The misunderstanding at the core of economics

THE economist Kenneth Arrow, who died last month at age 95, was a model academic - brilliant, creative, precise, unfailingly modest. If only his fellow economists would stop misrepresenting his work.

In the 1950s, Arrow and others proved a theorem that, many economists believe, put a rigorous mathematical foundation beneath Adam Smith's idea of the invisible hand. The theorem shows - in a highly abstract model - that producers and consumers can match their desires perfectly, given a particular set of prices.

In this rarified atmosphere of “general equilibrium,” economic activity might take place efficiently without any central coordination, simply as a result of people pursuing their self-interest.

It’s an insight that economists have used to argue for de-unionisation, globalisation and financial deregulation, all in the name of removing various frictions or distortions that prevent markets from achieving the elusive equilibrium.

Yet the theorem trails a dense cloud of caveats, which Arrow himself recognised could be more important than the proof itself. For one, it worked only in a perfect world, far removed from the one humans actually inhabit.

Equilibrium is merely one of many conceivable states of that world; there’s no particular reason to believe that the economy would naturally tend toward it. Beautiful as the math may be, actual experience suggests that its magical efficiency is purely theoretical, and a poor guide to reality.

Remarkably, academic macroeconomists have largely ignored these limitations, and continue to teach the general equilibrium model - and more modern variants with same fatal weaknesses - as a decent approximation of reality.

Economists routinely use the framework to form their views on everything from taxation to global trade - portraying it as a value-free, scientific approach, when in fact it carries a hidden ideology that casts completely free markets as the ideal.

Thus, when markets break down, the solution inevitably entails removing barriers to their proper functioning: privatise healthcare, education or social security, keep working to free up trade, or make labour markets more “flexible.”

Those prescriptions have all too often failed, as the 2008 financial crisis eloquently demonstrated. The result is widespread distrust of economic experts and rejection of globalisation.

In his recent book “Economism: Bad Economics and the Rise of Inequality,” James Kwak credits conservative think tanks funded by corporations and the wealthy for spreading the oversimplified belief in markets as wise machines for producing optimal social outcomes. He certainly has a point, yet such propaganda stemmed from an intellectual model that had been lurking at the center of economics all along - and remains there now, still widely revered.

This perversion isn’t Arrow’s fault. He merely helped to prove a mathematical theorem, and was no blind advocate for markets. Indeed, he actually thought the theorem illustrated the limitations of capitalism, and he was prescient in understanding how economic inequality might come to impair the workings of democratic government.

Perhaps it would be best to use his own words: “In a system where virtually all resources are available for a price, economic power can be translated into political power by channels too obvious for mention. In a capitalist society, economic power is very unequally distributed, and hence democratic government is inevitably something of a sham.”

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

  • Mark Buchanan is a physicist and science writer

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