Economics and Economic Policy

The Role of Economics in a Welfare-Oriented Economic Policy

An Article in the Compendium of Market-Based Social-Ecological Economics

Key issues in view of the neoliberal crisis:
How can we guarantee employment and fair income?
How can we protect the environment effectively?
How should we shape the economic globalization?
What should the economic sciences contribute?
What must be the vital tasks of economic policy?
How can we legitimize economic policy democratically?

Click here for the list of all articles: Compendium
Click here for the German-language version:Volkswirtschaftslehre und Wirtschaftspolitik

Table of Contents

  1. Overview
  2. A Brief History of Economics
  3. The Questionable Principles of Economics
    a) The Theory of Employment
    b) The Theory of Production
    c) Formalistic-Mathematical Statements
  4. A Perspective for Economic
    Complexity, Chaos and Apparent Accuracy

1. Overview

VWLund Politik02Today’s economics contributes its part to an economic order that has led us into a historically unprecedented social and ecological crisis within a few decades, a crisis that has been exacerbated by the collapse of the financial markets in 2008 and the subsequent effects on the real economy. In light of these experiences, a doctrine should be demanded from economists that does not make itself common with industrial interests pursued in a political vacuum, but rather, according to the normative mandate of economics, comprises a sustainable order that can be confidently represented vis-à-vis economic policy makers. And: a teaching that encourages its students to criticize the ruling order and that accepts factual criticism as a scientific enrichment.

2. A Brief History of Economics

Economics, also called economic science, for its part, is one of the social sciences alongside sociology and political science. Thus, its affiliation points to its object of study: the social reality. Within this framework, it deals with economic processes.

The systematic study of economic issues began relatively late with the emergence of the European nation-states: In the 18th century Adam Smith laid the scientific foundation for what was later called classical economics. In the 19th century neoclassical economics emerged on this foundation, which was then integrated into a comprehensive system of micro- and macroeconomic theories in the 20th century.

Microeconomics analyzes individual economic players and their interactions, mainly households and private and public enterprises, with the aim of further developing the microeconomic order. The focus is on how enterprises develop and how they should develop their strategies concerning business units, allocation of resources, pricing, domestic and foreign markets and competition. While business administration, as a specialized applied science, is focused on the management of enterprises including personell, accounting, finance, procurement, marketing, sales and service.

Macroeconomics, on the other hand, analyses the economy as a whole with the aim of further developing the macroeconomic order, in particular concerning the interactions and dependencies between the productive factors labor, capital and natural resources; the causes and possible control of economic cycles; the interactions, dependencies and the demarcation between foreign and domestic trade and how trade can be improved; and, above all, the various interacting variables of the economy and how they can be brought into equilibrium. For more details I recommend the article General Equilibrium.

Classical economics saw the entrepreneurial supply as the decisive driving force of the economy and assumed that every supply, regardless of its volume, automatically finds its demand. In the first half of the twentieth century the scientific focus moved towards demand, particularly pronounced in Keynesianism, the teaching of Maynard Keynes, who called for credit-financed government investments during an economic downturn (deficit spending) to stimulate macroeconomic demand. After the post-war economic order, the Bretton Woods System, failed at the beginning of the 1970s, the pendulum swung extremely in the other direction:

In the course of the deregulation of national markets and the emergence of open global markets thereafter, including the associated concentration of industrial power and capital, the supply-oriented perspective again advanced to an all-dominant doctrine. All the more irreconcilable is the dispute between the small group of demand-oriented economists and their supply-oriented colleagues who advocate the »neoliberal mainstream«. The financial market crisis that began in 2008, as well as the subsequent euro crisis, that is still incorrectly referred to as a sovereign debt crisis, have since created a new awareness of the dangers of limitless deregulation, the consequences of which are becoming more and more apparent.

More details about the historical development can be found in the following articles: Classical and Neoclassical Economics, Keynesianism, Bretton Woods System (English) and Economic Globalization.

3. The Questionable Principles of Economics

From the very beginning, the central questions of economics were very strongly related to the scarcity of production capacities and produced goods and thus to the conditions for increasing the production volume. But they were focused less or not at all on the scarcity of natural resources and on the structural and social conditions that are necessary for a welfare-oriented industrial production. This still existing self-conception is the reason why economics has not yet arrived in the social reality and why economists are still having difficulty understanding the economic prerequisites for social welfare as their scientific field of research (more on this in the article Sustainable Social Welfare).

To be criticized above all are the inadequate premises regarding

  • the employment theory and
  • the production theory, here especially the allocation of natural resources, as well as
  • the tendency towards formalistic-mathematical statements observed since the 1970s, which pose the danger of suggesting a misleading accuracy and probative force that stand in the way of realistic solutions.

It is true that economics as a social science cannot be an exact science. But more than in other social sciences, its object of study (the economic processes) is indispensable for the material existence of mankind, and at the same time is irrevocably integrated into the natural cycles of the biosphere and therefore dependent on the limitations of natural resources. The scientific responsibility to take these interrelations into account is still rejected by the majority of economists with the argument that socially and environmentally relevant questions and decisions would be the sole responsibility of policy makers. As a result of this ignorant demarcation, economics still remains today in a system of constructed, unquestioned axioms that has grown over two centuries, and which abstracts economic processes from social demands and natural constraints (see also the articles Economy and Biosphere and Economy and Entropy).

a) The Theory of Employment

It deals in isolation with issues relating to the capacity utilization of production facilities and the production volume achieved. This narrow perspective leads directly to a misunderstanding of productivity, because geographically centralized production appears more productive than decentralized production. The so-called economies of scale achieved through centralized mass production are absolutized and transfigured into the necessary prerequisite for productivity and prosperity. Thus economics fails to perceive economic life in the light of the self-determined participation of economic subjects (citizens) and their local social and ecological responsibility, and fails to understand the required decentralization of economic structures and production conditions as a function serving human and natural needs.

In other words: It neglects to give higher priority to macroeconomic production structure than to production volume of individual production sites. The consequences of this narrowed perspective are particularly devastating under the conditions of open global markets as they emerge in the course of the neoliberal globalization: the concentration of industrial power and capital is constantly increasing and causes a nationwide and worldwide de-industrialization of peripheral areas, while employment decreases to the same extent in the course of this process. At the same time, democratic influence and legitimacy at all political levels are dwindling. For further details, I recommend the article Scale Economies and Productivity.

b) The Theory of Production

The above mentioned microeconomic interactions between individual economic players include the decisions taken in the face of general scarcity of resources. The misjudgment consists in that scarcity is not seen in relation to the limited availability of raw materials, but rather related to the limited availability of production capacity, its correspondingly limited production result and its influence on price formation.

In other words: In prevailing microeconomic terms, scarcity and product price increases are exclusively due to scarce production capacities, but not to shortages of raw materials (at most when a raw material is obviously about to be exploited). In this understanding, raw materials appear to be available indefinitely, so that their price is set correspondingly low, and it even seems economically justifiable if it only contains the costs of exploration, development and production, i.e. the price of the bare resources is zero. Consequently, national economies fail to invest in the preservation of raw materials – for example by means of recycling or substitution – and fail to motivate economic players to include the fair costs of raw materials in the prices.

The inevitable consequence of this economic logic is the continued exploitation of natural resources. In order to prevent this, macroeconomics would have to broaden its perspective and understand the economy as a subsystem of the biosphere embedded in the natural cycles, and then address the justified demand to economic policy makers that raw materials be taxed to the extent that economic players automatically use them sparingly and sustainably.

c) Formalistic-Mathematical Statements

The new belief of academic economics in the rationality of market participants and the infallibility of markets, as well as the tendency to describe social reality with formalistic-mathematical statements, are essentially responsible for the financial market and economic crisis that began in 2008. The US Nobel Prize winner Paul Krugman unmistakably denounced the failure of his profession in a column in the New York Times:

»Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. … As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. … economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. … Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation. … At the latest when the all-too-human problem of recessions and depression comes about, economists must drop the pleasing but false assumption that people act rationally and markets are infallible.« (New York Times, 2nd september 2009)

It is ironic that Paul Krugman himself has succumbed to the blind infatuation with the beauty of mathematical expressions, despite his undisputed critical faculties. His theoretical work, dating back years, in which he attempted to represent international trade and economic geography in a »beautiful« model that, however, excluded social and ecological reality, was awarded the Nobel Prize by the equally blind Royal Swedish Academy of Sciences in 2008. It is worth getting to the bottom of this economic folly in the article Paul Krugman’s Blind Spots.

It is not surprising that most economic theories have little conclusiveness on the thin axiomatic foundation. In addition, the great uncertainty inherent in all economic hypotheses can only change to certainty, one way or the other, through subsequent economic practice. Since practical experience is subject to general social change, its validity is also limited in time. Each epoch is therefore faced with the task of re-evaluating traditional empirical findings and of venturing contemporary economic hypotheses. Although this procedure is a recognized scientific standard, many economists are tempted to transfer old ideas and theories one-to-one into the present.

The hope for an economic foundation that will stand the test of time, however understandable it may be, is inevitably associated with disappointments and dangers, especially when outdated ideas flow into economic policy. These dangers are undoubtedly greater by recourse to Marxist theses than when relying on the teachings of Maynard Keynes or Walter Eucken and Ludwig Erhard. But any backward-looking attitude is dangerous. Especially the present state of the world, which is characterized by the historically unprecedented occurrence of two existential crises – a social and an ecological one – requires new scientific approaches – also on the part of economics. This compendium is designed to contribute towards mastering this challenge.

4. A Perspective for Economics

In times of crisis it is all the more important that economics lives up to its responsibility as a social science and aligns its work with the social and ecological reality. Above all, it must make itself independent of industrial and financial power, but must also renounce political opportunism. In its scientific claim it must not limit itself to interpreting the prevailing economic order in an analytical way, but rather must make analysis the starting point for normative ideas and statements, and at all times self-confidently and persistently point out the recognizable path to the welfare optimum. In particular, it must derive the efficiency of the factors labor, natural resources and production capital from their interaction and take overall efficiency – as well as the overall productivity of production processes – as a yardstick to put a stop to dangerously one-sided capital efficiency and capitalist excesses (see also the article Excesses of Capitalism).

Therefore it is the task of economics to analyse the existential significance of economic processes and their interrelations for social welfare in the context of social and ecological reality and to derive a future-oriented model based on analysis for the purpose of proposing concrete actions to economic policy makers. And: if it is the task of the economy to provide for a better life, then it is the task of economics to show the way to a better life.

Sustainable welfare requires social and ecological equilibrium, characterized by full employment and closed material cycles, accompanied by qualitative growth and foreign trade equilibrium. Full employment means general participation of all citizens in economic life and a fair share of the economic outturn for everyone, closed material cycles serve to preserve the substance of natural resources, qualitative growth means progress in harmony with finite resources, and foreign trade equilibrium is achieved through controlled international exchange on a reciprocal basis guaranteeing a long-term equilibrium of trade in goods and services as well as in financial instruments.

Complexity, Chaos and Apparent Accuracy

In the course of the worldwide economic policy deregulation promoted under the neoliberal dogma, economics is constantly tempted to »scientifically« give its blessing to the facts created by the unbridled industrial expansion and to refer its »findings« to economic policy makers. This creates a vicious circle of positive feedback and constant self-affirmation of questionable statements of economic science.

As a result of deregulation, the complexity of macroeconomic interrelations and the chaotic behaviour of the world economy have increased immeasurably, offering ambitious economists inexhaustible opportunities for formalistic-mathematical »gimmicks« that produce nothing but a nonsensical, virtually meaningless fictitious accuracy of the representation and predictability of neoliberal economic processes. An analogy to the complex and chaotic weather events is consciously postulated, with the ulterior motive of paving the way for investments in complex and expensive »scientific« simulations of economic events.

Thus, the current mainstream of economics gives the impression that economic research must be conducted on the basis of »the natural complexity of the economy« in order to make the interrelations transparent, to continually adapt them in accordance with the neoliberal dogma, and to continually reaffirm the alleged ability of the system for self-regulation.

And thus, the realization falls by the wayside that the complexity of economic events can and must be reduced by regulation, and that not complex but simple rules best serve this purpose.

The rules must be designed such that economic players, instead of causing macroeconomic damage, generate the highest possible returns for the economy as a whole and for themselves. For this reason, incentives must be created or bans imposed which, for example, rule out or curb antisocial enrichment, cross-border transfer of production capital and jobs, and predatory competition. To use the weather analogy: Instead of complex simulation, an umbrella is sufficient to protect against unforeseeable rain.

Therefore, an independent economics is to be demanded that is committed to the scientific mission of designing domestic production structures under the conditions of an increasingly interdependent world that ensure full employment and environmental protection in decentralized responsibility and at the same time serve as a stable foundation for international exchange and globalization. Only then would economics have arrived in the social and ecological reality.

The awareness for the necessary changes has grown in recent years, especially among students of economics. They should be encouraged to express their criticism frankly despite all odds. Edward Fullbrook, editor of the book “A Guide to what’s wrong with Economics”[1], makes an exemplary contribution to this. In his introduction he explicitly addresses the students of economics and writes among other things (Fullbrook 2004, p.1):

»First, this book offers you some protection against the indoctrination process to which you are likely to be subjected as an economics student. There are many things that your teachers should tell you about the brand of economics they are teaching you, but, in most cases, will not. This book will make you aware of some of the many worldly and logical gaps in neoclassical economics, and also its hidden ideological agendas, its disregard for the environment and inability to consider economic issues in an ecological context, its habitual misuse of mathematics and statistics, its inability to address the major issues of economic globalization, its ethical cynicism concerning poverty, racism and sexism, and its misrepresentation of economic history.«

Click here for the German-language version: Volkswirtschaftslehre und Wirtschaftspolitik.

Sources and Literature

1. Fullbrook, Edward (Editor): A Guide to What’s Wrong with Economics. Anthem Press, 2004

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