Reassessing the Paradigm of Economics

Bringing Positive Economics Back into the Normative Framework

Valeria Mosini

• Publisher: Routledge
• Year: 2011
• Print ISBN: 9780415575119
• eBook ISBN: 9781136658204
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Business allgemein

When President Reagan and Prime Minister Thatcher adopted the neoliberal doctrine as the paradigm of economics, there was no evidence that the move would have been successful, but thirty years on, the recurrent crises that culminated in 2008 suggest a serious mis-match between expectations and outcomes: a re-examination of the paradigm is in order. This book focuses on Milton Friedman's formulation of the neoliberal doctrine, and analyses two aspects that were essential to turning it into a fully-fledged paradigm: the attribution of scientific status to positive economics, which led to informing public policies on the requirements of the market; and the characterisation of economic freedom as capable of promoting political freedom, which led to identifying free market with democracy.

The book exposes Friedman's methodological argument for attributing positive economics scientific status as a failure, and his characterisation of economic freedom as a delusion; it identifies in the emergence as the mainstream in economics of the neoclassical synthesis, which borrowed from Walras' the mathematical treatment of equilibrium but not the ethical and social framework in which it was inscribed, a development that facilitated the transition from the Keynesian to the neoliberal paradigm.

Dr. Mosini shows that the gigantic bail-outs carried out courtesy of the public purse, which institutionalised the practice of collectivising losses while keeping profits private, were no accident, but the consequence of the rethinking of the function of lender of last resort according to Friedman's conception of rationality in relation to risk, combined with his interpretation of the 1930s recession. The book concludes that the neoliberal paradigm has served the interests of the economically powerful social strata it was designed to benefit extremely well, but that the deep, and deepening, injustice it has brought about calls for a complete rethinking of the paradigm of economics according to ethical principles respectful of human values. This book should be of interest to students and researchers of Political Economy, Economic Methodology, History of Economic Thought and Philosophy.

1 Friedman's Essays in Positive
Economics

Logical consistency and validity

The importance of discussing Essays in Positive Economics

Essays in Positive Economics (henceforth Essays) occupies a special position within Friedman's contributions to the neoliberal doctrine. This is because it lumped together already published essays illustrating the core theses of the doctrine - free economic enterprise, free trade, low taxation, monetarism, reduction of the role of the state in economic affairs, flexibility and mobility as opposed to trade-unionism in the workplace - with the notable addition of a methodological essay that has come to be almost unanimously regarded as among the most influential ever written, having repercussions on philosophical debates and on economists’ practices (Backhouse: 2007).

‘The Methodology of Positive Economics’ served the crucial purpose of putting forward a method that, on Friedman's account, would confer scientific status on positive economics and, making it ‘an “objective” science in precisely the same sense as any of the physical sciences’ (Friedman: 1953, p. 4), should make it possible for its conclusions ‘to be widely accepted ... [and] go a long way towards producing consensus’ (Friedman: 1953, p. 6).

In other words, with the methodological essay, Friedman raised high expectations that the implementation of the conclusions of the theses that formed the core of the neoliberal doctrine, which he presented as belonging to positive economics, would deliver on the promises the doctrine made.

The early reactions to the publication of Essays, however, were cautious, and often contained elements of caustic criticism, particularly about the methodological essay (Hutchison: 1954, Newman: 1954, Vickrey: 1954, Hahn: 1954, Rotwein: 1959);¹ this remained highly controversial throughout the 1960s and early 1970s (Simon: 1963, Samuelson: 1963, Hahn: 1971) when other highly relevant works by Friedman, especially on monetarism, came under intense scrutiny (Johnson: 1971, Hahn: 1980, Desai: 1981, Wood: 1981, Hendry and Ericsson: 1989). That matters did not change, and that the core theses of the neoliberal doctrine presented in Essays, together with the methodological argument for attributing economics scientific status, remained highly controversial until the mid- to late-1980s is well illustrated in Cunningham Wood and Woods's (1990) four-volume edited collection, Milton Friedman. Critical Assessments.

Fifty years on from the publication of Essays, another important edited collection, Mäki's (2009) The Methodology of Positive Economics. Reflections on the Milton Friedman Legacy, was published, which, with few notable exceptions,² conveys the perception that Friedman succeeded in devising a method capable of endowing economics with the same degree of objectivity as the physical sciences.

Still, the far from satisfactory performance of the economic and financial systems under the neoliberal paradigm (see Chapter 6 for discussion) highlights a gulf between the promises Friedman made in the methodological essay and the capacity of the neoliberal doctrine to deliver, which urges further discussion of the relation between Friedman's method and the theses presented in Essays; to start, I here analyse the logical consistency and the validity of those theses.

Logical consistency depends on the extent to which the theses Friedman presented as being in positive economics turn out, under scrutiny, to have been reached according to the method for doing positive economics, because only in this case could they be attributed scientific status, and be adopted and implemented independently of ‘any particular ethical position or normative judgment’ (Friedman: 1953, p. 5).

Hence, discussing logical consistency is not a sterile exercise informed on generic, abstract, notions,³ and may, if anything, result in being pleonastic: given that the methodological essay was added to already published technical essays, it is likely to have been the reflection of a practising economist on his own work, not a philosophical piece unrelated to it, creating the expectation that the logical consistency of Essays should not be in question.

In terms of the validity of the theses presented in Essays, I separate ‘internal’ validity, relating to the robustness of the supporting arguments -formal or informal, necessary or probable, linked to already well-established knowledge or intending to cover new ground, analytic or substantive - from ‘external’ validity, relating to the standing of the arguments presented against those put forward by other leading figures in the field.⁴ Given that Friedman equated the theories of positive economics with those of the natural sciences in terms of degree of objectivity, discussing the external validity of Essays requires a comparison of the arguments presented there with those expressed by leading scientists and philosophers of science.

Method and theories

In stating his method for doing positive economics, Friedman identified it through two main characteristics: the relevance given to empirical evidence in corroborating theoretical predictions, particularly of ‘phenomena not yet observed’ (Friedman: 1953, p. 7):

the ultimate goal of a positive science is the development of a ‘theory or hypothesis’ ... [that would] provide a system of generalisations that can be used to make correct predictions about the consequences of any change in circumstances ... the only relevant test of the validity of a hypothesis is comparison of its predictions with experience ... only factual evidence can show whether it is right or wrong.

(Friedman: 1953, pp. 4, and 8-9)

and the irrelevance of concerns about the realism of assumptions derived from his conviction that, although

Hypotheses must be consistent with the evidence at hand ... truly important and significant hypotheses will be found to have ‘assumptions’ that are widely inaccurate descriptive representations of reality, and, in general, the more significant the theory, the more unrealistic the assumptions.

(Friedman: 1953, pp. 13-14)⁵

Friedman's method, however, was not as straightforward as the two characteristics above may suggest, as shown by the way in which he further qualified the role of evidence in economic theorising: having made the confirmation of theoretical predictions the sole criterion for accepting theories into the body of positive science, Friedman expressed scepticism towards the actual possibility of empirically confirming the hypotheses on which predictions rest, holding that, since the evidence related to any particular phenomenon is limited and circumstantiated, it ‘can never “prove” a hypothesis; it can only fail to disprove it’ (Friedman: 1953, pp. 8-9). On his account, evidence was particularly difficult to interpret in economics where it involves ‘chains of reasoning that seldom carry real conviction’ (Friedman: 1953, p. 11), concluding that, faced with the choice between rival hypotheses, economists must supplement evidence with metaphysical considerations - such as simplicity (which reduces the need for support from background knowledge) and fruitfulness (which broadens the field of application) - and accept that their choice ‘must to some extent be arbitrary’ (Friedman: 1953, p. 10).

Allowing a degree of arbitrariness in the selection of the theories to be included in the body of positive economics was Friedman's way of easing the friction between two mutually contradictory claims he had made: that the empirical confirmation of predictions should be the only criterion for validating hypotheses, and that economic evidence was so convoluted and difficult to interpret that it could seldom turn out to be decisive.

Yet, Friedman's acceptance that a high degree of arbitrariness affected the selection process of economic theories marked a dis-analogy with the natural sciences, in which, as I show later, the degree of arbitrariness in theory choice is acknowledged to be very modest.

On the logical consistency of Essays

To assess the logical consistency of Essays, it is useful to consider some specific examples illustrating the way in which Friedman enunciated his theses in positive economics in relation to the method for doing positive economics he defended.

In the essay ‘The Case for Flexible Exchange Rates’ Friedman discussed the means to rectify the balance of payments in the face of changes in international dealings, whether or not directly related to trade.

The essay opens with a bold assertion: that the system in operation at the time, embodied in the statutes of the International Monetary Fund - which sanctioned that changes up to 10 per cent could be introduced by individual governments while higher ones should be allowed by the Fund - was ‘ill-suited to current economic and political conditions’ (Friedman: 1953, p. 157). With this conclusion, apodictically presented upfront, Friedman listed the options available - flexible exchange rates, occasional changes in fixed exchange rates, changes in internal prices/income, direct controls on imports, exports and capital flows, and the monetary authority providing the additional currency demanded - soon revealing his bias in favour of the regime of flexible exchange rates that he called ‘a desirable objective of economic policy in its own rights as one of the basic freedoms we cherish’ (Friedman: 1953, p. 158). He further added that a regime of flexible exchange rates was essential for the establishment and maintenance of unrestricted multilateral trade, which, he affirmed, promoted the efficient use of resources through an appropriate international division of labour, increased consumer welfare by maximizing the range of alternatives on which consumers could spend their incomes, and fostered good relations between governments.

With these extrinsic merits attributed to the system of flexible exchange rates in the background, Friedman mentioned as its intrinsic merits the stability it would confer to the value of the currency and the stabilising effects on the economy due to the fact that, even in the presence of speculative transactions, the rates would change ‘rapidly, automatically, and continuously and so tend to produce corrective movements before a crisis develops’ (Friedman: 1953, p. 162).

In terms of the evidence in favour of his thesis - that flexible exchange rates would provide the best means for rectifying the balance of payments - Friedman mentioned two historical events: the crises in the United Kingdom around 1940 and the German crisis of 1950, blaming the governments of the time for, failing to act promptly, allowing large disequilibria to accumulate. He argued in a hypothetical fashion that, had a flexible exchange rate regime been in place, only a relatively minor ripple would have affected the rate, and no major crisis would have erupted, and concluded - on the basis of a one paragraph-long discussion of the United Kingdom and German crises - that ‘the rigidities and discontinuities introduced by substituting administrative action for automatic market forces have seldom been demonstrated so clearly or more impressively’ (Friedman: 1953, p. 163, my emphasis).

Having argued the case in favour of flexible exchange rates in this way, Friedman examined the alternative options available and found them all highly deficient.

As to the option of occasional official changes in otherwise fixed exchange rates, he claimed that it would be slow in responding to substantial difficulties and could only come into effect once these had already run their course for some time, causing speculative movements such as the (illegal at the time) exportation of capital. As to the option related to changes in internal prices, Friedman regarded it as outdated but used it as an opportunity to criticise the rigidity of workers’ wages, which he blamed for, in adverse economic phases, causing ‘unemployment rather than, or in addition to, wage decreases’ (Friedman: 1953, p. 165).⁶

Friedman objected to controls on imports, exports and capital movements claiming that they limited personal freedom and ‘will ultimately prove ineffective in a free society’ (Friedman: 1953, p. 172); he also objected to the use of monetary reserves that he considered ‘not a realistic, feasible, and desirable policy’ (Friedman: 1953, p. 172) regarding it as effective only in the case of small and temporary movements but very risky in general terms given the impossibility of knowing soon enough if the problem faced resulted from temporary or permanent factors.

Summing up discussion with the claim that ‘flexible exchange rates seem clearly the technique of adjustment best suited to current conditions’ (Friedman: 1953, p. 172, my emphasis), Friedman moved on to defend his preferred option from possible attacks.

Against the objection that speculation in foreign exchange markets would be destabilising and possibly cause capital flights he used cautious language, mixing positively stated convictions with tentative qualifications:

evidence from some earlier experience and from current free markets in currency in Switzerland, Tangiers, and elsewhere seems to me to suggest that, in general, speculation is stabilising rather than the reverse, though the evidence has not yet been analysed in sufficient detail to establish this conclusion with any confidence ... it does not follow, of course, that speculation is not destabilising.

(Friedman: 1953, p. 175, my emphasis)

Against the objection that flexible exchange rates may destabilise the real economy by spreading fear of inflation and producing further uncertainty, Friedman admitted that there was some truth in it, but rated the risk associated as very small, and added that fear of inflation might ‘provide something of a barrier to a highly inflationary domestic policy’ (Friedman: 1953, p. 178).

Against the objection that a system of flexible exchange rates may increase the level of uncertainty in the market, Friedman replied that it would actually reduce it, provided speculators could rely on futures to which he attribu...

Table of contents

• Front Cover
• Front Matter
• Reassessing the Paradigm of Economics
• Routledge INEM advances in economic methodology
• Title Page
• Copyright
• Dedication
• Contents
• Acknowledgements
• Introduction: reasons for the book
• 1 Friedman's Essays in Positive Economics: logical consistency and validity
• 2 The singularity of Friedman's conception of the positive-normative distinction
• 3 The disappearance of the normative framework from Walras’ s economics
• 4 Friedman's method for doing positive economics
• 5 Contradictions and delusions of the neoliberal paradigm
• 6 ‘What is to be done?’ The question crops up
• Bibliography
• Name Index
• Subject Index