Neoclassical Economics is Dead. What Comes Next?

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By Steven Klees, an economist, Distinguished Scholar-Teacher and Professor of International Education Policy at the University of Maryland. Originally published at Evonomics.

Much has been written about the failure of neoclassical economic theory (NCT), so I won’t belabor the point, but I do want to highlight what is too rarely said – that the central concept of NCT, economic (Pareto) efficiency is empty in theory and practice. 

The great feat of neoclassical economics has been to convince people that there is a vantage point to view society, separable from concerns with equity and distribution.  This vantage point, defined as economic efficiency, supposedly allows one to see if society as a whole is better off, such that decisions to produce a particular array of goods and services could be made in the interests of everybody, irrespective of how little one had, thus separating efficiency decisions from equity ones.  However, if prices are not defined according to the exact dictates of what economists call “perfect competition,” then private profitability tells us nothing about the comparative social advantages and the consequent “efficiency” of producing, let’s say, more yachts for rich people instead of more rice and beans for poor people.  Similarly, to argue that the allocation of resources can be “efficient” even if half the world is starving to death is ridiculous, but that is exactly what neoclassical economics says.

I find this legerdemain of inventing a concept of efficiency separate from equity, based on a completely unreal, obviously untrue, abstraction, is absurd on the face of it.  If the absurdity of this framework is not obvious, one only has to look at what NCT calls “second best theory.” The “first best” world is that of perfect competition; “second best” refers to a world with at least one “imperfection,” say, one monopoly in a world that was otherwise perfectly competitive.  Second-best theory essentially asks: “If we don’t live in the first-best world of perfect competition but have, let’s say, only one imperfection in an otherwise perfect world, what are the results?”  It turns out, reluctantly admitted by neoclassical economists – second best is their own theory, not a plot by critics – that with just one imperfection, there are ripples so that all market prices become distorted, and Adam Smith’s famous invisible hand is no longer a good guide to the social interest, and the system is no longer efficient — nor is there even any sense of whether it is close to efficiency.  In the real world of multiple imperfections – where none of the assumptions of perfect competition hold – even if the neoclassical concept of efficiency had some meaning in theory, in practice, it is an abysmal failure, a completely empty idea.

Economic Empiricism is a Dead End

Debates within and between economic theories are examined through empirical work.  But how valid and worthwhile are the studies produced, which in the aggregate cost hundreds of millions of dollars and are so influential in policy circles?  Much of the debate is about what are the effects of different programs and policies.  To assess quantitatively the impact of an intervention, there are two ways to rule out confounding variables – statistical controls and experimental controls.  Both are fundamentally problematic in theory and in practice.   To trust in statistical controls via some form of regression analysis, you cannot just include ad hoc a few control variables but need three conditions: include all variables that affect the dependent variable, measure them correctly, and specify the proper functional form.  These conditions never hold, and the result is that different studies come to different conclusions, rather arbitrarily as a result of the idiosyncrasies of the variables, measures, and models used.  In education, for example, hundreds of input-output studies (with student test scores as the dependent variable) offer no consistent findings.

Experimental controls via RCTs have been touted as a better strategy for impact assessment, indeed as the “gold standard” of research methods.  However, they have been strongly critiqued for their lack of generalizability because they do not account for context.  The validity of their findings is also suspect as too often control groups are not comparable to treatment groups, and effect sizes are small. In practice, RCTs very often come to inconsistent and divergent conclusions.  What this all comes down to again is that the evidence supporting the impact of policies and programs is cherry-picked, and “what works” is in the eye of the beholder.

Some Implications

The implications of my methodological critique go way beyond economics.  Fundamentally, it is a social science problem.  The social sciences have long been captured by physics envy.  Some observer once pointed out that physics would fall apart if particles had intentions.  We live on a planet with 7 billion human beings, all with different intentions living in very complex contexts.  Our empirical ability to find regularities is very rudimentary.  We do better in fields that have a base in the physical sciences, and we can generally believe things like wearing masks helps protect against virus transmission or that human activity is causing global warming.  Of course, even these are contested by some.  But agreed upon findings in the social sciences are much rarer – if indeed there are any significant ones.  The promise of the policy sciences – that social science could give us clear facts about causal impact – is belied in theory and in practice, as I have argued above, here, and elsewhere.  We need to recognize that and be much more modest in our claims and much more aggressive in ensuring that our policy choices are made with widespread debate and participation.

The implication of my critique of NCT is that if economic efficiency is meaningless, neoclassical economics is useless.  No amount of tinkering will help.  Without economic efficiency as its bulwark, capitalism loses its ideological justification other than one that says markets are practically a better allocation device than a command economy.  But markets can be circumscribed and regulated in any ways we find reasonable.  There need be no justification of externalities or public goods.  Equity can be the reason, and there is no equity-efficiency tradeoff, which is all fiction since efficiency is meaningless.  There is no reason to stubbornly hang on to NCT and its justification for capitalism in the way that even critical neoclassical economists like Krugman, Reich, Rodrik, and Stigltiz do.

Moreover, in practical, real-world terms, capitalism is the most inefficient system ever invented.  Although it produces riches for some, it leaves billions of people at its margins, many fighting to survive, many surviving in precarious positions, environmental destruction built into it, and climate catastrophe almost upon us,

It is very unlikely that there will be a Copernican moment where another grand theory replaces NCT.  NCT is an outlier in the social sciences – there is no one theory like it and especially not one that promises to tell you the right course for public policy (based on the efficiency idea).  Heterodox, left, intersectional political economy perspectives do offer a variety of useful alternative views on economic policies and practices, but empirical studies will never resolve or even enlighten the existing debates between competing economic paradigms.

So What to Do?

To my mind, we don’t need more economic theory and empirics. What we do need is more attention to the many alternative economic practices being written about and being practiced.  Contrary to Margaret Thatcher’s TINA, There is No Alternative, I’m a believer in David Bollier’s TAPAS, There are Plenty of Alternatives!  For 20 years, I have been teaching a course on alternative development.  In the beginning, it was difficult to find works to read; now, there are so many people writing about this, I can’t keep up.  To conclude this essay, I will talk briefly about some of the writing, efforts, and practices I have found most compelling.

Let me start with the wonderful new book, edited by Gus Speth and Kathleen Courrier, The New Systems Reader: Alternatives to a Failed Economy.  Its 28 essays explore a plethora of alternatives ranging from the Nordic experience to economic democracy to eco-socialism.  Pluriverse: A Post-Development Dictionary, edited by Ashish Kothari and colleagues, discusses a dozen or so “reformist solutions” like a green economy and smart cities but spends the most time on literally dozens of “transformative initiatives” like the alter-globalization movement, alternative currencies, buen vivir, the commons, degrowth, ecofeminism, solidarity economies and ubuntu. 

Most of the writing about alternatives to capitalism still see the need to rely on a market system.  One interesting and different approach is embodied in the many decades of work by two political economists, Michael Albert and Robin Hahnel, on participatory economics or parecon.  They and other point out that markets corrode human values and solidarity and propose a series of worker and consumer councils to make production decisions and allocations of goods and services.  While this may be difficult in practice, it is important food for thought.

These are more than academic exercises, and all connect with concrete alternative practices happening on the ground.  There are now many advocacy organizations promoting concrete alternatives.  WEAll, the Well-Being Economy Alliance, seeks to “transform the economic system into one that delivers social justice on a healthy planet” by moving beyond an orientation to GDP and economic growth.  The Next System Project (NSP) “promotes visions, models, and pathways that point to a ‘next system’ radically different in fundamental ways from the failed systems of the past and capable of delivering superior social, economic, and ecological outcomes.”  Especially interesting is the work of one of NSP’s founders, Gar Alperovitz, who argues that, in the U.S., capitalism is already being transformed by democratized ownership through millions of employee owners and thousands of community development corporations and cooperatives.  The Democracy Collaborative, of which the NSP is an offshoot, is collaboratively working to transform local communities and has been very successful in Cleveland, Ohio and Preston, England.  They are also working on promoting “next system studies” at universities.

Taking a worldwide perspective, especially but not exclusively oriented towards rural and indigenous communities, the Global Tapestry of Alternatives, has developed a network of people and organizations changing how people live.  During this pandemic era, they have offered about 15 fascinating webinars documenting and sharing alternative system practices including African ecofeminism, commoning, the Kurdish women’s movement in Rojava, and eco-socialism in Jackson, Mississippi.  Bernie and Jane Sanders and Yanis Varoufakis started another organization, Progressive International, to bring us all together: “to unite, organize and mobilize progressive forces behind a shared vision of a world transformed.”

Much of the work referenced above explicitly talks about the need to move beyond capitalism, to find a new modality of social organization.  But even some that doesn’t can be transformative.  A movement started by French female scholars, called Democratizing Work, has gone global with an op ed published in dozens of newspapers around the world and signed by over 5000 researchers calling for “democratizing firms, decommodifying work, and remediating the environment.”   Noted economists like Thomas Piketty and Dani Rodrik are supporting this.  Rodrik has even made the interesting argument that creating good jobs creates massive externalities.  Within neoclassical economics, this has devastating implications for a capitalist system which fundamentally relies on markets to create jobs.  If Rodrik is correct, neoclassical economics would imply that governments have a significant responsibility to see to good job creation.

I think even within-system alternatives like universal basic income (UBI) and a 4-day work week can have transformative implications.  UBI changes many things: reduces poverty and inequality; lessens workers’ willingness to do poorly paid work; allows for more part-time creative and craft work; allows people to return to school or do care work; and minimizes assistance bureaucracy.  Norway has a form of UBI, and other countries are experimenting with it.  A 4-day work week also changes many things: increases productivity; makes for a happier and more committed worker; improves work-life balance; and reduces our carbon footprint.  Combining UBI and a 4-day work week may have significant synergies, allowing for a much better quality of life.  Scotland is experimenting with both.  I think the slogan, “Share the Wealth, Share the Work,” could be popular politics.

I was fortunate enough to attend the World Social Forum (WSF) twice and march with 100,000 activists from all over the world and meet some of them who were struggling to engage in alternative practices to change the world in areas like education, health, food, water, environment, or development generally. These activists go home from the Forum and interact and network with millions, building a global network. The energy and optimism there was contagious. I am also optimistic because I have been fortunate to work in dozens of countries, and everywhere I found people who believed what is the slogan of the WSF — Another World is Possible — and who were struggling for it. Economics does not have to be the dismal science. A focus on alternative economic practices opens up a world of possibilities. Let me close with a quote from Arundhati Roy: “Another world is not only possible, she is on her way. On a quiet day, I can hear her breathing.”

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