Selling Globalization: The Myth of the Global Economy

Michael Veseth

Lynne Rienner Publishers, Inc.

1998

7. Unsettled Foundations

 

In the absence of equilibrium, the contention that free markets lead to the optimum allocation of resources loses its justification. The supposedly scientific theory that has been used to validate it turns out to be an axiomatic structure whose conclusions are contained in its assumptions and are not necessarily supported by the empirical evidence. The resemblance to Marxism, which also claimed scientific status for its tenets, is too close for comfort.

—George Soros 1

If the extravagant images of globalization that condition conventional wisdom are more political rhetoric than economic reality, why haven’t economists spoken up? Why hasn’t the concept of globalization been exposed to greater critical scrutiny? Why does the idea of a seamless global economic web persist virtually unchallenged?

The lack of a persuasive economic critique of the globalization myth is caused by a number of factors that I discuss in this chapter. There are practical, philosophical, and institutional factors that explain why economists have failed to critique globalization and in some cases actually have promoted the globalization myth themselves.

Economists generally favor policies that reduce government interference in free markets, and for some of them globalization is a convenient reason to advance these policies. Economists, like politicians, sell globalization so they can sell their favorite economic and social policies.

Some economists have tried to draw attention to the myth of globalization and the particular policy focus it creates, but they have failed because no one can understand them. Clear-thinking economists sometimes don’t know how to talk to noneconomist “civilians” who do not speak their technical lingo. They fail to communicate and they fail to persuade. Paul Krugman has made this point in a series of essays collected under the title Pop Internationalism. ₂   My discussion of this point draws heavily on Krugman’s excellent analysis of this condition.

This lack of communication and critique is exacerbated by a flaw in the fundamental nature of twentieth-century economics, which makes it difficult for economists to expose globalization to the same critical analysis as other sorts of issues. Globalization is all about markets, and the values and methods of economics are conditioned to consider markets in a very particular way. The built-in problems of global markets that I have pointed out in previous chapters challenge the values and methods of mainstream economics. It is not true, however, that economists for the most part consider and reject these criticisms of global markets. Rather, the idea of an economic critique of globalization is in some respects anti-economics or noneconomics and so in general never enters the economics discussion. This philosophical bias to economics makes possible the endless selling of globalization that we observe today.

Finally, I explain in this chapter why the lack of a persuasive economic critique of globalization matters. This discussion lays the groundwork for a concluding essay in the chapter that follows.

 

Garbage Can Policy Economics

The first reason why some economists have failed to critique hyperglobalization and may, in fact, have contributed to its wide acceptance as an inevitable force falls under what my political science colleague David Sousa calls “garbage can” politics. ₃   The idea of garbage can politics (and economics) is that the process of public policy isn’t very coherent. Problems and solutions are generated separately and tossed as scraps into the policy garbage can. Once in the can, problems and solutions stick to each other in sometimes unexpected ways. The solution to problem A may find itself stuck to seemingly unrelated problem B if problem B is hot and problem A is not. The trick is to get your solution stuck to the hottest possible problem. In politics, it seems, dumpster-diving is an art.

I don’t have to look very far to find examples of garbage can policy economics in action. Many of us in the education business, for example, favor increased national attention to higher education. When the problem is growth, educational solutions are offered. When the problem is inequality, the solution is education. When the problem is the trade deficit, the solution is education. In an earlier book called Mountains of Debt, I even proposed education as part of the solution to the problem of the national debt. ₄   I think that it is fair to say that people who believe sincerely that education reform is of the utmost importance will try to attach this solution to whatever problem is at hand—sometimes cynically, but most often in the honest belief that it would contribute at least to reducing whatever the problem may be.

Enter globalization. Sousa writes that “the ‘global economy’ is an enormously attractive problem. It can be linked with ease to other problems (wage stagnation and inequality, excessive regulation, welfare spending) and is amenable to solutions that meet the needs of domestic actors across the political spectrum.” ₅   As a result, the global economy is a very attractive problem to which to stick whatever solution is at hand. We saw this in the first chapter. Economists are no better and no worse than others in sticking their pet projects to globalization.

Economists tend for a variety of reasons to favor “solutions” that reduce the role of government in the economy. Deregulation, free-trade, market-based foreign exchange rate systems, labor market flexibility, and low taxes are among the “market friendly” policies that mainstream economists typically support. Even I think that these are good things, all else being equal, which it seldom is.

Economists as a group would favor this solution set as an effective response to many problems: growth, inflation, unemployment, inequality, and—this is my point—as the appropriate reaction to economic globalization. Globalization is, after all, the notion of creating worldwide markets, markets so broad and deep as to make government regulation obviously unwise and ineffective. The “problem” of globalization, therefore, leads directly to the sorts of solutions that mainstream economists are predisposed to favor.

Garbage can economics is, of course, simply a variation on the political use of globalization that was the main focus of the last chapter. Economics, because it is technically complex and quantitatively sophisticated but still of profound practical importance, is especially ripe for this kind of political exploitation, according to Paul Krugman. He writes that

If economics were a subject of purely intellectual interest like astronomy it would be regarded as a quietly progressive field, one in which there has been a steady accumulation of knowledge over the past two centuries.

But economics is not astronomy, because its conclusions have a direct impact on government policies that affect almost everyone. In an ideal world this would mean that large numbers of people would care about economics enough to study it closely. In our imperfect world people care about economics only enough to know what they want to believe.

Politicization is, of course, not unique to economics or even to social science.... while there is a steady accumulation of knowledge in economics, there is also a constant market for doctrines that play to popular prejudices, whether they make sense or not. In times of economic distress, the search for politically useful economic ideas—which often means ideas that are demonstrably wrong, but that appeal to those impatient with hard thinking—takes on a special intensity. ₆

Economic ideas like global markets are exploited by both politicians, as Krugman notes, and economists who have a policy axe to grind. My first argument—and not the strongest one I will present—is that economists therefore view globalization uncritically because the “problem” of globalization so nicely matches up with the “solutions” they typically favor.

 

Econspeak: What Economists Say Doesn’t Matter

A search of the EconLit American Economic Association CD-ROM database of economics articles from 1982 to March 1997 shows a growing interest in issues of globalization. ₇   Over this roughly 15-year period, a total of 452 books, articles, and working papers that dealt in some way with globalization appeared in sources that were indexed by the Journal of Economic Literature. Of this number, however, only 64 appeared before 1990; the vast majority (392) were published since 1990, with 148 appearing between 1995 and March 1997. By comparison, 15,621 references are found for “equilibrium or equilibria” out of a total stock of about 150,000 scholarly publications. Some economists write about globalization, but not many, compared with those who write about other things, and their analysis seems to have little impact.

Why are the economists who do write critically about globalization not more effective? Why do their studies have so little impact on public debate and public policy? One part of the answer is that what economists write and say doesn’t seem to be a very important part of the public discussion of any important issue. It is easy to understand why. First, economists as a species agree on hardly anything, so there are few opportunities to report that “economists favor” or “economists oppose” tax cuts, welfare increases, or anything else of substance. This lack of consensus on critical issues weakens the influence of economists on policy issues generally.

Even where economists do agree, however, their views frequently fail to persuade. Free trade, for example, is one of the few policy issues on which there is general agreement among professional economists. About 90 percent of working economists support the notion of free trade as a general economic policy. If economists ruled the world, it would be one giant free trade area. Yet the views of economists are seldom taken very seriously in trade policy discussions. The serene logic of the theory of comparative advantage is enormously less influential than the practical matters of jobs and votes.

Economic ideas underachieve because of what economists write (generally about models, especially mathematical ones, not about people), how they write it (in an almost impenetrably abstract style), and where it appears (usually in a scholarly journal or a book published by a specialist academic press). If you were to set out to hide your bright light under a bushel basket, it would be hard to concoct a more effective strategy than this.

Alfred Marshall, the great early neoclassical economist, apparently advised his students that economic theory should proceed in the following way. The process begins with a mathematical model of some important aspect of business. When you have solved the math, draw a graph of the model to help simplify and clarify the logic. Next, find a practical problem that can be addressed by the model’s findings. Write up an explanation of the practical problem in clear and simple language that can be understood by anyone generally familiar with business. Finally, tear up the math and the graphs, because you do not need them: It is the problem that counts. However, if you can do the math and the graphs but cannot use the model to solve any problem, then tear it all up, Marshall advised, because it doesn’t matter.

It seems as though many economists today spend too much of their time building models and too little of their time solving practical problems in a form that intelligent and informed citizens can understand. Although economic knowledge accumulates through this process, the influence of economists on real world problems is not advanced.

The influence of those few economists who write effectively for the public—who are public intellectuals more than footnote scholars—has long been noted. John Kenneth Galbraith, for example, has had much more influence over the economy (through the impact of his ideas on public policymakers) than he has ever had on professional economists. The same is true of Lester Thurow. When they are right, and especially when they are wrong, these wordsmith economists wield important influence.

But, right or wrong, the readable economists are vastly outnumbered by readable “civilians” (noneconomists) who write about economics from a more or less informed and unbiased perspective, sometimes reaching into the garbage can to find the problems they need to sell the solutions they champion.

Paul Krugman, an economist who sincerely wants to have influence, has noted this problem:

In other words, all of the things that have been painfully learned through a couple of centuries of hard thinking about and careful study of the international economy—that tradition that reaches back to David Hume’s essay “On the balance of trade”—have been swept out of public discourse. Their place has been taken by a glib rhetoric that appeals to those who want to sound sophisticated without engaging in hard thinking; and this rhetoric has come to dominate popular discussion so completely that someone who wanted to learn about trade without reading a textbook would probably never realize that there is anything better. ₈

Krugman, for his part, has resolved to try to reduce the influence of bad economic ideas by writing in a style and publishing in places that are more accessible to decision makers in particular and the informed public in general. He has become a regular contributor to the journal Foreign Affairs, for example, and writes a popular column for Slate, the Microsoft on-line magazine. ₉

The specific issue that provoked Krugman to take action is worth noting because it is really a globalization issue: competitiveness. Krugman has argued consistently that although international (global?) trade is important for individuals and for the nations of the world collectively, the main determinants of domestic economic well-being remain surprisingly, well, domestic. National saving, efficient investment, effective education—these are the factors that make nations rich or make them poor. Nations with high savings rates, high investment rates, and high-quality education systems naturally grow faster than other nations lacking these qualities. International trade makes a difference at the margin—and all nations benefit from an open trading system—but the fundamental factors of importance are domestic. ₁₀

Believing this, Krugman has been publicly frustrated with the focus of national economic policy on international competitiveness, not sound domestic policy. Krugman’s sound but boring message to save, invest, and learn—to eat your spinach, it’s good for you—has been less persuasive than the “competitiveness” message. In today’s cutthroat global market, the key to economic success is to stop the (Japanese/Germans/Chinese/etc.) from (taking over our markets/closing their markets to us/beating us in other markets/etc.), so we must (make them back down/make our markets as closed as theirs/subsidize domestic firms/etc.). He rightly calls this focus on competitiveness a “Dangerous Obsession” because it leads in the direction of bad policies aimed at winning the globalization race and also diverts attention from the sorts of national policies that might make a difference in the long run.

What needs to be done, according to Krugman, is to find a way to reach thinking citizens and educate them about basic economic principles such as comparative advantage so that they are less susceptible to proposals that use bad economic logic to back wrong-headed policy prescriptions. This means, as noted before, changing how, where, and to whom economists communicate.

Krugman has the right idea, but he cannot reform economics writing and economics thinking all alone. For every Krugman writing about “serious economics,” there must be a dozen civilians like Robert Reich, George Guilder, or William Greider writing for the general public. The serious economic case against exaggerated globalization, when it is presented, generally appears in places and in forms that cannot possibly make much of a dent in the conventional wisdom.

My second argument, therefore, is that Krugman is right. Some economists do think and write critically about globalization and its consequences, but no one (including the thinking public) can understand them, so no one pays any attention to them. They might as well be mute.

Most economists, however, are not just effectively silent on the issue of globalization; they are actually silent. They are silent, I argue here, because the idea of global market expansion is uncontroversial to them. The thought that this phenomenon should be subjected to critical analysis simply does not come up. Their attitudes toward globalization are not dictated by scientific analysis but rather by the very notion of what economics is. The discipline of economics has unexpectedly evolved in such a way as to make it difficult, if not impossible, for a person to question the properties of global markets and still remain an economist.

 

Greed, Rationality, Equilibrium

Everyone knows that economics is all about money. Economics textbooks define economics, however, somewhat vaguely as the study of how society chooses to produce and distribute scarce resources. ₁₁   The purpose of this awkward and complicated definition is to get students to think about the fact that the problems of scarcity and choice, which are inherent and obvious with money, are not limited to money. Scarcity and choice are facts of life, and we should try to think about them in a systematic and rigorous way. It is a good way to begin an economics course.

However, this is not generally the way that actual economists typically think about what they do. Economists, as noted above, work within the framework of models of behavior, not actual or observed behavior. They tend to define themselves by the nature of the models they work with—as macroeconomists or microeconomists, or as labor, development, monetary, or general equilibrium theory economists, depending on the properties of their models. An economist who is an expert in her model and yet knows virtually nothing about “the economy” can still be respected as a good economist by her peers. Indeed, knowing anything about the real economy can sometimes be a disadvantage.

That economics should have developed in this way would come as a surprise to Alfred Marshall and often comes as a surprise to “civilians” who pick up economics books expecting to learn about the real economy.

Since the box in which economists work is defined by their models, the set of problems that they find before them (and the larger set of problems that lie outside the box) depends on the qualitative nature of economic models. George Ackerlof has written that “economic theorists, like French chefs in regard to food, have developed stylized models whose ingredients are limited by some unwritten rules. Just as traditional French cooking does not use seaweed or raw fish, so neoclassical models do not make assumptions derived from psychology, anthropology, or sociology.” ₁₂

A few generations ago, this set of ingredients, to use Ackerlof’s metaphor, was very broad and not at all inconsistent with the everyday notion of what economists study. Johns Stuart Mill, for example, defined the scope of economics this way:

There is, for example, one large class of social phenomena in which the immediate determining causes are principally those which act through the desire of wealth, and in which the psychological law mainly concerned is the familiar one that a greater gain is preferred to a smaller one.... By reasoning outwards from that one law of human nature... we may be enabled to explain and predict this portion of the phenomena of society, so far as they depend on that class of circumstances only, overlooking the influence of any other circumstances of society.... A department of science may thus be constructed, which has received the name of Political Economy. ₁₃

Economics in the nineteenth century, according to Mill, looked at problems using models of greed and confined itself to activities and behaviors in which the desire of wealth was the principal but not necessarily the only motive. This class of behaviors being quite large, the domain of political economy was broad. ₁₄

Without much notice, however, this domain has narrowed considerably in the twentieth century. It has narrowed in a way that places a critical examination of globalization out of the economist’s box.

In the winter 1997 issue of Daedalus (the journal of the American Academy of Science), three economists were asked to assess the status quo of the discipline of economics. David M. Kreps insightfully noted the critical change in method:

In the fifty-odd years since World War II, economics has undergone a substantial transformation. Before the war the discipline was defined by the subject matter it encompassed, i.e., things connected with prices and markets. But the tools and theories used to study, say, international trade bore only scant resemblance to those used to study labor markets. In the two decades that followed the war, this largely changed. Mathematical modeling rose to preeminence in economics, and a sparse set of canonical hypotheses—Robert Solow has characterized them as greed, rationality, and equilibrium—became the maintained hypotheses in almost all branches of the subject. ₁₅  

Economic models assume greed, rationality, and equilibrium—or, as Kreps prefers to state, far-sighted rationality, purposeful behavior, and processes that tend toward a stable equilibrium. Economists cook with these ingredients and tend to ignore recipes that deviate from them. For the most part, economists see this parsimony as an advantage: Models based on a small set of assumptions are more robust than those that depend on a long list of special requirements.

At first glance, this aspect of economic methodology may not seem to be very important. What I now argue, however, is that this change in how economics defines itself is meaningful in terms of economists’ ability to frame problems and offer critical analyses of globalization and perhaps many other “economic” conditions and processes. If you cook only with greed, rationality, and equilibrium, you automatically, and perhaps unknowingly, exclude some dishes that might improve the menu.

Deep down, economics is about markets, and has been since the time of Adam Smith. Economics is even more about markets than it is about money, since money has value and significance only in exchange. The properties of greed, rationality, and equilibrium that condition all of economics have their roots in properties that economists find in markets. Economic knowledge begins with the market.

This property of economics is significant in that true globalization is correctly seen by economists as the logical expansion of markets from local institutions, to a regional, national, international, and finally global framework for production and distribution. Globalization, seen through the lens of economics, is therefore a highly efficient and altogether admirable process driven by greed (Solow) or the desire of wealth (Mill) or the love of money (Keynes) or purposeful behavior (Kreps). This process is rational; rational individuals interact through rational markets. It is also stable. Markets are inherently stable in economic analysis, tending toward stable equilibria.

Globalization, being the ultimate expansion of markets to a global scale, is therefore everything an economist believes in. To see why this matters, we need to examine briefly the economist’s trinity: greed, rationality, and equilibrium.

 

Greed and the Invisible Hand

How is it possible to believe in greed as a useful principle of social organization? Most noneconomists who confront the economic way of thinking are at least initially put off by the focus on greed or self-interest. Economists have a reputation for believing that “greed is good,” not like Gordon Gecko in the movie Wall Street, however, for the thrill of it, nor like Keynes, who thought that love of money was a potentially less harmful vice than, say, love of power. Adam Smith (1723–1790) taught economists that greedy self-interest could be admirably connected with benevolent public interest. The key to understanding this was his famous “invisible hand.” Smith was a realist in thinking that people commonly put their self-interest above the public interest. In some cases, individual and public interest may be in conflict; however, there is a range of activities in which they are naturally aligned:

Every Individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of society, which he has in view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to society. ₁₆

When the butcher and the baker make business decisions, they think first of their own welfare. To succeed in competitive markets, however, they must please their customers and efficiently provide goods of a quality and price that are, at a minimum, no less desirable than their competitors. The invisible hand of market competition causes them to serve consumer interests while intending only to maximize their profits. The invisible hand doesn’t always work, of course. The link between self-interest and public interest breaks down, for example, when competition is restricted. Smith the realist was as critical of monopoly and competitive restrains as he was favorably disposed toward the free market. As bad as monopoly, however, was government.

The Statesman, who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise. ₁₇

According to the tradition that derives from Smith, as long as competition exists, all participants are well informed, and a few other necessary conditions hold, markets serve both self-interest and the public interest. The expansion of these markets to a global scale, according to this logic, further increases both self-interest and public interest. This takes place without any sacrifice in national interest or national security, Smith argued, because self-interested individuals naturally include security issues in their decision making.

He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its own produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. ₁₈

The tradition within economics, therefore, is that markets, national markets, international markets, and now global markets, when driven by the invisible hand’s competitive force, are nearly always unambiguously good. The extreme version of this view was best stated by David Ricardo (1772–1823), who is second only to Smith in his influence on how economists think about globalization. In one of my favorite passages of economics, Ricardo wrote that

Under a system of perfectly free commerce, each country naturally devotes its capital and labour to such employments as are most beneficial to each. The pursuit of individual advantage is admirably connected with the universal good of the whole. By stimulating industry, by rewarding ingenuity, and by using most efficaciously the peculiar powers bestowed by nature, it distributes labour most effectively and most economically: while, by increasing the general mass of productions, it diffuses general benefit, and binds together, by one common tie of interest and intercourse, the universal society of nations throughout the civilized world. ₁₉

I call your attention to the last line of this famous quotation, because it provides a remarkably optimistic view of globalization. International trade stimulates industry and ingenuity, efficiently allocates jobs, creates material abundance, raises the general level of welfare, and leads to world peace. This view from the 1820s states very well how most economists today think about globalization.

My point, to conclude this brief section, is that the way that economists understand markets and the forces that drive them leads them to see markets in general as fundamentally positive factors in individual, national, and global welfare. When economists write about globalization, they focus on particular markets and industries—the ones their models are built for—not the general process of market expansion, which is taken as self-evidently stable and beneficial. ₂₀

 

Rational People, Rational Markets

The second axiom of modern economics is rationality, or rational or purposeful behavior. Rationality is assumed as a principle of analysis, not as a description of the world. Economic analysis restricts itself to the domain of rational behavior. If behavior is not based on rationality, which in the real world it often isn’t, then it is not economics—it is sociology or psychology or something else. As David Kreps has written, “... economists believe that behavior that does not accord with the standard model is irrational, unpredictable, and even somewhat unsavory—not a fit subject for serious discussion.” ₂₁

It is one thing to define economics in a way that restricts it to situations in which individuals behave rationally or according to their known interests, subject to their knowledge of the universe. It is quite another, however, to think, as economists often do, that Adam Smith’s invisible hand of self-interest extends to rationality—that actions considered rational for the individual are therefore also rational for society. There are too many counterexamples of this for us to feel comfortable with this assumption. To use an example from the classroom, it is well known that a good way to see better at a baseball game is to stand up. If everyone is rational and stands, however, no one sees better and some people cannot see at all.

Individual rationality and collective rationality don’t line up. Keynes’s famous paradox of thrift is another familiar example. If I am worried about hard economic times ahead, it is rational for me to spend less and save more, building up a cushion in case hard times come. If, however, everyone behaves rationally in this way, the result is a decline in total spending, surpluses of goods and services, and some combination of falling output and layoffs or falling prices and profits. The paradox of thrift is that it is rational for one individual to save but irrational for everyone to save.

The issue of market rationality is especially important to what I am saying in this book because irrational international capital markets represent a built-in limit to globalization. As I explained in Chapter 5, rational behavior under certain circumstances causes prices and quantities in international financial markets to behave in ways that defy normal notions of rationality. Sometimes the irrationality occurs through the Mexican peso-type mania-bubble-panic process that Charles Kindleberger and Hyman Minsky describe. In other cases, the cause may be a speculative attack as studied by Paul Krugman and others. But it is clear that, in the real world, market rationality breaks down at particular times and places, especially in the financial markets that are closely associated with globalization. Rationality may be a good general working assumption for much of economics, but it is a mistake to make it a definitional axiom of economics and assume that it applies everywhere.

Irrational markets get no respect in economics, except in the months immediately after a stock market crash (e.g., in 1987) or currency bubble (e.g., in 1997). Before too long, however, the rational market axiom reasserts its hegemony. Irrational markets, as I noted earlier, are considered unserious and simply not part of economics, so they get little professional attention. Kreps wrote of a conference on organizational theory in which a well-known labor economist spoke against labor market models that assumed that workers were “irrationally” motivated by relative wage rates—how their wages compared to those of their fellow workers (as opposed to those of “rational” workers, who think only of their own absolute purchasing power). He then explained that his own colleagues behaved in just such an irrational way. His real world observation of irrationality was then dismissed as “just an anecdote,” whereas the theoretical concern was deemed “something serious.” ₂₂

One problem with irrational markets is that, if the invisible hand fails, a visible (government) hand is perhaps needed. In the case of irrational international financial markets, for example, Charles Kindleberger has written of the need for a “lender of last resort” to provide the public good of stability. Economists since Adam Smith, however, have been distrustful of the government in particular and collective action in general. If the choice is between the extreme of perfectly free markets and the irrational but regulated ones, there is no question that typical economics will support and even believe in the former. Such a dichotomy is, of course, totally false, but this does not stop questions from being framed this way. ₂₃

Kindleberger found that discussions within the economics profession are often framed this way, with predictable results. He wrote that

Frequently the argument seems to be between two polar positions, one which holds that no market is ever rational, the other that all markets are always so. In a meeting on the influence of expert networks, Harry G. Johnson offered this description of the difference between the “Bellagio group” of older economists, interested in international monetary reform, and a younger one from Chicago-Rochester-Manchester-Dauphine-Geneva:
 

The difference can be encapsulated in the proposition that whereas the older generation of economists is inclined to say “the floating rate system does not work the way I expected, therefore the theory is wrong, the world is irrational and we can only regain rationality by returning to some fixed rate system to be achieved by cooperation among national governments,” the younger generation is inclined to say “the floating rate system is a system that should be expected to operate rationally, like most markets; if it does not seem to work rationally by my standards, my understanding of how it ought to work is probably defective; and I must work harder at the theory of rational maximizing behavior and the empirical consequences of it if I am to achieve understanding.” This latter approach is the one that is being disseminated, and intellectually enforced through the [younger] network. ₂₄

This observation by Harry G. Johnson is interesting because it gives us insight into why rationality is so important to economics. At first glance, it seems that the addition of the axiom of rationality is limiting and narrowing. It takes Mill’s social science of the desire of wealth and restricts it to a necessarily narrower set of problems, those where greed and rationality are the central factors. But this was neither the intent nor the effect of the rationality axiom. Rather, the idea was to convert economics from the narrow study of greed to the universal science of rational behavior.

Rationality makes economics more like physics than like sociology because if agents are rational, then theories can predict their behavior and the predictions can be evaluated. Specific hypotheses can be derived from the axiom of rational maximizing behavior, as well as those institutional factors that bear on an issue, and the hypothesis can be tested against real world data. Without rationality, none of this is possible. Without rationality, economics is not a science.

In adopting the rationality axiom, neoclassical economics became part of a bigger project—the program of a grand unified theory of science based on the methodology of logical positivism. The desire to make economics a science is thus embedded in the rationality axiom. As a result, there is much to lose if irrational markets exist, and especially if they exist where they may restrict the largest market process of all—globalization.

 

Illusive Equilibrium

Modern economics is built on the axioms of greed and rationality, which, I have argued in the last two sections, render most economists unexpectedly insensitive to possible difficulties with the global expansion of markets. Economists are predisposed to see global markets as the beneficial, rational outcome of natural processes.

The third axiom of neoclassical economics is equilibrium; like greed and rationality, the notion that economic processes are (stable) equilibrium processes is not an empirical statement or the outcome of a logical analysis of greed and rationality, but a free-standing maxim or self-evident truth. Economics, by definition, is the study of equilibrium. The essence of contemporary economics is contained in general equilibrium theory, which is the highly formal mathematical analysis of equilibrium-maximizing behavior. Few economists specialize in general equilibrium theory, but this theory forms the base from which economists approach virtually all problems.

That equilibrium should be at the unquestioned heart of economics is not obvious. Daniel Hausman talks about the “hegemony” of equilibrium theory: “Whether equilibrium theory is the best way to proceed is an empirical question; and there is little reason to reject other approaches because they cannot be integrated into a unified theory of an economic realm.” ₂₅   But by beginning from the self-evident truth of equilibrium, economists necessarily limit their domain. In particular, they exclude problems involving nonlinear dynamics and chaos. In effect, they exclude the possibility that chaotic international financial markets might exist to limit globalization.

The equilibrium axiom is as uncontroversial to economists as is the consumption of raw fish for breakfast for a resident of Japan. Equilibrium is how we were raised—brought up within the discipline. It is controversial, however, to “civilians” who have reason to closely examine the methods of economics. One such is David Ruelle, a physicist whose work on nonlinear dynamics helped open physics to the study of chaotic processes. In a chapter on economics in his book Chance and Chaos, he criticizes harshly the equilibrium axiom.

Let me state things somewhat more brutally. Textbooks of economics are largely concerned with equilibrium situations between economic agents with perfect foresight. The textbooks may give you the impression that the role of the legislators and government officials is to find and implement an equilibrium that is particularly favorable for the community.... The examples of chaos in physics teach us, however, that certain dynamical situations do not produce equilibrium but rather a chaotic, unpredictable time evolution. Legislators and government officials are thus faced with the possibility that their decisions, intended to produce a better equilibrium, will in fact lead to wild and unpredictable fluctuations, with possibly quite disastrous effects. The complexity of today’s economics encourages such chaotic behavior, and our theoretical understanding of this domain remains very limited. ₂₆

Ruelle’s critique unfortunately demonstrates his lack of understanding of the way economists think. Ruelle seems to believe that economics is about the making of rational equilibrium government policy (visible hand economics), whereas economists know that it is about rational equilibrium self-interest (invisible hand economics). Ruelle’s commentary is therefore unlikely to substantially influence the way economists think about what they do. His point, however, is extremely important. By assuming equilibrium, economists necessarily eliminate the possibility of not equilibrium when there is no particular reason to do so. Globalization, the increasing integration of the international economy, for example, need not be an equilibrium process.

A standard piece of economics wisdom is that suppressing economic barriers and establishing a free market makes everyone better off. Suppose that country A and country B both produce toothbrushes and toothpaste for local use. Suppose also that the climate of country A allows toothbrushes to be grown and harvested more profitably than in country B, but that country B has rich mines of excellent toothpaste. Then, if a free market is established, country A will produce cheap toothbrushes, and country B cheap toothpaste, which they will sell to each other for everyone’s benefit. More generally, economists show (under certain circumstances) that a free market economy will provide the producers of various commodities with an equilibrium that will somehow optimize their well-being. But, as we have seen, the complicated system obtained by coupling together various local economies is not unlikely to have a complicated, chaotic time evolution rather than settling down to a convenient equilibrium. ₂₇

Ruelle, a physicist, argues that globalization itself might be inherently unstable, particularly as the dynamical interaction of the nonlinear economic processes of national economies increases. This hypothesis goes well beyond what I argued in Chapter 5, namely, that international financial markets may be chaotic. Ruelle’s hypothesis, striking in its clarity and startling in its consequences, remains fundamentally uninvestigated by economists. The equilibrium axiom’s powerful influence persists.

I do not want to leave you with the impression that economists never consider the possibility of nonequilibrium processes. Rather I want to suggest that the fundamental influence of equilibrium theory overwhelms them. One of the most important economic problems of the first half of the twentieth century, for example, was the business cycle problem. This was the problem of explaining how an economy could go through a macroeconomic cycle as pronounced as the Great Depression—a good question indeed!

Joseph Schumpeter, the celebrated Austrian-American economist, addressed this important problem in his 1939 book, Business Cycles. ₂₈   Schumpeter found empirical evidence of three cycles: a Kondratieff long wave of 45–60 years due to technological change among other things; a Juglar medium wave of 8–11 years, caused by cycles in fixed investment, and a Kitchin short wave due to inventory fluctuations. ₂₉   It is the dynamical interaction of these cycles, Schumpeter argued, that creates macroeconomic cycles. Recently it has been argued that what Schumpeter had in mind in this analysis was that these three cycles created a nonlinear dynamic process highly sensitive to initial conditions that tended toward chaos over time. Wolfgang Stopler, a former student of Schumpeter, writes that

His “vision” was that the capitalistic process, which really encompassed all that was economic and social and even cultural in the history of the Western world at least as far back as the twelfth and the beginning of the thirteenth century when banking started in southern Europe, was a process never at rest. Equilibrium described only a small part of reality. It never has been reached. Various temporary “equilibria” existed at discrete intervals. They were never maintained for long and never repeated exactly. ₃₀

Schumpeter’s vision of economics was dynamic, Stopler argues, and ultimately chaotic. Stopler argues that Schumpeter lacked the sophisticated mathematical tools necessary to make his vision of a theory of nonlinear dynamical economics a reality. ₃₁

 

Unstable Foundations

Ironically, it was another of Schumpeter’s students, Paul A. Samuelson, who did perhaps the most to raise the equilibrium axiom to its exalted place in economic methodology. Samuelson is generally considered the most influential economist since Keynes. According to Philip Mirowski, “It is a testimony to his verve, his breadth, and his lucid writing style that his opinions were to be found in nearly every corner of neoclassical analysis from roughly the 1930s to the 1980s.... It was Samuelson... who by both word and deed was responsible for the twentieth-century self-image of the neoclassical economist as scientist.” ₃₂

Samuelson, as a Harvard graduate student under Schumpeter in the 1930s and 1940s, wrote the book that essentially defined the program of neoclassical economics in the postwar period (it was published in 1947). The book was called Foundations of Economic Analysis, ₃₃   and its influence has been enormous, as Mirowski just noted.

Samuelson’s intent in Foundations was simply to raise economics to the level of a science. This meant changing the way economists thought about and did their work. The ambitious goal of the project, as stated in the opening lines of the first chapter, was to show that “The existence of analogies between central features of various theories implies the existence of a general theory which underlies the particular theories and unifies them with respect to those central features” [italics in the original]. ₃₄   The language used here is important and was certainly carefully chosen. Samuelson aims to develop a general theory of economics in the same way that Keynes had sought a “general theory” of macroeconomics. In both cases, I think, the term general theory was meant to suggest a grand unified theory, rather than, say, an incomplete or “special theory” like Einstein’s special theory of relativity. If you reread the quote you will notice that Samuelson does not specifically refer to economics in his opening statement. He suggests, I think, that there is in fact a general theory of science that underlies the particular theories of the different areas of science (including economics). Samuelson’s Foundations was an attempt to work out the economic aspects of this general theory while linking economic science to the larger theoretical program.

Actually, Samuelson intended two ambitious outcomes from Foundations. Together they would make economics a science.

1. To explore the implications for theoretical and applied economics of the existence of a general theory—that is, a theory that underlies all the particular theories.
2. To derive operationally meaningful theorems from this general theory. A meaningful theorem is a hypothesis about empirical data that could conceivably be refuted.

I remember reading Foundations in 1972, as a first-year graduate student at Purdue University enrolled in Mathematical Economics. In no way did I find Samuelson’s ambitious agenda controversial. In fact, I don’t think I even noticed it, so accepted were these theoretical considerations. Instead, we all dove headlong into the guts of the book, where the mathematical theories of consumer, producer, and welfare analysis are developed. I was so interested in finally getting to do economic science that I gave no thought to what that meant and how it affected the way I approached economic problems. I suspect that few of my fellow students gave these issues much more consideration than I did. For us, Foundations was about technique, and we accepted unthinkingly, I believe, the conditions that came with that technique. Most of all, we accepted the equilibrium axiom.

We may not have known just what we were doing when we studied Foundations, but Samuelson knew what he was doing when he wrote it. He did not see equilibrium as a defining axiom of economic analysis. Although much of the book focuses on equilibrium and the characteristics of movements from one equilibrium to another (which is called comparative statics analysis), the climax of Foundations occurs in the final chapters, where the first steps are made toward a dynamical theory of economics.

In the conclusion, in fact, Samuelson holds that the real goal of economic science should be to develop a theory of comparative dynamics, which would consider how the dynamical evolution of the economy is affected by various events and policies. ₃₅   Along the way, he examines the properties of various dynamical systems and, through the economic examples he cites, makes clear that some of the most important problems in economics are really problems of dynamical analysis. He even discusses the problems of nonlinear dynamical systems, calling them by this name. Such systems are obviously important to economics, he says, “However, for now formal difficulties of solution are so great that very much remains to be done.... It is not unexpected that the simplest empirical notions may lead to the most complicated mathematical problems. This is a fact to inspire humility in both literary and mathematical investigators, but should prove discouraging to neither.” ₃₆

The vision of economics found at the end of Samuelson’s Foundations is thus clearly in the spirit of his mentor, Joseph Schumpeter. The goal of economics should be to understand change, not static states. So it is intensely ironic, I think, that the effect of Samuelson’s Foundations probably was to focus economic analysis instead on the concept of equilibrium.

The reason that equilibrium became so embedded in economic analysis goes back to Samuelson’s original goal of producing a general theory of economics from which one could derive operationally meaningful theorems. If Samuelson could have built a general theory on the axioms of greed and rationality, I suppose he would have tried. In fact, greed and rationality are enough for some kinds of economic theorems, such as those having to do with the profit-maximizing behavior of an individual firm or the utility-maximizing behavior of an individual consumer. But greed and rationality are not enough to predict how markets or systems of markets work:

When we leave single economic units, the determination of unknowns is found to be unrelated to an extremum position. In even the simplest business cycle theories there is lacking symmetry in the conditions of equilibrium so that there is no possibility of directly reducing the problem to that of a maximum or minimum. Instead the dynamical properties of the system are specified, and the hypothesis is made that the system is in “stable” equilibrium or motion. By means of what I have called the Correspondence Principle between comparative statics and dynamics, definite operationally meaningful theorems can be derived from so simple a hypothesis. ₃₇

In other words, a “hypothesis” that soon became an axiom needed to be added to make the system work. The hypothesis that Samuelson needed was that the system was in stable equilibrium motion. Without this added assumption, the project of a general theory of economics would have failed. He called this hypothesis the Correspondence Principle, a name surely borrowed from the correspondence principle that Niels Bohr developed for quantum physics. ₃₈   Bohr’s correspondence principle was the assumption that the quantum behavior of particles could be approximated by the predictions of classical or nonquantum physics. Without Bohr’s correspondence principle, an analysis of quantum behavior was impossible. Samuelson’s correspondence principle was that the behavior of dynamical systems could be approximated by the behavior of equilibrium systems. Without this assumption, as we just saw, there was “no possibility” of attacking the problem on the basis of rationality and greed.

Samuelson immediately recognized that the correspondence principle was problematic, but he could not proceed without it. Critical sections of Foundations are therefore devoted to defending the equilibrium hypothesis. On page five, for example, having introduced the correspondence principle, he accepts its theoretical problems while simultaneously arguing its intuitive appeal.

The empirical validity or fruitfulness of the theorems, of course, cannot surpass that of the original hypothesis. Moreover, the stability hypothesis has no teleological or normative significance; thus, the stable equilibrium might be at fifty per cent unemployment. The plausibility of such a stability hypothesis is suggested by the consideration that positions of unstable equilibrium, even if they exist, are transient, nonpersistent states, and hence on the crudest probability calculation would be observed less frequently than the stable states. How many times has the reader seen an egg standing upon its end? From a formal point of view it is often convenient to consider the stability of nonstationary motions. ₃₉

It is my sense that Samuelson is a little desperate here, and it is easy to see why. He wants to make economics a science, but to do this he is forced to rely on the uncertain center of gravity of an egg. The last sentence of this paragraph is the important one: From a formal point of view it is often convenient to consider the stability of nonstationary motions. The motion of economic systems may not be stable, Samuelson is telling us, but it is convenient to pretend that they are if you want to perform rigorous analysis.

From this basis, it is possible to imagine economics developing along two lines: one of “economic science” founded on the correspondence principle, relying heavily on the equilibrium assumption; and the other of “political economy,” unrestricted by equilibrium conditions. This second line of thought would have been less formal, more literary, more “historical” or descriptive, and well prepared to consider problems such as globalization from the ground up.

This bifurcation of economics was possible but was not part of Samuelson’s plan; it would have separated not just economic science from political economy but also economics from science. As Samuelson wrote in an early paper, “Technically speaking, we theorists hoped not to introduce hysteresis phenomena into our model, as the Bible does when it says: ‘We pass this way only once’ and, in so saying, takes the subject out of the realm of science and into the realm of genuine history.” ₄₀   So Samuelson was forced into further efforts to defend the correspondence principle. He was so successful in this that for 40 years it was impossible, or nearly so, to do serious economics without equilibrium.

Writing in the chapter on “Fundamentals of Dynamical Theory,” for example, Samuelson argues that different economic processes proceed at much different speeds (they do), with some much “faster” and others much “slower.” ₄₁   There is no harm in assuming that the slower ones are constants, he argues, and assuming that the faster ones are heavily damped, so that what remains can be assumed to be an equilibrium system. Thus a non-equilibrium system is approximated by an equilibrium system by squeezing all the dynamics out of it, so to speak.

It may be argued that so general a connotation is at variance with traditional usage of the word equilibrium. Is it not straining language to think of a cannon ball as being at equilibrium not only after it has fallen to the ground at rest, but also at every point in its flight, when it is on its mean trajectory as well as in its precession around this path? Perhaps such terminology may occasionally lead to confusion; however, with carefully stated qualifications it may be convenient. ₄₂

What Samuelson said was “convenient” soon became “necessary.” Neoclassical economy theory became equilibrium theory, as Hausman has noted. ₄₃

 

Physics Envy?

The problem with economics, according to Philip Mirowski, the self-described enfant terrible of the discipline, is physics envy. Economics sold its social science soul to gain the status of a real science. The Faustian bargain backfired. Mirowski writes: “one might quibble over the details, but I think most would agree that the mid-20th century Classical-style program of a unified science of economics has run out of steam.” ₄₄   He makes a surprisingly strong case for this position in his interesting and controversial 1989 book, More Heat than Light: Economics as Social Physics, Physics as Nature’s Economics. ₄₅   The gist of the argument is that by the middle of the nineteenth century, physics looked like it had the potential to be a general theory of the natural world. Economics aspired to be the general theory of the social world. By treating utility like energy, economics could be social physics. Thus, economics patterned itself on the physics of the 1860s, adopting the same types of principles, techniques, and mathematical models.

Mirowski’s case may be based to a considerable extent on circumstantial evidence, but it is persuasive nonetheless. Rereading Samuelson’s Foundations, it is difficult not to notice the many references to the method and results of natural science in general and physics (and biology) in particular. The giants of neoclassical economics, Nobel Prize–winners such as Paul Samuelson and Robert Solow, have pretty consistently denied that they suffer from physics envy. Solow, for example, argues that economists have stuck with their methodology, including equilibrium theory, because it works so well. ₄₆   It is such a good way of doing social science, in fact, that it has invaded political science and sociology successfully, Solow argues. However,

there is no doubt that economists are attracted to the style of explanation they see (or think they see) in physics. That is at least clear in the externals. Economists feel at home with equilibrium conditions deduced from first principles or from reliable empirical statements. Similarly, they are used to deducing dynamics from local assumptions or generalizations; economics is full of differential or finite difference equations. All this seems fairly harmless, as long as it works. ₄₇

The question of physics envy aside, there is the related question of why Samuelson’s vision of a science of comparative dynamics has not been realized in economics while the ideas of nonlinear dynamics have been integrated fairly rapidly into physics. This question is especially puzzling given that some of the most important early work on chaos theory (e.g., Beriot Mandelbrot’s key findings on fractals) derived from work with economic data (e.g., Mandelbrot’s study of price movements). ₄₈

Randall Bausor has recently studied the history of how nonlinear dynamical analysis has been treated by both physicists and economists, to try to understand why chaos is embraced by one group and shunned, for the most part, by the other. ₄₉   Bausor concludes that the difference is based on different empirical and evidentiary foundations and by the distinct cultural and metaphorical backgrounds of the disciplines. Compared with physics, nonlinear dynamical theories in economics are likely to be discounted as ad hoc, counter-intuitive, and empirically unsupported.

In physics it was easy to accept nonlinear dynamics and chaos because there was solid theoretical ground on which to build. The Navier-Stokes equations for fluid dynamics were uncontroversial and were considered a valid contribution because they generated chaotic outcomes. In economics, on the other hand, there is no similar solid core of theory. That is, whereas most economic models are based on the three axioms discussed in this chapter, there is little else that is standardized or accepted. Your model of wheat supply behavior is probably different from my model of wheat supply behavior if we are studying somewhat different aspects of the problem. If my model generates some chaotic patterns over time, it is likely that they result from the peculiarities of my model, not the peculiarities of wheat supply behavior itself. Because economics lacks a hard core of theory, any behavior that is at odds with the axioms can easily be dismissed as ad hoc. So it has been hard to get nonlinear dynamics to be taken seriously by economists. It would be hard to get any theory taken seriously that produces novel hypotheses.

Second, Bausor argues that economists and physicists have different attitudes toward stability. Physicists observe instability in nature frequently and can produce it in the laboratory easily:

By inclination and training, however, economists abhor instability.... To most economists competitive processes that rule the economy are inherently dynamically stable. Mathematically interesting dynamics and certainly “chaos,” in contrast, require instability somewhere.... Few economists are keen on any of this. For them instability of competitive processes manifests only a palsied malfunctioning of the invisible hand. Their most cherished attitudes towards markets and their most central presumptions about how the economy should be governed are all profoundly challenged by analyses conditioned on systemic instability. ₅₀

Finally, there are differences in the empirical standards in economics and physics that bear on this issue. Scientists are generally able to experiment under controlled conditions. They are able, therefore, to test for stability and instability. The empirical test of nailing down chaos is much harder for economists, however, as we saw in the discussion of chaotic exchange rate evidence in Chapter 5. “Empirically, economists cannot begin with a controlled phenomenon but must go straight to the wild, as it were. It is as if the student of fluid mechanics had to begin with Niagara,” according to Bausor.

If economists do have physics envy, then, it does not go so far as to allow them to comfortably embrace the theory and consequences of nonlinear dynamics, as their physicist colleagues have done unconditionally. The good news is that in the past 10 years more economists have begun to work within this framework, and preliminary results, such as those noted in Chapter 5, are being reported. Given the problems that Bausor outlines, however, it may be some time before there is general acceptance of these ideas in economics.

Until such acceptance, the theory of chaotic financial markets and the critique of globalization as I have used them in this book will be viewed by mainstream economists as ad hoc, counterintuitive, and empirically unsupported whereas the general theory of the stable, rational, socially beneficial global market system is true by definition.

Felix Martin, the young scholar who was my research associate at the Bologna Center, has suggested that the differences between economics and the natural sciences that Bausor outlines are more philosophical than practical. ₅₁   Martin argues that the philosophy of economics diverged from the philosophy of science in the 1930s; while the philosophy of science changed and adapted to new discoveries, the philosophy of economics remained unchanged, trapped in a methodology of logical positivism. Martin explains that

the dramatic scope of the logical positivist philosophy proved its undoing, and in particular the extension of the reductive method it implied from the natural sciences to the social sciences. It was in there that the cracks began to open. Partly in consequence of this, analytical philosophers began to move away from logical positivism during the 1930s and 40s, and by the 1950s new orthodoxies were emerging. A similar development in the philosophy of science can be traced, through Popper to Kuhn and Lakatos, forced on scientists through the inability of the logical positivist framework to cope with the expansion of the natural sciences. But in economics, no such process of methodological evolution was evident. In fact, neoclassical economic methodology was if anything recusant—after the war it became more positivist than it had been before, when it had at least enjoyed a variety of schools and methods and a Keynesian debate. ₅₂

Martin argues that Mirowski’s physics envy thesis is too narrow. What economics embraced at the end of the nineteenth century was not so much physics as it was the analytical philosophy of logical positivism that seemed to underlie it and seemed to be the philosophy of nature. When analytical philosophy and the natural sciences moved on to postpositivist methodology, however, economics did not. Neoclassical economists, according to Martin, “have proved particularly uninterested in delving into the epistemological basis for their research programmes, and partly as a result of this, have generally and unintentionally become stuck with a logical positivist view of science and knowledge.” ₅₃

By holding firm to logical positivism, Martin asserts, economics has fallen steadily away from the natural sciences and analytical philosophy, and hence steadily away from the fundamental goal of equilibrium theory, to make economics a science. An assault on equilibrium theory, therefore, shakes the discipline of economics clear to its deepest roots.

 

Globalization and the End of Economics

Globalization is not the end of history, the end of culture, or the end of the nation-state. But is it the end of economics? Well, no. As Felix Martin just noted, economists are pretty impervious to deep philosophical questions. They will likely continue doing what they do regardless of the final verdict on globalization, equilibrium, and logical positivism.

But it is a question worth thinking about. As global markets become increasingly integrated, I argued in Chapter 5, there is reason to think that chaotic fluctuations in international capital markets will increase. If this occurs—and there is no “proof” that it will, just as there are no guarantees that it will not—then neoclassical economics and its assumption of stable equilibrium will become irrelevant in precisely the most important market system in the world. Is this not the death of economics as a practical guide to business and public policy, if not as an academic industry? ₅₄

No, to repeat myself, I don’t think so; I don’t believe that economics is in any more danger than the other institutions that are supposedly doomed by globalization’s destructive force. Ironically, the failure of the equilibrium axiom in global markets will limit globalization, as I argued earlier, and thus also limit the extent to which globalization can generate real world movements that shake the general theory of economics down to its axiomatic roots. But this does not mean that economics will be unchanged by globalization and the international financial market chaos that I have associated with it.

Recently the general theory of economics has been sharply criticized from both the outside and the inside. George Soros, arguably the world’s most successful currency speculator, has attacked the axioms of economics from what I term a political economy framework; in this chapter’s epigram, for example, he compared the pseudo-science of economics to Marxism! ₅₅

The attack from the inside is less dramatic but more severe. Paul De Grauwe, Hans Dewachter, and Mark Embrechts have derived qualitatively realistic chaotic market behavior within the context of models based on greed and rationality. ₅₆   Equilibrium in these models, they argue, is an ad hoc assumption as it is in other models of rationality. By accusing economic theory of “ad hocness,” they aim an arrow at the heart of economic science. I’ll explain the more technical “inside” argument first, so that the chapter can conclude as it began, with Soros and the outside argument.

De Grauwe and colleagues focus their criticism on rational expectations theory, the pinnacle of neoclassical theory, which extends the rationality and equilibrium axioms to the extreme. Empirical support of the rational expectations theory is weak, but empirical economics suffers built-in problems that limit its credibility. Rational expectations theory exists and thrives within economics because it is a pure statement of what economics is in the postwar period.

When models of rational expectations are analyzed closely, however, it becomes clear that equilibrium is an axiom, not a result. This is especially true in models of financial markets, where chaos and crisis are often observed:

The rational expectations models produce an infinite number of explosive paths (speculative bubbles). It is customary in the rational expectations literature to ignore these bubbles.... One rationalization has been that since all (observed) bubbles explode at some time, rational agents, with perfect foresight, will be able to forecast the exact timing of this future explosion. Since this would allow them to make infinite profits by taking the right speculative position just prior to the explosion of the bubble, all speculators would do this, thereby bringing the time of the burst in the bubble closer to today. Repeating this reasoning, one arrives at the conclusion that the bubble cannot start....

This rationalization is unsatisfactory because it brings into the model an idea that is external to the functioning of the model, i.e., that every bubble must burst.... This problem is a very general one that appears in all rational expectations models. In all these models there is an infinity of possible solutions, most of which are unstable. The need then arises to select one particular solution. This selection will necessarily be based on information not contained in the model. Thus, even in rational expectations models, ad hoc assumptions will be necessary.... In a sense it can be said that rational expectations models introduce ad hoc assumptions at a higher level of abstraction than non-rational expectations models.... Ad hoc assumptions cannot be avoided. ₅₇

I do not want the significance of this statement to be lost. To an important degree, rational expectations theory is neoclassical economics. If it is ad hoc, then neoclassical economics is ad hoc and therefore not really science. This is not the end of economics, but it is the end of a certain vision of economics. Ad hoc economics would be more of a craft, like dentistry, in which different problems are approached using different tools and paradigms, with no single general theory to unite or justify them. This would not necessarily be bad for economics—it is after all what Keynes thought economics should aspire to—but it would make economics a very different animal, much more like sociology than physics despite its formalism and rigor.

This new characterization of economics would be a good thing, according to George Soros, whose outside attack on economic science appeared in an Atlantic Monthly article titled “The Capitalist Threat.” In this article Soros, who has used his fortune to finance prodemocracy initiatives in formerly communist countries, takes aim at the equilibrium axiom in economics. Although it is economic science that he critiques, it is the invisible hand that he is ultimately concerned with. He writes that, “The main scientific underpinning of the laissez-faire ideology is the theory that free and competitive markets bring supply and demand into equilibrium and thereby ensure the best allocation of resources. This is widely accepted as an eternal verity, and in a sense it is one. Economic theory is an axiomatic system: as long as the basic assumptions hold, the conclusions follow. But when we examine the assumptions closely, we find that they do not apply to the real world.” ₅₈

The markets in the real world, he argues, are characterized by “reflexivity,” which is his term for a feedback mechanism that creates nonlinear dynamical behavior. It is like the feedback between the chartists and the fundamentalists in the exchange rate models discussed in Chapter 5. Action produces reaction. “There is a two-way feedback mechanism between the market participants’ thinking and the situation they think about—‘reflexivity.’ It accounts for both the imperfect understanding of the participants (recognition of which is the basis of the concept of the open society) and the indeterminacy of the process in which they participate.” ₅₉

The open society that Soros mentions here is what is behind his critique. If we cannot scientifically know how to best organize society, then it is best to have an “open society,” open to ideas and influences and organized democratically, not according to some scientific principle. The notion of the open society derives from Karl Popper’s 1945 book The Open Society and Its Enemies. In a way, Soros is engaging in a political use of chaos. He is using the fact of chaotic behavior of financial markets to promote his political interest in an open society. He opposes all theories of everything that would enslave society to a theory or principle, whether communist or capitalist. His open society is a world in which such knowledge is impossible, so it is better to work things out on an ad hoc basis. Soros’s basic argument is summed up as follows:

If we look at the behavior of financial markets, we find that instead of tending toward equilibrium, prices continue to fluctuate relative to the expectations of buyers and sellers. There are prolonged periods when the prices are moving away from any theoretical equilibrium....Yet the concept of equilibrium endures. It is easy to see why: without it, economics could not say how prices are determined....

In the absence of equilibrium, the contention that free markets lead to the optimum allocation of resources loses its justification. The supposedly scientific theory that has been used to validate it turns out to be an axiomatic structure whose conclusions are contained in its assumptions and are not necessarily supported by the empirical evidence. The resemblance to Marxism, which also claimed scientific status for its tenets, is too close for comfort. ₆₀

Financial market crisis and chaos, therefore, seem to have surprisingly broad and important implications. My argument, which probably seemed extreme at the start but is by now beginning to look rather moderate, is that market chaos is a self-limiting factor of globalization. As globalization proceeds, financial markets become increasingly unstable, which limits the further spread of global markets.

In this chapter, however, we have seen that this tendency can also be interpreted to have much larger impacts: the end of economics as a science and the end of laissez faire—the ideology of global markets—as a valid political philosophy.

 

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Endnotes

Note 1: George Soros, “The Capitalist Threat,” The Atlantic Monthly (February 1997), p. 50.  Back.

Note 2: Paul R. Krugman, Pop Internationalism (Cambridge, MA: MIT Press, 1996).  Back.

Note 3: David Sousa, “Converging on ‘Competitiveness’: Garbage Cans and the Global Economy” (University of Puget Sound, Tacoma, WA, March 1997, mimeo). The original idea of the garbage can is found in Michael Cohen, James March, and Johan Olsen, “A Garbage Can Model of Organizational Choice,” Administrative Science Quarterly 17:1 (1972), pp. 1-25.  Back.

Note 4: Michael Veseth, Mountains of Debt: Crisis and Change in Renaissance Florence, Victorian Britain, and Postwar America (New York: Oxford University Press, 1990).  Back.

Note 5: Sousa, “Converging on ‘Competitiveness,’” p. 7.  Back.

Note 6: Paul Krugman, Peddling Prosperity: Economic Sense and Nonsense in the Age of Diminished Expectations (New York: W. W. Norton & Co., 1994), p. xiii.  Back.

Note 7: The numbers generated by the search are only roughly indicative of economists’ interest in globalization, however. These figures indicate the number of books, articles, and working papers in which the terms globalization or globalisation appeared in either title or abstract. Context is important; many of these articles were only tangentially concerned with globalization processes.  Back.

Note 8: Krugman, Pop Internationalism, pp. viii-ix.  Back.

Note 9: Krugman’s Slate column, the “Dismal Scientist,” was recently joined by another called “Global Vision” that is written by a faceless team of international management consultants. It is unclear, therefore, if sound economic ideas (about globalization and other matters) have made more than temporary gain via the Internet.  Back.

Note 10: Krugman, Pop Internationalism; see “Competitiveness: A Dangerous Obsession,” pp. 3-24.  Back.

Note 11: At least this is how I defined it years ago in my Introductory Economics (New York: Academic Press, 1981), p. 5.  Back.

Note 12: George Ackerlof, as quoted in Daniel M. Hausman, The Inexact and Separate Science of Economics (Cambridge, UK: Cambridge University Press, 1992), p. 260.  Back.

Note 13: John Stuart Mill, A System of Logic, quoted in F. Martin, “The Development of General Equilibrium Theory,” Part II, p. 7.  Back.

Note 14: Political economy did not become economics until Alfred Marshall made it so at the close of the nineteenth century in an attempt to distill science (economics) from moral philosophy (political economy).  Back.

Note 15: David M. Kreps, “Economics—The Current Position,” Daedalus (winter 1997), p. 59.  Back.

Note 16: Adam Smith, The Wealth of Nations (New York: Dutton, 1964), p. 398.  Back.

Note 17: Ibid., p. 400.  Back.

Note 18: Ibid., p. 400.  Back.

Note 19: David Ricardo, The Principles of Political Economy and Taxation (London: Dent, 1993), p. 81.  Back.

Note 20: This fact accounts for the structure of the present study, which tries to make economic sense of globalization through synthesis of the studies of particular aspects of the process.  Back.

Note 21: Kreps, “Economics—The Current Position,” p. 79.  Back.

Note 22: Ibid., p. 79.  Back.

Note 23: This is how Greider presented the issue of global markets, for example (see Chapter 6).  Back.

Note 24: Charles P. Kindleberger, Manias, Panics and Crashes: A History of Financial Crises (New York: Basic Books, 1978), p. 26.  Back.

Note 25: Daniel M. Hausman, The Inexact Science, p. 247.  Back.

Note 26: David Ruelle, Chance and Chaos (Princeton, NJ: Princeton University Press, 1991), pp. 84-85.  Back.

Note 27: Ibid., p. 84.  Back.

Note 28: Joseph A. Schumpeter, Business Cycles, 2 vols. (New York: McGraw-Hill, 1939).  Back.

Note 29: Wolfgang F. Stopler, Joseph Alois Schumpeter: The Public Life of a Private Man (Princeton, NJ: Princeton University Press, 1994), p. 65.  Back.

Note 30: Ibid., p. 58.  Back.

Note 31: Although theories of business cycles based on Schumpeter’s analysis are still used in some areas of business economics, his fundamental idea did not survive the influence of equilibrium theory. The mainstream theory of business cycles today—the real business cycle theory—is based on cycles that result from rational equilibrium behavior.  Back.

Note 32: Philip Mirowski, More Heat than Light: Economics as Social Physics, Physics as Nature’s Economics (Cambridge, UK: Cambridge University Press, 1989), p. 378.  Back.

Note 33: Paul A. Samuelson, Foundations of Economic Analysis (Cambridge, MA: Harvard University Press, 1947).  Back.

Note 34: Ibid., p. 3.  Back.

Note 35: Ibid., Chapter 12.  Back.

Note 36: Ibid., p. 340.  Back.

Note 37: Ibid., p. 5  Back.

Note 38: This is discussed in Mirowski, More Heat Than Light, p. 379.  Back.

Note 39: Samuelson, Foundations, p. 5.  Back.

Note 40: Quoted in Mirowski, More Heat Than Light, p. 390.  Back.

Note 41: Samuelson, Foundations, pp. 330-332 for the discussion referred to here.  Back.

Note 42: Ibid., pp. 331-332.  Back.

Note 43: Hausman, The Inexact Science, p. 272.  Back.

Note 44: Philip Mirowski, “Do You Know the Way to Santa Fe? Or, Political Economy Gets More Complex” (University of Notre Dame, Notre Dame, IN, December 1994, mimeo), p. 13.  Back.

Note 45: Mirowski, More Heat Than Light.  Back.

Note 46: Robert M. Solow, “How Did Economics Get That Way? What Way Did It Get?” Daedalus (winter 1997), pp. 55-56.  Back.

Note 47: Ibid., p. 55.  Back.

Note 48: Mirowski, More Heat Than Light, pp. 386-387.  Back.

Note 49: Randall Bausor, “Qualitative Dynamics in Economics and Fluid Mechanics: A Comparison of Recent Applications,” in Natural Images in Economic Thought, ed. Philip Mirowski (New York: Cambridge University Press, 1994), pp. 109-127.  Back.

Note 50: Ibid., p. 121.  Back.

Note 51: Felix Martin, “The Development of General Equilibrium Theory” (Johns Hopkins School of Advanced International Studies Bologna Center, Bologna, Italy, May 1997, mimeo).  Back.

Note 52: Ibid., Part II, p. 2.  Back.

Note 53: Ibid., Part II, p. 19.  Back.

Note 54: If the unsettled Foundations of economic science give way, then all we will be left with is political economy.  Back.

Note 55: George Soros, “The Capitalist Threat,” The Atlantic Monthly (February 1997), pp 45-58.  Back.

Note 56: Paul De Grauwe, Hans Dewachter, and Mark Embrechts, Exchange Rate Theory: Chaotic Models of Foreign Exchange Markets (Oxford: Blackwell Publishers, 1993). This model and its results were surveyed in Chapter 5.  Back.

Note 57: Ibid., pp. 68-69.  Back.

Note 58: Soros, “The Capitalist Threat,” p. 48.  Back.

Note 59: Ibid., pp. 48-50.  Back.

Note 60: Ibid., p. 50.  Back.