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The Flawed Theoretical Framework of Modern Economics

Economics / Economic Theory Sep 21, 2009 - 10:07 AM GMT

By: Fred_Buzzeo

Economics

Diamond Rated - Best Financial Markets Analysis ArticleEconomics is often referred to as the “dismal science.”  This expression is traced back to Thomas  Carlyle who claimed that economics “is not a gay science, I should say, like some we have heard of; no a dreary, desolate, and indeed quite an abject and distressing one; what we might call by way of eminence, the dismal science.”


As usual, Carlyle was dead wrong. In fact, the only thing dismal about economics is the analyses and predictions of most mainstream economists- analyses that many times are not based on fact but are instead clouded by a particular set of erroneous beliefs. I must concur with JB Say who stated that such economists were “idle dreamers whose theories, at best only gratifying literary curiosity, were wholly inapplicable in practice.”

Indeed, much of economic thinking revolves around a set of beliefs that have been proven false by actual experience. This is because most mainstream economists view the economy, and most of society, from a flawed ideological perspective. Therefore, the policies that they put forth and the courses of action that these policies entail are so often unsuccessful.

A review of basic economic issues reveals the flawed theoretical framework of modern economic thinking.  It also reveals the wisdom derived from the neoclassical economist- a wisdom embodied in the principles of limited government, individualism, and general laissez faire economics.

The Importance of the Individual

According to mainstream economics, the individual is an object of manipulation. The function of policy makers is to induce the individual to act in some predetermined and “beneficial” way. For example, the “cash for clunkers” program induces individuals to purchase small, fuel-efficient cars that government bureaucrats believe will save the planet from the evils of oil exploration, among other things.

The individual cannot be trusted to do “the right thing” so the decisions of government planners must supplant those of the individual for the benefit of all. So there is a heavy “sin” tax on cigarettes and alcohol to dissuade the consumption of those vices. Estate taxes are collected so that wealth created cannot be passed to heirs who did not earn it. After all, we don’t want to encourage laziness or lack of effort on the part of anyone- unless, of course, it’s on the part of the bureaucrats and politicians enforcing the regulations!

Nevertheless, this flawed economic thinking has never worked- not in this country or anywhere else. The undisputable evidence for this is the collapse of the Soviet Union. In addition, since China has moved away from a planned economy, it is becoming a world economic power- currently the largest holder of US debt instruments.

The Austrian school has always held the individual as the central and only force behind economic decision making. According to Rothbard: “The first truth to be discovered about human action is that it can be undertaken only by individual ‘actors.’ Only individuals have ends and can act to attain them. There are no such things as ends of or actions by ‘groups,’ ‘collectives,’ or ‘States,’ which do not take place as actions by various specific individuals. ‘Societies’ or ‘groups’ have no independent existence aside from the actions of their individual members.”

Therefore, it is the individual that determines what products will be produced. The actions of producers must focus on the needs and desires of individuals expressing their utility through purchases in the marketplace, not on the whims of government planners. Such a conception negates the role of the bureaucrat and his political masters.  Is there any wonder why it is held subservient to the nonsensical theories of welfare economics!

The Indisputable Value of Savings

Modern economic history is replete with attacks on individual savings. They have come from Hobson and the under-consumptionists, from John Maynard Keynes and the demand deficit school, and from Paul Samuelson and the paradox-of-thrift theorists. The most stringent attacks on savings, however, have come from Lord Keynes himself. Savings has been labeled unproductive and a drag on economic activity. Repeatedly, today’s financial papers ponder: “When will the consumer return?”

According to economic pundits, the economy cannot survive without a high level of consumption spending. For the first time in years, the savings rate has climbed. Instead of applauding this thrift, mainstream economists complain and fear that it will become a normal phenomenon bringing down the level of GDP.

Yet, Henry Hazlitt has stated the case clearly: “Savings in short, in the modern world, is only another form of spending. The usual difference is that the money is turned over to someone else to spend on means to increase production.” Money that is saved is kept in banks where it is lent to investors who use the money to purchase capital equipment that eventually increases productive capacity. Savings, therefore, is a vehicle for capital accumulation. Without capital accumulation there could be no technological progress, no increase in production, no lower consumer costs, and no increase in employment! Savings is simply the decision of the individual to postpone current consumption for greater future consumption. In short, it is just another expression of his utility- his desire to do what he believes is in his best interest. Once again, it is this individual control that frustrates the government planner and that baffles the legions of economist that provide the justification for his interventionist tactics.

The Invisible Hand Still Works Best

Most modern economic thinking has an expansive role for government. Since the Great Depression, the US has been referred to as a “mixed economy.”  For instance, Paul Samuelson has warned us that “deregulated capitalism is a fragile flower bound to commit self-suicide.” I am perplexed as to how a flower commits suicide, but I am even more perplexed as to how deregulation causes “capitalist suicide”- especially when deregulation allows the individual the ability to make decisions free from the blunders of the central planners.

Until the collapse of the Soviet Union, Samuelson continued to believe that it would surpass the US in industrial capacity, even in light of undeniable facts to the contrary published in his own textbooks- an adherence to a flawed ideology precluded his unbiased thinking. Samuelson further stated that “the Soviet economy is proof that, contrary to what many skeptics had earlier believed, a Socialist command economy can function and even thrive.” Apparently, the only skeptic is Samuelson himself who believes in the power of command over the spirit of individualism.

Nevertheless, the firm believers in the free market were never so deceived. Men like Ludwig von Misses, Friedrich Hayek, and Ronald Reagan stood firm in their belief that socialist economies could not survive the test of time. And they were proven correct.

Ludwig von Misses provided the theoretical framework.  Joseph T. Salerno summarizes the argument: “In ‘Economic Calculation in the Socialist Commonwealth,’ Ludwig von Mises demonstrates, once and forever, that, under socialist central planning, there are no means of economic calculation and that, therefore, socialist economy itself is ‘impossible’ (‘unmoglich’) - not just inefficient or less innovative or conducted without benefit of decentralized knowledge, but really and truly and literally impossible.”

Prior to von Mises, Austrian school intellects like Eugene von Bohm-Bawerk provided the first critical answer to the flawed economic theories of Karl Mark.  Many have said that his devastating critiques were the main reason that Marxism has never taken hold in the economics profession as it has in other disciplines such as political science and sociology. Without astute critics like Bohm-Bawerk, Marx’s theory of surplus value may have caused greater damage than it did since it is the driving force behind all economic theories of exploitation.

It Doesn’t Grow on Trees

Money may not grow on trees, but it certainly grows in the vaults of the central bank. Most economic textbooks refer to the central bank as a” banker’s bank.” In reality, it is a government run institution ostensibly created to smooth out economic fluctuations but used mostly to inflate the currency so that governments can continue to finance their profligate spending habits.

Callahan gives us the proper perspective when he states: “we will see that the central bank tends to be the creator, and not the dissipater, of economic fluctuations. When it is putting on the breaks and deflating the bubble, it was usually the one that inflated the bubble in the first place.” Empirical evidence clearly supports this position. The Great Depression, the stock market crash of the 1990s, and the current real estate meltdown all have their roots in the expansionary monetary policy of the Federal Reserve.

Yet mainstream economists continue to view the role of the central bank as a positive one. Keynesians view the central bank as playing a crucial role in economic stabilization. According to Keynes, it is the under-consumption of society that causes economic downturns. In such a scenario, the role of the central bank is obvious. Monetarist fare no better. They espouse a fundamental rule: the central bank should allow the money supply to grow at a constant rate- a rate low enough to avoid inflation. Both miss the point: it is the central bank itself that keeps the economy off balance and that causes the economic fluctuations to begin with.

On the other hand, the free market theory of the Austrian school has always debunked the role of the central bank. The Austrian Theory of the Business Cycle places the boom and bust stages of the business cycle squarely on the central bank’s expansionary monetary policy.

An expansion of the money supply above the rate of savings causes distortions and malinvestment. When investors realize that the capital structure to complete their projects is not there, the deleveraging begins, and we are in the midst of a downturn. A study of business cycles indicates one thing conclusively: the Federal Reserve is an economic rollercoaster bringing the economy sky high and then crashing to the ground.

The Gold Standard

The most powerful tool in existence to halt expansionary monetary policy is the gold standard. The financial history of the US is replete with government actions to debase the currency.  The most destructive currency debasement occurred after WWI when the Federal Reserve pursued an expansionary monetary policy aimed at stabilizing European currencies, more specifically the British pound. The result of this financial mismanagement was the Great Depression.

After WWII, an individual could no longer redeem dollars for gold. This privilege was reserved only for central banks. By 1971, the illusion of a gold standard was done away with completely. The dollar was now simply fiat currency.

You can search modern economic thought and you will find little support for the re-imposition of the gold standard. The general consensus among mainstream economists is that such an act would be devastating to the economy. The reason for this is simple: It renders the manipulative tenets of their economic theories impossible. With a true gold standard, the economic rollercoaster of the Federal Reserve would come to a screeching halt. Indeed, there would be no need for the Federal Reserve.

Hazlitt, Rothbard, and von Misses have been the few voices advocating a return to the gold standard. Rothbard summarizes the argument: “I therefore advocate as the soundest monetary system and the only one fully compatible with the free market and with the absence of force or fraud from any source a 100% gold standard. This is the only system compatible with the fullest preservation of the rights of property. It is the only system that assures the end of inflation and, with it, of the business cycle.” Unfortunately, their voices are silenced by the screams of economists who classify this reasoning as obsolete in the modern economy.

A Slippery Slope

Once again, pick up any standard economics textbook and you will find a significant portion of it dedicated to market failure- one of the major pretexts for government intervention. In his widely used textbook, Macroeconomics, Nobel Prize economist Paul Krugman states: “When markets don’t achieve efficiency, government intervention can improve society’s welfare.” Most economists today subscribe to this theory of market failure. They seem not to understand that in many cases the inefficiencies that resulted in the market failure were caused by the interventionist policies that they advocate.

As a former bureaucrat, it astonishes me that anyone, let alone a Nobel laureate, could believe that a bunch of (usually) untrained, inexperienced, and unengaged political appointees could solve complex problems of any kind. As the team leader in a project to rehabilitate low income housing, I was once sent a Director of Engineering whose only construction experience amounted to supervising a team of drywall installers. So much for real problem solving ability!

Austrian scholars have been the one consistent voice against the dangers of government intervention. Ludwig von Mises has explained the slippery slope of government regulations. He writes:

                       “The government believes that the price of a definite commodity, e.g. milk, is too     high…Thus it resorts to a price ceiling and fixes the price of milk at a lower rate than that prevailing on the free market…But as the outcome of its interference, the supply available drops…It (the government) must add to the first decree concerning only the price of milk a second decree fixing the prices of the factors of production necessary for the production of the milk…But then the same story repeats itself on a remoter plane. The supply of the factors of production required for the production of milk drops, and again the government is back where it started. If it does not want to admit defeat and to abstain from any meddling with prices, it must push further and fix the prices of those factors of production which are needed for the production of the factors necessary for the production of milk.”

As one regulation leads to another, the society edges closer to the socialist state. So a regulation to correct a supposed market failure leads to the greatest market failure of all- socialism. This has been the trajectory of the US since the New Deal. We are seeing today the greatest degree of government intrusion ever. FDR himself would be shocked to see the degree of interventionist legacy that he left behind.

Conclusion

In the 1970s, Michael Harrington published The Twilight of Capitalism. He argued that the capitalist system would not survive the financial shocks of that period. Fortunately, Professor Harrington got his isms confused. It was socialism and communism that did not survive the test of time.

The “internal contradictions” that caused the economic crisis of the 70s turned out not to be “internal contradictions “at all.  Instead, thecrisis of the 70s was caused by the application of the “new economics” to the profligate spending programs of the “Great Society.”
To the chagrin of the central planning crowd, the capitalist economy came roaring back in the 80s. A belief in the power of the individual was the main protagonist. Throughout economic history men like Menger, Misses, Hayek, and Rothbard kept the spirit of free enterprise alive. The wisdom of their thinking is evident in the collapse of the socialist state.

Murray Rothbard, Man, State, and Economy, (Ludwig von Mises Institute, 2004) pp.2-3.

For a summary see Mark Skousen, The Making of Modern Economics, (Armonk, NY: M.E. Sharpe, 2001)

Henry Hazlitt, Economics in One Lesson, (Ludwig von Mises Institute, 2008) pg.162.

Interview with Paul Samuelson conducted by Kiyoshi Okonogi and published in Asahi Shimbun.

See David Levy and Sandy Peart, The Fragility of a Discipline When A Model Has Monopoly Power, Review of Austrian Economics, Vol. 19, No2-3, 2006, pp 125-136.

Ludwig von Mises, Economic Calculation in the Socialist Commonwealth, (Ludwig von Mises Institute, 1990) pg51.

Gene Callahan, Economics for Real People, (Ludwig von Mises Institute, 2002) p. 210.

Murray Rothbard, The Case for a 100% Gold Standard, (Ludwig von Mises Institute, 1991) pg.176.

Paul Krugman, Macroeconomics, (New York: Worth Publishers,2006) pg.16.

Address given by Ludwig von Mises to the University Club of New York.

Fred Buzzeo is a real-estate developer and as a consultant to small property owners in the New York City area. He resides with his wife and two sons in the Town of Oyster Bay, (Long Island), NY. During the 1990s, he held executive positions in city municipal government. It is during this employment that he saw firsthand the pitfalls of government intervention and regulation. Send him mail. See his article archives. Comment on the blog.

© Copyright Fred Buzzeo 2009

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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