An Economic Fool’s Paradise

In a handful of controversial books and essays published in the mid-1990s, US economist Paul Krugman shed doubt on the sources of free-market economic prosperity. Fads and fashions, he argued, underwrote a global free-market orthodoxy that offered few real explanations of why some economies prosper and why some don’t. The great advances resulting from free trade that were often attributed to the Asian ‘tigers’ in the early 1990s offered a lesser understanding of the boom than the money that had been spent on education and infrastructure over decades, in what in some cases remained highly regulated economies. Yet, as he also pointed out, sweeping generalisations about the sources of growth had provided a doctrinal basis for economic policy around the globe. And despite the hundreds of books that had been written on the subject, economists didn’t know with any certainty why the 30-year period of postwar prosperity came to an end. That knowledge vacuum, he argued, had been filled by an unholy alliance between politicians trying to ‘find economists with ideas that they can package’, and economists wanting to translate their ideas into political influence. Few such ideas had any real rigour.

Economics, as even economists are beginning to agree, is a discipline that has lost its way. Krugman is among a growing retinue who since the 1980s have come forward to chastise orthodox free-market economics for having become an increasingly narrow, technocratic discipline, bound up in its own internal cultures, unable to satisfactorily explain how economies really work, and divorced from the needs of those it claims to serve.

Recently, things have moved on somewhat as orthodox economists, stung by criticism, have attempted to theorise their way out of trouble. Mainstream economists now talk of ‘bounded rationality’, which is the idea that people have multiple motives for their actions, not all of which are perfectly rational. The idea of ‘perfect information’, too, has been deeply problematised, not least by Joseph Stiglitz’s Nobel Prize-winning critique. The instrumentalist idea that people’s choices are fixed and unvarying has given way to more sophisticated models that allow for the possibility that people learn from the outcomes of previous choices, while ‘game theory’ recognizes that people make choices based on social pressures, and on imperfect information. And orthodox economists cite factors like ‘wage stickiness’ and ‘liquidity traps’ as reasons for markets failing to reach equilibrium. But despite a few spot renovations, orthodox free-market economics is still the same basic structure, sitting onthe same eighteenth- and nineteenth-century foundations. For all the talk of ‘bounded rationality’, at a fundamental level everything remains theorised at the level of the rational individual. And while recent developments in neoclassical theory acknowledge that there are complex reasons why people exercise the preferences that they do, the underlying theoretical framework remains resolutely instrumentalist: choices are still understood as little more than a means to an end. The idea of equilibrium, too, remains axiomatic. Put bluntly, neoclassical economic models describe a world no-one lives in, and in practice result in a world no-one wants to live in.

Ultimately, the problem is that markets can’t plan ahead. Only people can. Markets are mindless: they don’t know where they’re going or why, only where they’ve been.

While the economic reform agenda has slipped from political discourse and is unpopular with the public, the market consensus maintains its hold in powerful bastions of the bureaucracy, economic consultancies, academia, conservative think tanks and the media. It is held in place, in the first instance, by the elegance of the theory. As the academic Christopher Shiel has said: ‘The timeless, spaceless, elegant simplicity of neoclassical theory accounts for both its wide appeal and the fact that it has been criticised for over a hundred years for its lack of realism’.

The free-market agenda is held in place, too, by the force of its own mythologies. Too often commentators imagine post-reform economic history as a heroic triumph of sound reason over a benighted past. For instance, in his book The End of Certainty, Paul Kelly describes Australian economic history in more or less straightforward terms as the difference between a pre-reform ‘then’ and a post-reform ‘now’, a view that reflects a generic understanding held among many politicians and journalists.

Most of all, the orthodoxy is held in place by politics. Free markets and the consensus that surrounds them suit the short-term interests of speculative capital, and help to create a low-risk, high flexibility environment for business. Governments ignore such interests at their peril. And in so far as they pretend that theirs is a value-free, neoclassical science, free market economists are in denial about the degree to which their disciplinary practices are enmeshed in the neoliberal political project. Neoclassicism owes its institutional tenure to the work of neoliberal activists such as Milton Friedman and Friedrich Hayek and the local New Right ‘warriors’ of the 1970s, 1980s and 1990s, who were determined to put economic heresies from the nineteenth century back on the political map. As Shiel has said: ‘When "old-fashioned" neo classical economics was revived in the 1970s, the "new" liberalism gave it a cutting edge’. Neoliberals have provided the populist front end for attacks on the welfare system and the privatisation-by-stealth of unemployment services, child care, education and health care, while neoclassicals have provided the back-office grunt.

Lost in the revisionism and myth-making that surround recent economic history is the possibility of thinking through alternatives. Yet ours is a historic moment at the end of two periods of economic consensus, both of which have been found wanting, that offers the opportunity to build a humane market economy. Having spent decades labouring under the pernicious idea that ‘government isn’t the solution to the problem, government is the problem’, as Ronald Reagan once put it, the key question now is how to establish a better mix of government and markets. Government needs to be brought back into the economic picture. But this isn’t to suggest a UK-style, Blairite Third Way. The problem with the Third Way was that it was structured around a market economy in which private enterprise was expected to underwrite production with a minimum of regulation or public assistance. The role of government was to pick up the pieces: to rescue losers with a minimal welfare system and to use the tax system and education system to balance out inequalities in the longer term. The government, in other words, was meant to operate at arm’s length from the market, which was understood in neoliberal terms as potentially all-providing, and was merely to correct and to ameliorate its failures.

Government, instead, needs to have a central role.

This is because, as is becoming increasingly clear, there are certain things that only government can do. But this isn’t an argument against markets or for a return to the past. Whereas the myths that surround free-market orthodoxy offer a stark, doctrinaire
choice between ‘big government’ or ‘small government’, there are other possible ways of understanding the role of government. One is as the sophisticated manager of a mixed economy that prioritises both redistribution and sustainable prosperity.

It seems clear that open markets are a source of prosperity, but if it is equally clear that markets aren’t natural but are man-made (there is, after all, no such thing as a free market: all are regulated in so far as they require the rule of law to operate), then one role that would seem to be available for government is as a designer and orchestrator of markets. Environmental problems such as water management and global warming prompt a reconsideration of the key ideas of free-market orthodoxy, yet suggest hybrid strategies in which properly designed and constrained markets might be useful tools for progress. Technology is increasingly on the side of this sort of planning. After a period during which the idea of government intervention in markets has been distinctly unfashionable, in an information-based society the means now exist to manage markets, and to allocate resources with an efficiency that rivals the price mechanism, and to design, target and test policy accordingly. Moreover, in the wake of market failure in areas traditionally presided over by government such as health, education and infrastructure provision, it’s imperative that this happen.

Government also needs to take up a greater role because there are ends that only government can identify. Whereas economics traditionally places its emphasis on solving problems of scarcity, scarcity of wealth is no longer a serious problem in a Western nation such as Australia. There is enough overall wealth to go around and for everyone to live well. The problem is equity and distribution. Social priorities such as seeking equality are something that only government can define and address effectively. Markets, otherwise, tend to send wealth and resources to where they already are. The ‘spontaneous order’ that free-marketeers claim markets represent can doubtless achieve many things, but social justice isn’t often one of them.

Central to building a humane market economy is the question of risk management. Postwar consensus welfare-state politics was in part a response to the problem of risk, which government sought to take on its shoulders so as to protect and enhance the prospects of both business and workers. Tariff protections and the like shifted risk away from business and onto government. The commitment to maintain full employment and a minimum wage, and later, wage arbitration, and all the rest of the apparatus of the postwar system, moved risk away from workers towards government and business. The assumption was that, protected from risk, business and workers would do the right thing: they would continue to work hard and to innovate. It was a utopic assumption based on an overly optimistic view of human nature. Instead, business failed to innovate and preferred to rest on its laurels. And during the late 1960s and early 1970s, wage claims spiralled out of control as if employees wanted to be protected from risk altogether. Since then, neoliberals, professing the very opposite understanding of human nature, have worked hard to shift risk from government and business onto the shoulders of ordinary people. This harshly politicised approach to economics
(the rich are the main beneficiaries) is as unsustainable as it is inequitable. Instead, risk needs to be managed in partnership, and even used as a tool. In this, governments have a special role to play because they are ultimately the architects of economies, and because in the global economy only government can manage risk in such a way as to protect workers (and sometimes business) from the effects of inbuilt instability.

But nor should risk be completely shied away from. It also makes a useful tool, especially in the relationship between government and business. One of the problems of traditional protectionism is that it operates in the negative and rewards stasis. The emphasis should instead be placed on support systems that reward action, risk-taking and innovation by, for example, creating tax concessions for early movers, or granting research grants for those prepared to enter new areas, or offering start-up resources for small business. Exposure to risk is what makes business – and individuals – tick. The point is that risk needs to be strategically managed to make sure it falls where it’s useful, and to minimize the possibility that it will be carried too heavily by individuals and communities without the resources to do so.

None of these ideas is especially new. They draw on fundamental Keynesian insights: that there can be no such thing as ‘competitive equilibrium’; that without intervention, markets are inherently unstable; that people don’t necessarily act rationally or predictably; that no amount of theorising can anticipate the ways in which markets work in the real world; and that government is the only agency that can moderate these theoretical failings of neoclassical economics-even if the modes in which we understand government, and the relationship between people, business and government, are beginning to change in ways that render the ‘big government’ versus ‘small government’ opposition something of an irrelevance.

Bringing government back in not only makes economic sense, it makes political and cultural sense. As Andrew Charlton has said: ‘[I]n the new millennium individualism is less appealing than collectivism. Whereas in the past individualism was a liberating force that provided freedom from restrictive social and governmental systems, now the public has come to realise that modern challenges require collective action. Now effective government contributes to freedom: good public education increases choices; quality infrastructure increases productivity; labour market institutions increase the bargaining power of workers; product market regulation fosters competition and opportunity.’

The priorities of such an economy, too, need to be global. Beggar-thy-neighbour economic policy approaches such as protectionism are no longer viable in a world where global justice issues are increasingly obvious in their claims; nor are free-market policies that involve the expropriation of resources, a reliance on exploited labour, or the externalisation of environmental costs offshore. Global warming, again, is the signal event that brings home how globally interconnected the decisions and priorities of peoples and nations are.

Ultimately, what will define new ways of thinking about economics is that the idea of the market will no longer be at their centres. A new approach to economics would necessarily bring the requirements of citizens back into the picture on the understanding that people have needs, ambitions and ideals-cultural, traditional, filial, altruistic-that range far beyond anything conceived of in free-market orthodoxy. Rather than mistake the market itself for democracy, this will be a democratic economics that understands people, government and markets in the service of each other; that will embrace neither business nor government as its one true saviour but map out a strategic role for both; that will measure its progress by what happens at the bottom of society, not by what happens at the top; and above all, that will not be doctrinaire in the pursuit of some imagined ideological utopia, or founded in the illusions of its own mythology.

Less fundamentalism, more democracy: it sounds like a creed for the times.

This is an edited extract from The Land of Plenty: Australia in the 2000s by Mark Davis (MUP, 2008).


Leave a Comment