Developing A New Macro Economics

Written by Derryl Hermanutz

In her article, Teaching Macroeconomics to Undergraduates in The Post-Crisis Era, Wendy Carlin explains how she and associates are developing a more realistic theory of the macro economy as a dynamic system which includes the effects of banking and the financial sector.  Carlin asserts that the important direction for teaching today should increase emphasis on global issues beyond the focus on the financial world of the City and Wall Street.  She says [my added emphasis]:

“Economics students have started to establish new student societies, which focus not on how to get a job in the City, but on the question ‘How can economics be used to understand the world better and improve it?’ This suggests an increasing appetite to participate in policy discussions.”

Carlin expresses a concern about the complexity of the model being developed:

“Is teaching the 3-equation model plus financial sector to undergraduates practical?”

Perhaps Carlin’s concern does not go far enough.

Economic Models

Current mainstream macro, in both academia and policy making circles, models an imaginary world populated by homo economicus, a species of economically rational cost-benefit analysts whose sole purpose in life is personal profit maximization.  Everybody is both a producer and a consumer, and they trade their surplus outputs with each other in a marketplace.  These creatures inhabit a competitive free market system where none of them enjoys enough personal wealth or power to individually raise the prices they receive from their sales or lower the prices they pay for their purchases.  Everybody pays the full cost of the resources they use or ruin.  In this competitive environment each of the actors constrains the others’ ambitions to market dominating wealth and power, by emulating winning products and strategies and cutting prices and/or improving the product or service to gain market share, thus restoring the market to “equilibrium” where supply matches demand at the lowest possible prices.  And “as if by an invisible hand“, the market generates outcomes that optimize the wellbeing of all participants.

I will argue that in its aspiration to rise above the status of a “soft” social science and be recognized as a “hard” precise science, economics has become excessively mathematized, in light of the observable reality in which concentrated financial and economic power exercising market dominance, not myriad actors competing more or less equally in a free market, move markets in idiosyncratic ways that simply cannot be captured in any kind of principle based models.  Models seek to overcome this problem by noting exceptions to the rules, “market externalities“.  I suggest that in our real world environment is not one of market freedom but of market power, these externalities are the rule, not the exception.

Statistical Limitations

Statistically, it is possible to derive laws of averages from a system in which very many actors behave in individualistic ways.  This emergent predictability is the basis of Newtonian physics that underpins sciences such as civil engineering.  There are trillions, quadrillions of iron and carbon molecules in a piece of steel.  The molecules are individually chaotic but collectively predictable.  The predictability is an emergent property of the system, not a property of any of the individuals who contribute to the system.  Adam Smith imagined this kind of economic system, “the free market“.

Quantum mechanics recognizes that it is not possible to know what any one of the subatomic particles which comprise the atoms and molecules will do at any given time, though it is possible to calculate a probability for any given behavior.  “On average” the particles and the piece of steel will “probably” behave in ways described by Newtonian physics, and civil engineers depend on this predictability when designing bridges and buildings.  But quantum mechanics recognizes that none of the individual atoms is constrained to behave according to the laws of averages.  Nor is the system as a whole bound by any absolute law.  The world as it is knowable by us is probabilistic, not law bound.  Newtonian “law” is the law of “averages“.  Improbable behavior is not “likely“, but it is “possible“.

Two Worlds

The modern economic world is not accurately described in Newtonian terms, the terminology of “free markets” that generate macro predictable laws of averages.  Billions of individual humans acting individualistically are not the actors who determine the broad outlines of our macro economies.  In fact our world has become bifurcated, maybe has always been so underneath our pleasant republican and democratic dreams of individual liberty, into one world that has power, and another world that doesn’t.

There actually exists a species of economic actor who fits the homo economicus definition of a single minded profit maximizer, but this actor is not a human being.  It is an institution, a legal construct, an idea.  It is the large scale, politically and financially dominant business corporation.  And the corporation is populated with Homo Corporaticus, corporate man.  Corporate man must maximize corporate profits, or he will be replaced by somebody who will.  He is not at liberty to pursue any interest other than profit maximization.

Time for Modern Realism

Modern mass society requires modern mass business and finance.  Homo Corporaticus and too big to fail banking systems are of a piece with mass living.  You cannot have one without having them all.  This must be acknowledged within a realistic macro economics.  Leopold Kohr (The Breakdown of Nations, 1957) and EF Schumacher (Small is Beautiful, 1973) have described the inevitable pitfalls of living Big.  Those problems really are “inevitable“, so as long as we are committed to maintaining our mass civilization, we must incorporate into our macro understanding the inescapable causes and consequences of Bigness.

Friedrich Hayek (The Road to Serfdom, 1944) described the pathologies of power within a “government” corporate institutional structure.  But the same dynamics operate within private sector corporate structures.  The common denominator is that some people exercise command over many other people’s “money“, which puts “corporate power” in their hands that they could never acquire by their own individualistic free market efforts.  And the wealth and power of large corporate institutions, public or private, insulates decision makers from personally paying the consequences of their bad luck and bad choices.  “Market discipline” does not operate within the corporate institutional structure because corporations are run by “employees“, not by owners who personally gain and lose money via market vicissitudes.  Corporate decisions on income levels, and whether to impose or forbear punitive discipline on bad luck or decisions, are made by “men“, not by “markets“.

Time to Abandon the Toys

To understand how an economy works in this corporatized environment requires an entirely different approach to macro economic thinking: more conceptual and psychological and less mathematical with its false precision; unpredictable at both the micro and macro scales but comprehensible in terms of recognizing the forces who are acting and what they are trying to accomplish, for good or ill.  Macro economic theory cannot be rescued by tinkering within the existing woefully inaccurate models of a primitive free market populated by a species homo economicus who probably never existed in a non-corporate form (though the term “sociopath” captures the psychology and behavior of a person who is single mindedly self-interested).  What is needed is a wholesale revision of first principles, a paradigm shift to a whole new way of conceiving the macro economy.

I first studied introductory micro and macro economics in 1973-74, then in 1994-97 studied economic history and policy, political economy, and monetary economics toward my BA minor in political economy (my major was philosophy).  During the 20 year interim academic economics transformed from a concept based discipline described in equations and graphs to an almost entirely math based discipline where the equations and graphs replaced conceptual reasoning.

Math is a “formal” language.  Like its philosophical counterpart formal logic, it is the “form” of the statements and arguments that determines whether the statements and arguments are “valid” or invalid, but it is the “informational content” of the statements that determines whether the statements are “true” or false to reality.  By focusing too much of its brainpower on the very complex forms of mathematical language, which leaves insufficient neurons devoted to observing the workings of the real world, economics has lost its connection with “reality“.

Parallels With Physics

According to Lee Smolin (The Trouble with Physics, 2007), theoretical physics is suffering the same mathematical malady.  Though quantum electrodynamics offers the most precise and accurate descriptions of any science, physics has no idea what the realities that are described by the math equations “look like“.  There are holes in the theories, and physics has been trapped in a conceptual cul-de-sac for at least three decades.  Probabilities cannot determine actualities.  There are as many as 10⁵⁰⁰ possible string theories, for example, and no way of determining which of them is more or less true to reality, because physics has yet to find its grand unified theory of everything, its “big picture” of what reality is, what it looks like and how it works.  If economics seeks to emulate the precision of physics, economists should be aware that the mathematical methods of physics will not likely yield an accurate big picture of the macro economy.  History suggests that what is required is a “conceptual” paradigm shift.