Neo-classical economics

As it set out to eclipse its classical predecessor, neo-classical economics made a number of mistakes. One of the biggest was to dispense with land as a distinct factor of production. Economists chose to conflate land with capital, disregarding the quite obvious differences between the two. In a rapidly industrializing society, it’s understandable that people might imagine land to be less important, but economists should have known better. It remains the case today that nothing of tangible value can be produced without some contribution from land, which includes the natural resources that provide raw materials.

Martin Wolf of The Financial Times thinks, “The idea that land and capital are the same thing is evidently ludicrous. It requires us to believe that the economic machine is self-sustaining — a sort of perpetual motion machine.” He goes on to say that “there would be no economy — indeed no humanity — without a constant inflow of natural resources into the system.” So why do neo­classical economists continue to exclude land and resources from their calculations?

Followers of the nineteenth-century American economist Henry George argue that neo-classical economics was established to support the vested interests of landownership. If economics had continued to base its analysis on all three factors of production, then the massive advantage enjoyed by landowners — a tiny proportion of the population which controls access to most of the world’s natural resources — would be laid bare for all to see. Martin Wolf agrees: “The powerful owners of natural resources wished to protect their unearned gains. In practice, therefore, the tax burden fell on labour and capital. Economics, one might argue, was pushed into supporting this way of organizing economic life.” One consequence of excluding land from economic models (and academic textbooks) is that, while revenues earned by labour and capital are subject to taxation, those earned by landowners are not.

There is no doubt that classical theory needed updating to reflect changes that Smith and his contemporaries could not have foreseen. But, in virtually every aspect, the neo-classical school of thought got it wrong, and in most cases spectacularly so.

Having dispensed with land, neo-classical economists also decided to change the entire procedural focus of economics. Instead of assessing the economy in terms of factor classes, and the subsequent distribution of revenues between them, they instead chose to extrapolate macroeconomic models — models that try to explain the workings of the entire economy — from microeconomic behaviour. They looked at the way consumers and producers behave on an individual basis and assumed the same simple rules could be applied to the collective workings of entire economies.

This was a fatal mistake. Classical economics had always encouraged critical assessment of the impact of power relations on social outcomes. It implicitly asked questions about what today we call ‘economic justice’. Questions like: ‘Does each factor of production receive a fair reward for its contribution?’ Neo-classical economics deliberately asks no such questions, and it ignores differences in the power possessed by different participants in the economy. Rather simplistically, neo-classical economics looks only at the factors influencing the investment and consumption decisions of individuals and firms. It focuses on how things would work in an imaginary world where all participants in the economy shared full and equal knowledge, not only of the market but also of the consequences of their decisions. It also assumes that everyone faces the same choices in life. It has very little connection with the reality of human existence. Its refusal to engage with difficult political and moral questions smacks of either conspiracy or cowardice.

By shifting the focus of economic analysis to individual preferences and adopting a definition of economic efficiency that excludes human wellbeing, neo-classical economics essentially says: it doesn’t really matter how much is produced, or how many people are involved in production; as long as those who have jobs (and therefore purchasing power) can maximize their satisfaction by accessing goods and services that are produced as efficiently as possible, then everything will be fine. With this kind of approach to economics, is it any wonder that we live in an ‘I’m all right Jack’ society in which the ties that used to bind communities together have been broken?

Unsurprisingly, this move from methodological holism to methodological individualism left neo-classical economics totally unable to explain a whole range of real-world events. This reductionist approach not only ignores the importance of land in economic activity, it doesn’t much bother with considerations of money or debt either. The Efficient Markets Hypothesis ­the bit of neo-classical economics that professes to explain the workings of the financial markets — asserts that these cannot crash because, by their very nature, they are ‘informationally efficient’.

This means they will always tend to an equilibrium position where supply matches demand, and thus remain stable. Steve Keen argues that it is precisely this utterly false belief in the efficiency of financial markets that lies behind the current crisis: “By promulgating the efficient markets hypothesis, which is predicated on all investors having the foresight of Nostradamus, economic theory has encouraged the world to play a dangerous game of stock market speculation.” When the markets crashed in 2008, neo-classical economist and long-time head of the US Federal Reserve, Alan Greenspan, told the Senate Banking Committee that he was shocked, conceding that there was a serious flaw in his own philosophy that unfettered free markets sit at the root of a superior economy. When it was suggested to him that this ideology was not right and not working, Greenspan agreed: “Absolutely. You know, that’s precisely the reason I was shocked, because I have been going for forty years or more with very considerable evidence that it was working exceptionally well.”

Just as it was unable to foresee the current financial crisis, to which it still has no solution, neo-classical economics also failed to predict or explain the Great Depression of the 1930s. On that occasion its hopeless failure led to its temporary overthrow.

Excerpt from Four Horsemen: The Survival Manual.

Originally published at

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