27/06/2006 11 min #1523

A Few Pitfalls of Statist Economics

Teachers know that students learn in different ways: some by words spoken and written, some by mathematics, and some by visual means. Statist economists tell illustrated stories about economics. Words comprise the stories. Mathematics and graphs provide the illustrations. With reinforcement via problem sets, exams, and grades, students take away beliefs that externalities are important market failures that pervade economies, that free markets donít work, and that government is the remedy. These beliefs are as false as they are unfortunate.

Those who never study economics formally pick up these ideas secondhand from those who have studied them. But even those who have studied economics typically have either highly distorted views of the subjectís contents or only a smattering of conceptual understanding. I can say this because Iíve been through this mill myself and I know how hard it is to find real knowledge of economics. Iíve taken somewhere around 10 economics courses, most at the graduate level, besides putting in a great deal of self-study which continues up to this moment. I am the proverbial tortoise. One of the brighter moments was a three-day workshop on Austrian economics (in 1984 in St. Louis) at which Don Armentano and others spoke. However, Iíd be remiss in not mentioning that the Rochester contingent of ex-Chicago-ites and Virginia-ites (Don Gordon, Harry Gilman, Walter Oi, Bill Meckling, Mike Jensen, and Jim Ferguson) plus exposure to Armen Alchian, Milton Friedman, and others helped forge the multi-year path between a year-long 1961 benighted course using Samuelsonís text to Murray Rothbard and Ludwig von Mises. While at Rochester in 1973, I had by then learned enough to buy Human Action, Road to Serfdom, Spencerís The Man Versus The State and Molinariís Society of Tomorrow at a garage sale.

But my opinion is also based on having for years observed graduate students who have been indoctrinated by economics professors. They (the students) come out of these courses knowing very little and having confused and often wrong ideas. Having had the opportunity to converse at length with many economics professors (I am in finance not economics), it appears that the professors accurately convey their misunderstandings to their students combined with the usual and often substantial noise factor that all teaching exhibits.

Some of the statist words

The words statist economists use load the dice against free markets. There is a straw man called a "perfect" market, also known as atomistic competition or perfect competition. This is easy for economists to set up as an ideal. In the perfect market, no consumer or business has excessive power. No one affects price. Every firm is a price-taker for both inputs and outputs. What could be more fair? The perfect market is deemed to embody fair competition. In the beautiful (and non-existent) world of perfect markets, all firms are equal. No one competes "unfairly." Prices are never above long-run costs and profits are driven to zero. There is no waste. The economy is in a Pareto optimal condition.

The perfect market ideal is then easy for economists to knock down because by definition it cannot be attained. Students readily realize that markets are "imperfect" because it is accessible to everyoneís observation that the perfect markets description is not the world we live in. The perfect market is an unreachable heaven, an ideal to strive for. But this is a heaven that free exchanges and free markets cannot and do not reach, according to the economistís bible. By definition, free markets are imperfect and therefore to be shunned or viewed as problems. This is how words subvert thought. What stands in the way? There is a litany of obstacles including externalities, product differentiation, advertising, worker exploitation, and businessmen who strive to undermine the market. The invisible hand is viewed with a wistful longing as a desirable process but one that has little or no basis in reality. Cannot any dunce see that the conditions of perfect markets are not met? And if they are not met, mustnít the result be an economy far from its potential of perfection? But wait. There is hope. There is salvation. An impartial government armed with knock-down powers to intervene can overcome this unhappy state of affairs. It can remedy the "problems" of the free economy, its market failures, its business cycles, its unemployment, and its extremes of wealth and poverty. Such a government can tax and subsidize, it can insure uncertainties, and it can redistribute income unfairly obtained by the rats who are cornering and monopolizing every market they can.

To the statist economist, perfect markets (atomistic or perfectly competitive) exist as desirable impossibilities under freedom. Only under government intervention and authority can these ideals be approached. People simply cannot make themselves happy without the government intervening in their exchanges. Rhetorically, the concept of perfect markets in the hands of statist economists is a device to persuade the novice that government is good.

The graphs

The graphs that economists are fond of tell the perfect market story in a different and visually appealing way. There is definiteness here, the appearance of truth and clarity, and beauty. There are lines and angles. There are labels. There are identifiable areas that are supposed to convey meanings. Without the words and hidden assumptions that preface these graphs, they take on a life of their own. They impress the reader. They present their own independent reality. Here is a marginal cost curve and there are long-run average costs. Here is an Edgeworth box and there are contract curves. Here are deadweight losses and there is the monopoly price. Here is an IS curve and there an LM curve. They intersect. VoilŠ! The economy is in full-employment or perhaps underemployment equilibrium.

Surely this great graphical handiwork of so many brains built over so many years cannot possess flaws that mislead the apt student, can it? Each picture looks like something out of a Euclidean geometry book, and we know geometry to be true and a thing of beauty. The graphs beguile. They tantalize. If graphs accurately portray the daily temperature at the top of the Empire State Building and if they accurately show the intersections of a cubic equation with the x-axis, do they not also show that increasing the money supply will increase employment?

Graphs per se are not bad. Even Murray Rothbardís work uses them, and so does mine. What is bad is that to the uninitiated, to the unquestioning, they gloss over the assumptions that go into their appearance. They seem more definite than what they are. They leave out more than they contain, including variables not considered and variables held constant. In economics, graphs are summaries, not final truths. In the hands of statist economists, graphs can be turned into outright falsehoods.

The mathematics

The third means of persuasion is mathematics. Equations are truth if ever truth could be identified. Let us be careful about our symbols and definitions. Let us manipulate them carefully so as not to violate the laws of algebra, calculus, and real analysis. Then we are sure to have truth and no falsehoods before our eyes. If this is so in physics, must it not also be so in economics?

Can equations model economic behavior or an entire economy in the way that they model an electro-magnetic force field? They cannot, because they cannot accurately connect to or mirror the human "forces," which are those of subjective valuation, cost, and choice. This does not mean that mathematics is useless in economics. It is far from being so. It means that the usefulness is of an altogether different sort than in mathematics itself or physics. Mathematics can be very useful in economics in trying to pin down and understand oneís verbal concepts, especially when they interact. It can lead one to deeper understanding or to ideas one might not have had by staying solely in the verbal or graphical realm.

But mathematics is also treacherous in economics. It gives the appearance of stability, definiteness, specificity, and constancy where they are frequently absent. The physical constants of electricity and magnetism are stable, definite, specific, and constant. They do not change with the human will, with time, with other events, or with human invention. They are measurable up to small errors. By contrast, most of economics has no such description. As Pigou put it: "Even if the constants which economists wish to determine were less numerous, and the method of experiment more accessible, we should still be faced with the fact that the constants themselves are different at different times. The gravitation constant is the same always. But the economic constants Ė these elasticities of demand and supply Ė depending, as they do, upon human consciousness, are liable to vary."

The average student, asked to solve specific problems with numbers that are fictitious, unobtainable, or meaningless, develops a faith in the veracity of the mathematical formulations. The students asked to input data and run regressions using Excel will believe in the results, unless they are heavily precautioned in the uses and misuses of statistics. The average student who sees that GDP = C + I + G + NX will not remember the many provisos and reservations that go into such an equation that render it devoid of meaning. They will come away with a vague feeling that GDP (gross domestic product) is good and that C (consumption) is good because it contributes to GDP, as are investment (I), government spending (G), and net exports (NX).

The government

What is this government that statist economists refer to as the savior of efficiency? They prefer not to say. They prefer not to analyze it. This will raise questions in the minds of the students. This will interfere with the indoctrination. Take a political science course, the student is told, although that will typically not awaken the student either. Government is simply taken for granted. Where does this government get the lawful power or legitimate authority to do its taxing, subsidizing, and regulating? Does everyone have to agree to it? What if one person does not agree? Why must this government rule over a territory? Can people opt out if they want to? Donít the supposed welfare benefits occur only if everyone is compelled to participate? Economists donít like to face these questions.

There are implicit and unspoken answers. Traditionally, authority comes from might or from God. Democracies look askance at might, and God is dead in a secular age and country for purposes of being the source of authority. Authority now stems from "we the people" as Gary North has pointed out. Economists donít raise the issues of government because they and their students largely accept it as the God-replacement. It isnít. It replaces might.

The statist economist story

Freedom, among other things, means freedom of choice. Freedom cannot mean the imposition of government taxes or regulatory measures, no matter what form of government produces them. Freedom cannot mean centralized or collectivized controls backed up by the force of the State.

Cadres of statist economists support such centralized controls on the grounds that free markets fail. These economists teach armies of students that market failures are endemic. Freedom, they say, does not work and canít work. They teach the imposition of authoritarian solutions for the purported failures of freedom to solve imagined problems in which there are untraded items that affect utility. Although free people have decided not to address these "problems," economists wish to substitute force for freedom. They justify this illegitimate wish (amply fulfilled by many States over the past and whose results we now live with) by the idea that we will find ourselves happier as a consequence. Students are told that with State intervention we will have more products that we want. They are taught that we will have lower unemployment, greater income in our old age, better medical care, and better and less expensive education. They are persuaded that there will be more clean air and water, greater safety at home, when we travel, and in the workplace, and more security from foreign enemies.

These messages radiate in all directions. Many Americans are lured or lulled into acceptance of less freedom by promises of more of what they want and less of what they donít want. The general promise of more goods and fewer bads in exchange for less freedom sells. Many Americans endorse the despotism inherent in our democracy. Unable to measure the depredation brought into their lives by government, unable to attribute the harms wrought by the State to its source, constantly fed misinformation and propaganda that extols the State and blames other enemies, they think they are better off with less freedom. They are living in a foolís paradise.

June 27, 2006

Michael S. Rozeff [send him mail] is the Louis M. Jacobs Professor of Finance at University at Buffalo