Home > Uncategorized > The cost of focusing on general equilibrium theory

The cost of focusing on general equilibrium theory

from Lars Syll

The largest problem with the economics profession’s focus on general equilibrium theory is the opportunity costs of that exploration. Important policy problems are not addressed. Consider Pareto optimality and the welfare theorems, which Fisher sees as the underpinnings of Western capitalism. In a world, such as ours, where property rights cannot be allocated effortlessly and costlessly, economist’s welfare theorems have little policy relevance. Does a policy maker care whether any Pareto efficient allocation can be decentralized as a competitive general equilibrium? The chance of discovering a real-world Pareto optimal policy that can be shown to harm no one in some infinitesimal way is essentially nil.

what ifBy focusing their theoretical policy analysis on Pareto optimal policies, economists avoid coming to grips theoretically with the messy value judgments that must be made in the policy space, which means that their theoretical models provide little guidance on how to deal with the messy problems of actual policy that are designed to achieve both efficiency and fairness. In its almost exclusive focus on efficiency, modern economists have moved away from Classical economist’s utilitarian moral philosophy that underlay Classical economist’s support of markets. Classical economists supported markets because they worked reasonably well in the real world, not because of any deductive proof of the benefits of markets.

Dave Colander

  1. August 25, 2018 at 8:57 pm

    In his paper of 1972 The Irrelevance of Equilibrium Economics (in The Economic Journal), Kaldor started his paper by this statement:

    >>The purpose of my lecture today is to explain why, in my view, the prevailing theory of value-what I called, in a shorthand way, ” equilibrium economics “-is barren and irrelevant as an apparatus of thought to deal with the manner of operation of economic forces, or as an instrument for non-trivial predictions concerning the effects of economic changes, whether induced by political action or by other causes. I should go further and say that the powerful attraction of the habits of thought engendered by ” equilibrium economics ” has become a major obstacle to the development of economics as a science-meaning by the term ” science ” a body of theorems based on assumptions that are empirically derived (from observations) and which embody hypotheses that are capable of verification both in regard to the assumptions and the predictions.

    Collander concluded his paper cited by Lars Syll as follows:

    >>In conclusion, formal general equilibrium analysis is largely irrelevant to policy. In fact, the general equilibrium approach has the analysis precisely backwards. There is no need to prove that a decentralized system can exist or is best. We have a partially decentralized system that has evolved into a mixed system in order to assure continued existence. The policy question involves that real-world mixed system. The relevant policy question involves the nature of, and how much, centralization, and non-market coordination is needed to make our evolving decentralized system work. Theoretically that is a question that cannot be answered generally. But, by blending an understanding of markets with a study of history and institutions, it is a question that economists can shed light on.

    Compared with Kaldor (1972), Collander’s conclusion is a big retreat, because Collander implicitly admits the relevance of General Equilibrium Analysis (GEA) as a scientific theory. What he contests aginst is its policy relevance. He admits that the GEA is a valid theory of decentralized or market economy. This is what is claimed by Frank Hahn in his Inaugural Lecture in 1973 as “the most important intellectual contributions” of economics” (Hahn 1984 p.64). Kaldor contended that equilibrium economics is irrelevant as “an apparatus of thought to deal with the manner of operation of economic forces”. Colander could only argue against GEA as a tool of policy making. He could not show how and why the GEA is wrong as scientific theory. A big retreat, isn’t it? I wonder why Lars Syll copied and pasted a part of Collander’s paper in his blog. Is he thinking that the biggest problem of the mainstream economics is only a policy irrelevance?

    • August 27, 2018 at 10:02 am

      Yoshinori, it seems to me you are reading into Collander an implication (of the relevance of General Economic Analysis) which doesn’t exist: which in fact is being politely denied. Besides, we have here two lines of argument which are complementary rather than competitive. Why opt for one only?

      • Rob Reno
        August 27, 2018 at 10:42 pm

        I could not have said it better Dave. But your observation was exactly what I thought upon reading Yoshinori’s comment. One can, as Lars has done in his selection of quotations, agree with a specific point, without commenting on (or necessarily agreeing with) other points on the same essay.

      • August 29, 2018 at 4:43 pm

        Dave and Rob,

        please read my reply at August 27, 2018 at 2:36 am.

  2. David Harold Chester
    August 26, 2018 at 6:52 am

    If only your economics bods would focus like engineers do on the fact that equilibrium is a phenomenon created by inherent stability, and one which is never in perfect balance, all this discussion would be unnecessary!

  3. Frank Salter
    August 26, 2018 at 7:00 am

    I find it difficult to comprehend the extent of the mumpsimus of academic economists. My paper “Transient Development” passes the strong tests of both Poppler and Lakatos for validity. In predicting the characteristics of production, it is a counter example to equilibrium theory. Physically valid treatment of time is the key. The natural units of production are classical. It meets all the requirements of Occam’s Razor. Yet so far only Professor Yoshinori Shiozawa has seen any merit in it. Is it that the mathematics, well known in physics and engineering, are too unusual?

    Transient analysis is how economic analysis will be conducted in the future. It works!

    • August 27, 2018 at 11:44 am

      Nice word, Frank: “mumpsimus”. Never having heard it before, I had to look it up in my old dictionary, and found “an error cherished after exposure”. Delicious!

      What was equally interesting was the origin of the word: apparently “An ignorant priest’s blunder (in an old story) for L. ‘sumpsimus’ we have received, in the mass”. The ignorance was actually on the part of the story-teller, for ‘substance’ as understood by Aristotle was not material but meaning (as in “the gist or substance of what someone was saying”), and the gist of Christ, the Word expressing the love of God, being received as heavenly food in the mass, is its conveying the same meaning in another language.

  4. Prof Dr James Beckman, Germany
    August 26, 2018 at 10:00 am

    I’ll take a very practical approach, that of measurement. We have many definitions of employment/unemployment (largely number of hrs worked, in work force or not) as well as income (largely all those fringe benefits, how to deal with stock ownership). And the how do we measure price averages & interest rates of infinite variety? Without accurate & clear measurements there is no way we can test any hypotheses we may lay on the table, or am I wrong?

    • Edward Ross
      August 26, 2018 at 10:37 pm

      To Professor James Beckman, Germany
      From my practical experience in the real world and the logic gained from it you are definitely right. I also support Frank Salter’s comments and reference to Professor Yoshinori Shiozawa.

  5. Helen Sakho
    August 27, 2018 at 2:24 am

    In addition to earlier comments just now, including one on the necessity to avoid unhelpful confusions, I will only add the following from an undeniably genius of a man, Einstein.
    “I wished to show that space-time is not necessarily something one can ascribe a separate existence, independently of the objects of physical reality. Physical objects are not in space, but these objects are spatially extended. In this way the concept “empty space” loses its meaning. In the note to the fifteenth edition of Relatively in English, the words in space and empty space are italicised, which my machine does not allow me to do. What wisdom! What humanity! What humility! I wish one could be a fraction of him, regardless of race, class or gender, or geography – Universal.

    • August 27, 2018 at 10:15 am

      Great guy though Einstein was, he was wise enough to say it is “not necessarily” the case that “Physical objects are not in space, but these objects are spatially extended”. It might be less misleading to say that the objects are spatially localised; it is the spatial relationships between them that are extended.

  6. August 27, 2018 at 2:36 am

    What I want to say is simple. It is not good to cite this part or that part which supports ones own opinion. If economics is a science, it is a system of knowledge. It must be judged as such.

    I feel there is a wide spread misunderstanding that we can evaluate economics by its policy implications. In reality, theory and policy are almost independent. It is rare that a theory produces one unique policy. Such a misunderstanding rarely occurs in natural sciences. It is also strange that a people who accuse economics to have wrongly imitated physics have a strong tendency to judge a theory by so-called policy implications.

    • August 27, 2018 at 10:33 am

      So let’s not leave the economists out of economics. Would that scientists were always devoted to truth, but too many are more devoted to furthering their own ambitions. There is, sadly, fake science as well as fake news, especially when policy makers are also paymasters. Theory and policy are not independent if euphemisms, half-truths and misrepresentations can be used to divert attention from the real motives and wilful ignorance of policy makers.

  7. Helen Sakho
    August 29, 2018 at 1:34 am

    I agree. Segmented descriptions, segmented models, and segmented conscience lead only to segmented confusions. This type of confusion is the worst type, because it is too focused on nothing and as such misses everything. It needs to stop. If these people (any of them) did have a conscience, let all this rest on theirs. If they did not, I hope they will remember this dialogue at their next seminar or public meeting.

  8. August 29, 2018 at 6:48 am

    I feel there is a wide spread misunderstanding that we can evaluate economics by its policy implications. In reality, theory and policy are almost independent. It is rare that a theory produces one unique policy. Such a misunderstanding rarely occurs in natural sciences. It is also strange that a people who accuse economics to have wrongly imitated physics have a strong tendency to judge a theory by so-called policy implications. ~ Shiozawa Yoshinori

    Yoshinori wants a consequence free economics; to sit in an ivory tower and propose theories, which are then supposed to guide policy decisions, yet be immune from the consequences of those theories and their resulting welfare/illfare. Economics is not a natural science, it is social science, and removing the human being (culture, indeterminacy, etc.) is the attempt to turn it into a form of social physics. Dave is correct, “theory and policy are not independent,” and this is proven conclusively by the 2007-2008 GFC.

    To claim that economic theory is not related to or influencing economic policy is, frankly, ludicrous and to flat out deny or turn a blind eye to empirical evidence and witness testimonial of those who admitted as much, e.g., Alan Greenspan:

    The current direful crisis puts classical economics thinking under huge pressure. In theory, deregulated markets should be efficient, rational agents quickly correct any mispricing or forecasting error. Price faithfully reflect the underlying reality and ensure optimal allocation of resources. These “equilibrated” markets should be stable: crises can only be triggered by acute exogeneous disturbances, such as hurricanes, earthquakes or political upheavals, but certainly not precipitated by the market itself. This is in stark contrast with most financial crashes, including the latest one. The theory of economic equilibrium and rational expectations, as formalized since the 50’s and 60’s, has deeply influenced scores of decision-makers high up in government agencies and financial institutions. Some of them are now “in a state of shocked disbelief”, as Alan Greenspan himself declared when he recently admitted that he had put too much faith in the self-correcting power of free markets and had failed to anticipate the self-destructive power of wanton mortgage lending. Economic theories turn out to have significant impact on our every-day life. (JP Bouchaud, 2009, The (Unfortunate) Complexity of the Economy, 1-2)

    [I]f you believe that everyone will save just the right amount for retirement, as any Econ would do, and you conclude from this analysis that there is no reason to try to help people save (say, by creating pension plans), then you are passing up the chance to make a lot of people better off. And, if you believe that financial bubbles are theoretically impossible, and you are a central banker, then you can make serious mistakes—as Alan Greenspan, to his credit, has admitted happened to him. We don’t have to stop inventing abstract models that describe the behavior of imaginary Econs. We do, however, have to stop assuming that those models are accurate descriptions of behavior, and stop basing policy decisions on such flawed analyses. And we have to start paying attention to those supposedly irrelevant factors, what I will call SIFs for short. (Thaler, Richard H.. Misbehaving: The Making of Behavioral Economics (p. 9). W. W. Norton & Company. Kindle Edition.)

    The lesson taken home by most mainstream economists in light of recent professional failings, however, is that they need to redouble their efforts to improve the scientific quality of economic knowledge—and the resulting economic policy recommendations. Few have been willing to contemplate publicly even the possibility that the current prevailing economic methods are themselves the problem, that they may simply be unworkable for the tasks they are now being assigned. The orthodoxy that economics must necessarily seek to be a science in the manner of physics seemingly remains as unchallengeable within the profession today as other traditional articles of religious faith have been in the past. (It is not that technical methods in economics have no place but that their use should be newly subordinate to the higher goals of a more complete economic understanding, however it might be achieved.)

    (….) Former Federal Reserve chairman Alan Greenspan—holder of a Ph.D. in economics from New York University—had been among the first to admit his bafflement in October 2008, confessing at a congressional hearing that “those of us who had looked to the self-interest of leading institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”

    A key factor had been the collapse of the housing bubble, but, as Lo wrote, it had to be admitted that “despite their eight-hundred year history, bubbles are still rather mysterious economic phenomena” for members of the profession. Understanding bubbles would require economists to confront the prominent role of “nonrational” phenomena in society, events difficult to comprehend within the standard assumptions of scientific economics. The old conventional assumptions of competitive markets and perfect information—routinely made by economists up to the 1980s and still often found in current writings—virtually rule out from the start the possibility of bubbles. Contrary to the economic models, however, the search for profits is not always a matter of careful calculation and deliberation. Rather, as Lo would now explain in retrospect, an important factor in causing the Great Recession is that some leading Wall Street firms, such as Bear Stearns, had exhibited a “dysfunctional management and aggressive corporate culture—even by the standards of Wall Street.” Yet professional economic writings had long sought to avoid any appeals to culture—seen as the last refuge of a failed economist.

    Nonetheless, the effective working of markets requires a common commitment to ethical behavior, something historically most often instilled by a religion. Absent such ethics, transaction costs escalate rapidly, including the large costs of taking actions to combat opportunism and the large costs of failed implicit contracts. (Nelson, Robert H.. Economics as Religion: From Samuelson to Chicago and Beyond (pp. 355-357). Penn State University Press. Kindle Edition.)

    Economics … has direct responsibility for the economic storm we are currently experiencing…. [T]he beliefs and actions of economists made this economic crisis far worse … First, the naive theories they developed, especially in finance, encouraged reckless behavior in finance by their ex-students. More than a generation of business students were unleashed on the world who believed – or at least paid lip-service to – the fallacies that finance markets always price financial assets correctly, and that debt was good. Secondly, economists also developed many of the tools of the financial trade that Warren Buffett so aptly described as ‘weapons of financial mass destruction.’ Options pricing models, ‘value at risk’ formulas and the like were all based on neoclassical economics, and many were developed by academic economists – some of whom received the Nobel Prize in Economics for their inventions. Thirdly, probably their greatest negative contribution to human history was that, as regulators, they allowed the excesses of the finance sector to go on for perhaps two decades longer than would have occurred without their ‘rescues.’ (Keen, Professor Steve. Debunking Economics (Digital Edition – Revised, Expanded and Integrated): The Naked Emperor Dethroned? (Kindle Locations 1021-1033). Zed Books. Kindle Edition.)

    In my view, Dave is right again, let’s not leave the economists out of economics. The scientist, not science, perceives the reality of an ever changing socially constructed economic reality reified as the ‘the market’. In my view, it is philosophical naivete that leads to such silly claims as theory is independent of policy when in fact theory is used to justify policy.

    True philosophy grows out of the wisdom which does its best to correlate … quantitative and qualitative observations. There always exists the danger that the purely physical scientist may become afflicted with mathematical pride and statistical egotism, not to mention spiritual blindness.

    In every age scientists and religionists must recognize that they are on trial before the bar of human need. They must eschew all warfare between themselves while they strive valiantly to justify their continued survival by enhanced devotion to the service of human progress. If the so-called science or religion of any age is false, then must it either purify its activities or pass away before the emergence of a material science or spiritual religion of a truer and more worthy order. (The Urantia Book)

  9. August 29, 2018 at 1:57 pm

    [T]here are many “schools” within it [economics], most of them professing to deal with practical issues, they can be broadly divided into two basic approaches. Let me refer to them as ‘logic-centred’ and ‘life-centred’. The former creates an abstract economic system (a make-believe world, if you like) concentrating on what is a prioiri determined to be the central principle coordinating the decisions of its different participants and thus leading to what may be thought as the ideal set up. But, of course, the participants must behave as ‘theory’ expects them to. Internal consistency and universal applicability are claimed to be the features of such a system. If the real world throws up situations different from the ideal, the inference then is that some conditions required for the ideal have not been adhered to. Removing these external impediments through ‘policy instruments’ can get the real world closer to the ideal is the claim. Exposition of economics, especially in class room teaching turns out to be enumeration (rigourous or otherwise) of the conditions required for a smoothly functioning and (internally) self-adjusting economic system.

    In the second approach the emphasis is on contextuality, temporal and spatial, of economic phenomena as they arise from and reflect the ever-changing social processes. The basic premise is that the economy is not a self-contained closed entity governed by its own laws but part of and greatly contributing to larger social relationships. Hence economic problems must be probed keeping in mind such social factors as the ownership of resources, the manner of control over them, divisions and power configurations that arise from them and much more. Real human beings in the variety of social contexts are the actors that shape the economy. (C. T. Kurien 2015, Wealth and illfare An expedition through real life economics, WEA Books.)

    Theory lead Greenspan to not intervene to prevent the GFC. He was a faithful devotee of the religion of ‘logic-centred’ economics, despite clear signs where we were heading.

  10. August 31, 2018 at 7:57 am

    It is possible to show that a specific market in a specific time and place creates results that benefit some actors and not others. It is also possible to show that a specific non-market in a specific time and place creates results that benefit some actors and not others. How do we choose which route to follow? Human judgement. Neither mathematics, logic, nor empiricism of any sort is an escape from this obligation.

  11. September 2, 2018 at 7:13 am

    The Marx Brothers always figured it out before the rest of us.

    From “Duck Soup”
    Mrs. Teasdale: Your Excellency! I thought you’d left.
    Chicolini: [Impersonating Rufus T. Firefly] Oh, no, I no leave.
    Mrs. Teasdale: But I saw you with my own eyes!
    Chicolini: Well, who you gonna believe? Me or your own eyes?

    It’s always the same whether in everyday life or science. Accept what we think we see or what we’re told by others. Life is difficult.

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