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The Reformation in Economics: Back to the Future

REVIEW ESSAY
The Reformation in Economics:
A Deconstruction and Reconstruction of Economic Theory
by Philip Pilkington
Palgrave Macmillan, 2016

The plurality of thought that existed in economics from roughly the turn of the twentieth century to the 1960s was impressive and rather beautiful to behold. Reading books from that era not only gives the reader a vision of what economics had been and what it could potentially be again but also opens doors to so many novel ways of thinking about things.
                     —Philip Pilkington, The Reformation in Economics

It is almost four years since Philip Pilkington—an academically trained professional economist—addressed his book to economics students. The Reformation in Economics: A Deconstruction and Reconstruction of Economic Theory could appear to be just another treatise on the ills of economics education released since the global financial crisis. Yet what one encounters is a deeply informed, lucid, and concise critique of the edifice and history of the current dominant economics paradigm—what the author refers to as “marginalist economics”—coupled with a foundational reconstruction from first principles, “a firm grounding, a shrub that can, given time, grow into something far more robust.” It is a bold task, but one the author largely accomplishes with great precision, and more importantly, pedagogy. Its depth comes from its excursions into other fields of epistemological inquiry. The book is as much about economics as it is about the limitations of human knowledge and how we can hedge ourselves against these natural limits to make sense of the world. It is hard to think of another book of the same genre, less still one recently published, that provides such a clear and accurate guide to what economics should be about and how it should be employed to analyze actual economies.

The book is divided into three parts: “Part I: Ideology and Methodology,” “Part II: Stripped-Down Macroeconomics,” and “Part III: Approaching the Real World.” While there is a degree of overlap between the parts, they naturally interact through a common thread, from a positive account of the discipline, to a normative account for understanding the real world, to a realistic account for confronting it. The chapters within each part are not meant to be an exhaustive list or critique of every single area and subfield in economics, but they provide the reader with a self-contained guide to the nature, pitfalls, and potential of this social science.  This review is written in the same spirit.

Marginalist Economics: From Optimal Planning to Optimal Distraction

The dominant paradigm in economics for the last fifty years or so is a brand the author calls “marginalist” economics, which he deems more accurate than the more popularized, yet related, school of thought known as “neoclassical” economics. This is because the mainstream theories in economics (whether termed “Neoclassical,” “New Classical,” “New Keynesian,” “Chicago School,” vel sim.) all derive their form from the marginalist conception of the economy “as a means of allocating scarce resources in such a manner that the ‘marginal’ use of a given resource—that is, that last unit of this resource ‘at the margin’—is used in the most effective manner deemed socially desirable. Marginalism might thus be defined as being the idea of how a society, given a number of scarce resources, might allocate these resources in line with a sort of perfect ideal of efficiency.”

In this framework, the efficient optimal benchmark is defined by a single representative consumer maximizing marginal utility, given a budget constraint, and a single representative producer (firm) maximizing profits at the point where the marginal cost of production is equal to the marginal revenue. Factors of production are paid according to their marginal productivity. The government, if it is modeled, also seeks to maximize some welfare function subject to a budget constraint. The key feature is what happens at the margin: maximizing things the researcher implicitly assumes should be maximized (utility, profit). This is a benchmark against which all measurable policy outcomes should be measured. But the lure of efficiency confuses positive theories of human behavior with normative ones—early-day students and latter-day academic economists never really know which one they are proposing. The lone exception, perhaps, was Paul Samuelson, who saw the benefits of the normative route—we should behave in the way prescribed by the axioms because otherwise we wouldn’t be able to build them so neatly, and this is what gives economist their prestige.

The marginalist paradigm, as the author reminds us, is thus essentially about methodology—a set of axioms that are chosen for their mathematical properties of model closure, of tractability. It idealizes precision and detests arbitrariness in economic matters, as uncertain behavior cannot be modeled, and economics therefore cannot reign supreme as a social physics with greater academic authority than any of the other social sciences.

One of the book’s most insightful forays is the discussion of the instrumental link between ideology and methodology within the marginalist paradigm. Pilkington demonstrates how this method has served two different ideologies: centrally planned communism on the one hand (through the works of Léon Walras and Carl Menger) and free-market capitalism on the other (Cold War economics after Samuelson). The author cleverly unveils the irony in the development of marginalist economics, from its socialist origins in Walras—without a “benevolent planner” the system of equations could not get off the ground—to its free-market legacy—individuals optimizing their behavior to maximize their utility or profit through market exchange, unfettered by outside interference. The irony is that such a deterministic theory ends up branding itself as promoting freedom. But as the author continually reminds us, it is anything but. If you do not act according to the normative utilitarian axioms of marginalist economics, you are not rational, and if you are not rational you are not free. Ethics and morality play a large part in the book, as do questions of free will and determinism (which merit a whole section in the appendices)—issues to which most economists give not even a moment’s thought when setting up their models.

Economics Is Macroeconomics

What is the distinguishing facet of economics? This is probably the central question around which the book is structured. And it is very clear on the issue: proper economics equates, pure and simple, to macroeconomics. Full stop. This is controversial since the entire discipline today is heavily grounded in microeconomics through the fad of micro-foundations. The author instead views microeconomics to be a pale shade of psychology. In his view, there is little need to underpin economic theory with haphazard visions of how humans behave. In fact, we need not think much about individuals’ motivations at all. The reason for this, Pilkington tells us, is that interacting systems of individuals, no matter how they behave or why they behave the way that they do, generate what are called “emergent properties.” That is, these systems generate higher-order behavior that goes above and beyond individual actors but at the same time constrains them.

The “power of aggregation” in the macroeconomy is nicely illustrated in the book with the analogy of a football crowd . What’s good for the individual may not be good for society as a whole. Or, as the author puts it, one person standing up to get a better view at a football game induces those behind him to stand up, thus making everybody worse off as a result of having to stand to get a better view. And, importantly, different individuals in society have different social positions and different levels of access to power: those in the front row of the stadium have more power because of the number of people they can make stand than those in the back row. The famous paradox of thrift reveals how macroeconomic accounts for certain constraints on individual behavior. These relations shed light on the functioning of the economic system as a whole, as opposed to the speculations furnished by assuming “laws” of universal human behavior. This approach makes economics more humble, less imperialist, and better able to interact with other disciplines.

Macroeconomics, Pilkington tells us, studies “the inherent stability of the system and how it can produce and reproduce itself. . . . Thus [it] leaves effectively moral problems about how people behave and how resources are best distributed to the judgement of the macroeconomist.” The latter part of the statement is revealing, as it defines the social role of the macroeconomist. Individuals have a variety of moral values and aspirations, but the role of the macroeconomist is to make sure that the plans of those seeking different social objectives are consistent. The takeaway message of the book is highly empowering even for non-economists. By grasping some proper macroeconomics and replacing absurd axioms about human behavior with one’s own moral views, one can gain insights that will be able to reveal whether the plans for realizing one’s social preferences (regarding unemployment, environmental policy, fiscal policy, inflation, and so on) add up.

According to Pilkington, there are two core components of modern macroeconomics: “(1) the aggregation of various individuals into larger wholes that are then studied in an abstract manner and (2) the attempt to come up with a framework that is largely neutral in respect to the type of social organisation that is being studied.” Thus, a “proper macroeconomist” uses tools of accounting, algebra, basic statistics, and history to “track the cause and effect” between economic aggregates. Equilibrium—the point in time at which there is no change—only appears logical in a stock-flow sense (“generated by the level of stocks [capital] and flows [income] at any given moment in time”) and historically as an “expectations equilibrium.” The approach of closed-system modeling should be replaced by what Pilkington refers to as a “schema,” drawing from philosopher Immanuel Kant, which “is an organised pattern of ideas that help us to organise and interpret real world data.” This way of thinking is very much how Keynes approached economic inquiry in The General Theory of Employment, Interest, and Money.

The role of economic accounting in Pilkington’s schema is paramount. Rather than categorizing individuals in terms of preferences and behaviors, we should seek to break down income flows and form abstractions about these aggregates in terms of sectors or classes. The good news is that this is reflected in various quantitative approaches already out there from “input-output models,” to “social accounting matrices” or “distributional national accounts.” This is not to say that the micro sphere is unimportant. Indeed what the author deems a useful “micro” area is the firm, a smaller aggregated group of individuals. Analyses of firm operations regarding their pricing, determination of mark-ups, investment, etc., give powerful insights into demand dynamics and distributional aspects of the economy, as chapter eight of the book on “Profits, Prices, Distribution, and Demand” reveals.

Can Economics Be Non-Ideological?

“Whether economics can ever exist as a non-ideology is an open question. Personally, I believe that it can,” Pilkington states. To be more precise, the question should really ask whether economics as practiced by economists can exist as a non-ideology. This is because economics as interpreted by society at large will always be filtered through specific ideologies. Economics provides a lens with which to look at the world, but for it to be operational it must always be embedded in a context of values. This is the starting point—what does a particular society want? Examples may include a comfortable standard of living for all, full employment at living wages, social equity, high quality public services (including free education and healthcare), security in retirement, or stable prices. What the book effectively says is that the job of the economist is to see whether given societal plans add up, independently of economists’ own personal values.

In this power struggle over values and ideas, can we expect economists to act like Pilkington’s subservient technicians? One limitation is that even the choice of what to measure and how to measure it, a central part of an economist’s job, is inherently ideological. This is true with respect to even the most standard economic aggregates, such as GDP.1 Thus it may seem too much of a stretch to think that economics can be fully detached from ideology in this way. Choices of metrics always reflect objectives on the part of their producers (e.g., revisions to the System of National Accounts, inequality indicators, etc.). What the author is effectively saying is that, normatively speaking, macroeconomists should detach their personal ideology from their economic inquiry. Their job as macroeconomists is to precisely judge whether certain economic plans “add up,” or rather how to get from A to B. Paraphrasing Milton Friedman, it is not the economist’s role to decide what A and B ought to be—this should be left to philosophers, social planners, and politicians, in accordance with the wishes of society as a whole (which, of course, includes our macroeconomist, not in his or her capacity as a macroeconomist but as a citizen of a given polity).

The macroeconomist’s job, according to Pilkington, is to illuminate economic trade-offs. For example if the societal goal is to increase purchasing power, there will be a trade-off between this and inflation, given the productive capacity and real resources of the economy to absorb the additional spending. If there is one thing that Pilkington may underestimate, however, it is the inherent difficulty that economists—much more than biologists or physicists—have in detaching themselves from their role as citizens.

What about Distribution?

Pilkington holds the view that distributional questions (e.g., “how firms determine their profit margins”) are uninteresting from a “purely economic point of view.” Rather, the question of where aggregate profits come from is more interesting than how they are distributed; the latter being “largely a political, cultural or social question,” one regulated by “convention.” Given the sources of growth and profits (aggregate demand given real resource constraints), however, one can argue that the distribution of profits is indeed of first-order importance from a purely economic perspective. This relates to the Cambridge critique in the Cambridge capital controversies: aggregate capital cannot be determined independently of distribution, since it depends on real wages and profit margins. In the same way, therefore, the quantity of profit cannot be separated from the distribution of income.

Even from a pure accounting perspective, historical estimates of the amount of profits in an economy will always reflect the distributional conditions of the time—the determination of real wages and profit margins in firms, the role of finance, etc. It is possible to neutralize the distributional elements and take an accounting snapshot of profit determination at any moment in time. Yet one must realize that embedded in this snapshot will be certain distributional conditions that have been produced institutionally and historically. Thus, different distributions of income may end up producing different rates of growth and profits over the long run. For example, directing resources to where marginal tendencies to consume are highest and changing incentives to maximize business investment in productive capacity can spur investment and growth, while at the same time altering distributional outcomes through the very policies that lead to these outcomes (e.g., changes to the minimum wage, codetermination laws, or structure of taxation).

The author’s own insightful “parable” on the source of capitalist profits already embeds two distributional norms in the eventual determination of profits: the mandated $1 a week nominal minimum wage law and an effective “job guarantee.” These laws clearly matter for the outcome the author wishes to measure. However—and this is the authors’ intention by the end of the chapter—what determines these laws is a moral and political question. The point I make here is that, while true, this view should not be wholly separate from an economic point of view either. In the author’s parable, the capitalist’s profit is maintained thanks to the income from employment that results from the new president’s job guarantee program. This is a distributional outcome (being employed versus being unemployed), as is the decision to set a price floor for wages at a certain minimum level, which can affect profits directly via individual firms’ markups and private investment or via the consumption of workers.2

As the author states, even assuming wage and price flexibility, a fall in wages and prices is not desirable for the capitalist class, since “wages are the capitalist’s key source of demand.” If wages fall, it is not clear even in theory that the capitalist would hire more workers, since capitalists would have lower nominal profits, nor is it clear how cheaper labor would affect their capital investment decisions. This is the type of reasoning that partly led Henry Ford in 1914 to double the wages of his plant workers (the “five-dollar day”), knowing that his plant’s productive capacity needed a larger market and thus required his workers to be effective consumers of cars.

The economic implications of distributional choices would be more straightforward if all economic agents were of the same opinion and would always respond in the same manner. In reality, politically motivated reactions may alter the hypothesized dynamics to such an extent that action-reinforcing beliefs create a new reality. But this is all part of the economist’s realm of analysis. As the book highlights, in macro accounting, dividing up income between individual recipients is no different from dividing up income between personal consumption, between taxes and saving, or between aggregate expenditures (i.e., C + I + G + XM).

Why Does Irrelevant Economics Persist?

Believe me, do not fear crooks or evil people, fear the honest person who is wrong. That person is in good faith, he wishes everyone well, and everyone has his confidence: but unfortunately his methods fail to get the good out of humans.
                —Ferdinando Galiani, Dialogues sur le Commerce des Bleds

According to Pilkington, the reason why “irrelevant” economics persists as it does is that it is a wonderful distraction from the real issues. This is exactly why elites don’t put up any opposition to this brand of economics, even if they themselves don’t fully practice it in their working lives. This only widens the discrepancy between theory (academia) and practice (business, government, and society), and explains why the former is always playing catch-up to the latter. Mainstream economists are thus out of touch with reality while being under the illusion that they are in touch with it, through “being invited to all the right parties,” lecture invitations, journal publications, awards, etc. This gives rise to the belief that “the problem with economics is not economics, but rather individual economists.” It is the responsibility of the economist, the argument goes, to choose the right model for each specific setting. Pilkington, I think, rightly notes that “it is not the models that economists use that dictate how they think; rather, it is the paradigm that they are part of.” This does not mean that there is no  disagreement among economists; there is plenty. But the disagreements are mostly politically driven, hence the mainstream’s focus on the personal qualities of the individual economist.

The issue is that most economists think within the same framework, the same “a priori conceptions” of the capitalist economy that get embedded in their marginalist equilibrating models. Thus, quite a lot of consensus, contrary to what one may expect, is reached in policy terms. The book highlights the important phenomenon of “compartmentalization” as a defense strategy of mainstream economists to ignore criticisms about theoretical flaws: “prestige is no longer won by having a coherent, overarching view of how the economy functions but is rather won by specialising in a niche area closed off from the rest of the discipline.” Compartmentalization allows economists to avoid cognitive dissonance. Academic incentives currently in place make this research paradigm self-fulfilling. Extreme focus on one issue at a time, following the “flavor of the month,” is what makes it possible to survive as an academic and what largely directs the international funding of academic research.

Thus, rather than being consciously subject to vested interests of certain powerful groups in society, economists are subject to the apparent prestige of their ideas. This echoes Paul Samuelson’s admittance that “economists work for the only coin worth having—the applause of their peers.”3 And this is what makes economists “useful” but also dangerous in their delusion. Pilkington most surely had Keynes’s last words of The General Theory in mind: “I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas . . . But soon or late, it is ideas, not vested interests, which are dangerous for good or evil.”

Errors and Omissions

The Reformation in Economics can be criticized mainly for what the book omits rather than the faults it directly commits. Here I point to a few. First, although the book recognizes the role of economists’ ideas as weapons of distraction, there is little discussion of the power of economic ideas held by ordinary individuals, which can become self-fulfilling prophecies.4 Of course, individuals’ beliefs may depend on the ideas they are “sold.” But how people filter and employ these beliefs (in public opinion, voting, etc.) is crucial. Pilkington leaves this channel of investigation open when he cites how the Samuelsonian paradigm, which initially only took off in the United States, spread throughout most of the world by the late 1970s. “Why this occurred, as stated, has not yet been explored, but the primary motivation seems to have been to give the discipline a sheen of scientificness that the other social sciences lacked.” Pilkington focuses on the source of the changes—political considerations, which saw change instituted from above, and which were manifest in developments ranging from the creation of the Nobel Memorial Prize in Economics in 1969 to the campaign for central bank independence. But this ignores the intellectual reasons that populations at large had to believe in certain ideas in certain contexts.

Second, little space is dedicated to the macroeconomics of development. Some sections of the book are exceptions here: the chapter on trade theory and policy and part of the chapter on theories of money and prices contain snippets of a development perspective. But, on the whole, the book is written from the perspective of an advanced “Western” country.  In the book’s defence, the same remark can be made of Keynes’s General Theory. Nevertheless, some additional perspectives would have been welcome, especially in a world of compartmentalized economists.

Likewise, there is little discussion of the implications for public economics, especially tax policy. The reader is left pondering whether the author deems taxation to be a moral question, similar to how the he treats the distribution of profits in chapter 5. Interestingly Modern Monetary Theory (MMT) is mentioned on two pages, which holds that the function of taxation is to stabilize prices and to incentivize or disincentivize certain economic behaviors. In chapter 7, Pilkington briefly states how taxation is an example of a “conservative taboo” in the collective mindset of the left—the view that “taxation is an end in itself and should be required for any government expenditure,” which the author refers to as “balanced-budget socialism.” This issue is at the center of debates today, particularly among progressives in the United States and Europe.5 In the European case, its expression can be clearly seen in the debate surrounding proposals to reform the EU.6 Even acknowledging that these debates have peaked since the book’s publication, the author could have given more space to this important issue, especially since Pilkington has written about MMT in his popular blog Fixing the Economists.7 Although the book is more about economic theory, his chapter on trade raises the question of whether a similar nondogmatic analysis could have been made for the economics of taxation.

A similar point can be made about government fiscal policy more generally. In his examples of monetary circuits with a central bank (chapter 7), Pilkington assumes away a government sector (and thus fiscal policy) “[t]o make the example simpler.” His objective is to show the operation of a modern monetary system between the central bank and commercial banks, through the demands of firms and households. His working example of “loans creating deposits” is underpinned by the cash reserves over whose creation the central bank has a monopoly. One is led to believe that these reserves thus constrain the amount of money in the system, which is partly true. But the channel through which the government spends money into operation is left unexplored. This is a shame, given that it is a central aspect of MMT, whose theorists are credited by the author as having “done perhaps the best work in answering [the] question [of] what creates the acceptability of state-sanctioned money.”

Moreover, when debunking the “crowding out” theory of investment, Pilkington correctly notes that “there is no fixed supply of money, because loans create deposits,” and that the central bank controls the interest rate by creating new reserves. However, he makes the concession that, if the government borrows to fund deficit spending, it “leads the interest rate to begin to creep up.” The question one is left pondering is why he thinks so. Is it the same reasoning that applies to private spending (firms borrowing from commercial banks) in a context of reserve requirements and no central bank intervention? In this case, with high economic activity and reserve requirements in place, demand for reserves would eventually outstrip the supply of reserves, and the interest rate (i.e. the price of money) would be bid upwards “naturally.” Does this natural tendency exist in the same direction for government borrowing, according to the author?  We are left with some confusion, especially given his support for the “endogenous money” theory, which states that the quantity of reserves in the system, hence money, is determined by demand for funds, i.e. by “the state of expectations” in an economy. But by the same logic, expansionary fiscal policy would increase banks’ reserves and reduce demands for federal funds from the central bank, which would lower interest rates (as supply outstrips demand). Thus, the direction in which interest rates move seem to depend on the origin of the spending (government deficits as opposed to private sector borrowing). This reveals the distinguishing role of fiscal policy in the economy, due mainly to the state’s monopoly over money and the degree of the central bank’s de facto independence.

The function of government debt as a funding necessity, as opposed to its role as a monetary instrument, is also neglected. The monetary instrument interpretation argues that government borrowing can manipulate the amount of reserves in the system through bond transactions, thus changing the interest rate, the price of borrowing, and firms’ incentives for investment.8 Debt is thus issued by the government in the form of securities to manipulate the rate of interest. Why would the government want to raise or lower the interest rate? So that the government or central bank can maintain the interest rate target it deems appropriate for the prevailing circumstances.9 It does so either by “borrowing back” (bond sales by the central bank) to reduce reserves and increase interest rates or by lending (bond purchases by central bank) to expand reserves and lower rates. Conversely, the central bank can be instructed to increase or decrease the rate of return on overnight reserves (i.e., the federal funds rate or interbank lending rate). Thus, the government-central bank axis can arrive at its objective target rate with or without public debt. This implies that the decision to issue public debt is dependent on the desired proportions of securities and of money which the government wants the private sector to hold or, put differently, on the private sector’s wish for the government to issue it a risk-free asset that generates plenty of business opportunities.10 The political economy implications of the latter are notable—public debt can be interpreted, in essence, as arising out of a lobby for “corporate welfare.”11 A new version of the book may want to tackle the issues of public debt and central bank independence more directly, given their growing theoretical and practical relevance in an era of fiat money and “secular stagnation.”

The Reformation in Economics is not the first book to attempt a reconstruction of economics in such a way (think of the author’s key reference, Lord Keynes), and probably won’t be the last of its kind to meet with either plain neglect or fierce opposition. Only time will tell whether a reformation will come to pass. We are certainly not short of material on which to firmly ground the process this time around. Pilkington’s treatise is one of the best places to start.

This article is an American Affairs online exclusive, published February 18, 2020.

Notes
1 See Jacob Assa, The Financialization of GDP: Implications for Economic Theory and Policy (Abingdon: Routledge, 2016).

2 Notice the dynamics in the parable when a new president comes in and mandates a higher minimum wage. This leads to higher capitalist nominal profit, even in real terms over the long term.

3 Soma Golden, “Peers Applaud an Econometricist,” New York Times, January 7, 1974.

4 An interesting reference in this area is Mark Blyth, Great Transformations: Economic Ideas and Institutional Change in the Twentieth Century (Cambridge: Cambridge University Press, 2002).

5 For the United States, see Stephanie Kelton, “Paul Krugman Asked Me about Modern Monetary Theory. Here Are 4 Answers,” Bloomberg Opinion, March 1, 2019.

6 See Manon Boujou et al., “Democratizing Europe: By Taxation or by Debt?,” Social Europe, February 11, 2019, and Stuart Holland, “Where the ‘Piketty Plan’ Is Mistaken,” Social Europe, February 28, 2019.

7 Philip Pilkington, “Taxation, Government Spending, the National Debt and MMT,” Fixing the Economists (blog), August 18, 2014.

8 David S. Landes, “Abba Ptachya Lerner,” in Biographical Memoirs, The National Academy of Sciences, vol. 64 (Washington, DC: National Academies Press, 1994), 219.

9 Abba P. Lerner, “Functional Finance and the Federal Debt,” in Selected Economic Writings of Abba P. Lerner, ed. David C. Colander (New York: New York University Press, 1983), 297–310.

10 Lerner, “Functional Finance.”

11 Bill Mitchell, “There Is No Need to Issue Public Debt,” Modern Monetary Theory (blog), September 3, 2015.


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