Book of the Week + Brainstorm

As I mentioned previously, tomorrow night will be the much-anticipated Brainstorm with Dr. Steve Keen, one of, if not the most, significant economists working today. The event is open, it will take place on May 06, 2016 at 7:00 PM  Eastern, and you can register for it here.

As I was going over the second edition of his book, Debunking Economics, (which is also this week’s Book of the Week) in order to prepare a few questions, I was struck by the way in which his key observation, that demand is not stackable, completely demolishes the foundation of modern economics. I’m not entirely sure even Dr. Keen fully grasps the consequences of his revolutionary mathematical – and logical – observations. From the section entitled Don’t tell the children:

For many years, the leading text for Honors, Master’s and PhD programs was Hal Varian’s Microeconomic Analysis (Varian 1992). Varian ‘summarized’ this research so opaquely that it’s no surprise that most PhD students – including those who later went on to write the next generation of undergraduate textbooks – didn’t grasp how profoundly it challenged the foundations of neoclassical theory.

Varian started with the vaguest possible statement of the result: ‘Unfortunately […] The aggregate demand function will in general possess no interesting properties […] Hence, the theory of the consumer places no restrictions on aggregate behavior in general.’

The statement ‘no interesting properties’ could imply to the average student that the market demand curve didn’t differ in any substantive way from the individual demand curve – the exact opposite of the theoretical result. The next sentence was more honest, but rather than admitting outright that this meant that the ‘Law of Demand’ didn’t apply at the market level, he immediately reassured students that there was a way to get around this problem, which was to: ‘Suppose that all individual consumers’ indirect utility functions take the Gorman form [… where] the marginal propensity to consume good j is independent of the level of income of any consumer and also constant across consumers […] This demand function can in fact be generated by a representative consumer’ (ibid.: 153–4; emphases added. Curiously the innocuous word ‘generated’ in this edition replaced the more loaded word ‘rationalized’ in the 1984 edition.)

Finally, when discussing aggregate demand, he made a vague and reassuring reference to more technical work: ‘it is sometimes convenient to think of the aggregate demand as the demand of some “representative consumer” […] The conditions under which this can be done are rather stringent, but a discussion of this issue is beyond the scope of this book […]’ (Varian 1984: 268).

It’s little wonder that PhD students didn’t realize that these conditions, rather than merely being ‘rather stringent,’ undermined the very foundations of neoclassical economics. They then went on to build ‘representative agent’ models of the macroeconomy in which the entire economy is modeled as a single consumer, believing that these models have been shown to be valid. In fact, the exact opposite is the case.
The modern replacement for Varian is Andreu Mas-Colell’s hyper-mathematical – but utterly non-empirical – Microeconomic Theory (Mas-Colell, Whinston et al. 1995). At one level, this text is much more honest about the impact of the SMD conditions than was Varian’s. In a section accurately described as ‘Anything goes: the Sonnenschein-Mantel-Debreu Theorem,’ Mas-Colell concludes that a market demand curve can have any shape at all, even when derived from consumers whose individual demand curves are downward-sloping:

Can [… an arbitrary function] coincide with the excess demand function of an economy for every p [price …] Of course [… the arbitrary function] must be continuous, it must be homogeneous of degree zero, and it must satisfy Walras’ law. But for any [arbitrary function] satisfying these three conditions, it turns out that the answer is, again, ‘yes.’ (Ibid.: 602)

But still, the import of this result is buried in what appear to the student to be difficult problems in mathematics, rather than a fundamental reason to abandon supply and demand analysis. Earlier, when considering whether a market demand curve can be derived, Mas-Colell begins with the question: ‘When can we compute meaningful measures of aggregate welfare using […] the welfare measurement techniques […] for individual consumers? (ibid.: 116).

He then proves that this can be done when there is ‘a fictional individual whose utility maximization problem when facing society’s budget set would generate the economy’s aggregate demand function’ (ibid.: 116). However, for this to be possible, there must also exist a ‘social welfare function’ which: ‘accurately expresses society’s judgments on how individual utilities have to be compared to produce an ordering of possible social outcomes. We also assume that social welfare functions are increasing, concave, and whenever convenient, differentiable’ (ibid.: 117).

This is already a case of assuming what you wish to prove – any form of social conflict is assumed away – but it’s still not sufficient to generate the result Mas-Colell wants to arrive at. The problem is that the actual distribution of wealth and income in society will determine ‘how individual utilities are compared’ in the economy, and there is no guarantee that this will correspond to this ‘social welfare function.’

The next step in his ‘logic’ should make the truly logical – and the true believers in economic freedom – recoil in horror, but it is in fact typical of the sorts of assumptions that neoclassical economists routinely make to try to keep their vision of a perfectly functioning market economy together. To ensure that the actual distribution of wealth and income matches the social welfare function, Mas-Colell assumes the existence of a benevolent dictator who redistributes wealth and income prior to commerce taking place: ‘Let us now hypothesize that there is a process, a benevolent central authority perhaps, that, for any given prices p and aggregate wealth function w, redistributes wealth in order to maximize social welfare’ (ibid.: 117; emphases added).

So free market capitalism will maximize social welfare if, and only if, there is a benevolent dictator who redistributes wealth prior to trade??? Why don’t students in courses on advanced microeconomics simply walk out at this point?

I surmise that there are three main reasons, the first of which is banal. Mas-Colell’s book is huge – just short of 1,000 pages – and lecturers would cherry-pick the sections they teach. I doubt that most students are exposed to this statement by their instructors, and few are likely to read parts that aren’t required reading for pleasure alone.

Secondly, the entire text is presented as difficult exercises in applied mathematics. Students are probably so consumed with deriving the required answers that they gloss over English-language statements of these assumptions which make it blatantly obvious how insane they are.

Thirdly, by the time students get to this level – normally in PhD programs – they are so locked into the neoclassical ‘assumptions don’t matter’ mindset that I discuss in Chapter 8 that they don’t even worry if an assumption is insane.

If you followed that, then you can understand why this is critically fascinating material that is almost shockingly ignored by nearly everyone who should know better.