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Why Orthodox Economics Fails

Michael Perelman, Railroading Economics: The Creation of the Free Market Mythology (New York: Monthly Review Press, 2006), 238 pages, paperback, $20.00.

Carlos J. Castro teaches sociology at Clark College in Vancouver, Washington.

Paul Krugman in Development, Geography, and Economic Theory contends that the reason some economic theories are not widely engaged by economists is because they cannot be modeled mathematically. He goes on to highlight many good ideas that cannot be modeled mathematically. Michael Perelman in Railroading Economics: The Creation of the Free Market Mythology argues that there is another reason that economists do not accept these theories: some theories are rejected for ideological reasons because in economics, the orthodoxy is the free market. Perelman quotes Francis A. Walker, the first president of the American Economic Association, who said that laissez-faire “was not made the test of economic orthodoxy, merely. It was used to decide whether a man were an economist at all” (102). In other words, to be an economist, especially in the post-Soviet era, requires one to agree with the free market—that is, to believe that the market allocates resources efficiently, and that the job of the economist is to get the prices right.

Perelman’s Railroading Economics is a radical critique of this type of economics—the one that is practiced today. For some of us who studied economics, and who disagree with the theoretical paradigm behind it, what Perelman says rings true. In economic classes very few professors allow philosophical discussions. Students are trained to construct utility maximizing and equilibrium models without a discussion of the political philosophy and theoretical paradigm behind them. So, students come to accept many of the assumptions that supposedly undergird these models. For example, in economic theory—which has been reduced to microeconomics today—it is assumed that more is better, that individuals are rational (that is, utility maximizing individuals), and that the market is efficient. The students, either because they agree with this philosophy of economic liberalism, or because they are not made aware of it, end up accepting it as an accurate portrayal of social reality. The economic models, they are told, are abstractions, and this is because economics, like the other social sciences, constructs theories that explain the behavior of individuals and groups. People may not be aware of why they do what they do, it is contended, but we can explain people’s behavior based on economic theories tested by facts.

Really? The problem with this statement is that it is too general and can justify any theoretical abstraction. The real question is whether the facts support the theoretical paradigm. Perelman argues that in the case of orthodox economics they do not. According to him, the models used by economists, those of microeconomic theory, are those of the free market, and these models reflect neither how the world works nor how it ought to work. Other social sciences, like sociology, have a diversity of paradigms. In economics the core philosophy of the profession is that of economic liberalism as espoused by the classical economists, with the exception of Marx of course, and the marginalists, who started neoclassical economics. In microeconomics, the political philosophy of Adam Smith, David Ricardo, William Stanley Jevons, Carl Menger, Leon Walras, Alfred Marshal, and Milton Friedman, applied to economic problems, dominates the profession. In sociology this theoretical paradigm is known as rational choice; Gary Becker, who won the Nobel Memorial Prize for applying this paradigm to sociological issues, calls it simply “the economic view.” This tradition, of course, is very amenable to mathematical modeling, and this is why, perhaps, it is at the core of a profession that deals basically with numbers. Mathematics makes it look very rigorous and scientific.

Yet, economics claims to be a science directed at the explanation of economic phenomena. It is not supposed to be an intellectual enterprise for art’s sake only. The economic models have to explain the world outside the ivory tower—the real world. Perelman dismantles the dominant economy theory, exposing how free market ideology runs counter to a scientific enterprise. He shows how the basic microeconomic model of supply and demand is essentially a free-market model. He discusses how it does not account for sunk costs, and therefore cannot explain investment. So the profession is left with such unscientific notions as “animal spirits,” completely incongruent with the rational individual that lies at the core of microeconomics. Because it cannot account for investment, it cannot account for the “barriers to entry,” which were what led to oligopolies and monopolies, the very things that dominate late capitalism. In other words, it cannot explain how the real world works.

Perelman also examines why the world should not work according to the logic of the free market. The free market has been shown to fail again and again. From the railroads in the nineteenth century, the Great Depression, the Savings and Loans scandals of the 1980s, to the recent housing bubble meltdown and financial crisis to cite only some examples from the United States, the market has proven to be irrational from the point of view of society as a whole. It is no wonder that businessmen, as Perelman shows, have not been completely committed to the idea of the free market, and as a result they have called for government intervention when this furthers their interests. Perelman provides empirical evidence that businessmen like Andrew Carnegie and J. P. Morgan were not convinced about the virtues of the free market. Even economists like John Bates Clark, who was known as a proponent of the free market and who taught neoclassical economics, had thrown away this model in practice, because he saw that capitalism was becoming less competitive, as in the case of the railroads. Clark was against the free market in practice, at the same time that he taught it as economic theory at the university.

What Perelman calls “Clark’s schizophrenic attitude toward competition” (98) can be explained by the fact that he faced a chasm between theory and practice, which is something that some liberal economists face today. At least this is what the New York Times has reported about Paul Krugman and Lawrence Summers, who support free markets and free trade, but who now see that in real life there are many problems, such as the de-industrialization of the rich countries and the loss of the well-paying jobs that came with it. Their problem is that they have an ideology and believe it is a theory. The firm belief of microeconomics is that if the world worked like the theory, that is, if it were a free market, then there would be efficiency and economic growth, and everybody would be better off. But this is a belief, not a fact. The free market just produced a major housing bubble and a banking crisis, as Marxist political economy had predicted, and this crisis will mean more hardship for millions of working people around the world. A scientific ethos requires that if the theory does not explain the facts, the theory is wrong. Are Krugman and Summers going to get rid of the theory or are they going to be schizophrenic as was Clark regarding free market ideology and practice?

There is, to be sure, a part of economics that deals with non-competitive markets. But this is relegated to the second part of microeconomic textbooks, and it is taught at the end of the term. By then, the supply and demand curves, derived from the marginal cost and marginal benefit curves, have become the foundation of the profession. Other courses in economics, such as labor economics, urban economics, or environmental economics, are built around the concepts taught in the first part of microeconomics, which deals with competitive markets.

Building on Marx’s criticism of political economy and Baran and Sweezy’s criticism of economics, Perelman’s critique aims at the core of economic theory. His exposé and insights will help people understand why the great majority of economists believe in the free market and support the agenda of free trade, and why most of them failed to foresee the current banking crisis. It unveils how this ideology is employed to “naturalize” a system predicated on endless accumulation. At the same time, he provides insights concerning the shortcomings of this theoretical perspective, which has been hegemonic for the last two decades, and which has promised untold riches for everybody; but instead has undermined the standard of living of the majority of working people, accelerated environmental destruction, and increased social inequality within and among nations. In this, he helps us see beyond the constraints of the current economic debate, allowing us to ask big questions regarding what type of economy would actually serve human needs, rather than one driven by the logic of capital.