From  the Social Science Research Center a nice speech explaining some history of economic thought by economist Erik Reinert.  Thanks to Mark Thoma at economist’w view for highlighting Reinert’s speech.

What we’re undergoing today has happened before; in 1848, the 1890s, the 1930s, and again today.  In each period economic thought became dominated by classical economics.  Other, often complementary, economic approaches were pushed aside.  In each instance it became apparent that classical economics failed to avoid  or explain, subsequent economic collapses.   In each case other more practical theories came to the rescue.  Call it common sense or applied economics–whatever–classical theories turned out to be just that, theories.  And in each period classical economics were, at minimum, salted with other economic ideas that worked better in reality.

Today we’re back in the soup, again.  And just as occured the last couple centuries those classical theories, resurrected and now formalised in elegant mathematics, have produced mal-investments and extreme economic underperformance.  From the speech:

In the case of financial crisis, long periods of economic stability produce easy credit, which with time creates instability and systemic risk, even with a small economic downturn. In the case of economics, long periods of economic stability create a belief that a Physiocratic (today’s laissez faire) approach of deregulated market – which may work well for a while – will forever solve all problems. Both the French Revolution and the European Revolutions of 1848 were results of an overdose of Physiocratic thinking, and both cases produced a return to Anti-Physiocratic – active – economic policies. The present financial crisis falls in the same category of an overdose of Physiocratic de-regulation, the famous “flaw” that Alan Greenspan discovered was a typical Physiocratic flaw: the market, if left alone, did not produce automatic harmony, but financial collapse. It remains to be seen if – and how fast – Anti-Physiocratic regulatory measures can be put back. Strong vested interests wish to prevent it….

A key problem of mathematized neo-classical economics that came into fashion during the Cold War was that it only came with one very high level of abstraction: the tools used automatically disregarded any and all real-life nuances and differences. By disregarding all differences between economic activities, between human beings, and between cultures, economics became a science depicting markets as producing automatic harmony. Economists proved, not very surprisingly, that a standardized humanity in a world where all economic activities were identical, would produce equality. When communism promised “from each according to ability and to each according needs,” this became an unnecessary complication of things: the market would also produce equality. That the apparent equality of outcome that the models produced was simply a result of the assumptions on which the theory was based – how could a model where everything is identical and equal produce anything but equality as an outcome? – was simply not listened to. The West sorely needed models supporting the perfection of the market system, and we got it…..

When Margaret Thatcher famously said “there is no such thing as society” she was merely stating a fundamental assumption of ruling economic theory. Assuming no difference between economic activities and a frictionless economy, economists modeled a world where a coordinating nation-state was no longer needed. So Ronald Reagan’s statement that “government is not the solution to our problem; government is the problem”[41] was completely in line with ruling economic theory at the time. The society modeled in neo-classical economics did not need governments, only centuries of experience would contrast what had become the mathematically obvious fact expressed by Reagan. Economic theory modeled a world with no voluntary unemployment, and it therefore became legitimate to label all the unemployed of the world as “lazy.” Neo-classical economic modeling produced that blend of wishful thinking, ignorance, and intolerance which we call neoliberalism….

That by abstracting from key agents and key phenomena economics had also abdicated from studying reality only became evident much later. Under a guise that the magic of the market would create factor-prize equalization, the opposite movement – towards a polarization of incomes – is taking place. In the meantime vested interests took over increasingly larger slices of the economy. Under the assumption that the financial sector can be treated as any other sector in the economy, and under the assumption that no regulation of the financial sector was necessary (the abandonment of the Glass-Steagall Act), individuals and nations are increasingly becoming debt slaves to the financial sector. Under the assumption of perfect competition, what used to be called natural monopolies – the opposite of perfect competition – have been privatized, and long-lasting monopolies and quasi-monopolies have been created. All in all, the economics profession became a useful tool (and fool) for the vested interests of a ‘plutocracy’. Under the assumption that markets would create automatic harmony, the West – particularly the United States – is embarking on a process of Darwinian survival of the fittest, a movement that previously had been stopped starting in the 1890s and again in the 1930s. The distribution of wealth and income is moving in the direction of a post-industrial feudalism, but a new type of feudalism, where power is not narrowly based on land ownership but on financial ownership in general…..

What needs to be reconstructed is a science of practice:a theory based on human observations of facts. This contrasts with today’s standard economics, where observations of reality tend to be filtered through a set of arbitrary and – from the point of view of observable reality – mostly totally inappropriate assumptions. This theory produces accuracy, but at the expense of relevance.

Margaret Thatcher famously said “there is no alternative,” and in this tradition capitalism is often presented as one solid block of theory to which there is no alternative. Hyman Minsky, on the other hand, argued that there are fifty-seven varieties of capitalism.[43] To explore and reconstruct the many alternative versions of capitalism, we need to resurrect the methodology of the historical schools: creating new knowledge by connecting previously unconnected facts. Present mainstream theory cannot for ever explain away important phenomena as “market failure” rather than recognize them for what they really are: theory failure.

Beezer here.  We’ve had a series of ‘market failures’ the past 22 years in particular: The Orange County (CA) bankruptcy in 1989, the S&L collapse of 1990-92; the Long Term Capital Management (LTCM) collapse of the late 1990s, the North Atlantic banking collapse of 2007–08 and the European Union banking crisis of today.   Neo-classical economics got blindsided by all of them, yet those theories simply won’t die even though they’re obviously seriously flawed.  These cannot be simply wished away as ‘market failures.’  These are theory failures. We need to get back to a less formalized economics approach, one that’s flexible, facts based and empirical.  That which makes the patient better is what is used.  Today we desperately need jobs.  The private economy is still struggling and cannot profitably hire new employees fast enough.  Tax cuts piled on top of tax cuts plus super low interest rates and dramatic Federal Bank intervention in markets have not turned the trick.  The one tool we haven’t used is the tool that guarantees jobs:  Direct hiring to rebuild America’s infrastructure.    

Tags: 1848 revolutions, Anti-Physiocratic, Applied Economics, Classical Economics, Economic History, Economist's View, Erik Reinert, Federal Reserve, Gilded Age, Mark Thoma, Neo classical economics, Physiocratic, Social Science Research Center, the Great Depression, The Great Recession, unemployment

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