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Mainstream, Vol XLVI, No 19

Critique of Neo-classical Economics

Sunday 27 April 2008, by P R Dubhashi


Like all academic disciplines, economics has also been continuously engaged in the examination of its definition, nature, scope and significance. This article seeks to give an overview of this from Classical Economics to modern times.

Classical Economics

THE foundations of Economics, more appropriately known as political economy in those days, were laid by the “classical economists” in the wake of rise of industrial capitalism in Great Britain (1760-1820). Adam Smith’s “Enquiry into the Wealth of Nations” 1776 is acknowledged as the first comprehensive treatise on the subject. He considered broadening of the market as the key to the Wealth of Nations. He brought out some of the basic forces and impulses governing the market economy—the most important of which was the basic impulse of the economic agents participating in the market to pursue “self-interest”. In a famous sentence he pointed out that the butcher, the baker and the brewer do not supply meat, bread and wine for satisfying the consumer but for serving their own self-interest, namely, making a living for themselves; yet thanks to the invisible hand in the market, their self-serving activities redound to public good. He emphasised the importance of division of labour and specialisation in increasing the productivity of the market economy. He identified demand and supply as the basic market forces. His successor, Ricardo (Principles of Political Economy and Taxation, 1817) extended the thinking to international trade and formulated the law of comparative advantage, which holds ground till this day. He formulated the law of diminishing returns especially in relation to land. J.S. Mill, the last amongst the classical economists, synthesised thinking in his “Principles of Political Economy”, 1848. He made a distinction between production and distribution, the former being the sphere of the free market economy while the latter leaves scope for intervention.

Thomas Malthus (Principle of Population, 1798) brought out the long-term race between economic (agricultural) and population growth—while the former grows in arithmetic proportions, the latter in geometric proportion thereby creating an imbalance which can only be rectified by pestilence, disease and famine.

Karl Marx (Das Capital) was the deviant who predicted the collapse of capitalism because of its inner contradictions. Exploitation of the working classes (wages paid being less than the value of labour) would lead to under consumption, collapse of demand and fall in profits leading to the economic crisis of capitalism.

Neo-classical Economics

THE 1870s and later years saw the emergence of neo-classical economics which formulated precise “economic laws” regarding consumption, production and distribution based on the theory of optimisation through calculation of cost and benefit at the margin. The consumer optimises his purchasing power by equalising the marginal utility of all commodities, purchased according to his scale of preference, derived from the last unit of money spent on them. The producer optimises the use of the factors of production by equalising their marginal productivity to the amount paid (that is, wage equals marginal productivity of labour, rate of interest equals the marginal efficiency of capital and rent to marginal productivity of land except, as pointed out by Ricardo, in the case of land of higher productivity which would receive higher returns called rent). A firm would produce up to the point where marginal cost equals marginal revenue.

There would be the tendency towards equilibrium in the market at which point demand and supply of goods, services and factors of production would be in balance through the operation of the price mechanism. If at any time demand exceeds supply there would be the tendency for the price to go up which would result in fall in demand and increase in supply, the latter because of increase in the profit margin. In the case of some commodities there would be equilibrium in the short run while in the case of others it would be in the long run depending on the elasticity of supply. The Pareto equilibrium states the theoretical property of the competitive market to produce optimum results. The general implication of the competitive market equilibrium theory is that the role of the government should be as small as possible.

There was increasing sophistication and precision in the formulation of these laws. Alfred Marshall in England (Cambridge), J.B. Say in France, Knut Wicksell in Sweden, and Irving Fisher and J.B. Clark in the USA were some of the leading economists who gave shape to neo-classical economics.

Mathematical Economics

TWO economists of the neo-classical school, namely, William Stanley Jevons of Manchester University and Leon Walras, of Lausaune University felt that the economic laws being concerned with quantities lend themselves to mathematical formulations. They introduced mathematical systems of analysis. Walras pioneered the concept of “general equilibrium” based on simultaneous equations relating to all the transactions in the economy. The culmination of the mathematical approach to economics was P.A. Samuelson’s “Foundations of Economics” (1947), a 379-page book of mathematical formulations. Econometrics evolved as a specialised branch of Economics but it had no empirical content.

The recent contribution of mathematicians to Economics is the fascinating “Game Theory” which dates back to “The Theory of Games and Economic Behaviours”, 1944 by John Van Newmann and Oskar Margenstern followed by John Nash, on whom the movie “A Beautiful Mind” has been prepared. One classic example of the game theory is the “prisoner’s dilemma”. There is a best strategy for each individual but if chosen it will make each individual worse off. Economists like Thomas Schelling, the winner of the 2005 Nobel Prize, made the game theory popular. But the “Game Theory” does not give concrete examples with real data or observed facts.

The techniques of complex theory also have had a big impact on Economics which worships mathematical techniques, pays little attention to behavioural and institutional forces in the real world, which is too messy to model with tidy equations. Alfred Marshall, who did include some mathematics in his Principles, had widely observed: “Use mathematics as a short term language rather than as an engine of enquiry.” Keynes, originally trained in Mathematics, decided that a purely mathematical approach to Economics was not fruitful.

Though economic phenomena are often measurable, mathematical methods are hardly appropriate for the problems which economics has to handle. The analogy between Physics and Economics is misleading.
The classical economists used the term “Political Economy”; after the 1870s the term went out of fashion and was replaced by the term “Economics”.

Economists started talking of their subject as science like Physics. This distinguished Economics from other Social Sciences and lent it a prestige which the latter lacked because of their imprecise formulations.

Definition of Economics

THE term “Political Economy” had a wider connotation while the term “Economics” was narrowly focused. Adam Smith, who wrote the treatise on Wealth of Nations, had earlier published his “Theory of Moral Sentiments”. Though his theory of the market was based on the concept of self-interest, he considered moral values as important. He condemned the tendencies of business people to indulge in conspiracy against the interest of the common people. He recognised the role of the State in supporting the moral and legal framework in which market has to operate. Ricardo considered that the whole purpose of the subject of Economics was to improve human welfare.

Even Alfred Marshall, the fountain-head of neo-classical economics, defined Economics in wider terms. On the first page of Principles (1890) he gave the following definition: “Political Economy or Economics is the study of mankind in the ordinary business of life, it examines that part of individual and social action which is most closely connected with the attainment and the use of material requisites of well being.”

The break came in 1932 with the publication of the essay “Nature and Significance of Economics” by Prof Lionel Robbins. It re-defined Economics as the science of individual choice concerned with the optimum use of “means” which are limited for the attainment of “ends” which are unlimited. Thus, Economics became a technical subject, cutting its umbilical knot with the social phenomena and social sciences. Its focus became narrow and highly specialised.

Teaching of Economics

THE narrow focus of Economics soon started getting reflected in teaching of Economics in the universities and other academic institutions. The courses in economic history and history of economic thought which formed an integral part of the syllabi for graduate and post-graduate courses started getting omitted and replaced by technically and mathematically oriented courses. Students started getting involved in curves and equations without any background of classical economics and historical evolution of the subject. Economics taught in abstract terms started getting divorced from the economic reality and perspective of historical evolution.

The Birth of Keynesian Macro-economics

IN spite of its scientific pretensions the so-called laws of Economics, divorced from reality, were found wanting in anticipating and providing sound policy prescriptions to tackle challenges confronting capitalist economies. The greatest challenge was posed by the unprecedentedly severe and long lasting depression in the US economy from 1929 onwards. The laws of Neo-classical Economics required cut in wages to cut costs and create profits, which would stimulate business and raise the economy out of trough. But this did not happen. On the other hand cut in wages reduced demand and deepened depression. Market did not provide an automatic correction and public intervention on a massive scale in the shape of President Roosevelt’s New Deal Programme became necessary. It is against this background that J.M. Keynes came out in 1936 with his “General Theory of Employment, Interest and Money”. He presented a new theoretical construction. He moved from micro to macro and focused attention on Aggregate Demand and Aggregate Supply. Aggregate Demand and Aggregate Supply could be in equilibrium but at less than full employment level. For the economy to be lifted to equilibrium at full employment level, public authorities would have to stimulate aggregate demand by augmenting investment and consumption. Inducement to invest and propensity to consume are the dynamic elements in the economy which have a multiplier effect. These new concepts and insights came like a breath of fresh air ushering in what came to be known as the “Keynesian Revolution”. Books on new Economics known as Macro-economics soon appeared embodying and elaborating the Keynesian analysis. Papers on Macro Economics came to be included in the syllabi of academic courses. Whole statistical systems focusing on income, investment, consumption, money and interest were designed. Robert Engle and Clive Granger, who won Nobel Prize in 2003, made statistical analysis of a series such as GDP, inflation, stock prices etc.

But World War II intervened and the economic stimulus provided by the war effort absorbed unemployment. On the other hand, demands for war supplies created scarcities and inflationary pressures, which continued even after World War II. Keynesian remedies, that is, fiscal policies in reverse were required to cut public expenditure and curb excessive investment and consumption. Instead, Keynesian economics was held responsible for inflation. The centre of gravity shifted from fiscal to monetary remedies. Under the leadership of Milton Friedman emerged the Chicago School which debunked Keynesian economics and returned to orthodox economics and its remedies and focused on inflation rather than employment. If inflation is curbed through a steady money supply, flexible labour market, cut in wages, control over TU demands and curtailment of social benefits of a welfare state, free market would take care of the economy. The sole function of the Central Bank of a country should be to keep a stable money supply and prevent the emergence of inflationary pressures. If there is still some amount of unemployment, it should be treated as “natural unemployment” which was bound to exist in any economy. Thus, to the old concepts of “frictional unemployment” and “structural unemployment” was added “Natural Rate of Unemployment” (NRU). There is a trade-off between inflation and unemployment. When inflation accelerates, actual unemployment persists below NRU. The concept of natural unemployment was vague but it served the purpose of exempting the Central Bank or the Government from any responsibility. The pain caused by “Natural Unemployment” was considered necessary to provide incentives to the working classes to work harder on lower wages. The influence of this kind of thinking was reflected in the increase of more than 200 in the average working hours per year in the USA.

Macro-economics is also sought to be brought within the fold of Micro-economics. Some economists of the neo-classical type have envisaged that if “an auctioneer” would be placed in charge of the Macro-economy, he will govern it according to the optimising rules of Micro-economics. New Macroeconomics books are full of analyses of prices, market, competition etc. Ozgur Gun of the University of Remschampague Ardene considers that the whole effort is “absurd”. There is no need to give “micro-economics” foundations to “macro-economics”.

Development Economics

FROM about the middle of the twentieth century, several countries of Asia and Africa started emerging as independent countries free from the yoke of imperialism of the Western countries. They felt that political independence should be used for rapid economic development so that their peoples can get out of the vicious circle of poverty and enjoy better conditions of living and reduce the gap between their own living standard and that of the Western countries. These countries came to be known as “developing” countries as compared to the “developed” countries of the West. “Development” had to include building the infrastructure of transport, communication, education and health facilities, power generation, modernisation of agriculture, industrialisation and diversification of the economy. Countries like India felt that such comprehensive and balanced development could not be left to the vicissititudes of the market forces of demand and supply; development had to be deliberately designed and fostered by the State as was pointed out by Freidrich List at the time of the German economic development. While economists like Rauel Prebisch of Argentina advocated the strategy of import substitution, which was followed by a country like India, others like South Korea followed the strategy of export promotion. In both models, it was recognised that entrepreneurial activity needs judicious state support. Through a combination of visionary government and entrepreneurial activities, Singapore has risen rapidly to a level higher than that of many European countries. But the government has to be efficient. Waste and inefficiency in the public sector should have no place. The public sector in Singapore works like a company. Various alternative strategies like big push (Rosenstein Rodain, 1943), unbalanced growth (Alber Hirschman), take-off (Walter Rostow) were advocated. In all these different approaches, capital formation through investment emerged as the key factor though the importance of technology and human resource development was well recognised. Ragner Nurske suggested capital formation through mobilisation of manpower as in China. A lot of economic literature emerged, and these came to be recognised as a distinct branch of Economics that is, “Economics of Development” for which academic courses were established as a part of the curriculum. A number of textbooks were written—such as W.A. Lewis’s Theory of Economic Growth, or Kindleberger’s “Economic Development”. But orthodox economists like Peter Bauer rejected any special category of “Development Economics”.

Neo-classical Economics had paid little attention to answer the question “what makes economies grow?”, apart from dwelling on the theme of static equilibrium with optimum allocation of resources. But faced with the challenges before the underdeveloped countries, economists tried to provide a theoretical analysis to supplement the record of empirical evidence the most comprehensive of which were studies published by Angus Maddison—“The World Economy: A Millennial Perspective” and “The World Economy: Historical Statistics”. Economists identified savings, investment, and accumulation of capital, innovations and technology as key factors in development. The first amongst the models of development was the “Harrod Domar Model”—investment rate divided by capital-output ratio determines the rate of growth. Robert Solow’s 1956 article emphasised the role of technology for long-term growth. Papers by Robert Lucas (1988) and Paul Romer (1986-1990) focused on human capital (stock of knowledge) and technological innovation respectively. A paper by Arvind Dixit and Joseph Stiglitz (1976) drew attention to the role of differentiated products and increasing returns to scale. Paul Krueger emphasised the role of geographical clusters, education, research and innovation in boosting productivity and growth. In addition to traditional, physical capital of machines and buildings, investment in skills and abilities of work forces were emphasised.

Eradication of poverty has been the greatest challenge before the developing countries. It was expected that if economic growth takes place, the fruits will eventually percolate to the poor. However, Micro-economics has not explained how the percolation theory works. In several Latin American and African countries, poverty has proved intractable. Most of the decline in poverty is in China and to some extent in India. On the whole, the income level of poor countries has failed to cope up with the income level of rich countries.

In recent years, it is realised that per capita income figures are not adequate; they should be supplemented by human development index, as developed by the UN. The index includes items like availability of drinking water, sewage disposal system, and rates of infant mortality, life expectancy etc. In affluent countries too GNP growth is supplemented by measures for economic welfare. Economic growth has allowed fewer working hours, for example, Sweden, a welfare state, has 1300 to 1400 hours in a year as against 1600 in Britain and the USA and 2000 in Japan. But in these countries domestic labour with no help absorbs much of the leisure time.

Development Economics, however, suffered a set- back when as a part of the “Washington Consensus”, the World Bank and International Monetary Fund and later the World Trade Organisation after it was set up in 1995, started insisting that countries approaching them for assistance should strictly follow the Structural Adjustment Programme (SAP) which envisaged marketisation of the economy as against planning, liberalisation as against dirigisme or state control and regulation and privatisation as against the public sector, open economy as against autarky and fiscal discipline implying minimisation of public expenditure and “minimal state”. The programme was uniformly insisted upon irrespective of different socio-economic, geographical and historical background and different problems faced by different counties. The approach was “one size fits all”. The result was hardly beneficial—several countries of Latin America and Africa suffered a set-back after the SAP was imposed as brought out by economists like Jeffrey Scotts and Joseph Stiglitz.

When the poster boys of development, the East Asian countries—like Thailand, Malaysia, Indonesia and South Korea—suddenly suffered an unanticipated economic crisis in 1998, the remedy suggested was also on the lines of the SAP which made for painful recovery. A country like Malaysia, which did not follow the advice, did better.

Under the leadership of Milton Friedman and the Chicago boys, a “shock therapy” was imposed by dictator Pinochet’s regime in Chile. A similar strategy was imposed on Russia after the collapse of communism. In both countries it led to the emergence of oligarchies who looted the natural resources of these countries.

Shaky Foundations of Micro-economics

WHILE market economy seems to have emerged triumphant in today’s era of globalisation, there is a keener realisation that neo-classical Micro-
economics, which is supposed to provide intellectual support to the free market economy, is itself based on questionable assumptions. Kenneth Arrow, a Nobel Prize winner, through his papers, made economists aware of the stringent conditions required for competitive equilibrium.

First, the concept of “homo-economics”, the individual economic agent, whether consumer or producer, making choices or taking decisions is a faulty one. An individual does not exist in isolation. He or she is a member of a family and society and his or her choices and decisions are influenced by interpersonal relationships and community values. The economic activity is embedded in a web of social institutions. An individual should be placed in a social context, as observed by the economist, Nobel Prize winner Trygve Haavelmo, in his lecture “Economics and Welfare State” (1989).

Secondly, the stipulation that an individual makes “rational” choices and takes “rational decisions” in “self-interest” is not valid. The behaviour of the individual is influenced by many factors including moral and ethical considerations and is not purely “hedonist” in character. “Impulse buying”, spontaneous consumption decisions, adventure and desire for the unknown are not always “rational”. But they do characterise individual decisions.

Thirdly, the assumptions relating to a perfectly competitive market are inconsistent with the conditions in the real world. One of the assumptions is that there are innumerable buyers and sellers none of whom by themselves are able to influence the market. In actual world, there are conditions of monopoly, oligopoly and imperfect competition based on differentiated products. In the thirties, E. S. Chamberlain and Joan Robinson wrote books to modify the “laws” formulated to suit a perfectly competitive market. This was before the emergence of modern corporations. As J. K. Galbraith has pointed out, corporations of today are so powerful that with the aid of advertisements and money power they are able to reverse the proposition that supply is according to demand. Corporations manipulate demand to be in accordance with supply.

Nor is the assumption of “perfect knowledge” valid. Consumers are often ill informed about the products and services they buy. There is no “instantaneous omniscience”.

Fourthly, firms in the real world do not take decisions regarding production by equating marginal cost with marginal revenue or by constantly substituting at the “margin” one factor of production for another with a view to optimisation. These decisions are often influenced by compulsions of machinery and capital equipment and technology. There are no “constant coefficients of production”, no perfect divisibility of goods or factors of production.

Fifthly, market as conceived in textbooks of Micro-economics bears no resemblance to the market in the real world. That is why syllabus relating to marketing in business courses deal with practical issues like “brand” and “goodwill” rather than the theorectical stipulations of a competitive market.

Sixthly, market equilibrium as envisaged by Micro-economics is in “stationary state”. It does not deal with dynamics in the economy. Uncertainty is an integral part of economic life and yet will not be analysed in any rigorous way in the competitive model until the early 1950s when Kenneth Arrow introduced uncertainty in equilibrium analysis, although in a specific and restrictive way. Its input-output relationship is lineal whereas in the real world there are dynamic changes and non-lineal and even chaotic relationship is the rule rather than exception.

Seventhly, Micro-economics completely overlooks the institutional set-up in the context of which the market functions. The institutional set-up includes the legal framework, educational set-up, cultural institutions etc.

Eightly, Micro-economics confines its attention to economic activity in the “market”, overlooking economic activity conducted in the fold of family, health and educational institutions and government to give a few examples. It has been estimated that the family activity in the Western economies account for 40 per cent of the GNP.

Ninethly, the record of Micro-economics in understanding and forecasting the economy at macro level is not impressive.

Economists in recent years, some of them Nobel Prize winners, have tried to grapple with these uncomfortable questions for the votaries of Micro-economics. The following provides a succinct review of this literature.

Recent Work in Micro-economics

RATIONAL man—Though Adam Smith based his theory of market on “pursuit of self-interest”, he was well aware of the influence of “moral sentiment” in organisation of society. His colleague, David Hume, stated: “Rational conclusions vanish like phantoms of the night.” However, latter day Neo-classical Economics broke away from “the richer psychological tradition” of “soulful economics” and placed the “rational economic man” at the centre-stage. But in recent years, economists have tried to explore the “psychological realm” leading to the emergence of behavioural economics. In 1977 Amartya Sen, a Nobel Prize winner, described the selfish calculating agents of economic theory as “rational fools”. George Akerlof, another Noble Prize winner, and Janet Yellen presented the “efficient wage” hypothesis on the basis of the psychology of workers. Economists have started using results from psychological and neurological studies and laboratory experiments to explore the ways of real humans— sometimes non-rational—which differ from those of the “economic man”. Nobel Laureate Herbert Simon introduced the concept of “bounded rationality”, which aims at “satisfying” as against “optimising”. Vernon Smith and Daniel Kahneman created the field of “experimental economics”. Neuro-economists use medical techniques to monitor people’s brains as they take economic decisions. Experiments have demonstrated inertia and shortsightedness in financial decisions which people take. Decisions are often taken spontaneously and intuitively. Preferences are not purely self-interested; a strong sense of fairness also prevails Loss of aversion and reciprocal altruism influence utility functions. Utility functions are not stable. Immediate gratification gets the better of long-term calculations. Behavioural insights are important in labour economics, savings and insurance.

By the 1980s a rich literature developed on Economics of Information. One of active contributors to this literature is another Nobel Prize winner—Joseph Stiglitz. He explained why “share cropping”, apparently an unjust system for the tenants, is “rational” in the context of the tenant’s uncertainty about the future and asymmetric information available to the landowner about the worker’s skills and efforts. Another example of the information gap is the modern corporation, where managers are paid high salaries to incentivise them to perform well without knowing how productive these managers actually are. Another Nobel Prize winner George Akerlof, in his 1970 paper “The market for lemons”, showed why only cars in terrible shape (lemons) get sold in second hand car markets in the absence of “information”. Michael Spence. in his Ph.D thesis on “market signalling” (1976), shows how employers figure out which potential employees are more highly skilled than the others. The concept of “asymmetrical information” has been found relevant in a number of areas like insurance, contracts, labour markets, industrial organisation, corporate finance, development economics, public services etc. In two-and-a-half decades since the pioneering work on Economics of Imperfect Information, a huge amount of research on specific application of these insights has emerged. The research has led to a flourishing field of experimental economics concerned with how best to design markets; how to combine administered and market based policy. Trading schemes regarding environmental pollution being widely adopted is another example. Information markets, it is suggested, can outperform experts in collecting, aggregating and sharing private information. The reach of markets should therefore be extended into areas which have traditionally been reserved for social and governmental action.

Economics and Social Institutions

JUST as Darwin discovered the law of evolution in organic nature, Marx discovered the law of evolution in human society.

Thorstein Veblen in the late nineteenth century was next in the line of social theorists of capitalism. He made a critical analysis of the idle rich and their conspicuous consumption.

In the twentieth century, Austrian economist Joseph Schumpeter was the one to present the sociological critique of capitalism in his book “Capitalism, Socialism and Democracy”. He identified innovation as the dynamic element in the capitalist system leading to “creative destruction”. In this he focused on the dynamic role of the entrepreneur. Despite disagreeing with Marx he also felt that capitalism was doomed. He saw the emergence of bureaucracy stifling entrepreneurial initiative. According to F. A. Hayek, the modern capitalist economy was an interconnected system made possible by institutions and laws which replaced personal trust underpinning transactions in a traditional society.

The recent revival of evolutionary theorising in Economics was pioneered by Richard Nelson and Sydney Winter, who published their papers on evolutionary growth models in the late 1960s and 1970s. Firms constantly innovate and allocate investment in profitable technologies. Many firms exist while few, increasingly large, survive as in the car industry.

More recently economists have turned to sociology, that is, the study of social networks, norms, culture and social institutional capital from which neo-classical economics had abstracted itself. Family is one such institution to which Gary Baker’s work is related. He applied economic approach to social phenomena. Another approach was provided by the 1991 Nobel Prize winner, Robert Coase. In his article on “The Nature of the Firm” (1937), he pointed out that big firms reduce transaction costs involved in using market, by “internalising” the transactions.

Nobel Laureate Douglas North gave rise to “New Institutional Economics” which showed how institutions throughout history have been built to create order and reduce uncertainty in exchange. Another economist was Oliver Williamson who analysed the structure of organisation—business corporations and trade unions.

All these economists came together in 1997 to set up the International Society for New Institutional Economics.

Gvanovetter took Sociology to the heart of Economics through his research, which showed how both social obligations and self-interest play some part in decisions, which make up economic and social life alike.

The study of “Social Capital” shows that participants in the economy are more than the sum of self-interested individuals. Social Capital enhances cooperation between individuals for mutual benefit. Social capital gives good economic results. It builds up trust, which is fundamental to economic development. According to Partha Dasgupta, social capital comprises social network of the economy.

Social capital, social networks, cultural norms, in addition to markets and governments, turn individual choices into collective action.

Extension of Principles of Micro-economics to Politics and Government

NOBEL Prize winner James Buchanan extended the tools of microeconomics to politics and government through his “public choice” approach (Calculus of Consent, 1962). It opened up a debate on the motivation of politicians and public officials. He argued that like business people in the market, elected representatives too are motivated by self-interest rather than public interest or social concern. Politicians are vote maximisers rather than concerned with matters of people. He advocated his “Theory of Collective Choice” as analogous to the economic theory of markets. Following Buchanan, Mancur Olson, in his “Logic of Collective Action”, looked at politics as a competition between the private interest of specific groups advocated by “lobbies” rather than a process of delivering “public interest”. Politicians engineer short term economic booms in the period before elections. This contradicted the idealistic view that government and public administrators are guardians of public interest. In any case, the economic performance of the government has marginal influence on election results. This gave a radical conservative like Margaret Thatcher to argue that the government cannot set right social problems. “No government can do anything except through people; people must look after themselves. There are individuals and families. There is no such thing as society.”

Economics and Ecology

ENVIRONMENTAL pollution and threat to natural resources have emerged as the grave danger to future of humanity. From the early 1970s studies relating to limits to growth imposed by ecological factors were taken up. Continuous emission of toxic gases from industrial enterprises and transport vehicles etc. has polluted air and water. The adverse impact of development in the form of pollution and waste need huge defensive expenditure. Development has created “illth” not just wealth. Green house gases have led to the phenomenon of global warming which has upset the balance of nature. Different parts of the world have suffered from unexpected torrential rains and cyclones in some parts of the world and droughts and high temperature in others. This has upset the agricultural cycle and caused forest fires. The Intergovernmental Panel on Climate Change has recommended the planned reduction of emission of toxic gases by 5.8 per cent but the biggest polluter, the USA, has refused to accept the target on the ground on the plea that it would put a constraint on its economic growth and its high living standard, and that it is not prepared to accept. Emerging economies like China and India are also unwilling to accept limits to their growth. Economic processes create wastes which negatively impact on human welfare. On the other hand, unrelented demands of the economy have created the possibility of exhaustion of finite and non-renewable resources. The superpower is attempting to grab control over scarce hydro carbon resources through invasion and lets loose violence on other countries which are endowed by nature. At the same time, the technology for development of alternative sources of energy like solar, wind and wave energy as well as biological energy has received less attention than it deserves.

Economy is embedded in ecology; it is a part of the ecosystem and cannot function without natural resources which, however, in Neo-classical Economics are taken for granted with no or little value attached to them. With its short-term perspective, it takes no notice of the threat to natural resources in the long run. The benefit-cost analysis of projects does not account for cost in terms of depletion, denudation or degradation of natural resources nor in terms of ecological benefits, which some types of economic activities can confer. This leads to wrong assessment of projects. Running down the stock of natural resources reduces the future capacity to produce and is unfair for future generations.

The idea of externalities was a step in the direction of recognising social costs and social benefits as against private costs and private benefits. But this is hardly enough. A whole new environmental economics needs to be developed going far beyond the narrow vision of mainstream Micro-economics in order to come to grips with the issues relating to “sustainable development”. The economy has to be ecologically sustainable.

Micro-economics and Neo-liberalism

THE basic weaknesses of Micro-economics go far beyond those imposed by its unsound assumptions mentioned above. They arise from its preoccupation with the short run rather than the long run, with static state than dynamic changes, with efficiency in terms of optimum allocation of resources rather than equity through deliberate redistribution of income, with money and wealth rather than welfare and well-being. That is what made Paul Ormerod talk of “the death of economies”. Conventional Economics (mainstream of Micro-economics) gives a very misleading view of the way the world actually operates and that needs to be replaced. The preoccupation with theoretical and mathematical equations rather than great the problems of the day has reduced Economics to “esoteric irrelevance”. Economics should reinvent itself and rather than arrogating to itself the exclusive status of being “scientific” as distinguished from other social sciences, it should join hands with them to understand the reality and tackle the problems of the real world. An interdisciplinary approach with inputs not only of Economics but also other Social Sciences like Political Science and Sociology as well as History, is likely to be more successful than theoretical models and mathematical equations. It is high time that economists go far beyond the narrow limits, which Micro-economics has imposed on itself.

Idealogical Biases

WITH all its scientific pretensions, Micro-economics claims to be a positive, value-neutral discipline, but its ideological biases are quite apparent. It has provided in recent years intellectual support to a neo-liberal policy, initiated in 1982 by Ronald Reagan in the USA and Margaret Thatcher in the UK and imposed by the “Washington Consensus” on all economies and the world economy. Deregulation of the private sector and minimal government became the key words. This has created acute disparities between countries and people within countries. In neo-liberal Britain, managers of companies draw salaries thousand times more than the wages of its own employees on the ground of efficiency and productivity. The underpaid are asked to improve their own productivity before claiming a better deal. Farmers in India, who commit suicide, are asked by the Chief Minister not to be lazy. In the home of neo-liberalism, namely, the USA, when Hurricane Katrina wiped out the homes of the poor, the local Republican Senator was cheerful that natural disaster has removed the blot which human agency could not have! The task of rehabilitation of the homeless was entrusted to a private company because the public agency could not be trusted; it made money but made a hash of the job leaving the poor in a miserable state. The task of security in Baghdad was entrusted to a private agency which itself shot dead eleven Iraqis, an act which scandalised even the puppet government. The reckless lending for sub-prime housing mortgages threatened the banking system not only in the USA but also in Europe and there was run for return of deposits on the North Rock Bank in England forcing Gordon Brown, the PM, to assure the depositors that the government would guarantee the safety of their deposits and yet the run would not stop. Such is the rationality of the market. Some years back, deregulation of financial markets in the USA led to a savings and loan scandal. With her fetish for privatisation, Margaret Thatcher squandered away the precious oil resources discovered in the North Sea, while the Government of Norway used these resources as assets out of whose income the standard of welfare services were improved.

The neo-liberal philosophy downgrades the role of the government in creating the legal framework, regulating the private enterprise so as to ensure that it works within the framework of common good, penalising illegalities and financial scandals, building up essential infrastructure, caring for those whom market does not take care of and using natural resources for social benefit. As Ha-joon Chang of Cambridge University, a teacher of Economic History, has shown, rich countries did not develop on the basis of policies that they now force upon the developing countries.

With the neo-liberal ideology generated by Micro-economics, it can hardly be called “Soul Economics”; rather it is “dismal economics” a title conferred on Economics by Thomas Carlyle. The mainly technical contributions of modern-day economists like the Game Theory or mathematical economics with little empirical base and purely intellectual model building can do little to widen the horizon of Economics. Above all, Economics needs to be “humanised” by restoring the place of value, morality and happiness in economic theory and studies.

Broader Economics

THE academic movement to broaden the scope of Economics so as to enable to deal with the reality and make it a truly social science than a branch of Mathematics has gathered strength. In June 2000 Economics students in Paris called for reforms in their academic curriculum so as to broaden its spectrum. In 2001, 27 Ph.D students of Cambridge University, UK, launched the movement for “opening up Economics”. In August of the same year teachers from 17 countries who had gathered in Kansas City in the USA issued an international open letter to all Economics Departments, calling on them to reform Economics education and research. Thousands of economists from scores of countries have also taken up the cause for broad band Economics under the banner of “Post Autistic Economics”.

The present division between Micro-economics, Macro-economics, Development Economics, Econometrics, Managerial Economics, Institutional Economics, Environmental Economics etc. needs to be ended. Economics needs to be blended into a more integrated presentation of the subject building bridges between different divisions of the subject.n


The Death of Economics by Paul Ormerod, John Wiley & Sons Inc., New York, 1997.

A Guide to What’s Wrong with Economics, edited by Edward Fullbrook, Anthem Press, 2005.

The Soulful Science: What Economists Really Do and Why it Matters by Diane Coyle, Princeton University Press, 2007.

Prof Dubhashi is the former Vice-Chancellor, Goa University, and an erstwhile Secretary, Government of India.

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