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The Character and Role of Economic Theory

Posted by Alex M Thomas on 8th November 2012

Over the years, much has been written about the methods employed in economic theory. The recent financial crisis and the ongoing economic crisis in Europe have resulted in a marked increase in criticisms directed at mainstream economic theory – neoclassical economics (more precisely, marginalist economics). Internal critics of neoclassical economics have been modifying certain assumptions of marginalist economics and have ‘developed’ new forms of economic knowledge such as law and economics, welfare economics, neuroeconomics, new institutional economics and so on. Critics external to marginalist economics, often known as heterodox economics (examples include Classical/Sraffian economics, Post-Keynesian economics and Marxian economics), have provided compelling logical critiques of the theory. Additionally, they also supplement their analysis with empirical and historical details (which is not uncommon in neoclassical economic either). This post is reflective in nature and tries to comprehend the character of economic theory along with a commentary on its contemporary function in the form of questions, thereby reinforcing the reflective nature of this blog post.

First, the definition adopted has a critical influence on the aims and scope of economic theory. For instance, the definition of economics as a study of reproduction and accumulation of wealth/income (characteristic of the heterodox economic theories mentioned above) is qualitatively different from a definition which views economics as a study of allocating scarce resources among competing ends (characteristic of neoclassical economics). The former definition is more modest in scope and seeks to provide answers to a limited number of questions vis-à-vis the latter one which encompasses any and every issue where human decisions are involved. Examining the causes of accumulation and growth warrant the following theories: a theory of value and distribution; a theory of activity-levels (at times, this is absent); and a theory of economic growth. While examining the causal connections within these theories, some features of human behaviour are taken as given. The most important, perhaps, is the human propensity for self-betterment in material terms. Such a limited domain enables these economic theories to be more specific and definite thereby improving their explanatory power in the analysis of economic growth, unemployment, technical progress, wage dynamics and so on. An extremely wide scope is entailed by the definition of economics present in neoclassical economics; consequently, we see the emergence of sub-fields such as: cognitive economics, neuroeconomics, economics of philosophy, experimental economics, evolutionary economics, cliometrics, etc. The questions addressed in many of these sub-fields often have nothing to do with the generation of income or its distribution. The questions being asked are different, and quite relevant in understanding various aspects of human behaviour and institutions. However, if the aim of economic policy and economists is to improve material well-being, neoclassical economics and its sub-fields are not entirely satisfactory, primarily for logical reasons. The two most dangerous tenets of marginalist economics are the marginal productivity theory and the tendency to full employment.

Second, economic theory, I think, has two broad functions. One is to explain the logically necessary connections which exist between various economic variables, and the direction of causation. Usage of terms such as exogenous, endogenous, dependent and independent variables convey the direction of causation. For example, classical/Keynesian theory argues that activity levels and economic growth is demand-led whereas marginalist economics posits that activity levels and economic growth is supply-driven. This is a theoretical debate, which cannot be resolved by recourse to empirical data given the high degree of correlation present among (macro)economic variables such as income, investment, saving, etc. Another reason for the debate being unresolved is the incommensurability of the two kinds of economic theory involved – classical/Keynesian vs. marginalism. The other broad function of an economic theory is to provide an explanation for the manner in which these (marco)economic variables grow over time; strictly speaking, the dominant economics influences the way in which data is collected and presented and the explanation for the data is also provided by the dominant economics. (A chief, although not very reliable, exception to this is the econometric technique known as VAR which attempts to undertake ‘measurement without theory’.) Much of these numbers will need to be supplemented with contextual and historical details. Also, in economics, one needs to be careful about assigning too much ‘reliability’ to data so much so that they are considered ‘adequate’ to overturn a particular economic theory. This is not to say that data does not matter, but that it should be treated with significant caution.

Third and finally, it is of great practical importance to know what economic policies can be advanced based on economic theory, supplemented by data or not. In other words, what conditions must a particular theory fulfil in order for it to be reliable? Is an empirical assessment necessary or is it sufficient? How sound must the logic be? To what extent must the assumptions be scrutinised? Can econometric analysis provide conclusive evidence?

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Posted in Classical Economics, Cliometrics, Economic Philosophy, Economic Thought, Economics, Experimental Economics, Macroeconomics, Marginalist economics, Neoclassical Economics, Sraffian Economics | No Comments »

Kaushik Basu’s Economic Methodology and the Economic Survey of India 2011-12

Posted by Alex M Thomas on 1st May 2012

As the title suggests, this blog post examines a couple of policy recommendations made in Chapter 2 (Micro-foundations of Macroeconomic Policy) of the Economic Survey 2011-12. This examination is carried out in conjunction with Kaushik Basu’s economic methodology which is scattered across the Economic Survey and very visible in his 2011 book Beyond the Invisible Hand: Groundwork for a New Economics (Princeton and Oxford: Princeton University Press). Note that we are making an assumption, albeit very plausible, that Basu authored and/or significantly influenced the contents of Chapter 2 of the Economic Survey. On the basis of these two texts – Chapter 2 and his 2011 book, this blog post evaluates (1) Basu’s method of doing economics, (2) his affinities towards the micro-foundations approach and (3) his (select) macroeconomic recommendations. The blog post concludes with a critical look at the role of economics as espoused by Basu.

Basu writes in the Economic Survey that ‘monetary and fiscal policies are part science and part intuition and common sense’ (p. 24). This statement reflects the openness to knowledge possessed by the author. However, owing to his role as the Chief Economic Advisor of India, he is an economic architect. Therefore, at a deeper level, one wonders whether he is talking about the ‘intuition and common sense’ of a particular individual (himself?) or a certain group of individuals. We get to read more of his thought on ‘intuition’ in his 2011 book. Some priceless extracts are reproduced below:

‘My view is that in economics, the need for intuitive understanding is much greater than most economists would have you believe. Good economic policy requires a “feel” for things over and above the knowledge of theorems and regression coefficients’ (p. 14).

‘Both interventions and noninterventions have too often been left to the ideological whims of believers. They need to be founded on analysis and reason, not faith’ (p. 23).

‘What we so often take to be features of the world are actually propensities of the mind’ (p. 51).

‘My belief about the puzzle of knowledge lies somewhere between the skeptical and evolutionary claims. I have faith in our intuition’ (p. 53).

‘Causality lies in the eyes of the beholder’ (p. 54).

‘To sum up, scientific knowledge has to be combined with intuition and a shot of skepticism for it to be useful’ (p. 54).

On p. 23, he argues that policy interventions should be based on reason and not faith. However, on p. 53, he asserts that he has faith in (his?) intuition. Most of his comments seem to indicate a certain sense of confusion on what the scientific method entails and the role of economic theory in particular. This is quite unfortunate, since it comes from the pen of the current Chief Economic Advisor of India. If it is not confusion then it seems to be a proposal that ‘any idea goes’ wherein obviously the ‘idea’ is decided by those in power. Whatever happened to reason? At the risk of repetition, let me state that this is an extremely dangerous outlook to possess because bad economic policies have devastating implications for majority of the population.

Basu rightly points out in his 2011 book that ‘the economy must be viewed as embedded in society and politics’ (p. xi). No one disputes this fact of reality. A worthwhile digression follows. Classical economists such as William Petty, Adam Smith, David Ricardo and Karl Marx in their contributions to political economy, as it was called then, never said otherwise. They stressed the need for proper social and political institutions. Coming back to Basu, he further writes: ‘Minimally, a proper understanding of economics requires recognizing that our economic relations are a part of a larger sphere of social and cultural interactions and institutions’ (p. 104). Based on this premise, he criticises neoclassical microeconomics for restricting individual choice to their budget sets for, in reality, they make choices outside their budget sets. In other words, there is a wide range of behavioural options which cannot be captured by the budget set and therefore Basu arrives at the conclusion that traditional microeconomic theory is very unqualified to deal with human behaviour. But, isn’t the aim of microeconomics to explain (economic) prices and quantities? Or, should we consider microeconomics as the study of human behaviour? Basu seems to think of the latter when he discusses economics. For him, economics is primarily the study of human behaviour and actions and not primarily a study of incomes and prices (on this, see Economics: The Study of Commodities). It also must be kept in mind that Basu’s scientific strengths lie in game theory, behavioural economics and related fields. In his 2011 book, he himself states that his analysis ‘belongs predominantly to positive social science’ (p. 98).

Since his objective is to study human behaviour, he proposes that we expand the scope of economics. This proposal, as we all know, has important repercussions on economic theory and eventually on economic policy. As Malthus pointed out, to study wealth and its distribution, one needs depth and not breadth; in short, the boundaries or scope of economics must be clearly outlined, however limited they might seem. Introducing several aspects of culture as Basu suggests will only make the explanatory and causal content of economic theory very weak. In fact, it might make economic theory too open that it can be used to explain everything. This must be resisted at all costs for it is knowledge that is at stake here (see also Malthus: The Scope of Political Economy). Basu therefore hopes to expand the scope of economics by altering and widening its foundations in order to usher in the micro-foundations approach in macroeconomic theory as well as in policy making. One glance at the title of Chapter 2 of the previous three Economic Surveys is sufficient for this purpose – 2009-10: Micro-Foundations of Inclusive Growth; 2010-11: Micro-foundations of Macroeconomic Development and 2011-12: Micro-foundations of Macroeconomic Policy. The mark of Kaushik Basu is indelible.

Basu seems to be doing exactly what Gary Becker did when he applied microeconomic tools to a variety of human behaviour around the 1970s. Although, things have improved since then and research in game theory and behavioural economics have been reasonably successful in dispelling the very nice-to-hear qualities of the individual/agent in the economy. Cooperation, reciprocity, trust, etc have once again (Adam Smith talked about a lot of this in his Theory of Moral Sentiments; although he believed that it was necessary to assume certain behavioural propensities when studying the generation and distribution of wealth) begun to play an important role in economics. Basu does provide the reader with many such insights in his 2011 book by drawing upon his earlier research. As a consequence, he criticises the manner in which mainstream neoclassical/marginalist economics employs methodological individualism, especially the textbook version of it. Basu is unhappy because the agent in mainstream economics still does not carry out identity-based behaviour (p. 49). He demands an agent who is more social which does not imply a complete rejection of methodological individualism. Basu is candid about this: ‘It is not within my ability to break away from methodological individualism to the extent that we will eventually need to in order to have a more powerful social science and at the same time retain rigor’ (p. 101). He wants an increased role for identities in economic theory – caste, gender, race, language, etc. As pointed out earlier, bringing too many variables when studying a specific problem often muddies and obfuscates the phenomenon under study. Moreover, the cognizance of such identity-based behaviour can easily be taken into account while formulating policies without having to call for an overhaul of economic theory. Therefore, Basu calls for widening the scope of economics:

‘A fundamental step in broadening the scope of economics is to recognise that the feasible set of actions open to individuals is much larger than our models make it out to be’ (p. 27).

‘Minimally, a proper understanding of economics requires recognizing that our economic relations are a part of a larger sphere of social and cultural interactions and institutions’ (p. 104).

‘How a nation functions at the level of macroeconomic aggregates depends a lot on the nuts and bolts of the economy. In our concern with managing the large and attention-catching variables, it is easy to let attention slip on the small, which may be vital’ (p. 39, Economic Survey 2011-12 ).

Given Basu’s view about the scope of economics, it is easy to understand why he promotes the micro-foundations approach in macroeconomics. This is undertaken in a manner which shows complete disregard for alternative/heterodox macroeconomic schools such as the Post-Keynesians, the Sraffa inspired Classical/Keynesians, the Marxians or the Kaleckians. These schools of thought are built on the belief that the economy is a system which has a logic and working distinct to itself. They criticise the neoclassical/mainstream economists of committing the fallacy of composition when they conceptualise the economy as an aggregation of individuals (see Some Logical Fallacies in Economics). Basu strongly advocates using the micro-foundations approach to macroeconomic issues in the Economic Survey. He writes:

‘The error has usually been in misreading the incentives and behavioural traits of the individuals who are to benefit from the policies and those who are supposed to carry out their day-to-day functioning. Fortunately, this is beginning to change both in the discipline of economics as well as in the design of policies in India. There is increasing recognition that flawed micro-foundations can devastate the best of macro intentions’ (p. 24).

‘Macroeconomic policymaking entails a mix of science and intuition. To ignore either of these would be a mistake. We need to marshal the best scientific knowledge available and study the microeconomic foundations of these macroeconomic concerns and then blend them with intuition and commonsense to craft policy’ (p. 25).

In short, according to Basu, micro-foundations is THE way forward both of economic theory and for policy.

His macroeconomic policy recommendations are problematic because of two reasons. First, his method of doing economics seems to be lack focus on the issues at hand – unemployment, poverty, inflation, agricultural growth and so on; instead, his entire focus is on human behaviour and micro-foundations. Second, he appears to lack a solid understanding of macroeconomics, especially its alternative schools. In any case, let us take a look at two of his major macroeconomic proposals – on fiscal deficit and Government as an enabler.

‘In the interest of medium- to long-term growth, it is important for us to bring the fiscal deficit down. While an expanded deficit can boost consumption and economic growth, this is medicine akin to antibiotics. It is very effective if properly used and in limited doses, but can cause harm if used over a prolonged period. Hence, government’s aim must be to effect rapid fiscal consolidation. A large deficit over a long period tends to squeeze out the private sector from the credit space. This dampens private investment and productivity and, more significantly, worsens the options of the inflation-growth mix available to government’ (p. 27).

‘This is what is meant by the enabling role of government. It should create a setting where it is in the interest of private agents to deliver on what needs to be delivered’ (p. 28).

As long as the economy is not at the full-employment level of output, crowding-out can never happen. Moreover, Basu forgets that the economy is not a stagnant organism; instead it is a growing one. The idea that government investment crowds-out private investment precariously hinges on the notion of scarcity in the economy. In a setting where the Central Bank controls interest rates so as to maintain price stability, it is difficult to see how crowding-out occurs as a result of government expenditure (see Introductory Macroeconomics: On Crowding Out). As for the enabling government, Basu seems to forget that India requires significant government expenditure/intervention in the form of Right to Food, Right to Education, Right to Employment, Right to Information, etc so that a dignified ‘setting’ can be constructed for everyone.

To conclude, it appears that as a game theorist who has important socially relevant insights, Basu is well on the mark. However, his macroeconomics, unfortunately, is grounded on extremely weak foundations and therefore is well off the mark.

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Posted in Book reviews, Classical Economics, Economic Philosophy, Economics, Game Theory, Government, India, Macroeconomics, Neoclassical Economics, Political Economy | 1 Comment »

Is Marx (Ir)relevant?

Posted by Alex M Thomas on 1st February 2012

Karl Marx (1818-1883) is an important figure in most social sciences. His works have been translated into several languages. One might not agree with his views, but he cannot be ignored. Some love him. A lot more hate him. Note that the like and dislike are not targeted at his works, which are seldom read, like most ‘classics’. Having recently read the first part of Theories of Surplus-Value, 3 volumes of Capital and a discussion with a friend who works closely with Indian realities has resulted in the following blog post.

Classical political economy, according to Marx, begins with William Petty in Britain and Boisguilbert in France and ends with Ricardo in Britain and Sismondi in France. In the Theories of Surplus-Value, Marx mainly scrutinises the works of these classical political economists. However, Marx does not provide an overall summary of their entire work but focusses on his central question: how did these authors conceptualise and comprehend value? Particularly, he discusses the why and how of classical political economists theorising of ‘appearances’ while forgetting the ‘essence’. In any case, Marx does not have the last word on the theoretical framework on the classical political economists. Hence, reading Marx motivates one to go forward and read the works of the classical political economists.

But, why read Marx or the classical political economists? They did not write in the 20th century. The world is different today. Facts have changed. Are their works relevant anymore? Firstly, ‘progress’ or growth of scientific theories does not follow a linear path; the path could be non-linear. The implication is that what was considered unscientific in the past can resurface (with adjustments) with a greater explanatory strength and challenge the contemporary ‘scientific’ theories, at least in principle. For institutional reasons, this might never happen; mainstream journals, scientific associations, university teaching and textbooks are, what I label, institutions in this context. Thus, a priori, there exists no scientific basis for not reading the works of classical political economists, Marx and other economists. Secondly, a distinction needs to be made between theory and fact. A theory is not (necessarily) a fact. A fact is never a theory. A theory is general while a fact is specific. Theory tells us a way of thinking about facts – in identifying them, classifying them and ascribing relations to them. The classical political economists as well as Marx theorised a capitalistic economy; in this regard, the rate of profit was taken to be uniform across industries through the process of competition. It is obvious and very clear that in a country like India, which cannot be classified as capitalist or non-capitalist (perhaps, 10% capitalist), using Marx’s theoretical apparatus blindly is going to result in perverse outcomes. The reason for choosing 10% and not 20% is because the share of the organised sector in the GDP is 10%. Maybe, Marx’s theory has certain insights to offer to the 10% of India. The remaining has been visualised as pre-capitalist. (Remember the mode of production debates.) But, one wonders whether this is the desirable (or even scientific) way of characterising the remaining 90%. When reading an author’s work, it is not solely for the theory. Often, it is for the method too. There has been and will be many books and articles on Marx’s method. But, whatever the agreements and disagreements are, there are always fresh possibilities. Given this, not reading Marx seems unscientific!

Often, the works of classical political economists and Marx are confined to the class rooms of history of economic thought (HET). Teaching their works in HET classes is not considered irrelevant. One reason for this thought arises from the linear view of scientific progress. The other, perhaps, has to do with the pride every generation possesses over their ancestors in terms of knowledge. Although, this ‘pride’ is not solely our own creation but it has been passed on to us. It is perhaps our responsibility to check whether we have been taught the ‘correct’ theories and facts about our world. This is all the more reason to assess the foundations of our current beliefs and theories. HET is one way to do this, in economics.

Marx has interesting insights to offer contemporary economics on property rights, labour conditions, economic crises, concentration of markets (inter-linked markets?) and so on. To conclude, reading Marx is important to an economist. Secondly, his observations regarding the ‘evil’ nature of capitalism can be addressed so as to improve the existing laws, institutions, markets, morals and values. After all, the objective and aspirations of scientific knowledge is to better the lives of all.

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Posted in Economic Philosophy, Economics, Economics Education/Teaching, History of Economic Thought, India, Karl Marx, Theory of Surplus Value | 3 Comments »

Alfred Marshall (1842 – 1924)

Posted by Alex M Thomas on 8th January 2012

Alfred Marshall made lasting contributions to economics. No economist will question that. However, his precise contributions to economics are often forgotten. In a way, the microeconomics that we learn and apply today has strong Marshallian foundations. This post draws on Peter Groenewegen’s excellent (concise) biography of Alfred Marshall (2007) which has been published as part of the Great Thinkers in Economics Series published by Palgrave Macmillan.

Marshall is most famous for his Principles of Economics first published in 1890; the definitive eighth edition was published in 1920. In addition, he wrote Industry and Trade (1919), Money, Credit and Commerce (1923) and Economics of Industry (1879) which he wrote along with his wife, Mary Paley Marshall. Besides these, he also printed and privately circulated his work entitled The Pure Theory of Foreign Trade. The Pure Theory of Domestic Values (1879). Overall, he taught for more than forty years in Bristol, Oxford and Cambridge. The most notable among his students are John Maynard Keynes and Arthur Cecil Pigou.

He took German lessons in order to read Kant in the original. Hegel’s Philosophy of History had a strong influence on his thought. Marshall commenced his study about economics with a close reading of John Stuart Mill’s Principles of Political Economy. He also read the methodological works of Mill on logic and particularly criticised Mill’s conception of the individual as a ‘self-seeking, wealth-maximising homo economicus’. His other economics readings included Smith’s Wealth of Nations, Ricardo’s Principles and Marx’s Capital. Other important influences were Cournot’s Mathematical Investigations in the Theory of Wealth and von Thunen’s The Isolated State; they motivated Marshall’s use of diagrams.

For Marshall, ‘the proper work of economic science…was solving economic problems’. ‘The necessity of economic theory, the importance of facts and continual striving to keep economic analysis relevant and practical were all crucial parts of Marshall’s promise to devote his professional life to the improvement of economic science’ (p. 74). It is also quite well known now that, for Marshall, the ‘mecca of the Economist lies in Economic Biology rather than in Economic Dynamics’ (p. 106).

Groenewegen informs us that Marshall had a personal dislike of the use of textbooks in university teaching (p. 77). Not surprisingly, ‘[t]he Principles of Economics remained a leading textbook on the foundations of economics not only during the life of its author, that is, from 1890 to 1924, but for the next quarter century as well, that is, until the early 1950s’ (p. 111).

The use of mathematics in the Principles has garnered lot of attention since he ‘banished’ all equations to the appendix. In any case, Marshall considered economics as ‘form of reasoning’. Perhaps, given the use of mathematics during his time, his relegation of equations to the appendix might have been appropriate. I quote an interesting letter Marshall wrote to his student Bowley: ‘(1) Use mathematics as a shorthand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples which are important in real life. (5) Burn the mathematics. (6) If you can’t succeed in 4, burn 3. This last I did often’ (p. 114).

Marshall identified time to play an important role in the theory of value. He developed the concepts of the short and long period. He paid particular attention to ‘elasticity’. Besides these, he laid the foundations for the theory of the firm, use of offer curves or reciprocal demand curves in international trade and distinguished internal and external economies.

This post has only very briefly touched upon the way Marshall viewed economics, especially his use of mathematics and his evolutionary notion. We have not detailed his precise contributions to economics. This post serves the purpose of being a very short introduction to Marshall. As students of (micro)economics, it will be fascinating to read Marshall’s works, especially his Principles.

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Posted in Alfred Marshall, Consumer Theory, Economic Philosophy, Economic Thought, Economics, Economics Education/Teaching, History of Economic Thought, Neoclassical Economics, Value | No Comments »