On the Need for New Economic Foundations: A Critique on Mainstream Macroeconomics

The body of macroeconomic theory known as the neoclassical-Keynesian synthesis, hereafter mainstream macroeconomics, has dominated the practice of economics since the middle of the twentieth century and is largely unchallenged in institutions that teach economics. Not only does mainstream macroeconomics underlie monetary and fiscal policies intended to promote economic growth, full employment, and price stability, but it also provides the lens through which economic activity is measured and performance is evaluated. Most importantly, it has spawned a generally accepted ideology or conventional wisdom that frames economic issues and ‘acceptable’ policy responses to them. Woe to the economist or politician who strays beyond the constraints imposed by the beliefs emanating from this body of theory. Mainstream economic theory has always had its critics, but the failure of mainstream economists to predict the collapse of 2008 and the failure of the policy responses to the crisis have stimulated a new round of criticism. This paper surveys a range of criticisms made by economists and non-economists alike and finds that grounds exist for the rejection of mainstream macroeconomic theory. It is mathematically incoherent and irrelevant insofar as the assumptions upon which it is based are not supportable; its concepts are abstract and not measurable, and not capable of addressing the real questions of sustainability, economic stability, power, justice, and equity that affect the human condition. The conclusions reached are: 1) mainstream economic theory took a profoundly wrong path in the mid-twentieth century 2) foundations for a new synthesis of economic thinking are needed capable of addressing the issues that emerged in the late 20th century and integrating findings from other sub-disciplines of economics and other sciences.

1. Introduction
John Ralston Saul, a social critic who has freed himself from the chains of political correctness, in his 1995 Massey lecture, “The Unconscious Civilization,” assessed economics in the following terms:

“Economics, as a prescriptive science is actually a minor area of speculative investigation. Econometrics, the statistical, narrow, unthinking, lower form of economics is passive tinkering, less reliable and less useful than car mechanics. . . . . . economics has been spectacularly unsuccessful in its attempts to apply its models and its theories to the reality of our civilization. It’s not that the economists’ advice hasn’t been taken. It has, in great detail, with great reverence. And in general, it has failed.”1

This is a serious condemnation, and Saul is not alone. The list of those who have critiqued various aspects of neo-classical economics begins as early as 1898 when Thorstein Veblen penned “Why is Economics not an Evolutionary Science?” published in The Quarterly Journal of Economics which includes such eminent authors such as Oskar Morgenstern2, Nicolas Georgescu-Roegan3, Fred Hirsh4, Kenneth Boulding5, Wassily Leontief6, 7, Herman Daly8, 9, Robert Nadeau10, 11, Charles Hall12, Eric Beinhocker13, Steve Keen14, Giovanni Dosi15, John Kay16, Daniel Kahneman17 and David Graeber18, to name a few.

Is the condemnation warranted? If it is, can mainstream economics be adjusted or is it time to devote effort to the task of formulating a new set of principles that should underlie a new synthesis in economics? These are the questions addressed in the following essay.

2. Elements of mainstream macroeconomic theory
Mainstream macroeconomic theory frames economics as a global optimization problem that can be stated in the following terms: maximize the value of production subject to the availability of the factors of production, labour and capital. Production is the value added by labour and capital to freely available natural resources. Mainstream economics is, in essence, a theory of value.

Mainstream macroeconomic theory is a structure of deductive reasoning based on two first order behavioural axioms: consumers act rationally to maximize their individual utility, and; producers are price takers who adjust output levels to maximize profits. Two second order restrictions on these behaviours are assumed to be true: Individual consumer utility functions are separable and hence additive, and; individual producer cost curves are U-shaped, thereby giving rise to increasing marginal costs (decreasing returns to scale).

Under these conditions, according to generally accepted macroeconomic theory, utility or value added is at its maximum when prices are set at the point where marginal costs equal marginal revenues at the intersection of downward sloping demand curves and upward sloping supply curves. At this point of competitive general equilibrium, profits for all producers are zero. It follows from this theory that market prices are objective and universal measures of value that can be used as weights for aggregation. Macroeconomics can then be legitimately specified in terms of relationships among a small number of aggregate variables such as gross domestic product, consumption, investment, savings, exports, imports.

If it is further assumed that labour and capital are immobile, international trade between nations is mutually beneficial. This is known as the law of comparative advantage.

3. The Conventional Wisdom
Mainstream economics has spawned and rationalized the ideology of free-market capitalism. Tenets of the conventional wisdom that emerge from and are rationalized by mainstream economics can be summarized as follows:

  • The economy is a self-regulating system set in motion by the ‘invisible hand’ identified by Adam Smith in his The Wealth of Nations. Barring market imperfections, the factors of production, labour and capital will be optimally utilized in the creation of value.
  • The main objective of economic policy is to ensure sufficient economic growth to achieve ‘full’ employment and price stability.
  • Externalities, such as pollution and global warming, are the result of market failures and these are best addressed by economic instruments such as special taxes or cap and trade systems that internalize external costs rather than by bureaucratic regulatory intervention.
  • Concentrations of market power or monopolistic practices are market failures that can be addressed by competition policy.
  • Profit maximizing behaviour by private enterprise that creates shareholder value is socially beneficial.
  • Producers and consumers alike should be free to pursue private interests.
  • Speculation and hedging are stabilizing activities and are of social value.
  • Market prices, once corrected for imperfections, are objective indicators of value and lead to an optimal allocation of resources.
  • Cost-benefit analyses using market prices for summing and comparing costs and benefits and a discount rate for establishing the present value of future costs and benefits are appropriate for establishing public policy.
  • Private enterprise and private ownership are to be preferred over government and state ownership in the provision of goods and services.
  • Market determined wage rates reflect workers’ productivity and generate an appropriate distribution of income.
  • Globalization involving free trade among nations is mutually beneficial.
  • The performance of the economy can be adequately monitored by measuring the rate of change of a few macro economic variables: total production indicated by GDP, the rate of unemployment, inflation, the rate of savings and investment, consumption, exports and imports, the foreign exchange rate, and productivity indicated by output per employee or total factor productivity.

4. What’s Wrong with Mainstream Macroeconomic Theory?
A first basis for rejecting a theory would be to show that the theory is irrelevant either because the wrong problem is being addressed, wrong in the sense that it is not one that is empirically given or because the theory is cast in terms of concepts that cannot be observed with the consequence that the theory cannot be empirically rejected.

A second basis for rejection would be to show that inappropriate, inadequate, or over-simplifying assumptions have been made. Arguments of the second kind are often identical with the first kind.

A third basis would be to show that, even if the assumptions are granted, the asserted conclusions do not follow. This basis for rejection is unequivocal.

From the arguments below, mainstream macroeconomic theory and the conclusions derived may be rejected on the grounds of all three bases.

Robert Hoffman: President, WhatIf? Technologies Inc.; Associate Member, Club of Rome
1. John Ralston Saul, The Unconscious Civilization (Toronto: Anansi Press, 1995).
2. Oskar Morgenstern, “Thirteen Critical Points in Contemporary Economic Theory: An Interpretation,” Journal of Economic Literature 10, no. 4 (1972): 1163-1189.
3. Nicholas Georgescu-Roegan, The Entropy Law and the Economic Process (Cambridge MA: Harvard University Press, 1971).
4. Fred Hirsh, Social Limits to Growth (Cambridge, MA: Harvard University Press, 1976).
5. Kenneth Boulding, Ecodynamics: A New Theory of Societal Evolution (London: Sage Publications, 1978).
6. Wassily Leontief, Letter to the editor, Science 217(1981): 104–107.
7. Wassily Leontief, Faye Duchin and Daniel B. Szyld, “New Approaches in Economic Analysis” Science 228, no. 4698 (1985): 419-422.
8. Herman E. Daly and John B. Cobb Jr., For the Common Good (Boston MA: Beacon Press, 1989).
9. Herman E. Daly, Beyond Growth: the Economics of Sustainable Development (Boston MA: Beacon Press, 1996).
10. Robert L. Nadeau, The Wealth of Nature: How Mainstream Economics has failed the Environment (New York: Columbia University Press, 2002).
11. Robert L. Nadeau, The Environmental Endgame: Mainstream Economics, Ecological Disaster, and Human Survival (New Brunswick, NJ: Rutgers University Press, 2006).
12. Charles Hall and Kent Klitgaard, “The Need for a New, Biophysical-Based Paradigm in Economics for the Second Half of the Age of Oil,” International Journal of Transdisciplinary Research 1, no. 1 (2006): 4-22.
13. Eric J Beinhocker, The Origin of Wealth: the radical remaking of economics and what it means for business and society (Boston: Harvard Business School Press, 2006).
14. Steve Keen, Debunking Economics: The Naked Emperor Dethroned (New York: Zed Books, 2011).
15. Giovanni Dosi, “Economic Coordination and Dynamics. Some Elements of an Evolutionary Paradigm,” Institute for New Economic Thinking Working Paper 2011.
16. John Kay, “The Map is not the Territory: An Essay on the State of Economics,” Institute for New Economic Thinking October 4, 2011
17. Daniel Kahneman, Thinking, Fast and Slow (Toronto: Doubleday, 2001).
18. David Graeber, Debt: The First 5,000 Years (New York: Melville House Publishing, 2011).

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