This article appears as part of a special report, "What the Free Market Can't Do," in the Winter 2015 issue of The American Prospect magazine. Subscribe here.
Despite the practical failures of free-market economics, too many mainstream economists have continued to embrace simplistic ideas about how the economy works. Such ideas are often rooted more in ideology than in evidence. These beliefs and the policies that follow led directly to the 2008 financial crisis and the Great Recession. They also centrally contributed to the nation's subpar performance beginning in the late 1970s, and to our widening inequality. They continue to endanger America's economic health.
The mainstream of the profession claims to qualify oversimplified free-market ideas. But when it comes to key policy choices, the premise that markets are efficient usually trumps a more complex analysis. Thus, most mainstream economists are usually for less regulation even when more is required. They argue for reducing deficits even when expanded public outlay is indicated. They favor letting markets set wages without many safeguards for workers, even when the result proves neither equitable nor efficient. The consensus in the profession is that widening inequality must be the result of deficiencies in the skills of the workforce, rather than the result of structural disadvantages inadequately addressed by government.
To be sure, there are dissenting economists. A few even win Nobel prizes. But in the academy, free-market ideas are still the dominant ones.
The neoclassical insights at the core of standard economic thinking were once exciting intellectual breakthroughs. These ideas could still be useful, if adapted to the times, with their limitations understood, and tempered by other kinds of economic thinking. But the profession has largely turned its key ideas into faux-scientific rules of thumb that in fact reflect (and reinforce) the conservative political attitudes of the time. Disguised in technical terms, these ideas have increasingly become mainstream justifications for a reduced role for government in the economy.
The central propositions of free-market economics boil down to these:
The Invisible Hand. The premise of Adam Smith's invisible hand is that buyers and sellers, free of any government interference and merely following their self-interest, will arrive at an optimal distribution of goods and services at the "right" price, as if guided by an unseen hand.
Mainstream economists often say they don't literally believe in the invisible hand. They concede that many assumptions must be made for free markets to produce optimal outcomes. These include transparent access to information and product prices, no undue power for oligopolistic corporations to set prices or control distribution, highly rational buyers and sellers pursuing their self-interest, etc.
But in fact, for the economic mainstream, the invisible hand is the default principle whether or not these assumptions are met. Why, for example, do so many economists oppose increases in the minimum wage? Over the past 10 to 15 years, empirical evidence began to show that an increase in the minimum wage in many communities did not result in more than a trivial number of lost jobs and may have actually resulted in more jobs, as demand for goods and services increased with higher purchasing power. In the real world, a hike in the minimum wage did not perform according to the invisible hand, yet economists assumed it would.
People Get What They Deserve. If labor markets worked according to Adam Smith's principles, you could explain inequality not as a market failure, but as an efficient market mechanism. Some economists do worry about the social costs of unequal wages. But most economists believe a rise in inequality is a signal of the economy's technological progress. The claim that unequal education and skills explain unequal wages is an invisible-hand argument. If people with more education are better qualified, the market will justifiably pay them better. This premise allows mainstream economists to ignore the role of power shifts in labor market institutions and the fact that educational opportunity itself increasingly reflects hardened class lines-who your parents were, principally-more than the acquisition of skills. In a nation of fewer opportunities, whom you know and what social skills you have become an entrée to a job, not learned skills. This is all beyond the grasp of the invisible hand.
Sure, investing in education matters. But recognizing that unequal opportunity begins at birth-or earlier-and devising compensatory policies is more important. Labor markets often compound these disadvantages; they don't compensate for them.
Say's Law and Austerity Economics. A close cousin of the invisible hand is Say's Law, legacy of the 19th-century economist Jean-Baptiste Say. In shortened form, it argues that supply creates its own demand. In other words, if you make it, people will buy it. John Maynard Keynes devoted his classic General Theory to dismantling the idea. Say's Law is the corollary to Smith's premise that economies are self-adjusting as long as government steps out of the way.
Closely related to this proposition is another assumed accounting identity-the claim that savings equal investment. This is true only retrospectively, but too many still accept the proposition that more savings will generate more investment. With more savings, the price of investment-the interest rate-will fall; due to the invisible hand, business will invest more. Not so, said Keynes. If more savings come at the expense of more buying, investment will likely fall, especially in a weak economy.
Again, some economists will tell you they know better than to believe Say's Law without qualification. There are diminishing returns to savings, for example, so the general gain from more saving peters out in the end. In an Adam Smith world of self-adjusting economies, people would reduce savings as the interest rate falls. But in a recession, worried people ignore these market signals. They often increase savings because they fear they will soon be out of a job. Individual behavior does not aggregate to general efficiency.
But read the literature, and few mainstream economists acknowledge that point. More savings are always good. This thinking is behind austerity economics. Government deficits reduce national savings, so these deficits must be minimized, even if that means tax hikes and reduced social spending during a prolonged slump. Democratic economists, it is largely forgotten, loudly called for reduced deficits in the 1980s under Republican Ronald Reagan. A Say's Law–type of argument was used by President Clinton's economists to channel budget surpluses to reduction of the national debt rather than, say, increases in public investment. Advisers to President Obama in 2010 called for deficit reduction long before the economy was on the mend. Of course, not all economists believe this; and there are times (during full employment, for example) when even Keynesians favor deficit reduction. Yet simplistic ideas about deficit-reduction as cure-all dominate the profession. They seep into the public consciousness and are not easy to reverse, especially when both Democratic and Republican economists and presidents have advocated them at one time or other. Keynes defeated Say's Law only temporarily.
Financial Markets Are Efficient. One of the more extreme abuses of the invisible hand has been efficient markets theory. Economists like Eugene Fama of the University of Chicago claimed that markets for stocks, bonds, and other financial instruments were so rational that they accurately reflected the future value of the underlying company. In such a rational marketplace, there could be no lasting speculative bubbles. Moreover, you could tie a CEO's compensation to the stock price and get better managerial results.
Rational financial markets require minimal regulation. But financial deregulation, which began in the 1970s and was reinforced by Reagan and Clinton, led directly to the subprime bubble and the 2008 collapse. Many economists now know better. Robert Shiller of Yale has been arguing for decades that bubbles exist. But do most economists appreciate the overwhelming evidence for bubbles? As the Dodd-Frank Act is slowly eviscerated, there is no groundswell within the mainstream profession calling for more effective re-regulation of finance.
Inflation Targeting and Price Stability Are Holy. Ben Bernanke, the former Federal Reserve chairman, was a leading theoretician in favor of targeting a low inflation rate as a primary government policy. Low and predictable inflation is said to remove uncertainties about the future, and thus allows the invisible hand to work its miracles. Market efficiency in turn will lead to prosperity.
Right up until the eve of the 2008 collapse, mainstream economists were convinced that inflation-targeting was the main justifiable intervention; the free market would do the rest. They even created their own self-congratulatory measure of success, called The Great Moderation. From the early 1980s to 2007, the U.S. gross domestic product fluctuated less than it had in prior decades. The stability was taken as proof that economists knew what they were doing at last.
But consider what else happened during these supposedly ideal years. Income inequality rose to the heights of the 1920s; debt soared as consumers tried to maintain living standards by borrowing; men's wages fell dramatically. Median income for the bottom 90 percent declined to levels of the 1960s; public investment was tragically neglected; and there was one financial crisis after another: 1982, 1987, 1990, 1994, 1997, 1998, 2000, and finally 2008.
What's more, growth was on average slower in this period than it was in earlier decades. If slower growth is the price paid for stability, what is the purpose of economics? If the conditions are created for a market crash, inflation targeting can't be the summa of policy.
More Cross-Border Trade Is Always Good. In the 1990s, Western nations developed a set of policies known as the Washington Consensus which involved not merely free trade but also the free flow of capital around the world. It was a classic invisible-hand argument. One-size-fits-all policies should be adopted everywhere, no matter the developmental stage, educational attainment, or culture of a nation.
But the Washington Consensus badly failed in the 1997 East Asian financial crisis. In fact, there is a great deal of doubt that free-trade agreements have created the jobs that economists claim for them. Moreover, widespread assertions that free-market reforms led to enormous reductions in global poverty foundered on a hard fact: Most of the reduction occurred in China, and to a lesser degree in India-countries that did not adopt the Washington Consensus.
Yet simple free-trade agreements are still backed aggressively by many economists. These agreements often favor rich nations, or the elite in poor nations. We don't even know what is in the new 12-nation Trans-Pacific Partnership proposal, organized by the U.S. government and its corporate allies. The secrecy is apparently needed to reduce likely controversy. We do know that the intellectual property of big companies in rich nations is likely to be well protected; that "trade" norms are intended to be used to undermine domestic regulation; and there are doubts that workers in either poor or rich nations will be similarly protected.
We should learn a few non–invisible-hand lessons about trade. First, nations need space to develop their own industries and institutions. This might require subsidies and other supports that violate trade agreements. Second, free trade should be adopted gradually-no shock therapies, please. Third, we should admit that there are losers in free trade, and the social safety net should always be expanded accordingly.
Markets Invariably Work Better than Governments. Mainstream economics has no strong theory of government, except that it is a corrector of market failures (which are presumed to be rare). We might call this a negative theory. The Fed can intervene to save the economy from collapse. Or anti-trust authorities can make sure markets are competitive (which they don't do much of these days). Governments are also supposed to fill the hole for social goods that markets don't provide, like highways and schools and clean air and water. But in free-market economics, failures like these are hard to define; they make mainstream economists uncomfortable because they depart from core theory. The nation needs a positive theory of government, which recognizes how valuable social policies and public investment have been, and how much more of them we need.
Invisible-hand purists often love to oversimplify economic history, claiming, for example, that in the 19th century America lived by the invisible hand of laissez-faire. This is simply not true. Transportation, education, health care, wage protection-all these were the work of government.
Today, fears of a big federal deficit block adequate government investment. But the nation won't grow without more government.
The dominance of bad mainstream thinking, which leads to resistance to public investment, has been especially damaging because it undermines the foundation of future prosperity.
What, then, is behind the strong hold these ideological principles have on mainstream economists? There are three main explanations: faux science, careerism, and political acceptability.
Faux Science. The acceptance of the invisible hand is taken as a close approximation of reality not only for a single market but also for the whole economy. This is known as general equilibrium. With that assumption taken almost as scientific fact, economists can build highly complex models. Some economists, even on the left, will say that the invisible hand is much like Galileo's law of falling bodies, which states that heavy and light objects will fall at the same rate of acceleration to earth, air friction aside.
But the invisible hand, as I observe in my book, Seven Bad Ideas, is not in any way comparable to such verifiable physical phenomena. It is a compelling metaphor, but not a scientific one. The authority it provides economics is a false one because there are many immeasurable frictions that keep the invisible hand from producing the best outcome for all. We don't even know how the magic price where the supply and demand curves allegedly meet is arrived at. Leon Walras, one of the first theorists who postulated that there was a general equilibrium, argued the price was found through an imaginary auction process, but there is no serious proof that a general equilibrium exists.
From these assumptions, however, it logically follows that an economy is almost always self-adjusting-and the politically conservative assumption that government interference is almost always bad becomes axiomatic. The extreme form is found in rational expectations theory, which argues government stimulus is almost always unnecessary or damaging. On these assumptions complex mathematical models can be built, which divert attention from the real world of work, investment, and wages, and allow economists a studied ignorance of economic history and real-world phenomena. As Robert Lucas, the father of rational expectations theory, put it: "Economic theory is mathematical analysis. Everything else is just pictures and talk." The faux-scientific principles make a clean theory out of a dirty world.
Careerism. Another reason mainstream economics retains its magnetic hold is that it provides a safe basis for career advancement in academic institutions. Mathematical methodologies can be evaluated. These are often complex and sometimes brilliant, but they are based on foundations that may not relate to the real world. Contradictions in outcomes of economic research are ignored, because the evaluation is of methods, not outcomes. This is hardly science.
For example, Alberto Alesina of Harvard and his co-authors long argued that austerity economics could generate economic growth, even in a weakening economy. IMF economists, led by Olivier Blanchard, more recently showed persuasively that this was not true. But Alesina's career continues to thrive. As Keynes famously wrote, it is better for reputation to fail conventionally than to succeed unconventionally. As noted earlier, Eugene Fama of the University of Chicago remains skeptical of speculative bubbles because markets are too rational. His prestige remains undiminished. Robert Shiller argues that there clearly are such irrational bubbles. They simultaneously won the Nobel Prize in 2013. Can this be science?
The lack of a model-building methodology resulted in the reputational suppression of Hyman Minsky, now among the most cited of economists for his work predicting the inevitability of speculative bubbles and the damage they can do. He was more historian and psychologist than technical economist, but now mainstream economists are paying attention. One wonders for how long. Similarly, John Kenneth Galbraith's championing of public investment over tax cuts was neglected because of his lack of modern methodologies. On the other hand, Joseph Schumpeter, who was also an old-fashioned narrative economist, is still heralded because he was basically a conservative.
Political Reward. Finally, the movement toward simplified ideological economics has had great appeal to increasingly conservative policymakers, think tanks, and business organizations. By its very nature, a firm belief in the invisible hand means a faith in laissez-faire policies: reduced taxes and regulation. The less government, the better. Markets, as noted, will reach the right price on their own. If a stock is priced too high, a smart market participant will sell it. It just happens that these principles provide scientific grounding for the policies that business elites prefer. No wonder mainstream economists are showered with support, prestige, and well-lubricated career trajectories.
The turn in the nation's attitudes against government began with the high inflation of the 1970s, which many economists, led by Milton Friedman, pinned on government deficits. Ronald Reagan sealed the political argument in a debate with Jimmy Carter when he said: "We don't have inflation because the people are living too well. We have inflation because the government is living too well."
Arguments for free-market solutions, rather than social spending, followed as night follows day. Social programs were afterwards mostly tied to tax incentives, like the earned income tax credit, not to cash outlays. Industrial policies, where government invested in technologies and new business, were scoffed at. Invisible-hand thinking fit this new political environment perfectly. In an interview in 2001, Larry Summers, then Clinton's former Treasury Secretary and Obama's future chief economic adviser, told PBS, "There is something about this epoch in history that really puts an emphasis on incentives, on decentralization, on allowing small economic energy to bubble up."
To win the ears of government officials and the public, economists not coincidentally fit their theories to the new elite attitudes in America. Believing that markets solved social problems and that expensive social programs did not was music to the ears of business and right-wing politicians. Research could be produced that big government and high taxes diminished economic growth. The research was flawed, but no matter.
The dominating policy ideas of the invisible hand have failed. Combined with deregulation, the Great Moderation and inflation-targeting created a bubble economy. Neglect of public investment in infrastructure, clean energy, and education, a consequence of Say's Law–type thinking, has undermined the nation's foundation. All these ideas were compatible with the prevailing conservative economic ideology of the time, and earned economists the attention of Washington and the media, but they failed America. The media in particular fell hard for the putative scientific nature of economics and hardly picked up on the ideological foundation of the economic advice.
Science is universally true. The premise of economics as science was a great cover for conservative ideology. But one-size-fits-all economics, which best describes economic advice over the past 30 years, is a practical failure. Anti-government economics failed, pure and simple.
Only a little seems to be changing. Targeting absurdly low inflation rates is still alive. One wonders whether regulation of finance will ever be adequate. The pressure for globalization is over-simplified, where one-size-fits-all policies are particularly damaging. We need economists who revise their theories based on evidence, but there is little room for reformers-few prestigious universities make space for heterodox thinking.
It is hard to be optimistic about economics. Being an economist has become a career, though not an intellectual profession. Money talks loudly in their academic hallways, and a small-government philosophy still rules the nation, despite the calamities that began in 2008.
