The failure of modern economics

Today's economists overlook the most basic element of economic science

By Geoffrey Lawrence, Roy Cordato, Ph.D.
  • Tuesday, October 16, 2012

With the second presidential debate scheduled for tonight, Nevadans will hear, once again, how political candidates from the major parties love to inundate us with various economic theories. They pontificate upon such theories as rationales for the policies they propose.

This is true whether they advocate for higher or lower taxes, the merits or drawbacks of government stimulus, the direction of health care reform, or cap-and-trade taxes to "fight global warming." Indeed, as John Maynard Keynes himself once said:

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.

It is therefore critical to examine the framework of economic analysis that politicians rely upon when crafting public policy.

Unfortunately, the overwhelming majority of modern economists formulate their conclusions based on a framework that ignores the most basic attribute of economic behavior: entrepreneurship.

All human beings behave entrepreneurially. That is, they always search for opportunities to increase their personal wellbeing. This could be through the attainment of material goods or additional income, but it could also include spiritual enlightenment, intellectual achievement, or helping others. Since every individual has different resources at his disposal and aims to achieve different ends, he places a unique, subjective value on every commodity that might help him achieve those ends. A skilled carpenter, for example, will find lumber more valuable than a software developer, because it's critical to allowing the carpenter to earn a living.

Individuals coordinate their actions by responding to the price signals sent by others. Those who find innovative means of beating current prices can earn profits that will be used to pursue their own unique ends. Hence, entrepreneurial action results in a constant changing of market prices as individuals discover superior production techniques, develop new markets and learn to better cater to the needs of others.

Since Leon Walras and Alfred Marshall founded the Neoclassical School in the late 19th Century, economists have largely neglected the study of entrepreneurship. From Keynesians on the Left to Milton Friedman's disciples on the Right, most economists focus their analyses on general equilibrium models. These models consist of a series of simultaneous equations that allegedly yield "the efficient" price and output combination for all goods and services, assuming conditions do not change.

There's only one problem: Conditions are always changing, and equilibrium models are hostile to the critical role that entrepreneurship plays in driving economic growth. Entrepreneurship occurs, after all, because markets are not in general equilibrium, which is a state of the world where all opportunities for profit, and therefore creativity and entrepreneurship, have already been exhausted.

Eventually, economists who rely on these models find themselves face-to-face with reality. Some become hostile to the very exercise of entrepreneurship and advocate for controls so that potential entrepreneurs cannot undermine the economic calculations devised by planners. Others lose credibility when their predictions are not borne out in the real world.

In the first case, economists will lead politicians toward a progressively totalitarian state. In the second, they will haphazardly lead policymakers toward a variety of economic policies that fail to achieve their stated objectives.

For example, take the models used by President Obama's advisors to predict the impact of the "stimulus" — which was supposed to hold unemployment rates below 8 percent. It's not just that their models were inferior to models used by the administration's critics. Instead, all the models pretend to know what cannot be known in a dynamic economy built on the dispersed and subjective knowledge possessed by private individuals. Indeed, Nobel laureate Friedrich Hayek criticized such models for creating a "pretense of knowledge."

This central failure of modern economics sets up repeated failures in the policymaking realm.

Economists and policymakers alike should discard this approach and return to studying what drives and influences entrepreneurship — an approach typically associated with economists of the Austrian School, named after the geographical origin of their intellectual forbearers. Austrian School economists were the only economists to correctly predict and identify the causes of the recent recession because they alone properly acknowledge how individuals respond to and change price signals and how those entrepreneurial efforts can be misdirected through various government interventions in the marketplace, both directly and indirectly through monetary policy.

It's time for citizens and policymakers to see through the flawed analyses offered by Keynesian and more traditional neoclassical economists. Without acknowledging the role of entrepreneurship and the limitations of general equilibrium models, economic policy will continue to be misdirected and result in outcomes the "experts" never saw coming.

Geoffrey Lawrence is deputy policy director at the Nevada Policy Research Institute and Dr. Roy Cordato is vice president for research and resident scholar at the John Locke Foundation.

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