Academic Agent on “Six Key Lessons from Classical Economics”: A Critique

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“The Academic Agent” has a video here on what he calls “Six Key Lessons from Classical Economics” (but actually from both Classical and Neoclassical economics):

Of course, not all of his points are wrong. And, since I assume various followers of “Academic Agent” will read this, let me state: I support Post Keynesian economics, a non-neoclassical version of Keynesianism.

But let us break this down as follows, point by point:

(1) “Wealth is not Money”.

This is true. Money is clearly not wealth (if we understand by “wealth” the good and services we consume). Money cannot be consumed in the way that commodities can. Libertarians are fond accusing Keynesians of saying that “money is wealth” or that “money creation is wealth creation.” But I can’t even recall seeing any left heterodox economists who even say this. The maxim that money is not everything – which many people on the Left are fond of saying – is even a subtle admission of the point.

One can readily agree that money is not wealth. Money is (1) a unit of account, (2) a medium of exchange and (3) a store of value.

So this point, while true, is largely a straw man, if it is supposed to be directed against Keynesian economists.

Further reading here:

Money: Is it Wealth?, October 12, 2010.

(2) “The Economy is not a Zero Sum Competition”.

While there are numerous economic activities in modern capitalism that are indeed not zero sum games, there clearly do exist economic activities which are precisely that.

Many speculative activities are like this: for example, activity on secondary financial asset markets where two (or more) parties engage in a trade in which one loses and the other gains. If I “bet” on a futures option or on a currency trade, I win or lose. This is a type of zero sum game.

It is notable that “The Academic Agent” doesn’t even bother to discuss financial markets, which are a fundamental part of modern capitalism.

Furthermore, if a person goes to a casino and gambles (which is clearly a form of capitalist exchange), he wins or loses. Either he comes out with more money than he went in with or less. This is a zero sum game. One could argue that, even if a person loses, he got in return the possible thrill of winning.

But this is a specious argument, because one can also point out that gambling addicts “lose” not only their money but also social well-being as they experience devastating negative personal and social consequences as the result of gambling problems. Such people are losers, and their gambling is a zero sum game.

Of course, plenty of other economic activities and transactions are not zero sum games, but the point remains.

(3) “International Trade is not a Zero Sum Game.

Once again, while a lot of international trade may well be mutually beneficial, not all trade is.

“The Academic Agent” relies on Ricardo’s Principle of Comparative Advantage, which claims that free trade is always mutually beneficial to nations engaging in it.

Ricardo’s argument takes the example of cloth and wine production in Portugal and England. Ricardo’s argument is simple: Portugal can produce more wine by concentrating on the production of wine (where it has a comparative advantage in needing less labour), and import cloth from England, even if (as in Ricardo’s example) it takes fewer labourers to produce cloth in Portugal than in England. The aggregate effect of England concentrating on producing cloth (where its comparative advantage lies in needing fewer workers or labour hours per unit) and Portugal producing wine is that a greater quantity of these commodities can be produced in total, and Portugal and England can exchange them to mutual benefit, instead of producing fewer goods in isolation and autarky.

But this argument contains all sort of unrealistic assumptions, and a fatal flaw in that Ricardo (like other Classical economists) assumed a pre-Marxist Labour Theory of Value.

First, the argument for unrestricted free trade by Ricardo’s principle of comparative advantage requires a number of stated or hidden fundamental assumptions to work properly, as follows:

(1) if a nation focusses on comparative advantage, domestic capital or factors of production like capital goods and skilled labour are not internationally mobile, and will be re-employed in the sector/sectors in which the country’s comparative advantage lies and within that nation;

(2) workers are fungible, and will be re-trained easily and moved to the new sectors where comparative advantage lies.

(3) it does not matter what you produce (e.g., you could produce pottery), as long as you do it in a way that gives you comparative advantage;

(4) technology is essentially unchanging and uniform; and

(5) there are no returns to scale in all sectors.

Assumption (1) doesn’t hold today and what happens is movement of capital under the principle of absolute advantage. By practising free trade a nation could experience capital flight and severe de-industrialisation. This results in a type of race to the bottom for industrialised countries that do not protect their industries. Movement of capital to a place where it has absolute advantage tends to cause de-industrialization in Western countries, as capital moves to nations with the lowest unit labour and factor costs, and higher wage countries experience falling wages, high unemployment and rising trade deficits.

Assumption (2) is plainly untrue.

Assumptions (3), (4) and (5) are utter nonsense.

In essence, Ricardo’s argument ignores the long-run benefits of industrialisation (a sector which gives increasing returns to scale), and manufacturing and industrialisation are the only real way to escape the grinding rural poverty of underdevelopment (unless of course you are lucky enough to be one of the minority of nations that has lucrative commodities like energy, or to be some tiny city-state that can get by on service industries).

In the long run, Portugal is better off producing cloth and other manufactured goods, not just wine. By adopting free trade, Portugal will reduce its future aggregate output and reduce its future per capita wealth.

Finally, there is also another devastating flaw in Ricardo’s argument: Ricardo actually uses a naive Labour Theory of Value assumption in its argument! (see also Reinert 2007: 301–304 for discussion). To be more precise, one of Ricardo’s crucial arguments in favour of free trade by comparative advantage is based on the idea that specialising in the production of some commodity is inherently better just because of the comparatively lower labour time involved in production. But this is false.

Even if it takes more labour hours and human labourers to produce manufactured goods, in the long run this is a key to becoming rich, whereas dead-end production of commodities with diminishing returns to scale, even if it requires fewer labour hours and labourers, is a path to Third World poverty.

Erik S. Reinert explains the flaw here:

So, quite clearly, international trade can be a zero sum game in that some nations engaging in free trade will lose, in the sense that they will have much lower future aggregate output and lower future per capita wealth.

It also follows that protectionism may be a better policy to create industries that gave increasing returns to scale (generally manufacturing) – rather than dead-end “diminishing returns to scale,” since this is what marks successful economic development. Once the new manufacturing sectors become internationally competitive, it is possible to reduce or eliminate tariffs. Note also that this policy is perfectly compatible with the fact the other types of tariffs (protecting inefficient rent seekers) or poorly targeted tariffs can be harmful to economic development.

Further reading here:

“Robert Murphy’s Debate on Free Trade,” August 7, 2016.

“The Cult of Free Trade in a Nutshell,” July 4, 2016.

“Ricardo’s Argument for Free Trade by Comparative Advantage,” July 5, 2016.

“Erik Reinert versus Ricardo on Free Trade,” July 5, 2016.

“Erik S. Reinert on Heterodox Development Economics,” July 9, 2016.

“Britain’s Protectionism against Indian Cotton Textiles,” July 12, 2016.

“Mises on the Ricardian Law of Association: The Flaws of Praxeology,” January 25, 2011.

(4) Say’s Law.

“The Academic Agent” seems to define Say’s Law in two senses, as follows:

(1) you must produce commodities before you consume them, and

(2) supply and demand are not independent of one another, but dependent in the sense that factor payments by producers or income to producers provide the source of demand for other goods.

No serious economist even disputes (1) or (2), and certainly not Keynesians, who would merely add that the creation of credit money within capitalism (for example, by banks) is a further source of demand for goods.

The trouble is that “The Academic Agent” then proceeds to garble Say’s law and what it actually says.

He also seems unaware that historians of economic thought like Thweatt (1979: 92–93) and Baumol (2003: 46) conclude that Jean-Baptiste Say’s role in formulating the law is grossly overrated, and that Adam Smith was in fact the real father of what is recognisably Say’s law in Classical economics, with the major work in developing the idea conducted by James Mill (1808), not Jean-Baptiste Say himself.

Furthermore, Keynes did not misrepresent what the 19th century economists had said about “Say’s Law.”

If we look at how Say’s law was formulated by the Classical economists, as defined by Thomas Sowell (1994: 39–41), it was as follows:

“(1) The total factor payments received for producing a given volume (or value) of output are necessarily sufficient to purchase that volume (or value) of output [an idea in James Mill].

(2) There is no loss of purchasing power anywhere in the economy. People save only to the extent of their desire to invest and do not hold money beyond their transactions need during the current period [James Mill and Adam Smith].

(3) Investment is only an internal transfer, not a net reduction, of aggregate demand. The same amount that could have been spent by the thrifty consumer will be spent by the capitalists and/or the workers in the investment goods sector [John Stuart Mill].

(4) In real terms, supply equals demand ex ante [= “before the event”], since each individual produces only because of, and to the extent of, his demand for other goods. (Sometimes this doctrine was supported by demonstrating that supply equals demand ex post.) [James Mill.]

(5) A higher rate of savings will cause a higher rate of subsequent growth in aggregate output [James Mill and Adam Smith].

(6) Disequilibrium in the economy can exist only because the internal proportions of output differ from consumer’s preferred mix—not because output is excessive in the aggregate” [Say, Ricardo, Torrens, James Mill] (Sowell 1994: 39–41).

It is not clear that (1) is true, since most real-world prices include a profit mark-up and their aggregate value is much higher than the aggregate value of factor payments paid out in the production of the commodities.

Ideas (2), (3) and (6) are ridiculously false, since people can hoard money. In reality, people can hold money without purchasing goods and services. Furthermore, money can be spent on secondary financial or real asset markets where it is not used to purchase commodities.

This will lead to situation where aggregate output is excessive, since some people do not wish to purchase commodities at all but save their money, hoard it, or spend it on financial assets.

In any real world economy, money from income streams from production, either to capitalists or workers, can become diverted to asset markets and may not be spent on goods. For this reason alone, Say’s law is a grossly unrealistic picture of market economies. Capitalists themselves have subjective expectations about the future and the future profitability of investment, and when their expectations are shattered, they will not necessarily invest out of retained earnings.

Lastly, as a matter of historical interest, eventually Jean-Baptiste Say actually repudiated the strong form of Say’s law that we call “Say’s Identity” in his letters to Malthus.

But “The Academic Agent” is blissfully unware of this.

More reading here:

“Say’s Law: An Overview and Bibliography,” April 13, 2013.

(5) “Every part of the economy is connected to the whole of economy… .”

While this is true, this does not vindicate Léon Walras’ Neoclassical economics, which “The Academic Agent” cites as his source for this insight, which has quite specific assertions about capitalist economies.

“The Academic Agent” argues against government intervention in the economy (by quoting a passage of Thomas Sowell) and tacitly invokes Walrasian Neoclassical theory and Austrian economic theory that envisage a capitalist economy as a self-correcting or self-equilibrating machine, which gravitates towards a long-run general equilibrium state.

But this is a profoundly mistaken view of market economies, and is wrong for the following reasons:

(1) both Austrian and Neoclassical theory ultimately hold that free markets have a tendency towards general equilibrium, and hence economic coordination by means of a flexible wage and price system, and a (supposed) coordinating loanable funds market that equates savings and investment. This is an empirically false view of market economies: it is essentially the product of Marginalists from the 1870s onwards who had physics envy and wanted to model a market economy like a self-equilibrating physical system.

(2) the core Neoclassical and Austrian model in (1) is false because:

(i) market systems are complex human systems subject to degrees of non-calculable probability and future uncertainty, so that market economies would not converge to general equilibrium states even if wages and prices were perfectly flexible. This makes human decision-making highly different to the fundamental model proposed by Neoclassical economics (even with their modern ad hoc models that invoke asymmetric information and bounded rationality), and, even if Austrians supposedly accept subjective expectations in decision making, they fail spectacularly to apply it properly in their economic theory. At the heart of this failure of both Neoclassical and Austrian theory is the mistaken ergodic axiom.

Investment is essentially driven by expectations which are highly subjective and even irrational, and come in waves of general optimism and pessimism;

(ii) the loanable funds model is a terrible model of aggregate investment (partly because the mythical natural rate of interest can’t be defined outside one commodity worlds) but very importantly because of (i) (which is the point that kills both Austrian economics and Neoclassical loanable funds models).

(iii) the price and wage system is highly inflexible, and even if it were flexible all sorts of factors prevent convergence to equilibrium states anyway (e.g., the reality of a non-ergodic future, subjective expectations, shifting liquidity preferences, failure of Say’s law, spending of money on non-reproducible financial assets, wage–price spirals, debt deflation, failure of the Pigou effect);

(3) the quantity theory of money is virtually useless, because of the following reasons:

(i) the modern money supply is endogenous because broad money creation is credit-driven (that is, created by private banks and its quantity is determined by the private demand for it), and, furthermore, a truly independent money supply function does not actually exist in an endogenous money world, since credit money comes into existence because it has been demanded, and so the broad money supply is not independent of money demand, but can be demand-led;

(ii) money can never be neutral, neither in the short run nor in the long run.

(iii) the direction of causation is generally from credit demand (via business loans to finance labour and other factor inputs) to money supply increases, contrary to the direction of causation as assumed in the quantity theory, and

(iv) changes in the general price level are a highly complex result of many factors, and not some simple function of money supply.

(4) the (non-Keynesian) Neoclassicals and Austrians have an obsessive-compulsive fixation with the supply-side, but this cripples their economic theory. In our capital-rich Western economies historically (and once we re-implement some kind of industrial policy now), what mostly constrains our prosperity is the demand-side, not the supply-side.

Once we realise there is no reliable or automatic tendency to general equilibrium in capitalist economies, then nearly all arguments against government interventions to promote economic activity collapse. The whole basis of Neoclassical and Austrian economics collapses.

For example, the assumption of “The Academic Agent” that a government program to build a bridge would automatically destroy private sector jobs, or harm the economy, does not follow at all, and certainly not if we have a recession or depression and vast resources are idle, and there is no private sector impetus for using such idle resources on capital investment or production.

Finally, George L. S. Shackle summed up the essence of Keynes’ theory as follows:

[sc. Keynes’s] ... theory of involuntary unemployment is perfectly simple and can be expressed in a paragraph, or in a sentence. If you express it in a sentence, you simply say that enterprise is the launching of resources upon a project whose outcome you do not, and cannot, know. The business of enterprise involves investment, the investing of large amounts of resources--huge sums of money--in things whose outcome you cannot be certain of, which could perfectly well turn into a disaster or a brilliant success.

The people who do this kind of investing are essentially gamblers and they can lose their nerve. And if they decide to withdraw from trade, they sweep their chips up from the table. If they decide it’s too risky, if their nerve gives out and they can’t bring themselves to go on investing, they cease to give employment and that is the explanation.

When business is at all unsettled--when there’s any sign at all of depression--or when there’s been a lot of investment and people have run out of ideas, or when their goods are not selling quite as fast as they have been, they no longer know what the marginal value product of an extra man is—it’s non-existent. How can you say that a certain number of men have a certain marginal productivity when you can’t know what the per unit value of the goods they would produce if you employed them would sell for?”
“An Interview with G.L.S. Shackle,” The Austrian Economics Newsletter, Spring 1983.

This is actually a splendid summing up of what Keynes’s theory is about, and why both Austrian and Neoclassical economics are nonsense.

More reading here:

“The Essence of Keynesianism is Investment,” December 8, 2012.

“Steve Keen, Debunking Economics, Chapter 6: Wages,” February 12, 2014.

“Steve Keen, Debunking Economics, Chapter 5: Theory of the Firm,” February 13, 2014.

“Kaldor on Economics without Equilibrium,” March 9, 2013.

“Kaldor on the Irrelevance of Equilibrium Economics,” May 15, 2013.

“Steve Keen on Consumer Theory,” March 14, 2014.

“What is Wrong with Neoclassical Economics?,” March 30, 2014.

“The Law of Demand in Neoclassical Economics,” June 1, 2013.

“What is the Epistemological Status of the Law of Demand?,” September 19, 2013.

“Steve Keen on the Law of Demand,” September 20, 2013.

“Price, Average Total Cost, Average Variable Cost and Marginal Cost,” November 28, 2013.

(6) “Marginal Utility”.

“The Academic Agent” ends with pointing out the “value” in the sense of desiring or evaluating commodities is subjective. This is true, but does not take you very far.

The law of diminishing subjective marginal utility states that, as a person consumes an additional unit of the same good (or a homogenous good), then the satisfaction or utility derived from the consumption of that good diminishes and continues to diminish with each additional good.

As a general empirical principle, it is true, but there are important exceptions, as can be seen here. But this general principle does not refute the case for government intervention in the economy.

Moreover, most prices in modern capitalist economies are not determined by the dynamics of supply and demand, but in reality are cost-based mark-up prices, which tend to be relatively inflexible downwards. Moreover, this is now the overwhelming conclusion of the Neoclassical empirical research literature itself, as can be seen here (with full citation of literature on price determination).

The relative downwards price rigidity in modern capitalism (largely an outgrowth of businesses and corporations themselves trying to avoid flexible price markets) also destroys the whole basis of the correction mechanism envisaged in Neoclassical and Austrian economics, since they think that product markets have a tendency to clear by highly flexible prices, when in reality this is confined to a minority of markets.

More reading here:

“The ‘Law’ of Diminishing Marginal Utility,” March 7, 2014

Mark-up Pricing in 21 Nations and the Eurozone: the Empirical Evidence.

BIBLIOGRAPHY
Baumol, William J. 2003. “Retrospectives: Say’s Law,” in S. Kates (ed.), Two Hundred Years of Say’s Law: Essays on Economic Theory’s Most Controversial Principle. Edward Elgar Pub, Cheltenham and Northampton, Mass. 39–49.

Reinert, Erik S. 2007. How Rich Countries Got Rich, and Why Poor Countries Stay Poor. Carroll & Graf, New York.

Sowell, T. 1994. Classical Economics Reconsidered (2nd edn.). Princeton University Press, Princeton, N.J.

Thweatt, W. O. 1979. “Early Formulators of Say’s Law,” Quarterly Review of Economics and Business 19: 79–96.