March 11, 2017

Where economics went wrong

Comment on Lars Syll on ‘Where modern economics went wrong’

Blog-Reference and Blog-Reference adapted to context and Blog-Reference on Mar 13

Lars Syll identifies the point where he believes economics went off the rails: “The main problem with mainstream economics is its methodology. The fixation on constructing models showing the certainty of logical entailment has been detrimental to the development of a relevant and realist economics. Insisting on formalistic (mathematical) modeling forces the economist to give upon on realism and substitute axiomatics for real world relevance. The price for rigour and precision is far too high for anyone who is ultimately interested in using economics to pose and (hopefully) answer real world questions and problems.”

It is obvious, methodology is a major problem of economics. More precisely, neither orthodox nor heterodox economists apply the scientific method correctly. This started with Adam Smith and has not changed since then.

To recall, the classicals called themselves Political Economists. Therefore, it is of utmost importance to distinguish between political and theoretical economics. The main differences are: (i) The goal of political economics is to successfully push an agenda, the goal of theoretical economics is to successfully explain how the actual economy works. (ii) In political economics anything goes; in theoretical economics the scientific standards of material and formal consistency are observed.

The last thing political economists do is to comply with well-defined and well-known scientific standards: “As some one has said, it would seem that even the theorems of Euclid would be challenged and doubted if they should be appealed to by one political party as against another.” (Fisher)

The quite natural outcome has been that political economics, which had dominated theoretical economics from the very beginning, has produced NOTHING of scientific value in the last 200+ years.

Let us locate exactly the point where economics went scientifically wrong. Smith’s method consisted of common sense and loose verbal reasoning: “Smith … disliked whatever went beyond plain common sense. He never moved above the heads of even the dullest readers. He led them on gently, encouraging them by trivialities and homely observations, making them feel comfortable all along.” (Schumpeter)

Smith defined total income and what we today call GDP as: “Wages, profit, and rent, are the three original sources of all revenue as well as of all exchangeable value.#1

With this seemingly commonsensical definition, Smith got profit, the pivotal magnitude of economics, wrong. Needless to emphasize that neither orthodox nor heterodox economists rectified Smith’s foundational blunder until this day.

Realism, common sense, and loose verbal reasoning are always popular but do not cut much ice. Science goes beyond common sense and requires some abstraction. The functioning of the price and profit mechanism for the economy as a whole cannot be observed with naked eyes but only with the third eye of theory. So let us identify exactly where economics went wrong and fix the profit and price theory.

For the determination of monetary profit of the economy as a whole one has to start with the most elementary case of a pure production-consumption economy without investment, government and foreign trade.#2 In this elementary economy three configurations are logically possible: (i) consumption expenditures are equal to wage income C=Yw, (ii) C is less than Yw, (iii) C is greater than Yw.

In case (i) the monetary saving of the household sector Sm≡Yw-C is zero and the monetary profit of the business sector Qm≡C-Yw, too, is zero.
In case (ii) monetary saving Sm is positive and the business sector makes a loss, i.e. Qm is negative.
In case (iii) monetary saving Sm is negative, i.e. the household sector dissaves, and the business sector makes a profit, i.e. Qm is positive.

It always holds Qm+Sm=0 or Qm=-Sm, in other words, loss is the counterpart of saving and profit is the counterpart of dissaving. This is the most elementary form of the Profit Law.

It is important to note that (1) overall monetary profit is entirely INDEPENDENT of the average productivity of the business sector, and (2), NO share of output corresponds to monetary profit. This tells us that the familiar distribution theories are false.

When distributed profit Yd, investment I, goverment expenditures G and taxes T are added the correct profit equation reads Qm=Yd+I-Sm+G-T.

In other words, deficit spending of the household and government sector and profit distribution of the business sector are the determinants of total monetary profit in the market economy. Total profit has NOTHING to do with marginal costs or productivity or exploitation or monopoly power or the smartness of CEOs. These factors can only influence the DISTRIBUTION of total profit BETWEEN firms.

The lethal blunder of Walrasianism, Keynesianism, Marxianism, Austrianism is that ALL four approaches lack the true profit theory. And this is the ultimate reason why economics is a failed science. The main problem of economics is the scientific incompetence of economists.

Better to get accustomed to the fact that neither orthodox nor heterodox economists can be taken seriously. NOT ONE of their economic policy proposals ever had a sound scientific foundation. It is brain-dead political blather since 1790, when Adam Smith completed the last revision of The Wealth of Nations. Economics is a fake science since then.

Egmont Kakarot-Handtke

#1 See ‘Wealth of Nations
#2 The macrofoundations approach starts with three systemic (= behavior-free) axioms: (A0) The objectively given and most elementary configuration of the economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm. (A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L, (A2) O=RL output O is equal to productivity R times working hours L, (A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.