Posted by: Dirk | November 5, 2012

The State of Economics during the Crisis

Following a lunch discussion with two colleagues I try to summarize some thoughts on the discipline of economics. The big question is what models can do and what they should do. Is a model based on wildly unrealistic assumptions useful? Alan Kirman has recently published a piece at VoxEU asking ‘What’s the use of economics?’ and specifically attacking the idea of equilibrium:

However, other economists such as myself feel that we have finally reached the turning point in economics where we have to radically change the way we conceive of and model the economy. The crisis is an opportune occasion to carefully investigate new approaches. Paul Seabright hit the nail on the head; economists tend to inaccurately portray their work as a steady and relentless improvement of their models whereas, actually, economists tend to chase an empirical reality that is changing just as fast as their modelling. I would go further; rather than making steady progress towards explaining economic phenomena professional economists have been locked into a narrow vision of the economy. We constantly make more and more sophisticated models within that vision until, as Bob Solow put it, “the uninitiated peasant is left wondering what planet he or she is on” (Solow 2006).

The article continues to attack more established ideas of mainstream economics, for all the right reasons. Nevertheless, I think it is useful to look back in time to one of the greatest economists of the late 19th and early 20th century: Thorstein Veblen. In his classic “The Theory of the Leisure Class” from 1899 he tries to understand why people – aggregated to classes – consume what and why. The resulting mixture of sociology and economics is highly interesting when it comes to explain the way people act. While some economists claim (tongue in cheek) that people are motivated by motivations or incentivized by incentives Veblen describes how people are influenced by institutions and then as things change people change these institutions. Here is a longer quote from his book that describes an alternative way of thinking focusing on a dynamic self-organizing system along the lines of Alan Kirman that would surely lead to a different type of economics, based on biology rather than physics (ch. 8, paragraph 2 and following):

The forces which have shaped the development of human life and of social structure are no doubt ultimately reducible to terms of living tissue and material environment; but proximately for the purpose in hand, these forces may best be stated in terms of an environment, partly human, partly non-human, and a human subject with a more or less definite physical and intellectual constitution. Taken in the aggregate or average, this human subject is more or less variable; chiefly, no doubt, under a rule of selective conservation of favorable variations. The selection of favorable variations is perhaps in great measure a selective conservation of ethnic types. In the life history of any community whose population is made up of a mixture of divers ethnic elements, one or another of several persistent and relatively stable types of body and of temperament rises into dominance at any given point. The situation, including the institutions in force at any given time, will favor the survival and dominance of one type of character in preference to another; and the type of man so selected to continue and to further elaborate the institutions handed down from the past will in some considerable measure shape these institutions in his own likeness. But apart from selection as between relatively stable types of character and habits of mind, there is no doubt simultaneously going on a process of selective adaptation of habits of thought within the general range of aptitudes which is characteristic of the dominant ethnic type or types. There may be a variation in the fundamental character of any population by selection between relatively stable types; but there is also a variation due to adaptation in detail within the range of the type, and to selection between specific habitual views regarding any given social relation or group of relations.

For the present purpose, however, the question as to the nature of the adaptive process — whether it is chiefly a selection between stable types of temperament and character, or chiefly an adaptation of men’s habits of thought to changing circumstances — is of less importance than the fact that, by one method or another, institutions change and develop. Institutions must change with changing circumstances, since they are of the nature of an habitual method of responding to the stimuli which these changing circumstances afford. The development of these institutions is the development of society. The institutions are, in substance, prevalent habits of thought with respect to particular relations and particular functions of the individual and of the community; and the scheme of life, which is made up of the aggregate of institutions in force at a given time or at a given point in the development of any society, may, on the psychological side, be broadly characterized as a prevalent spiritual attitude or a prevalent theory of life. As regards its generic features, this spiritual attitude or theory of life is in the last analysis reducible to terms of a prevalent type of character.

The situation of today shapes the institutions of tomorrow through a selective, coercive process, by acting upon men’s habitual view of things, and so altering or fortifying a point of view or a mental attitude banded down from the past. The institutions — that is to say the habits of thought — under the guidance of which men live are in this way received from an earlier time; more or less remotely earlier, but in any event they have been elaborated in and received from the past. Institutions are products of the past process, are adapted to past circumstances, and are therefore never in full accord with the requirements of the present. In the nature of the case, this process of selective adaptation can never catch up with the progressively changing situation in which the community finds itself at any given time; for the environment, the situation, the exigencies of life which enforce the adaptation and exercise the selection, change from day to day; and each successive situation of the community in its turn tends to obsolescence as soon as it has been established. When a step in the development has been taken, this step itself constitutes a change of situation which requires a new adaptation; it becomes the point of departure for a new step in the adjustment, and so on interminably.

It is to be noted then, although it may be a tedious truism, that the institutions of today — the present accepted scheme of life — do not entirely fit the situation of today. At the same time, men’s present habits of thought tend to persist indefinitely, except as circumstances enforce a change. These institutions which have thus been handed down, these habits of thought, points of view, mental attitudes and aptitudes, or what not, are therefore themselves a conservative factor. This is the factor of social inertia, psychological inertia, conservatism.

Social structure changes, develops, adapts itself to an altered situation, only through a change in the habits of thought of the several classes of the community, or in the last analysis, through a change in the habits of thought of the individuals which make up the community. The evolution of society is substantially a process of mental adaptation on the part of individuals under the stress of circumstances which will no longer tolerate habits of thought formed under and conforming to a different set of circumstances in the past. For the immediate purpose it need not be a question of serious importance whether this adaptive process is a process of selection and survival of persistent ethnic types or a process of individual adaptation and an inheritance of acquired traits.

Social advance, especially as seen from the point of view of economic theory, consists in a continued progressive approach to an approximately exact “adjustment of inner relations to outer relations”, but this adjustment is never definitively established, since the “outer relations” are subject to constant change as a consequence of the progressive change going on in the “inner relations. ” But the degree of approximation may be greater or less, depending on the facility with which an adjustment is made. A readjustment of men’s habits of thought to conform with the exigencies of an altered situation is in any case made only tardily and reluctantly, and only under the coercion exercised by a stipulation which has made the accredited views untenable. The readjustment of institutions and habitual views to an altered environment is made in response to pressure from without; it is of the nature of a response to stimulus. Freedom and facility of readjustment, that is to say capacity for growth in social structure, therefore depends in great measure on the degree of freedom with which the situation at any given time acts on the individual members of the community-the degree of exposure of the individual members to the constraining forces of the environment. If any portion or class of society is sheltered from the action of the environment in any essential respect, that portion of the community, or that class, will adapt its views and its scheme of life more tardily to the altered general situation; it will in so far tend to retard the process of social transformation. The wealthy leisure class is in such a sheltered position with respect to the economic forces that make for change and readjustment. And it may be said that the forces which make for a readjustment of institutions, especially in the case of a modern industrial community, are, in the last analysis, almost entirely of an economic nature.

If this is the way society is understood, than the role of the economist would be changed completely. Instead of using theoretical models to explain reality with a focus on theory, the focus would instead be on history and explanations of episodes. The first is taking the past to predict the future, the second uses the past to understand the present and then only think about the future. There seems to me to exist a deep gulf between these two approaches. Charles S. Peirce wrote in an article named ‘How to Make Our Ideas Clear’  in 1878:

The Machinery of the mind can only transform knowledge, but never originate it, unless it be fed with facts of observations.

What economists do in economic education is the opposite. The put the model first and then afterwards apply it to some problem. However, the parts of the models are not investigated regarding their empirical validity. Hence, rational actors, full sets of information, independent decisions of all actors, no transaction or transport costs and exogenous fixed behavior – like profit-maximization instead of debt-minimization – are assumed and worked with. Building only one lamp-post leaves a lot of space in the dark, and the users of DSGE models are probably still wondering why reality in countries like Greece and Spain still doesn’t fit their model. Any ad-hoc tinkering with the models to explain the reality now is in the end nothing but an attempt to cover up for the failure of these models. After the fact, anything can be explained by any model. Models have to explain the consequences of policies for the future, and if some can do and some cannot then evolution should lead to some models being discarded.

Of course, circumstances change very often and that is why pluralism in economics is important. In Argentina, household, firm and public sector debt levels are very low and we have something which maybe resembles a neo-classical economy (apart from the monetary part). However, in Japan we had a demand deficiency as explained by Richard Koo and Keynesian models were more useful to explain policy. Economics will move to a more pluralist approach or it will fail as the mainstream “money does not matter” models taught are no longer working in the face of a huge and unsustainable debt burden in most developed countries of the world.


  1. Dirk,
    I conceptualized a theory call “system Gap Theory” which proves that the economic system is in natural disequilibrium of demand and supply at total output level but we put it into equilibrium ( which is necessary if do not want a crisis) by a component of bad debt created in the system through Fractional Reserve Banking. So, the accumulation of bad debt in short to medium term is not a individual choice even though quntum and spread of debt could be attributed to coices of economic agents and policy makers. Also it is common sense that the system should collapse when the bad debt could not be sustained. The solution links to deflation of bad debt. Dirk I invite you and your friends to explore this point.
    Hema Senanayake
    New York

    • Sounds interesting. In order to understand better what your point is, can you say how your concept relates to existing concepts, like monetary circuit theory? After all, the idea that bad loans create a crisis and that these are part of capitalism is not that new. (I quoted a recent book with some comment on Schumpeterian creative destruction to show that there are discussions today.)

      • Banks, under fractional reserve system, creates money known as “credit money.” This process was accurately explained in MacMillan Committee Report of 1933 in British parliament. Monetary circuit theory expalins the same process. I agree the contemporary monetary system is fractional reserve system which system could create more credit out of a relatively small incoming deposit. It is true that creation of bad debt by capitalism has been pointed out before and is not new and that is why we have bankruptcy laws. But the specific question is whether the system needs a component of bad debt to put the demand and supply equilibrium at macro level. My answer is yes and that is what I prove. I think we, economists need to pay our attention to this practical question. If we do so honestly then we will find a solution.

      • Monetary circuit theory explains and admit the Fractional Reserve Banking system. This system of banking for the first time was explained accurately in Mac Millan Committee Report of 1933. Many text books stiil explain it inaccurately. My theory is this. The contemporary economic system is in disequilibrium at macro level. The demand-and-supply at total output level must be in equilibrium if we do not want an economic crisis. But this equilibrium can only be met with a component of bad debt created in the system. Therefore accumulation of bad debt is a systemic problem and not a problem of choice of individual economic agents. Only the quantum and the spread of bad debt could be attributed to individual choices of economic agents and policy makers. These bad debts can be accumulated in consumer debt regime or in stock and derivative market debts or in sovereign debt regime or in all three.

        The existence of the said disequilibrium has been proved by “The System Gap Theory.” I argue that there is no known mechanism to prevent systemic bad debt accumulation while ensuring dynamic growth. Therefore we are left with only one solution that solution being the periodic debt deflation. Bankruptcy laws are inefficient and not sufficient for a systemic debt deflation how extensive they are. In order to deflate debt what was-and-is needed is a new macroeconomic policy tool and wisdom beyond the Federal Reserve.

        Do you agree? Thanks.
        Hema/ New York

  2. I struggle with the idea of “bad debt”. How do you know it’s “bad”? After all, nobody can see into the future and there are always investment schemes going on that speculate on this or that. Ex-post, it is easy to see the “bad debt”: non-performing loans, defaults, etc. If I find some time, I will try to look into your theory. The vocabulary you are using is not familiar and I cannot judge on the spot what for instance “there is no known mechanism to prevent systemic bad debt accumulation while ensuring dynamic growth” means. Of course, you cannot lend money without risk of default, if you are private sector bank. The more you lend, the higher the systemic risk. Is that what you want to say or is there something else? I need to read some more in order to form a judgment.

    • The question of “bad debt”: How do we know it’s “bad”? Let us assume that a household lives beyond its income by taking loans. Then we know that debt keeps on accumulating and in future the debts go “bad.” We know it from the present behavior of the household. The economic system is like that. If equilibriums achieved beyond debt free consumable income then that system should create bad debt. We have such a system. That is what has been proved by System Gap Theory. If the system could be run without debt created beyond savings then the best banking system we need is Full Reserve Banking system not Fractional Reserve system. Even Milton Friedman wanted to have Full Reserve system. I cannot post here the proof of my System Gap Theory due to lack of space. I will send it to you later and before that let us get use to words and meanings. I agree my terminology is not familiar because I try to tackle the issue of macro system with new theory and not the risk and bad debt of individual banks. Think what happens to the financial market if we have full reserve banking system.

    • Dirk,
      I tried to find out a simple way to explain the system gap. You may find it here.

      In the contemporary economic system an entrepreneur can sell his output to a consumer or another entrepreneur. Total proceeds are the sum of sales. A= A1+ A2 whereas, A=total proceeds, A1= sales to another entrepreneur, A2= sales to consumers. If A1= 0 then A=A2; this means total proceeds equal to consumer sales. In economics such a system is defined as a fully integrated economic system.

      Let us now take a numerical example. In a fully integrated economic system an entrepreneur spends $500 to produce something. Since he expects a return higher than the amount invested he values the output, say, at $590. Since he is not selling his output to another entrepreneur in this system he expects consumers to buy the output at $590. Also we know that the entrepreneur invested $500 and since he is not buying anything from another entrepreneur logically he must spend this amount to pay for the labor means consumers. Therefore the amount paid for the consumer is $500. The value of consumable output is $590 and the consumer income is $500. This means consumers need extra $90 to put the system into equilibrium (I name this gap as System Gap).

      Now let us assume that some consumers save $100. And if some other consumers borrowed what is saved, still $90 is short. But if the system can create credit amounting to $190 based on the saving of $100 then the system will be in equilibrium. This implies two things; (1) the system needs a banking system that could create more credit out of a small incoming deposit and (2) consumers need to live beyond their income. In such a system demand and supply equilibrium can be achieved temporarily by the Fractional Reserve Banking System but should accumulate bad debt. This is exactly what happens in contemporary economic system but instead of consumers accumulation bad debt those bad debt accumulates in three debt centers. That is why I previously said that there is no known mechanism to prevent accumulating bad debt in contemporary economic system. How is this clarification?

  3. –The Machinery of the mind can only transform knowledge, but never originate it, unless it be fed with facts of observations–

    Relevantly said. Age old realities of demand and supply still hold good. So long as production is achieved by putting together all the factors of production, economic rules of consumption and investment will remain in force.

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