages drastically
changed
fiscal policy, monetary policy, regulatory policy and many aspects
of how
societies are organized, each time along the neoclassical lines.
This could
take
the form of cutting food subsidies for the financially weak or
privatizing
the
supply of drinking water, thus often pricing the poor out of
their
water supply. The neoclassical policy agenda was usually supported
by the
US
Treasury, which did much to advance the neoclassical consensus
of
Washington-based international
organizations.
Wherever the World Bank and the IMF became active â most of the
developing
world â they soon seemed to know the true problems of each
country.
Little local research was necessary to reach their conclusions.
Switching the
country name from an earlier study seemed to do much of the job,
since the
policy advice is highly predictable and appears to apply to all
countries:
structural reform to implement liberalization, deregulation and
privatization,
we
are told, is the only path to prosperity.
The
fall of communism in the late 1980s provided another major boost
to
the
already dominant neoclassical school of thought. Commentators
hailed
this
as evidence that government intervention must be inefficient and
only
free
markets would lead to economic success. There was even talk of
the
âend
of historyâ, as the paradigm of free market capitalist economies
with
minimal government intervention now stood unopposed and without
rival
(Fukuyama, 1992). Free market economists
were in great demand as wellpaid
advisers to the governments of transition economies, where they
duly
recommended âshock therapyâ â the simultaneous introduction of
free
markets in almost all industries.
The empirical record
The
rise of the neoclassical school of thought to dominance and
influence
must
be considered remarkable, perhaps unprecedented. What, then,
has
been
the result of its dominant influence on the
world?
Have
the major global economic problems come closer to a solution?
Has
poverty become less of a problem? Has inequality declined? Has
economic
growth accelerated and become more stable in the many countries
that
adopted neoclassical policy advice? Have business cycles receded?
Has free
market âshock therapyâ delivered the desired results? Has happiness
increased?
Since the late 1990s, a growing number of people have become
disillusioned
with
neoclassical economics. They range from students at leading
economics
departments to established intellectuals in many disciplines, from
independent
activists to politicians. Many accuse neoclassical economics of
failing to
deliver on its promises. Often, criticism is targeted against an
important
aspect of the neoclassical agenda, namely the âglobalizationâ of
the world
economy through free trade (mainly for developing countries) and
fewer government
constraints on large-scale multinational corporations. The
neoclassical
doctrine, the âWashington consensusâ of unfettered free
markets and
neoliberalism, has since been labelled âmarket fundamentalismâ,
âmarket
extremismâ or even a âreligionâ.4 Experienced civil servant and
economist
Robert Nelson, for instance, makes the case that economics has
become the
modern secular religion, complete with a priesthood (economists), a
sacred
text
(Samuelsonâs Economics) and a plan of salvation (material progress
and
the
liberalization agenda will solve the problems of mankind) (Nelson,
2001).
The
pure free market dogma is still preached by academia and the
corporate
media, and implemented by central banks, governments and the
leading
international organizations. However, unease about its results and
implications
has
spread widely over the recent years.
Careful economists had long been aware that the neoclassical
paradigm
did
not offer all the answers. There were many important empirical facts
that
neoclassical macroeconomics could not explain. However, the
dominant
school of thought proved adept at distracting attention from its
flaws, for
instance by labelling inconvenient empirical facts âpuzzlesâ,
âanomaliesâ or
âparadoxesâ â mere curiosities that one need not worry about.
Whether the
âmystery of the missing moneyâ, the âpuzzle of the velocity
declineâ, the mysterious
âbreakdown in the money demand functionâ, a surprising collapse
in
savings, the inability to explain exchange rates or asset prices,
or the problem
that
interest rates appear to follow economic activity, not lead it as
the
mainstream proclaims â neoclassical economists have succeeded in
keeping
a
lid on the difficulties that their approach has had in reconciling
their
theories with reality.
However, just when communism fell and many celebrated the
unrivalled
supremacy of the neoclassical free market model, a formidable
empirical
challenge was raised that could not easily be covered up: the East
Asian economic
success.5 The stellar economic performance of Japan and
the East
Asian economies had not been achieved through free markets,
liberalization
or
deregulation policies advanced by neoclassical economics. In 1993,
this
was
reluctantly recognized by the World Bank in its âEast Asian
miracleâ
study. Quite to the contrary, the East Asian success was due to
government
intervention in the form of clever institutional design and direct
intervention
in
resource allocation, especially in the credit
markets.
Until the end of the 1980s, the postwar Japanese economic
structure
was
characterized by restricted and incomplete capital markets, reliance
of
corporate finance on bank funding, weak shareholder influence, a
large
number of government regulations, direct government interference in
the
6
New Paradigm in Macroeconomics
Prologue
7
form
of âguidanceâ, a large number of formal and informal cartels,
inflexible
labour markets offering full-time staff at large enterprises job
security,
promotion based on the seniority in terms of years spent with the
firm and
in-house company unions. In the other East Asian countries there
were close
similarities, some put in place already under Japanese colonial
rule.
Thus
according to neoclassical economics, the East Asian economies,
foremost
among them Japan, should have been
economic disaster zones
throughout the postwar era: the fundamental theorem of
neoclassical
welfare economics identifies the particular set of assumptions
under which
the
competitive economy is efficient. These assumptions, which
include
perfect information, complete markets, perfect competition, no
transaction
costs, and so forth, define an economy where interventions, such as
by the
government, cannot but reduce allocative efficiency. The Japanese,
as well
as
key East Asian economies, have at no time during the postwar era
resembled
such
an economy.
Yet
instead of low performance, Japan, as well as the main East
Asian
economies, delivered high economic growth for many decades. The
phenomenal
growth of the Chinese economy over the past two decades has
also
occurred without the benefits of the free market model proposed
by
neoclassical economists.6 Meanwhile, many of the IMFâs free market
pupils
in
Africa and Latin America languished in
economic misery. While many
neoclassical economists put up a last defence, arguing that
East Asia
and
China have
been successful despite their different systems, and would
have
been
even more successful if they had implemented neoclassical policies,
others
realized that important lessons for economic theory had to be
learned
from
the East Asian success story. Foremost among them is Joseph
Stiglitz,
who
in the late 1980s turned his eyes towards Japan and East
Asia and
produced a series of path-breaking articles that profoundly
challenged the
neoclassical paradigm.7
But
just when more and more economists and policy-makers were
becoming
willing to accept that there were serious problems with
neoclassical
economics and to consider alternative, Asian-inspired approaches,
disaster
struck the region. Firstly, Japanâs
economy moved into a decade-long
economic downturn beginning in 1992. Then, in 1997, a major
financial
and
economic crisis hit Thailand, Malaysia, Korea and Indonesia,
resulting
in
currency collapses and contracting economies. Proponents of
neoclassical
economics were quick to place the blame. Ignoring the fact that
mainstream
economics could not explain the East Asian success, they quickly
argued that
the
economic crises had been inevitable: after all, there was significant
government
intervention and market regulation in East
Asia and the economies
had
been far removed from the free market paradigm. That, we were
told
once
again, was a recipe for disaster.
Today, many neoclassical economists feel vindicated by the
weak
economic performance of Japan over the past decade,
although they have to
admit that most other East Asian economies have returned to their
highgrowth
ways. Japan remains the linchpin
around which a major economic
argument will be fought: was the extraordinarily long recession of
the 1990s
really due to Japanâs economic structure? If not, what then
explains it?
Whether a supporter of current mainstream thinking or a proponent
of an
alternative school of thought, all have to grapple with the
realities of Japan.
Its
economy has become both the stumbling block and also the
measuring
rod
for economic theories.
The Japanese challenge to
economics
While there are many empirical facts that neoclassical
macroeconomics
cannot explain, the concentration of âpuzzlesâ and âanomaliesâ has
indeed
been
largest in the case of Japan â and instead of
disappearing alongside with
the
Japanese recession, the challenge to neoclassical
macroeconomics
became ever bigger throughout Japanâs
long downturn. Since Japan is
the
second largest economy in the world, it is a challenge that
mainstream
economics cannot easily ignore.
Having puzzled neoclassical economists in the preceding decade
through
its
high growth, during the 1990s Japan sank into an equally
inexplicable
recession. Unemployment rose to postwar highs, reaching over 3.8
million
officially unemployed in the late 1990s.8 Since 1990, over 210,000
firms
have
gone bankrupt. This has created much dislocation and bad debts.
Every
year
about 30,000 people have been committing suicide in Japan.
According
to
the National Police Agency, the increase in suicides is connected to
corporate
failure, unemployment and debt that resulted from the
decade-long
downturn. In addition, Japan also holds the postwar
record for deflation
among industrialized countries.
Japanâs
downturn also lasted longer than what is normally
understood
as
merely cyclical. Most of all, the Japanese economy appears to have
confounded
every policy response mounted by the authorities. The key
policy
recommendations of the mainstream schools of economic thought
have
been
implemented over the past decade, yet for years with very little
to
show
for it.
Firstly, the mainstream prescription to reduce interest rates
proved to be a
disappointment. Most macroeconomic models argue that lower
interest
rates should result in higher economic growth. This is also the
claim made
by
the worldâs central banks. In their frequent publications they do not
tire
of
repeating their assertion that the key variable driving the economic
cycle
is
interest rates, and that lower interest rates will stimulate growth.
This
theory has become so absorbed into modern journalism that the
media
regularly present it as a well-proven
fact.
The
Bank of Japan started lowering interest rates as early as 1991.
Shortterm
interest rates have since been reduced from 6% in 1991 to 0.001%
in
8
New Paradigm in Macroeconomics
Prologue
9
early 2004. Long-term interest rates, as measured by the ten-year
benchmark
government bond yield, have fallen from over 7% to a record low of
0.4%
in
early 2003. The most powerful policy tool according to leading
theories,
central banks and perceived wisdom had been entirely exhausted over
the
past
decade, without having had any noticeable effect on the
economy.
The
lack of effectiveness of interest rate policy encouraged the
implementation
of
fiscal stimulation. Between 1992 and 1999 over a dozen
fiscal
spending packages were implemented, amounting to well over Â120
trillion.
Together with these explicit government spending programmes, the
âautomatic
stabilizerâ of recession-induced rises in social support
expenditures on
the
one hand and reductions in corporate, income, capital gains and
transaction
taxes on the other produced a record amount of national
debt.
The
amount of outstanding central government debt rose to over 150%
of
annual GDP in 2002. Japan thus embarked on one of
the largest fiscal expansion
programmes in peacetime history. This also failed to deliver
the
expected result: whenever government spending increased, private
sector
economic activity shrank by a similar amount, so that government
spending
never succeeded in improving economic growth, let alone in
âkickstartingâ
or
âpump-primingâ the economy.
The
fact that a decade of record interest rate reductions and vast
fiscal
expansion failed to help Japanâs economy poses a
profound challenge to traditional
mainstream economics that remains unanswered. While one or
two
years of incongruence between theory and reality might have been
tolerated,
over
a decade of underperformance despite textbook-style stimulation
policies
is a
sign of a major flaw in mainstream theory.
Instead of weakening the mainstream paradigm, however, the failure
of
the
traditional demand-side theories ironically provided a boost to the
more
extreme proponents of neoclassical economics, known as
âsupply-sideâ
economists. They proposed two arguments, both of which
recommended
that
Japan must respond to the
recession by deep structural reform in the
form
of deregulation, liberalization and privatization: one was based on
the
assumption that economies always operate at their full employment
level.
Since demand factors were by assumption excluded in such theories,
an
economic slump can then only occur when the supply of factors of
production
restricts the economy. Thus these neoclassical economists argued
that a
lack
of labour (due to demographic problems), insufficient capital, or
lagging
technology were to blame for Japanâs
recession. Failing that, Japanâs
recession
must
have been due to low productivity, we are told. Since an
insufficient
supply of production factors or low productivity are seen as the
causes
of
the recession, structural reforms to release more production factors
and
raise productivity were seen as the answer. Another camp of
neoclassical
economists cited their theorem of welfare economics, which purports
to
show
that only a deregulated, liberalized and privatized economy
with
minimal government intervention could be efficient and productive.
Since
Japanâs
economic structure has been characterized by regulations,
government
intervention and a number of publicly owned companies, such as the
post
office, these economists also argued that deregulation,
liberalization and
privatization were the answer.
While both rationales for structural reform are widely supported in
the
financial press, they turn out to have no foundation in empirical
evidence.
As
will be seen, there is ample evidence of an excess supply of factors
of
production and significant and sustained downward pressure on
factor
prices. The argument that insufficient demand has caused
Japanâs
recession
remains far better supported by the facts. Given the reality of
record unemployment,
it
appears difficult to justify models that assume full
employment.
It
is also not explained how measures to improve the supply side
of
the
economy should help boost demand. Furthermore, the substantial
trade
surpluses that Japan accumulated during the 1990s, rivalling the
record
surpluses of the 1980s, were evidence that Japanâs
economy was, after all,
among the most competitive and productive in the world, even during
the
1990s.
Nevertheless, the neoclassical demand for structural reform became
mainstream
opinion and thus the Japanese government embarked on a
major
structural reform programme during the 1990s, including several
thousand
deregulatory measures, administrative reforms and the âBig Bangâ
liberalization
of
financial markets. Yet there is no evidence that these
structural
reforms boosted economic growth. To the contrary, the empirical
relationship
between economic performance on the one hand and deregulation,
abolition
of
cartels and greater market reform on the other has been quite
the
opposite of what neoclassical economics proclaims: when Japan
significantly
increased the number of cartels in its economy during the 1950s,
economic
growth accelerated sharply. It is less well-known that structural
reforms
towards greater market orientation were already started in the
1970s â under
US
political pressure â resulting in the scrapping of cartels and a
steadily
growing role for market forces. Thus the number of cartels fell
sharply during
the
1970s. When the structural reform programme accelerated during
the
1980s and 1990s, the number of cartels came down further, finally
dropping
to
zero. However, this shift away from the cartelized Japanese economic
structure
to a
market-oriented economic structure was not accompanied by
higher
economic growth, as the neoclassical theories had predicted. To the
contrary,
as
the number of cartels fell, so did economic growth. The decade of
zero
cartels was also when GDP growth dropped to
zero.
Since none of the traditional theories could explain events in
Japan,
some
economists became interested in a more fact-based search for
possible
answers. A group of economists became aware that the state of the
Japanese
banking system was less than satisfactory during much of the 1990s.
It took
years for this fairly obvious fact to become acknowledged by most
economists,
because banks and their role in the economy are greatly neglected
in
10
New Paradigm in Macroeconomics
Prologue
11
mainstream economics. Strictly speaking, neoclassical economics has
no role
for
money in its models. And those models that grudgingly introduce
money
make
no room for the function of banks. However, since the early 1990s,
an
increasing number of economists had argued that banks serve a
special function
in
the economy through their activity of lending. This âlending
schoolâ
represented a renegade group of empirically-oriented neoclassical
economists
that
hoped to explain some of the âanomaliesâ that mainstream
models
could not deal with. They argued that bank lending was a wrongly
neglected
variable, which mattered especially in times when banks did not
lend sufficiently,
for
instance due to their own balance sheet problems. Then,
they
argued, there could be a âcredit crunchâ in the economy, as was
argued in
case
of the US downturn of
1990 and 1991, as well as Japan during the
1990s:
banks were increasingly suffering from bad debts, which appeared to
render
them
more risk averse, so that they could not lend to those who wished
to
borrow. The implication was profound, for this explanation relied
on the
argument that markets were not actually clearing. However, the vast
majority
of
economics textbooks and mainstream theories are based on
the
assumption that markets clear. Without it, most of neoclassical
economics
would become irrelevant. There was therefore a great reluctance to
accept
this
âlending viewâ and its implication of market
rationing.
However the lending view, including its âcredit crunchâ variant,
also had
a
problem. While the empirical evidence seemed to suggest that there
was
something special about banks and their lending, it proved
difficult for
economists to pinpoint precisely what this was. Theories were
proposed that
banks serve the function of collecting and administering
information on
potential borrowers, or of âmonitoringâ them. But capital markets
do the
same
thing. Thus the argument ended up focusing on how banks served
a
special role in âintermediatingâ between savers and small-scale
borrowers:
small and medium-sized enterprises had imperfect access to capital
markets
(the
acknowledgement of which was another move away from the
âefficient
marketâ equilibrium economics of mainstream
textbooks).
Yet
this lending view also found it very hard to explain the Japanese
experience
of
the 1990s: if indeed a lack of credit supply from Japanese banks
had
been
the cause of Japanâs recession, then the
incipient credit demand should
simply have been met by foreign banks, which apparently had been
vying
to
gain access to the Japanese market. Furthermore, borrowing from
capital
markets increased throughout the 1990s, a disintermediation process
which
diminished the reliance on bank funding. The âbank lendingâ
theories failed
to
explain why borrowing from these alternative sources did not
substitute
for
a potential lack of bank lending.
The
sudden recovery of 2004 once again took economists by surprise
and
few
agree about what caused it. So far, there is no evidence that any of
the
standard theories explained, let alone predicted, the strong growth
rate
experienced in this year.
Thus
today traditional economics has to face the embarrassing reality
that
it
still has not explained events in Japan. What are the
implications of this
fact? Most economists have tried to shrug it off as being the fault
of Japan
â
that
weird economy that seems to defy theory. Is this response
scientifically
justified? Any economic theory that claims general validity must
also apply
to
the second-largest economy in the world.
Disillusionment with mainstream
economics
It
is a good time to revisit Japan, because there is today
increasing disillusionment
with
neoclassical economics on other grounds as well. More
and
more
economists feel that neoclassical economics has simply failed
to
deliver on too many counts.
Privatization, for instance, was meant to increase the quality of
services
and
reduce their prices. But in many cases this was not achieved.
British
railways or electricity providers in the US are but
two examples from the
industrialized world. In many transition and developing countries,
privatization
was
often even more disastrous, appearing akin to a
get-rich-quick
scheme for a small elite at the expense of everyone
else.9
Unemployment was said to be the result of âinflexible labour
marketsâ,
which result in excessively high and rigid real wages. Cut the
wages and
unemployment will decline, neoclassical economists assured us. But
when
real
incomes fell â as they did in the US for most middle-class
families, or in
much
of Europe due to the euro-induced
inflation â or when real wage
growth lagged behind productivity growth â as recently in many
countries
in
the world â there was little sign of an increase in employment, let
alone
improved standards of living for the majority. Unemployment
increased in
many
cases when real wages fell.
Deregulation, liberalization and other market-oriented structural
reforms
were
meant to bring prosperity to the developing countries. After decades
of
painful and costly World Bank and IMF programmes, Africa has very little
prosperity to show for it. Many Latin-American and Asian developing
countries
also
do not appear any better off as a result of these programmes.
There
is
ample evidence pointing in the opposite
direction.
Proponents of neoclassical policies raised hopes that standards of
living
and
the quality of life could be improved all over the world, that poverty
and
deprivation was going to be a thing of the past. As recent as the
1950s
and
1960s, many economists were convinced that, thanks to the advances
of
economics, an era of stable economic growth and ever-increasing
wealth and
prosperity had begun and would spread welfare across the world.
This is not
what
happened. There is very little empirical evidence that poverty,
destitution,
disease and economic inequality have been defeated. To the
contrary, many
studies seem to indicate that inequality has been increasing.10
True, the
super-rich have done very well from neoclassical policies: in the
UK in
2003
12
New Paradigm in Macroeconomics
Prologue
13
their wealth increased by 30%, 15 times as fast as inflation.11
However, this
is
true only for the top 0.002% of the population. There is no evidence
that
the
wealth of the majority rose anything like it. The number of people
living
in
urban slums is rising rapidly. Poverty remains an urgent and
growing
problem. The gap between the well-off and the poor is not closing
but
widening. While empirical data on this question is interpreted
differently
(usually depending on oneâs school of thought), there is little
denying that
the
rich receive more, while the poor are getting less â or that the little
they
own
may even be taken from them. In some countries the concentration
of
wealth and power that resulted directly from neoclassical policy
advice has
become so enormous that even an institution such as the World Bank
has
warned of the âinefficiencyâ of such wealth concentration.12 The
fruit of the
neoclassical reforms has been increasing inequality, which in turn
has
triggered new social, political and even military tension in many
parts of
the
world.
According to the neoclassical âWashington consensusâ emanating from
the
international organizations, there is no need for poor countries to
develop
indigenous industries, because free markets will ensure that
everyone focuses
on
their comparative advantage, and that will enhance social welfare.
This
is
the famous theory of comparative advantage, proposed by David
Ricardo
in
the nineteenth century and widely cited by the British leadership at
the
time
when dealing with other countries. For the developing countries of
the
postwar era this argument implied that they had to continue to
produce lowvalue-
added and low-priced commodities, whose relative prices are
known
to
decline inexorably, while their consumers must buy finished goods
at
ever-rising relative prices from abroad â importing them from the
largest IMF
and
World Bank shareholders. Since the well-known long-term trends
of
falling commodity and rising finished goods prices mean that
developing
countries will receive ever less for their exports, while having to
pay ever
more
for their imports, they cannot help but become indebted to the
rich
countries. When debt becomes large, the IMF seems ready to take
over the
government and arrange for further âbeneficialâ market-oriented
reforms,
such
as cutting food subsidies and social welfare, while seizing key
domestic
assets as collateral for the foreign investors. The outcome has
been a significant
deterioration of economic performance and standards of living in
the
Third
World.
The
free flow of capital was meant to increase prosperity in the
Third
World. Instead, developing countries have merely become more
indebted,
spending an increasing amount of their resources on interest and
interest-oninterest
payments. Often, the interest payments alone are larger than
any
initial loan received. Furthermore, the liberalization of
international capital
flows that was strongly urged on developing countries by the US
Treasury,
the
IMF and the other neoliberal international organizations has often
produced
major economic disasters in the form of balance of payments
crises
and
currency and financial market collapses, as happened during the
Asian
crisis or many times in Latin
America.
The
promise of stable economic growth, without cycles, has also not
been
met.
Economic cycles have not disappeared. On the contrary, there is
indication
that
the former business cycles may have turned into larger
boombust
cycles in many countries. There is evidence that over the past 30
years,
financial crises have increased in number and become more
destructive and
menacing in their amplitude. Despite the declared aim of achieving
price
stability, stability of economic growth and of exchange rates
thanks to neoclassical
economics, governments and central banks have failed to
deliver.
The
structural reforms of the labour markets were meant to increase
jobs
and
prosperity. However, it appears that the benefits of labour
market
reforms have mostly accrued to the employers and large-scale
shareholders â
a
small minority in any country. Employees today generally have less
job
security, often less pay or less real purchasing power. Meanwhile,
the phenomenon
of
âjobless recoveriesâ puzzles observers in many post-reform
or
post-recession countries, even the US.
The
focus of neoclassical economics on the pursuit of self-interest
and
profits has not helped to protect the environment. The mathematics
of compound
interest â with interest rates being a key variable in the
mainstream
representation of an economy â produces pressure constantly to
deliver
growth. This growth is measured as the gross addition in economic
value
added as booked in the national income accounts, without netting
out the
costs of drawing down our (unaccounted) stock of natural assets.
Any
true
cost-benefit analysis must, however, take the environmental
destruction
and
its consequences, including its effect on health and happiness,
into
consideration. Ever larger parts of the public are becoming aware
that the
current approach to economics, with minimal government
intervention
into
the workings of large corporations and large-scale shareholders, is
producing
very
costly, often irreparable damage to our most precious asset
and
the
heritage of humankind: our planet.
Neoclassical economics is built on the fundamental axiom that the
main
motivation and goal of mankind is to accumulate more material
wealth.
However, scientific studies have demonstrated time and again that
this is not
what
motivates people. The main human motivation is often not
economic
at
all.13 To spend less time at work and more time with family is
usually
found to increase happiness. This is not, however, where
neoclassical policy
advice has been leading the world. As a result, many of the reforms
inspired
by
neoclassical economics have failed to make people happy. Instead,
there
is
evidence that they have become unhappier as a result: many
neoclassical
structural reforms have implied an increase in working hours
required to
maintain the standard of living.14 There is evidence that both
parents of
middle-income families in the US now have to work, while they did
not have
to
several decades ago. Educational reform, endorsed by neoclassical
thinking,
14
New Paradigm in Macroeconomics
Prologue
15
has
saddled students with substantial debts. Psychologists have found
that
this
is a main source of depression among students.15 Job stability is a
main
factor determining happiness, according to empirical research. The
increasing
job
insecurity of neoclassical âflexible labour marketsâ has thus
left
substantial parts of society worse off. There is no evidence that
the increasing
commercialization of television, cinema and the print media
has
rendered people happier. On the contrary, companies are attempting
â often
succeeding â in exploiting human weaknesses for their gain, not
seldom
leaving people worse off. Studies have found that a stable marital
relationship
is a
main determinant of happiness, and, indeed, of longevity
and
health. However, the commercialization and trivialization of sex
outside
marriage â another commodity subject to the free market
mechanism,
according to neoclassical economics â has not had a salutary effect
on
marriage and thus has not contributed to making people
happier.16
Reflecting public dissatisfaction, the British government has
recently
declared the goal of creating âsustainable communitiesâ.
Disillusionment
with
the commercialization and draining of local communities has
even
prompted business lobby groups to abandon the previous emphasis on
barebone
profit maximization. The president of the CBI employersâ
body
recently lamented in a government-commissioned report that Britain
now
boasted âugly retail parks, isolated schools and hospitals and
business parks
hermetically sealed from the outside worldâ, where businesses felt
no need
to
provide leadership to the communities they serve.17 The
neoclassical,
market-oriented and planning-averse type of policy introduced in
Britain
since the early 1980s had not taken into consideration the desire
of residents
to
live in a pleasant social setting.
Increased inequality has had an impact on public safety. In some
countries,
such
as the US and the UK, the prison population has
increased
significantly. The fruits of neoclassical policies have been
alienation of longterm
unemployed, a feeling of disenfranchisement due to a lack of
opportunities
to
improve oneâs status and hence a lower level of loyalty to
society.
Higher crime rates are one outcome, which in turn affects the rest
of society
negatively â though without showing up as a minus in the national
income
accounts (greater spending on police, the legal system and prisons,
as well
as
on the military, are recorded as a positive contribution to
national
income).
Neoclassical economics is built on the premise that individuals
care most
of
all for themselves and act independently of each other. The state of
happiness
of
one is assumed to have no impact on others. Social
relationships
and
the desire of individuals to relate to others and receive respect
within
social groups are outside the neoclassical model. A growing group
of economists,
originating in France but quickly spreading across the worldâs
economics
campuses, has thus argued that neoclassical economics is âautisticâ
â as it has
difficulties in recognizing that humans need to relate to
others.18
Neoclassical economics talks about competition as a key mechanism,
but
at
the same time ignores the reality that most mature industries are
highly
concentrated and dominated by a small number of firms. Some of
these
firms have become highly influential and it is not clear that the
pursuit
of
their profits increases overall prosperity. This may be most apparent
in
the
case of the weapons and war services industries. Indeed, in a world
where
a
small number of firms or large-scale shareholders maintain a
dominant
position, and where the neoclassical agenda has severely limited
the
restraints that governments can place on corporations, it even
becomes
questionable whether democracy can be maintained, or whether
vested
interests will not simply âbuyâ the politicians (for instance by
funding their
election campaigns).
Mainstream consumer theory assumes that individuals know
everything
and
face no time constraints on their activities. According to this
theory,
consumers cannot be duped easily by unscrupulous corporations. But
the
reality is different, which is why government intervention is often
required.
The
evidence is that consumers are not perfectly informed, hence even
the
largest supermarket chains get away with misleading pricing of
products that
costs consumers dearly and earns their large-scale shareholders
nice profits
purely due to misinformation.19
Military conflicts have not abated. While the causes may be
different in
each
case, there are also common threads: often, economic
inequality,
rivalry and competition over limited economic resources, ranging
from
water to oil, other minerals, raw materials and arable land appear
to be
fundamental causes of conflict. Whether it was Hitlerâs declared
quest for
âliving spaceâ in the East, or Japanese efforts to gain economic
autarky and
establish an independent economic bloc that could not be
blackmailed by
outside colonial powers, economic motives have never been absent
in
warfare. The Middle East, including the occupation of Iraq, may be
another
case
in point. Despite its dominant position, neoclassical economics has
not
been
able to make any positive contribution in this important area. To
the
contrary, its policy prescriptions, by increasing inequality and
strengthening
oligopolistic large-scale corporations, may have made matters
worse.
On a
fundamental level, neoclassical economics talks much about
market
equilibrium â that state of affairs when demand is said to equal
supply. Even
many
critics of neoclassical economics find the neoclassical case
plausible
that
markets tend towards equilibrium and often can be considered in a
state
of
equilibrium, or at least approaching one. However, for market
equilibrium,
there are many conditions that must necessarily be
fulfilled.
Neoclassical economics deals with this by simply assuming them to
be
fulfilled. Foremost among these assumptions is the requirement that
everyone
has
perfect information of all relevant facts. If this is not true, markets
will
not
be in equilibrium. And then the entire edifice of neoclassical
economics
is
irrelevant. In this case, a quite different kind of economics is
required.
16
New Paradigm in Macroeconomics
Prologue
17
The fundamental flaw
A
different kind of economics is indeed what many are now demanding.
A
large number of students have lost interest in neoclassical
economics, as
they
recognize that it has become divorced from reality. While high
hopes
existed in the 1960s about the ability of mathematical models to
explain or
forecast economic developments, the business world today does not
place
great store by economic forecasters. Institutional investors prefer
to talk to
strategists rather than economists. Even major asset management
firms have
abandoned taking positions on currencies, for instance, as
economics has
failed to explain exchange rates. Professional economists working
at corporations
and
financial institutions have long realized that they cannot
stick
to
academic economic models if they want to remain relevant. They
have
long
abandoned them, leaving the academic economists as followers of
an
esoteric science that has little, if anything to do with economic
reality.
Could it be, one hardly dare ask, that we got things upside down?
Could
it
be that many of the worldâs ills are actually caused by the drive
to create
free
markets and by the wrong type of economics? Neoclassical
economics
has
had its chance at improving things. It has failed. The time has come
for
a
new kind of economics.
The
critics of neoclassical economics agree that economics should be
about
economic reality and should be demonstrably relevant to it. This
will strike the
non-economist as obvious. However, it is not obvious in mainstream
economic
thinking: the neoclassical school of thought is based on the
deductive
approach. This methodology argues that knowledge is brought about
by starting
with
axioms that are not derived from empirical evidence, to which
theoretical
assumptions are added (again not empirically backed), and on the
basis
of
which tools of logic (mathematics) are utilized to prove theoretical
results.
There is an alternative approach. This approach examines reality,
identifies
important facts and patterns, and then attempts to explain them,
using
logic, in the form of theories. These theories are then tested and
modified as
needed, in order to be most consistent with the facts of reality.
This methodology
is
called inductivism.20 All the natural sciences and most scientific
disciplines
use
this approach. Inductivism is not only dominant in science,
it
also
describes how we learned as infants about this world. When we
touched
the
hot stove in the kitchen and burnt our fingers we learned
inductively
that
doing so again would also hurt again. When men saw the sun
ârisingâ
in
the East several times, they induced that it would continue to do so in
the
future. Inductivism is not only scientific, it is also common
sense. This is
why
before the arrival of neoclassical economics (and its nearly
identical
historical predecessor, classical economics), the majority of
economists quite
naturally followed the inductive
approach.21
Neoclassical economics turns out to be the one school of thought
within
the
discipline of economics, indeed one of the very few intellectual
disciplines
in
general, that rejects the inductive approach favoured by scientists,
and
prefers deductivism. It must be considered a unique phenomenon in
the
history of thought that the originally marginal and eccentric
deductive
approach to economics has today become the mainstream school of
thought.
Unhindered by economic reality, deductive economists can start
with
their preferred axioms, which do not need to be supported by facts
â such
as
the axiom that individuals only care about the maximization of their
own
material benefit. Additional unrealistic assumptions produce the
theories
that
are so removed from reality. While this is certainly allowed and may
be
useful as an exercise in logic, the theories, which are specific to
the hypothetical
environment created by the assumptions, are then used to
advance
policy recommendations. By this stage, no further mentioning is
made of
the
assumptions necessary for the validity of the argument. The jump
from
the
theoretical and hypothetical models to actual, supposedly
workable
policy advice is not usually explained. It is striking how
seamlessly neoclassical
economists have bridged the gap from their wholly fictional world
of
unrealistic models to recommendations of policies that actual
politicians are
supposed to implement in reality.
Obfuscation has certainly played a role: to hide the fact that much
of theoretical
mainstream economics consists of irrelevant existence theorems
and
axiomatically asserted âfindingsâ, impenetrable jargon was used. It
seems
that
lack of content was covered up by shrouding models in
ever-more
advanced mathematics that awes mathematicians and that makes
even
experts reluctant to criticize.22 Many observers where blinded by
what masqueraded
as
science, when, by comparison, it would be unthinkable
for
physicists to suggest that one should assume the laws of physics
were
suspended â for the sake of argument and to see what type of
interesting
model one gets â and then proceed to act on these findings in this
actual
world, where the laws of physics do apply. Political supporters of
the conclusions
and
policy recommendations of neoclassical economics (these
are
often the economists themselves) are guilty of failing to point out
the highly
unusual conditions necessary for their theories and recommendations
to be
valid. Abstract models that rely on unrealistic assumptions and
apply only
to a
theoretical dream world are prone to be usurped by interested
parties
and
thus may simply become excuses for advocating policies preferred
by
some. Thus deductivism is certainly useful for those who wish to
support
preconceived ideas with the cloak of being âscientificâ. Yet few
scientists
would consider purely deductive approaches
scientific.
It
can be seen that the deductive methodology is the fundamental
reason
why
economics could end up so far removed from reality. If a gap
between
reality and theory is pointed out (by some pesky inductivist),
deductivism
does
not require neoclassical economists to change their theory.
Instead,
deductivists are entitled to demand that reality be changed to suit
their
theory (which is correct by axiom). If the long list of assumptions
required
18
New Paradigm in Macroeconomics
Prologue
19
for
neoclassical models to work â perfect information, complete markets,
no
government intervention, perfect competition, no increasing returns
to
scale â does not seem to reflect reality, it is logically
consistent for deductivists
to
suggest that structural changes be implemented so that
reality
moves closer in line with their models. The deductive approach also
explains
why
the increasing dominance of the neoclassical approach resulted in
a
relegation to secondary status of those branches of economics that
do look
at
reality, such as applied economics, economic history, political
economy
and
regional economic studies. They dealt with uncomfortable facts
and
thus
their influence had to be reduced so as not to threaten the
deductive
mainstream.
The main contribution of neoclassical
economics
Nevertheless, despite its deductive methodology and unrealistic
assumptions,
neoclassical economics, like its predecessor, classical economics,
has
not
been useless. To the contrary, interpreted correctly, it can be seen to
have
provided a valuable service to mankind. To recognize this
contribution, it is
necessary to recall what neoclassical theories actually say. Many
observers,
and
even many economists, believe that neoclassical economics has
proven
that
only free, unimpeded markets and free trade can lead to
economic
success, while government intervention is doomed to inefficiency
and
failure. This is not in fact true. Instead, neoclassical models
have demonstrated
quite precisely that free markets and free trade would only then
lead
to
optimum welfare, and government intervention would only then be
an
inefficient distortion of the economy, if and only if we
lived in a world where
everyone had perfect information about everything, and a number of
other
stringent conditions (such as zero transaction costs, constant
returns to
scale, complete markets, perfect competition, and so on) were met.
Likewise,
neoclassical economics found that liberalization, deregulation and
privatization
would only
improve economies
in situations where everyone had perfect
information (and transaction costs are zero, there are constant
returns
to
scale, complete markets, perfect competition, and so
on).
The
most familiar diagramme in economics shows a
downward-sloping
demand curve and an upward-sloping supply curve. It is said that
prices
adjust so that markets clear at the point where the two curves
cross â and
thus
markets are in equilibrium or a state approaching it. In actual fact
the
model says no such thing. It has demonstrated that demand will
equal
supply if and only if everyone had perfect information. The
string of highly
restrictive and unrealistic assumptions on which the neoclassical
models are
based are like the uncomfortable small print in a contract that
gets easily
overlooked. But they have far-reaching implications. Thanks to the
rigorous
neoclassical models we have learned just how stringent and how
exceptional
the
necessary conditions are in order to obtain market equilibrium, or
to
obtain the result that free markets or free trade produce an
optimal resource
allocation. The question is now whether these conditions or at
least some of
them, could ever hold to be true. If not, then neoclassical
economics has
rigorously proven to us that free markets and free trade cannot
be expected
to
result in optimal resource allocation, maximum welfare or even
simple
market clearing. In this case, neoclassical economics has proven
that deregulation,
liberalization and privatization cannot be expected to
improve
anything â which may well explain why the numbers of
economically
disenfranchized has increased and globalization à la Washington
consensus
is
being increasingly opposed. More than that, if markets do not
actually
clear, economies would function quite differently from what we
have
been
told by the mainstream textbooks for decades. A very different kind
of
economics would be required to explain economic reality and help
us
improve it.
Probably the most important of the premises needed by
neoclassical
economics for its tenets to hold is the assumption of perfect
information. It
is
so crucial, because even simple market clearing â a very fundamental
tenet
of
much of modern economics â requires it. Joseph Stiglitz, who became
the
most
influential economist to turn against mainstream neoclassical
economics,
started out his research by ârelaxingâ just this one assumption
that
was
presented as fairly innocuous by neoclassical models. Many
trained
economists had become so familiar with the assumption of âperfect
informationâ
that
ârelaxingâ it seemed an unusual thing for
them.
Since the fiction of âperfect informationâ is a standard
assumption, most
economists have become thoroughly hardened to its enormity. To
assume
perfect information is a monstrous distortion of reality. It
creates a fictional
world that is not just a little different from reality, but one
that is diametrically
opposed to what constitutes the very essence of the world we live
in.
All
economic activity is based on the very fact that information is not
perfectly
and
equally distributed. To realize the far-reaching implications of
the
assumption of perfect information, consider what a world would look
like if
the
neoclassical assumption of âperfect informationâ indeed held
true.
If
there was perfect information â
â
there would not be meetings at companies, government agencies
and
other institutions. In actual fact, much activity at any
organization is
taken up by holding meetings in order to inform, communicate,
discuss,
decide, motivate, and so on;
â
there would be no need for firms to exchange information. In actual
fact,
gathering information is crucial for businesses. Since medieval
times,
trade fares, product shows, conferences, symposia and events are
welldocumented
as
important engines of growth and innovation:
such
growth depends on information flows, on firms getting to know
other
firms, meeting customers, and so on;
20
New Paradigm in Macroeconomics
Prologue
21
â
there would be no books, no newspapers, no news programmes on
TV.
Reuters and Bloomberg, even the internet, would not be
viable.
Customers would not pay to obtain information about what they
know
already. The large media conglomerates, such as Bertelsmann or
AOL
Time
Warner, would not exist;
â
analysts would not have to spend hours poring over corporate figures
to
analyse the state of a company. All the multitude of data would not
only
be
instantly known, people would also have the requisite knowledge
to
interpret them correctly;
â
there would be no corporate accounting scandals, which
surprised
investors, regulators and, on occasion, accountants alike and
resulted in
multibillion-dollar losses for investors. The scandals include
Enron,
WorldCom, Tyco, Parmalat, and so on;
â
there would have been no surprise at former NYSE chairman
Richard
Grassoâs enormous pay cheque, which became a scandal when it
became
widely âknownâ. It had been agreed much earlier and was no
secret;
â
there would not be any secret services, indeed there would not be
any
secrets â political, military, commercial or otherwise. Instead,
secret services
command multibillion-dollar budgets;
â
actors would not be able to become politicians. In reality, actors
have
become governors, even presidents of major countries. The fact that
they
are
known to many people is often sufficient for them to get elected
to
highest office. This demonstrates the enormous value of information
and
of
being known. It seems to beat any other quality that politicians
might
have. In a world of perfect information this would be
unthinkable;
â
all products would be equally well-known and easily available to
consumers.
In
reality, the biggest bottleneck for sellers of new goods
and
services is to get their product and its availability known to
potential
buyers. This is why distribution channels are so important and
valuable
for
businesses. Shelf-space in shops is limited. The market for prime
shelfspace
is
rationed. Psychologists are paid to suggest which places are
more
likely to be spotted and which arrangements in shops are more
likely to
trigger purchases. None of this would be possible or necessary in a
world
of
perfect information. In bookshops those books for which the
publishers
have
paid large advances appear in prominent places and stay
on
shelves much longer. Others are in remote corners, with only one
copy
available for only a limited time, or not in the shop at all. Which
book
will
get bought? Is it really the quality of the book that decides it? Or
the
advertising and positioning in the bookshop? The internet has
not
changed this reality: the profusion of websites means that putting
up
oneâs product on the internet does not ensure any sales or even
hits. The
time
during one day is limited (rationed). So is the time each
computer
user
sits in front of a screen. Thus only a limited number of
websites
can
appear before the eyes of each computer user. While the supply
of
websites is very large, the effective demand for them is much
smaller: the
market for website watching is rationed, like every other
market;
â
there would be no need to learn different languages, mathematics or
any
subject at all â least of all economics. People would know the true
economics
already! There would be no need for education and training, no
need
for
schools and universities, no need for companies to spend on
training
their staff and acquire further technical skills. The money spent
by India
over
several decades to achieve a high level of education
(government
intervention often criticized by neoclassical economists) would
have been
unnecessary and today African countries would be as much leaders
in
software development as India. There would be no need to learn
local languages
and
customs for a firm entering a different market. There
would
be
no need for any expertise at all;
â
there would be no need to hire anyone except new graduates, since
work
experience would count for nothing. However, wages as determined by
the
labour markets indicate that work experience is valued by
employers, as
inexperienced new graduates command lower wages in the market.
Despite
being the cheapest offering on the labour market, firms choose to
hire only
few
new graduates, instead relying mostly on more expensive
staff;
â
there would not be any advertising or the attempt to build brands. The
existence
of
brands is a reflection of imperfect information: consumers
cannot
be
sure whether a product will fulfil its claimed purpose, whether it is
faulty
or
whether it will have a sufficiently long lifespan to make the
purchase
worthwhile. The only way around this information problem is
for
producers to build a reputation for high quality, based on the past
track
record. Once this has happened, consumers will have confidence.
This was
realized in early medieval times in Europe, where trade guilds were
created
and
implemented strict quality control. Essentially they were cartels
that
forbid people from engaging in their trade, except with the permit
from the
guild, which would only be granted after examinations and quality
controls.
As a
result, many European cities developed a high reputation for a
specific
product, which in turn helped convince customers to buy their
products as
they
inspired confidence. If knives or other steel equipment were
stamped
as
originating from Sheffield, Solingen or Toledo, customers would,
based
on
the reputation built up over the years, have confidence in the
product.
This
means that each product carries a reputation externality with it,
which
the
price does not reflect, and which each individual producer may not
even
consider. The significant sums spent on advertising by corporations
are
evidence of how important information imperfections are and
how
important it is for firms to be known and to have a good
reputation;
â
there would not be money. Barter proved cumbersome in the absence
of
the
coincidence of wants, if one did not know exactly who might wish
to
buy
which amount of oneâs produce. Money was an answer and its
existence
demonstrates that information is not perfect and never has
been;
22
New Paradigm in Macroeconomics
Prologue
23
â
there would be no technological innovation, and hence there would be
no
real
growth. Empirical studies, including by Solow (1957) have shown
that
much
of economic growth is accounted for by technological
innovation.
However, such innovation is the result of improved recipes (Romer,
1990)
to
rearrange already given resources. In other words, growth is due
to
information. Without new information, there could not be real
growth.
To
assume perfect information means that all information is already
available
and
equally disseminated. There are two levels at which this
is
relevant: perfect information means that future technology should
already
be
known today. Secondly, if we accept imperfect information of
future
technologies, then the dissemination of this new technology may
occur
imperfectly â as indeed patent laws ensure. Either way, imperfect
information
exists. In reality, one of the most important investments by
firms
is
on research and development of new recipes, that is, new
information,
about what new products could be made, how new goods and
services
could be assembled, and so on. Once such new information has been
generated,
firms will try hard to keep it secret and prevent it from falling
into
the
hands of competitors. Patents represent one way to maintain an
information
advantage temporarily. Secrecy is another. Anyone who
has
worked in a firm will know that corporate secrets are important and
often
protected explicitly in employment
contracts;
â
there would be no talk about or need for âtechnology transferâ to
developing
countries. All technology would already be
known;
â
there would be no headhunters: financial sector headhunters
usually
charge 30% of the first yearâs pay package of the person they
have
successfully introduced to a firm. With a modest start-up annual
package
of
US$100,000 base salary and an annual bonus of US$200,000,
this
would amount to almost US$100,000 just for one deal. There are
many
headhunting firms, in many countries. None of these could exist if
there
was
perfect information;
â
there would be no export/import firms, which capitalize on their
knowledge
of
another country. In reality, knowledge of language, customs,
laws,
taxes and customs duties is worth money. Thatâs why such firms
can
charge a commission, which usually continues as long as the goods
are
exported or imported;
â
there would be no literary agents. They know the publishers and
the
names of the suitable editors, usually because they worked as
editors at
publishers before. They then sell their knowledge, charge 10% or
15% (for
overseas deals, when sub-agents are involved, 20%) of all monies.
There
is
also the reputation aspect, another result of imperfect
information:
agents act as a screening device and try to build up a good track
record of
books, so that editors at publishing houses will trust their
recommendations.
If
there was perfect information, editors would not need
that
service, neither would authors;
â no
activity could exist, which is based on an information advantage
or
the
provision of specialized knowledge of a trade, for which
commissions
or
fees are charged. All these are based on asymmetric information:
the
counterparties do not know each other, or the details of the
transaction,
but
the intermediary knows. If we knew where the right apartment
is
becoming available, or if we knew which editor at which
publishing
house might like our book, or if we knew which wholesaler or
distribution
chain in another country might be suitable for and interested in
our
product, would we pay the 3%, 15% or sometimes higher agency fees?
If
we
start up a hedge fund, we will need to raise money. Would we offer
up
to
50% of all the revenues to the fund âintroducerâ â agents who
market
the
fund to their contacts â as is often happening, if we knew the
names
and
contact details of those pension funds, funds of funds or
family
offices that are interested in our hedge
fund?
â
entire industries would not exist, such as
â
the entire financial sector, including banking, fund
management,
investment advisers and stockbroking (if investors knew about
who
needed money, they could invest directly without financial
intermediaries),
ratings agencies as well as stock market index compilers
and
disseminators of such indices
â
the entire telecommunications and internet industry, which works
on
relaying information
â
the consulting industry
â
accounting and auditing firms (the accuracy or inaccuracy of
accounts
would be well-known)
â
scientists, teachers or instructors
â
lawyers, who inform about laws and how to proceed with
defending
oneâs rights
â
doctors, who use their knowledge to diagnose diseases and
prescribe
suitable therapy
â
tax advisers and qualified accountants, who perform the service
of
advising on ways to account for transactions appropriately and
minimize
taxes; with perfect information unqualified clerks could just
perform
the
obvious duties of inputting data into
spreadsheets
â
police officers working on solving crimes
â
economists.
The
list could go on. If there was perfect information, people would
not
spend much time or money on gathering and relaying
information.
Monitoring an average day of an average employee should show that
usually
the
majority of our time is spent on this activity: in the morning,
reading
the
newspaper, checking the mail, attending the morning meeting,
checking
email, checking a few internet websites, researching in libraries,
looking
up
company reports, looking up files, searching for files or searching
for
24
New Paradigm in Macroeconomics
Prologue
25
information, calling up colleagues and contacts to find out
something,
receiving enquiries from potential customers, colleagues,
subcontractors,
suppliers who ask many questions, meeting colleagues for lunch to
discuss
matters, visiting potential customers to explain products and
services,
visiting suppliers to clarify requirements and specifications or to
avoid
misunderstandings, having business dinners to facilitate
communication,
going home and seeing advertisements on the train, watching the
news or
commercials on TV, asking the spouse how their day was
â
It
is no exaggeration to say that each one of us spends most of our
time
gathering, analysing, disseminating information and communicating
with
others. It is the very essence of our activities. It is the essence
of commercial
activity and hence of what happens in an economy. To assume perfect
information
is
to assume that none of this happens.
In
the real world people and companies make money because others
do
not
know everything. The information that others do not have is
their
advantage. It is their value added. Asymmetric information is not
an eccentric
exception to models, as economics textbooks make it appear.
Instead, it is
the
very essence of business and economic activity. Where
information
asymmetries are largest, the profits are largest. This is why in
transparent and
highly competitive industries profits are smaller. They are largest
in the
financial sector, because least is known about the actual working
of financial
markets and economies â partly thanks to neoclassical
economics.
Information is at the very heart of the economy. Its value lies
precisely in
the
fact that it is not perfectly and symmetrically distributed. To assume
perfect
information means to assume away the most crucial aspects of the
reality
we
live in. It is tantamount to assuming that the moon is made of
cheese,
and
then building theories on this premise.
Despite these facts, the majority of economists has for several
decades
happily worked on the assumption that there is perfect information.
This is
particularly worrying, since this and other assumptions are crucial
to obtain
the
conclusions emphasized by the neoclassical theories. What should be
of
interest to anyone is the question of what happens when we
acknowledge
the
reality of pervasive information imperfections. Neoclassical
economics
has
made little contribution to this important
question.
But
there are other necessary assumptions to obtain the
neoclassical
conclusions, and they are equally unrealistic. Most models assume
perfect
competition, despite the reality of oligopolies and monopolies in
most
mature markets. Most models ignore the importance of increasing
returns to
scale (by assuming constant or diminishing returns to scale), when
there is
evidence that scale economies are pervasive and important for
much
economic activity. Another necessary assumption for neoclassical
theories to
work
is the assumption that resources are always fully employed. This
not
only
defies the reality of markets and economies, but also the facts of
human
nature: on an individual level, neoclassical economics assumes that
individuals
always use their talents and abilities, always work at âmaximum
capacity
utilizationâ. In reality, humans are not machines. They need to be
motivated.
If
they are not sufficiently motivated, they may not put as much effort
into
their activities as might theoretically be possible. Once this
reality is
acknowledged, the subject of how humans can be motivated becomes
of
crucial importance. This is where rules and norms, social
institutions and
hierarchies come into play, and the question of how such incentive
structures
should be designed in order to elicit maximum potential. One
only
needs to consider how motivation can influence physical performance
in
the
case of sports, and the role of coaches. Similarly, soldiers, as well
as
indeed anyone who is part of an organization or hierarchy, will be
subject
to
motivational policies implemented in order to obtain the type of
performance
desired. Indeed the motivation â and also manipulation â of
people
is a
major activity engaged in by large industries. Incentives and the type
of
information provided are used as tools to get people to do what is
desired by
others.23
Another area where assumptions of traditional economics are
crucially
flawed, thus compromising the entire model, is the theory of the
consumer.
Individuals are assumed to be only motivated by their own
self-interest and
individual utility functions are assumed to be independent. The
present
book
is focused on macroeconomics and this issue will thus remain
outside
its
scope. What can be said here is that this model of the individual also
has
little to do with reality. Individuals are born into society and
mostly are
interested in relating to others in society. Their status and
ranking in society
is
an important motivation that has been ignored by mainstream
economics.
An
inductivist approach would form a model of
individual
behaviour based on reality. Only then are conclusions likely to be
relevant
and
accurate. The realistic study of incentives leads to the conclusion
that
institutions, hierarchies and ranking are important. Thus incentive
structures
that
are designed to increase motivation take this into
consideration.
Institutional design is therefore a crucial paradigm in economics
that has
so
far been neglected by the mainstream. As we will find, credit creation
is
another.
The
reality of human nature, the reality of imperfect information,
the
reality of increasing returns to scale, the institutional reality
of financial
markets, the reality of large-scale businesses, all must be
possible in the new
economics, if not integral features of economic
models.
Ingredients of the East Asian economic
âmiracleâ
Since economic activity is always the result of human activity,
this means
that
the design of rules and settings, within which markets are
embedded,
becomes a powerful tool of government intervention to enhance
economic
26
New Paradigm in Macroeconomics
Prologue
27
performance successfully. It is one that is ignored by the
mainstream
economics paradigm. But it is one that was at the heart of the East
Asian
economic success, including Japanâs.
With
imperfect information, markets do not clear. This includes
the
market for money and credit. Markets that do not clear are
rationed.
Rationed markets are determined by quantities, not prices,
according to the
âshort-side principleâ: whichever quantity of demand or supply is
smaller will
determine the outcome. The limited liability of directors within
corporations
means that incentives are skewed such that entrepreneurs who
borrow
money may gain disproportionately compared to their potential
downside.
This
has been one of the driving forces of capitalism. Concerning the
market
for
money and credit, it means that demand is likely to outstrip
supply,
leaving it supply-determined. This, then, becomes the central focus
of our
investigation: the institutional setting of the supply of money and
credit and
its
implication. For this purpose, inductive research into the
development
and
operation of the banking system is necessary. It is found that banks
are
truly special, although their unique feature has not been
recognized by
mainstream economics, or by banking and finance
textbooks.
In
rationed markets, an allocative decision is made. Thus market
rationing
provides a justification for government intervention to ensure that
resources
are
allocated such that welfare is enhanced. However,
heavy-handed
government intervention is unlikely to work. The East Asian
economic
success story in general and the Japanese in particular were based
on clever
government intervention, which took mainly two forms:
institutional
design to shape the incentive structure and direct allocative
intervention
largely limited to one specific area, namely the credit market.
Here, a powerful
credit control tool was used that remains largely unknown, despite
the
fact
that it has been at the heart of the East Asian economic miracle,
and
indeed at the core of the success of a number of other economies,
including
Germany.
Sometimes the success of the East Asian âmiracleâ economies is
claimed
by
neoclassical economists as evidence of the success of
market-based
capitalism and hence of the neoclassical paradigm.24 This, however,
is an
empirical question: did the Japanese and East Asian policies
originate from
neoclassical policy advice? Or did they originate from theories
quite explicitly
and
fundamentally opposed to the neoclassical
approach?
But
just when more present-day economists are beginning to
recognize
some
of these issues in the latest, revised theories, Germany and Japan are
in
the
process of adopting the British and US neoclassical model
through
liberalization, deregulation and privatization. If this process
continues,
shareholder fundamentalism will reshape society and increase the
share of
economic activity devoted to profit-seeking by shifting ownership
certificates
from
A to B. After all, adopting US-style capitalism means
that
Germany and Japan are importing its disadvantages and social
problems.
If
the structural reforms in Europe and Asia continue, there may soon be
less
talk
of an alternative model to the Washington consensus policy package,
as
the
most outstanding examples of successful development policies
(as
opposed to those favoured by the international institutions) will
have been
dismantled. Then, neoclassical economics may remain the entrenched
and
dominant economic ideology. This is another reason why it is high
time to
re-examine the neoclassical paradigm, especially in the context of
the
Japanese economy, and test whether an alternative approach can be
found
that
is empirically superior.
Joseph Stiglitz has called for a new paradigm in economics. He has
laid the
foundations and done much to make the world aware of the problems
with
mainstream economics. The present book merely represents another
step
towards laying the groundwork for the new paradigm in the area of
macroeconomics.
Much
work remains to be done in this exciting and vast
research
programme on a new kind of economics.
Work
on the new kind of economics must be rigorously tested, using
the
most
difficult challenges to macroeconomics. One of the most
powerful
empirical challenges has been posed by Japan,
which is where many of the
empirical data for the present book are drawn from. The new
economics
should not only explain whatever the old theories could explain. It
should
also
be able to explain the many âanomaliesâ that the previous
neoclassical
paradigm could not account for. Finally, the new kind of economics
should
offer solutions â workable, actual solutions â to many of the
worldâs problems.
For,
as John F. Kennedy said, manâs problems are manmade. They
can
therefore also be solved by man.