Foundations of Real-World Economics

What Every Economics Student Needs to Know

John Komlos

• Publisher: Routledge
• Year: 2019
• Print ISBN: 9781138296527
• eBook ISBN: 9781351584708
• Edition: 2
• Topic: Business
• Subtopic: Business General
• Index: Business

The 2008 financial crisis, the rise of Trumpism and the other populist movements which have followed in their wake have grown out of the frustrations of those hurt by the economic policies advocated by conventional economists for generations. Despite this, textbooks continue to praise conventional policies such as deregulation and hyperglobalization.

This textbook demonstrates how misleading it can be to apply oversimplified models of perfect competition to the real world. The math works well on college blackboards but not so well on the Main Streets of America. This volume explores the realities of oligopolies, the real impact of the minimum wage, the double-edged sword of free trade, and other ways in which powerful institutions cause distortions in the mainstream models. Bringing together the work of key scholars, such as Kahneman, Minsky, and Schumpeter, this book demonstrates how we should take into account the inefficiencies that arise due to asymmetric information, mental biases, unequal distribution of wealth and power, and the manipulation of demand. This textbook offers students a valuable introductory text with insights into the workings of real markets not just imaginary ones formulated by blackboard economists.

A must-have for students studying the principles of economics as well as micro- and macroeconomics, this textbook redresses the existing imbalance in economic teaching. Instead of clinging to an ideology that only enriched the 1%, Komlos sketches the outline of a capitalism with a human face, an economy in which people live contented lives with dignity instead of focusing on GNP.

1 Welcome to Real-World Economics

We must grant to markets what belongs to markets—and retain for people what rightfully belongs to them.

The author

The financial crisis of 2008 illustrated vividly how markets often do go haywire, yet textbooks remain unchanged, failing to convey the fundamental flaws and systematic weaknesses of the free-market system. The recent election of Donald Trump was fueled by the frustrations that have been accumulating due to an economic system that skews its benefits to a select few and leaves too many people behind scrambling to eke out a bare existence. Yet, academics and politicians continue to sing the praises of abstract markets as if they had descended straight from heaven while maintaining a conspiracy of silence about the fact that without government help countless giant corporations would have landed in the dustbin of history.¹ When the chips were down, only the Fed could print the trillions of dollars to prop up markets and save them from extinction.

The doctrinaire approach to the teaching of economics is well illustrated by the oft repeated but rather arrogant assertion, “We know that markets work.” Instead, teachers of economics should admit at the outset that while markets do work well in some circumstances they only do so within an appropriate institutional framework, and they not only work inefficiently in others but often tip the stream of benefits toward a few insiders. Hence, our job is also to explore and delineate clearly the circumstances that prevent real markets from working as well as their theoretical counterparts and suggest remedies for their failings. The ideological commitment to “market fundamentalism,” which led to the excessive reliance on markets in the making of public policy, has brought us to our current, precarious situation. I hope the present volume can help rectify this misconception and improve the teaching of economics by presenting a real-world perspective as opposed to the fantasy world of mainstream textbooks.

Alan Greenspan’s post-meltdown confession that he made a ghastly error in believing in—and aggressively preaching—market deregulation demonstrates vividly the miscalculations of the fundamentalist approach to economics. When asked by Congressman Henry Waxman, “You have been a staunch advocate of letting markets regulate themselves . . . Were you wrong?” Greenspan responded:

I made a mistake in presuming that the self-interest of organizations, specifically banks . . . were such that they were best capable of protecting their own shareholders and equity in the firms . . . The problem here is [that] something which looked to be a very solid edifice and indeed a critical pillar to market competition and free markets did break down and . . . that . . . shocked me. I still do not fully understand why it happened.

History is, of course, replete with people wearing similar ideological blinders. Greenspan makes a number of serious mistakes in that short statement: banks are incapable of assessing the impact of their policies on the rest of the financial system. That is the role of the oversight authority. This is known as systemic effects. They just see their own balance sheets and not those of their rivals. The Fed is supposed to have the overview. Other problems with his statement were noted by the Nobel Prize winning founder of behavioural economics, Daniel Kahneman. Referring to the above statement as “Greenspan’s confession,” he was surprised by:

[Greenspan’s] assumption that agents are fully rational, and there is a lot of evidence clearly that they’re not. The other is the idea that firms are actors; that firms are rational agents. But firms are really not actors . . . there are executives making decisions; the interest of those executives and the interest of that abstract idea that we call the firm are clearly not aligned and if we want to understand why firms are suicidal it is in part because the agents are . . . quite frequently not committing suicide. So, there is a mismatch between firms and the actors who act in their behalf.²

Waxman continued his query of Greenspan by asking, “You had an ideology . . . and this is your statement: ‘I do have an ideology, my judgment is that free competitive markets are by far the unrivaled way to organize economies.’” Greenspan answered by offering the congressman a philosophical lesson: “Remember . . . what an ideology is . . . [it] is a conceptual framework with the way people deal with reality. Everyone has one . . . Yes, I found a flaw . . . in the model that I perceived . . . how the world works.” Waxman: “In other words, you found that your view of the world, your ideology was not right.” Greenspan: “Precisely. That’s precisely the reason I was shocked.”³ Greenspan was right in this case: ideology is unavoidable in economics because one approaches it with some values and an organizing system of thought, that is, some preconceived notions of how the world works.⁴ This is unavoidable.

Greenspan should not have been so shocked. There were plenty of warnings: Brooksley Born, Edward Gramlich, Paul Krugman, Raghuram Rajan, Nouriel Roubini, Peter Schiff, Robert Shiller, Joseph Stiglitz, Nassim Taleb, and John Taylor, to name but a few eminent proponents of opposing views. They were no strangers to Greenspan or to the establishment. They were not outsiders. They are mostly scholars who have held professorships at major universities or have distinguished themselves in other ways. All he would have had to do was to listen with care to their well-reasoned warnings with an open mind. Instead, Greenspan dismissed their ideas out of hand and cold-bloodedly thwarted Brooksley Born’s valiant efforts to regulate derivatives a decade before the meltdown.⁵

One did not need a PhD to recognize that housing prices were off the charts. Yet, Greenspan and Benjamin Bernanke, his successor in 2006, ignored all the evidence because they were blinded by their ideology of the infallibility of markets. They were prisoners of their own ideology. If one does not subject that ideology to empirical evidence, the ideology becomes dogma.

The notion that ideology plays a major role in the social sciences has a long history. Observers of human societies cannot be free of their preconceived notions “because the understanding of a ‘social’ experience itself is always fashioned by ideas that are in the researchers themselves.”⁶ One of the many limitations of mainstream economists is their reluctance to address the problem of ideology adequately and to acknowledge the need to understand its role in economic policy. Textbooks simply ignore the issue. Yet, as Greenspan suggested, we cannot help but begin to organize our thoughts without making some fundamental assumptions, and these assumptions are a function of our own mindset, worldview, and intellectual and emotional commitments and therefore influence greatly the rest of the ideas developed in the discipline.

Hence, economics cannot be purged of ideology; our political, moral, and philosophical likes and dislikes—conscious and unconscious—are reflected in our assumptions and thus in how we structure our economic thinking and our understanding of the world around us. Much of that ideology is colored by our political philosophy. In other words, contrary to received wisdom, economics—despite the extensive use of mathematics—will not be a rigorous discipline until it is based essentially on verifiable empirical evidence. Our long-range goal should be to provide such an empirical foundation to the discipline. Our more immediate goal here is to present evidence to support the notion that the mainstream view is misleading. Our aim is to introduce the student to alternative perspectives, thereby providing a complement to standard presentations of the subject and widening the student’s understanding.

My Credo

Perhaps I should first clarify my own credo—the assumptions that underlie my own worldview of economic matters. I consider my views to be progressive, democratic, and humanitarian.⁷ These values imply that I believe that we could restructure the economy so as to improve our lives by focusing on increasing our life satisfaction instead of on income growth. I am also convinced that we should begin our economic analysis with empirical evidence rather than on ivory-tower theorizing. Experiential evidence should be at the core of the discipline rather than assumptions. In the words of Deirdre McCloskey, a U.S. economics professor, “economics is supposed to be an inquiry into the world, not pure thinking.”⁸

In other words, I believe that economics should reduce its reliance on deductive logic and mathematics and become more of an inductive discipline.⁹ Human beings are not inanimate objects whose trajectory can be described accurately by a mathematical function of a handful of variables. Unlike planets, they can and do change direction. Economics should not attempt to be an axiomatic discipline like geometry. Sir Isaac Newton said as much: “I can calculate the movement of the stars, but not the madness of men.”¹⁰

To understand the world around us we need an economic theory based on empirical evidence, one that can hold its own when transferred from the blackboard¹¹ to, say, the slums, areas with a concentration of poverty in our big cities. The pieces of the economic puzzle do not fit together as smoothly in Bronx’s 10454 zip code area with a median household income of $20,210 as they do in Loudoun County, Virginia’s 20129 zip code district, with a median household income of $250,000—four times the national average.¹² Moreover, we need a theory of economics that is not isolated from other social sciences but integrates insights derived from sociology, psychology, political science, and philosophy. Economists who focus on mathematics at the expense of these disciplines tend to neglect those issues that are not easily tractable mathematically and end up with a mechanistic view of the world.

In addition, my economic principles are humanistic in that they focus on values that enhance the human experience and lead to mass flourishing. Pain also plays a major role in my thinking. I advocate its minimization. In contrast, the mainstream does not give pain much thought. But the current economic system treats some groups with an in...

Table of contents

• Cover Page
• Half Title
• Title
• Copyright Page
• Contents
• List of Figures
• List of Tables
• List of Illustrations
• 1 Welcome to Real-World Economics
• 2 Markets Are Neither Omniscient Nor Omnipotent
• 3 The Nature of Demand
• 4 Homo Oeconomicus is Extinct: The Foundations of Behavioral Economics
• 5 Taste Makers and Consumption
• 6 Firms and Imperfect Competition
• 7 Returns to the Factors of Production
• 8 The Case for Oversight, Regulation, and Control of Markets
• 9 Microeconomic Applications on and off the Blackboard
• 10 What Is Macroeconomics?
• 11 Macroeconomics Part II
• 12 Macroeconomics Part III
• 13 International Trade: Open Economy Macroeconomics
• 14 The Financial Crisis of 2008
• 15 Conclusion: The Foundations of Real-World Economics
• Index