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The Unity of Science Principle and the 'Unreasonable Effectiveness' of Neoclassical Economics

Neoclassical economics occupies a virtually unshakeable position in current, mainstream economic thinking, which is attributable to an uncritical acceptance of an orthodox version of the unity of science principle in philosophy. This paper traces the philosophical discourse, distinguishing between the orthodox version and the newer and more flexible version of neoclassical economics. Can we find an alternative approach that breaks away from the limitations of neoclassical economics?

SPECIAL ARTICLEEconomic & Political Weekly EPW march 22, 200879The Unity of Science Principle and the ‘Unreasonable Effectiveness’ of Neoclassical EconomicsD M NachaneNeoclassical economics occupies a virtually unshakeable position in current, mainstream economic thinking, which is attributable to an uncritical acceptance of an orthodox version of the unity of science principle in philosophy. This paper traces the philosophical discourse, distinguishing between the orthodox version and the newer and more flexible version of neoclassical economics. Can we find an alternative approach that breaks away from the limitations of neoclassical economics?The difficulty is to detach the framework of fact – of absolute undeniable fact – from the embellishments of theorists...– Arthur Conan Doyle,The Memoirs of Sherlock Holmes.Perhaps a word of explanation on the title of this paper is in order. Ever since Wigner (1960) titled his Richard Courant lecture in the mathematical sciences as ‘The Unreasonable Effectiveness of Mathematics in the Natural Sciences’,a number of authors have used variations on this theme as titles of their writings. I use the title to emphasise my central thesis that the virtually unshakeable position that neoclassical economics occu-pies currently in mainstream economic thinking is attributable in considerable measure to an uncritical acceptance of an orthodox version of the unity of science principle (USP) in philosophy. The plan of my presentation is as follows. Section 1 sets out the main elements of the philosophical debate, in what in contempo-rary philosophical discourse terms is termed the “Erklaren versus Verstehen”controversy. In particular, I distinguish between an older orthodox version of the USP and a more flexible modern version. In Section 2, I review the hesitations that some of the late 19th century economists had on excessive formalism of econo-mics, as encapsulated in the famous Edgeworth-Walras contro-versy, and how the Walrasian view with its emphasis on mathe-maticisation triumphed. Section 3 is a critique of the orthodox version of modern neoclassical economics, especially in its gen-eral equilibrium manifestation. Section 4 broadens the critique to a less orthodox and more flexible version of neoclassical eco-nomics, which is currently regarded as mainstream. Section 5 briefly touches upon policy issues, especially those bearing upon structural reforms in the third world. In Section 6, I indulge in some highly tentative speculations about the future evolution of economics from a science of “the overeducated in pursuit of the unknowable” to one of “the appropriately educated in pursuit of the knowable”.11 Unity of Science PrincipleIn his seminal treatise,Cours de Philosophie Positive, Auguste Comte (1842) outlined a scheme through which he claimed all fields of human knowledge evolved. Comte’s schemata comprised three sequential stages: (i) the theological; (ii) the metaphysical; and (iii) the positive. The theological stage was characterised by the conviction that all observed events are to be explained by the citation of will or intention. The metaphysical stage substitutes abstract concepts like powerand forcefor the earlier notions of will or intention. I am profoundly grateful to the Bengal Economic Association, the University of Jadavpur and Alaknanda Patel for inviting me to deliver the second A K Dasgupta memorial lecture.In my article on Dasgupta for the Oxford Companion (2007), I fell back on the phrase “child of the nineteenth century Indian Renaissance”to encapsulate his versatile and intellectually adventurous life, deeply committed both to the highest academic principles and to a liberal humanism. Dasgupta’s achievements were manifold. He made important contributions to economic theory and gave detailed critiques of classical, neoclassical and Keynesian economics. His work greatly improved our understanding of the working of less developed economies. He also deliberated a great deal on the applicability of economic theory, as developed in the west, to problems of less developed countries. Being an ardent believer in the power of ideas to influence policy in the direction of social welfare, he also was often involved in offering advice to high-level policymaking bodies in India as well as in various multilateral agencies. Above all, he was a great teacher and institution builder. I therefore regarded it as a great honour to be asked to speak in his memory, and felt quite overwhelmed by a feeling of my own inadequacy for such a distinction.The views expressed in this paper are personal and do not reflect those of the institute that the author works for.D M Nachane (nachane@hotmail.com) is at the Indira Gandhi Institute of Development Research, Mumbai.
SPECIAL ARTICLEmarch 22, 2008 EPW Economic & Political Weekly80Finally, in Comte’s view, the field of inquiry graduates to the status of science when the third stage is attained. This apex stage is thus concerned with the unravelling of laws of coexistence, association and conjunction.2 Comte, along with Berkeley, Kant and J S Mill, may be regarded as a proponent of the USP, which takes the view that all sciences are methodologically similar. However, at this juncture, sharp differences emerge among the proponents of the USP. A majority of them maintain a deductive-theoretical model of explanation as the core of any scientific endeavour, simultaneously subscrib-ing to the reducibility of other methodological procedures to causal explanations [for example, Nagel 1961; Hempel 1965]. This may be referred to as the orthodox version of the USP or the Erklaren school. While this school strongly believes that the aims of any science ought to be the discovery of causal or nomological laws, there is also a more moderate version of the USP whose adherents (including Kant, Berkeley, and most notably Comte him-self) were Humeans with a deep distrust of causality and for whom laws were not meant to transcend the limits set by “coexistence, association and conjunction”. Karl Pearson who may be considered as a modern exponent of the moderate USP version understood the principle as connoting nothing more than “a unity of methods employed in analysing and learning from experience and data” [Pearson quoted in Zellner 2007]. Jeffreys (1967) the subjective probability theorist expresses the idea even more lucidly There must be a uniform standard of validity for all hypotheses irrespective of the subject. Different laws may hold in different subjects, but they must be tested by the same criteria; otherwise we have no guarantee that our decisions are those warranted by the data and not merely the result of inadequate analysis or of believing what wewanttobelieve.In this moderate form, the USP appears far more appealing, and would claim general acceptance from natural and social scientists alike. For ease of later reference we may term the orthodox and moderate versions of the USP as USP-1 and USP-2 respectively.TheUSP (especially in its orthodox connotation) was methodo-logically challenged by a group of German philosophers in the latter half of the 19th century. They argued for methodological autonomy of the “historical” sciences (or social sciences in the modern terminology), in which phenomena were to be under-stood rather than explained in terms of prior causes. Such sciences were termed “idiographic”, and in their analysis, abstract concepts like meaning, language, intuition and even rhetoric played an important role. The term verstehen was introduced to denote an admixture of these abstract concepts.3 It is important to note that the original proponents of verstehen did not set it up as an anti-thesis to erklaren, rather viewing the two as essen-tially complementary. They were thus not so much in opposition to the erklärenconcept itself, as against an exclusive obsession with it, to the neglect of verstehen. The modern philosophical school of realismmay be viewed as a lineal culmination of the USP-1 movement. Broadly speaking, realism may be characterised as embracing three distinct aspects: (i) the object of research exists independently of the inquiry of which it is an object; (ii) the objective world does exist, and “true” theories are supposed to discover it; and (iii) Popperian falsification of theories is important but this can only be achieved via deductive methods not by empirical verification.Such an attitude made realists strongly favour deduction to the virtual exclusion of induction as the preferred method of analysis, and to espouse mathematical formalism (in its Hilbertian mani-festation) as the most suitable technique of reasoning. The positivist view by contrast is best illustrated by the physi-cist Feynman’s (1985) rhetorical question about the existence of the “inside” of a stone. No one has ever seen the inside of a stone; even if one tries to do so by breaking a stone into pieces, all that one observes is new “outsides”. Positivism, thus, does not worry too much either about the realism about theories or about enti-ties. It does not explicitly reject objective reality but it maintains that the search for such a reality is a fruitless one. The tasks of science are to construct hypotheses about the real world, based on the entities which can be (at least approximately) quantified, and to confront such hypotheses with data. In its more rigid manifestations, positivism continues to reflect a Humean anti-causality bias. This means that the hypotheses to be tested are only of the “constant conjunction” variety with little, if any, causal connotations. These features have led positivists to focus on data measurement and collection of stylised facts, on the one hand, and on the other, to concern themselves with statistical methods aimed at empirical verification and predic-tion. Their position is best stated by van Fraassen (1989) who argues that “scientific activity is one of construction rather than discovery: construction of models that must be adequate to the phenomena, and not discovery of truth concerning the unobservable”.4 This accords well with the modest claims expressed by Keynes for economics when he says “if economists could manage to get themselves thought of as humble, compe-tent people, on a level with dentists, that would be splendid [Keynes 1930, p 373]. In the same vein Velupillai (2005) has recently observed “I should happily settle for economics being compared to archaeology and our scientific activity placed on a level with that of the archaeologist”. However, most modern-day economists would be reluctant to arraign themselves in such honest (but humble) robes. 2 NeoclassicalEconomicsand Edgeworth-Walras ControversyTurning now to the role of formalism in economics, one runs into an immediate difficulty. There is some controversy as to what exactly constitutes neoclassical economics and when it originated. An early, possibly first use of the term classical occurs in 1847 when Marx used it specifically to describe the formal economics of Ricardo and contrast it with the vulgar or romantic economics of some of his contemporaries. Later, writers used the classical appellation in a more general sense to refer to the economic theories prevalent from 1776 to about 1870. By the 1870s, under the impetus of the works of Gossen, Walras, Jevons, Marshall, Menger and others, the subject of economics underwent a fundamental metamorphosis with the introduction of concepts like utilitarianism, marginalism etc, and the rise to pre-eminence of the deductive method of analysis. Dasgupta dates the paradigm shift to W S Jevons’
SPECIAL ARTICLEEconomic & Political Weekly EPW march 22, 200881Theory of Political Economy in 1871. The watershed is best described in his own wordsThe advent of marginalism marks a decisive shift in the nature of economic theory. Economic theory ceases to be an enquiry into the causes and implications of the growth of wealth, it becomes an enquiry into the problem of allocation of given resources among competing lines of production [Dasgupta 1985, p 77].In his opinion, the following four aspects encompass the salient features of marginalism: (i) in contrast to the dynamic preoccu-pations of classical thinkers, the marginalists (with the notable exception of Marshall) employ a static framework shifting the focus of analysis from issues of growth to that of resource alloca-tion; (ii) consumption, rather than accumulation is (in the mar-ginalist scheme) the end of all economic activity; (iii) the classi-cal search for an absolute measure of value is replaced by a search for the determinants of relative prices; and finally (iv) the prob-lem of distribution is envisaged as the derivation of factor prices from commodity prices and isolated from the phenomenon of class relations.Dasgupta refrains from the appellation neoclassical while referring to the works of Jevons, Walras, Menger, J B Clark, Wick-steed and others, preferring to use the term marginalist instead. This is mainly to emphasise the fact that their theories mark a fundamental discontinuity with classical thought.5 Marshall’s contributions, on the other hand, preserve a strong link with the classicals, and hence, according to Dasgupta, could be legiti-mately termed neoclassical.The problem of economics as he (ie, Marshall) views it is not just a problem of the allocation of given resources; for him the problem involves a study of how the resources come to be what they are … Methodologically, Marshall’s analysis of equilibrium points to a dynamic element, even though it bears a static garb. So it is that Marshall, in spite of his allegiance to the marginalist principle traces his ancestry to Ricardo [Dasgupta op cit, p 101].6 Dasgupta’s position is thus close to Veblen (1900) and contrasts strongly with the more inclusive use of the term neoclassical introduced by Hicks (1932) and Stigler (1941). I think the Veblen-Dasgupta distinction is extremely useful intracing the late 19th century and early 20th century evolu-tion of the subject. However, when I come to the more recent developments, I will fall back on the conventional termino-logy and use the term neoclassical in its more inclusive (i e,Hicks-Stigler)sense. The last decade of the 19th century was marked by a heated methodological debate between the marginalists (as represented by Walras) and the neoclassicals7 (represented by Edgeworth, Marshall and later Pareto). The controversy revolved around two important issues, viz, (i) Walras’ notion of the ideal entrepreneur and Edgeworth’s allegation of his (ie, Walras’) neglect of indus-trial competition, and (ii) Walras’ description of tatonnement, which Edgeworth regarded as unrealistic and which he sought to replace with his now well-known notion of recontracting. As dis-cussed at length in Marchionatti (2004, 2007), the controversy could be really traced to the differing views that Walras on the one hand and Edgeworth, Marshall and Pareto on the other held about the nature of economics and the role of mathematics (in economics). Walras’ aim was to create a theory of economics in the Newton-Laplace mould of celestial mechanics which would result in “throwing out phraseology and charlatanism, and in making precision and consciousness reign” [Walras’ letter to Gide dated November 3, 1889 in Jaffe 1965, p 370]. Marshall by contrast emphasised that “economists must never lose sight of the real issues of life; and these are all... affected more or less by motives that are not measurable” [Marshall 1890, p 78]. Similarly, Edgeworth cautions against the excessive use of symbols in the work of the Helvetian Jevons (as he called Walras). This contro-versy is important, not only because of the stature of the person-alities involved but also because it had a very important role in determining the future course of the subject. In philosophical terms, the controversy may be seen as one involving therealist and positivistschools discussed above. As to why the former tri-umphed over the latter is difficult to say, though there has been some attempt at this [see Creedy 1986, Bridel and Huck 2002, Costa 2002, etc]. What is indisputable however is that most leading economists of that time (with the notable exceptions ofKeynes) displayed a marked preference for working in the realist framework. Similarly, Schumpeter in (1954) his magnum opus strongly tips the scales in Walras’ favour by commenting that the debate showed Edgeworth’s failure to understand Walras who, accord-ing to Schumpeter, achieved a clearness, rigour and synthesis far greater than Marshall or Edgeworth.8 As is now well known, the general equilibrium strand of modern neoclassical economics (now using the term in its inclusive sense) is strongly rooted in the Walrasian tradition and inherits the progenitor’s enthusiastic bias towards the use of formal (axiomatic) mathematical meth-ods in economics. 3 OrthodoxNeoclassicalEconomicsMany historians of economic thought take exception to the description of modern mainstream economics as neoclassical economics [see Blaug 1998; Aspromourgos 1986], maintaining that “Neoclassical economics transformed itself so radically in the 1940s and 1950s that someone ought to invent an entirely new label for post-war orthodox economics” [Blaug 1998, p 2]. While not disputing this point of view, it is equally true that modern mainstream economics maintains several features of the neoclassical economics that prevailed in the period 1870-1930. Besides, the bulk of the criticism of heterodox economists against the modern orthodoxy revolves around features of the latter, which are directly traceable to the earlier neoclassical doctrines. Hence, one can be sympathetic to the use of the term neoclassical economics as a generic term to describe modern orthodox eco-nomics. The issue can be put in a Lakatosian perspective. Accord-ing to Lakatos (1970), a doctrine could be viewed as comprising (i) an immutable hard core and (ii) a variable protective belt. Eggertsson (1990) identifies the hard core of neoclassical eco-nomics as a set of three axioms, viz (1) stable preferences of eco-nomic agents guided by narrow self-interest (sometimes dubbed greed for short); (2) rational choice; and (3) equilibrium-based interactions among economic agents.The protective belt of assumptions comprises three aspects: (1) situational (including institutional) constraints; (2) assumptions
SPECIAL ARTICLEmarch 22, 2008 EPW Economic & Political Weekly82about information available to agents; and (3) type of interactions permissible among agents.Modifications to the protective belt occur continuously but they do not constitute a paradigm shift. The latter is said to occur only when the hard core is touched. Thus, modern orthodox eco-nomics incorporating the important contributions to information theory, transaction costs and externalities by Arrow, Stigler, Stiglitz, Townsend, Coase, etc, does not constitute a departure from neoclassical economics, only its continuation and reaffirma-tion under more general boundary conditions. It is in this sense that I will be referring to the mainstream economics of today as neoclassical economics. But it is useful to recognise that the term currently encompasses a vast spectrum. At one end of this spec-trum, we have modern general equilibrium theory, which still maintains a very strong affinity to Walrasian economics, with an exclusive reliance on the deductive method and a heavy emphasis on formal mathematics. At the other end of the spectrum we have a miscellaneous group of theories loosely relying on standard neoclassical assumptions (but with differing degrees of emphasis), often embodying peripheral (in the Lakatosian sense) modifica-tions to some of these assumptions, and utilising eclectic model-ling methods [Colander 2002]. This approach marks a combina-tion of both deductive and inductive reasoning and the preferred methods derive from applied(as opposed toformal) mathematics and statistics. The first strand of modern neoclassical economics is thus strongly rooted inUSP-1, while the second falls back on the less restrictiveUSP-2 principle. In this section we attempt a critique of the orthodox version of neoclassical economics, with the next section dealing with the more flexible version. Our critique in this section is particularly directed at what its propo-nents often regard as the crowning achievement of neoclassical economics, viz, general equilibrium analysis.In view of the Lakatosian distinction introduced above, essen-tially any challenge to neoclassical economics has to be based on a demonstrably convincing rejection of any of the three postu-lates listed above as comprising the hard core. First Core Assumption: ‘Greed’Let us begin with the first core assumption which we have dubbed for short as greed. Firstly, as pointed out by Bair (2003), the extent of self-interest characterising members of a society is crucially conditioned by the society’s culture, religion, politics, economic circumstances, etc. Once these normative considerations are introduced into the analysis,9 the limitations of the ordinal utility calculus immedi-ately come into focus. In an interesting study, Elster (1998) intro-duces six grades of emotional feelings based on a sociality rank-ing ranging from malevolent envy at one extreme to extreme altruism at the other.10 Using game theory, he then goes on to demonstrate that the welfare of a community varies com-mensurately with the number of altruists in that community. Thus, altruism is not only a respectable individual trait, it has practical social consequences. This is quite apart from the Gandhian viewpoint that the societal elevation of greed to a virtue under the laissez faire doctrine constitutes a kind of debasement of human beings. Experimental economics has also revealed that the greed assumption seems to have very limited value when it comes to actually predicting human behaviour. Experiments such as the “ultimate game” indicate that people are actually quite concerned about others, even when it conflicts with their own pecuniary interest.11 We now turn to the criticism relating to the second (viz, ration-ality) postulate. This has been contested by numerous writers including such respected names as Frank Knight, Schumpeter and Keynes. General Theory,for example, focused criticism on the rationality postulate, especially as it applied to expectations. Keynes in his typical style dubbed it as “a pretty polite technique” that tries “to deal with the present by distracting from the fact that we know very little about the future”. The rational expecta-tions revolution, which has been hailed by the mainstream eco-nomics profession, has virtually no foundations in psychology. Several studies of actual behaviour conducted, for example, by Tversky and Kahneman (1974) and others have shown that in real life expectations are not only irrational but very little learning or “convergence to rationality” is evident. At the most fundamental level, rational behaviour has been challenged by Herbert Simon (1953), who maintains that the model of the rational man opti-mising an objective function, subject to constraints hardly reflects the complex actuality of business decision-making, where sur-vival, conventions, rules of thumb and other common business practices lead to what he calls as “bounded rationality” or “satis-ficing behaviour”. There is a highly developed strand of modern literature in this vein, exploring the links between behavioural psychology and economic decision-making, including most notably Sen (1977), Bertrand et al (1997), Mullainathan and Thaler (2001), Ariely and Wertenbroch (2002) etc.The third postulate regarding the existence and stability of an overall economic equilibrium is tied up to the possibility of aggre-gating over individual demand/supply curves to arrive at their market counterparts. Sraffa (1960) had demonstrated the futility of measuring capital independent of distribution and prices, thus demolishing the neoclassical concept of an aggregate production function (except in the trivial one commodity “Ricardian corn” model). Sraffa’s contribution however was not generally accepted as a refutation of neoclassical economics for two reasons. Firstly, missing in Sraffa is any theory of human agency and interaction, thus making it a technical rather than a behavioural theory. Secondly, his criticism is confined to the aggregate neoclassical production function only, leaving intact other disaggregated versions of neoclassical theory such as the general equilibrium model of Arrow and Hahn (1971), in which capital was treated as heterogeneous.12 A more devastating line of criticism had been advanced earlier by Keynes (1936) based on the “fallacy of com-position” involved in the neoclassical mode of deriving results for the economy as a whole by assuming identical agents, acting independently of each other, and then simply aggregating indi-vidual relations at the micro level.13 This criticism has been refined and formalised through the successive writings of Debreu (1974), Sonnenschein (1972) and Mantel (1974), and goes by the name of theDSM theorem. TheDSM theorem may be explained in several ways. Our exposition here is based on Kirman (1989). The
SPECIAL ARTICLEEconomic & Political Weekly EPW march 22, 200883foundations of neoclassical economics rest on the assumption that if individual demand functions satisfy Wald’s weak axiom of revealed preference (WARP) – implying individual demand curves are downward sloping then a unique stable market equilibrium exists. The DSM theorem asserts that whereas the WARP is suffi-cient to ensure the existence and local uniqueness (of a market equilibrium), global uniqueness and stability are not ensured by WARP (or by even stronger restrictions on individual demand functions).14 In spite of Hahn’s (1975) admission that the DSM results are “most damaging to neoclassical theory”, the main-stream economics profession has largely ignored these implica-tions [plausible reasons for this neglect are discussed in Hodgson 1997 and Rizvi 1994].The ripostes of orthodox neoclassical economic orthodoxy to these criticisms are puzzling to say the least. Firstly, as Hutchison (1984) has observed, neoclassicals sometimes adopt the defence that their assumptions are only designed as approximations to the real world and that attempts are continuously being made to relax the assumptions to fit real-world situations better.15 But if this is the defence, the neoclassicals have no right to make the kind of exaggerated claims for the real world applicability of some of the more extreme versions of their doctrines such as real business cycle theories and public choice theories.A second line of defence pertains to what Hicks (1979) disap-provingly observes as a tendency to pursue economics “for no better reason than its intellectual attraction; it is a good game”.16 This “good game” approach lies behind the ambivalent attitude of orthodox neoclassical economists to empirical verification. The rigid version of neoclassical economics rejects empirical veri-fication altogether [Caldwell 1982]. This position seems to have a close affinity to that of the philosopher Paul Feyerabend whose Against Methoddowngraded the importance of empirical argu-ments and in particular, Popper’s falsification criterion by sug-gesting that aesthetic criteria and social factors play a more deci-sive role in the history of science than rationalist or empiricist methodology. But this kind of methodological anarchism (or “anything goes” attitude) has meant that neoclassical economics has not really countered its criticisms effectively but has rather flourished by ignoring its critics and often dismissing or even ridiculing them. This “irresistible predilection for deductive rea-soning” leads economists “from sets of more or less plausible but entirely arbitrary assumptions to precisely stated but irrelevant theoretical conclusions” [Leontief 1974] and has the unfortunate consequence of a narrowing of the research focus on price deter-mination to the virtual exclusion of the institutional arrange-ments underlying different markets (on this also see below). Exclusive reliance on the deductive method also poses several limitations for an imperfect science like economics. As Reichen-bach (1958) has noted, deductive inference leads to three extreme positions with regard to a proposition viz, validity, falsity or igno-rance. It does not admit statements like “This patient will most likely recover from this surgery” or that “lowering interest rates by theRBI will lead in all probability to an asset prices boom”, which are typically characteristic of imperfect sciences like medi-cine, economics etc. Thus, the deductive mode of explanation becomes quite limiting for such sciences. In recent years, philosophers have been devoting a great deal of attention to these distinctions among the types of explanations relevant in differ-ent sciences. The formal theory of philosophical explanations is of relatively recent origins, starting with the seminal 1948 paper of Hempel and Oppenheim. This early contribution was later elaborated by Hempel himself (1965, 1966), and several others. Hempel and Oppenheim (op cit) advocated two distinct models of inference – the deductive-nomological (D-N) model for deter-ministic systems and the inductive-statistical (I-S) model for non-deterministic systems (these and other modes of explanation are discussed at length in one of my earlier papers). There is, however, one strand of the orthodox neoclassical approach, which could be interpreted as a constructive attempt to respond to some of the criticisms viz the induction of game theory into the analysis of markets. Instead of presuming con-sumers with (possibly heterogeneous) preferences acting inde-pendently of each others’ actions, it incorporates strategic behav-iour into the definition of economic rationality. However, in spite of the visible enthusiasm of its practitioners, it is doubtful whether it advances mainstream economics in any significant way, still falling woefully short of providing a satisfying theoretical frame-work for understanding real world markets. An early criticism that market phenomena are not all about “outsmarting” oppo-nents as game theory (then prevalent) seemed to presume, is still relevant against some of the more exaggerated conclusions drawn from two-person non-cooperative game theory (such as those in industrial organisation analysis). But even with the far more sophisticated advancements that have occurred in game theory since the 1980s, certain criticisms are still germane. As argued by Foss (2000), game theory proceeds in either of the two extreme frameworks. Standard game theory presumes hyper-rationality with agents having information about other players’ complete preference orderings. Evolutionary game theory goes to the other extreme of assuming that agents follow rigid rules with no scope of modification through learning or discovery. Neither approach thus really captures salient features of the economic behaviour of consumers or firms. A second and related critique relates to the coordination problem of Hayek (1948). While much energy is spent on exploring the existence and uniqueness of Nash equilibria in a given situation, there is virtually no indica-tion on how agents zero in on such an equilibrium (except by a pure process of introspection) with no allowance for the process of learning, discovery, disappointments etc, so crucial in the real world.17 In conclusion, one can say that in spite of some limited progress in the direction of realism, most of the major drawbacks of neoclassical economics still persist and cannot be salvaged by appeal to game theory.4 Modern Mainstream Economics and USP-2The critique in Section 3 was primarily directed at the orthodox version of neoclassical economics, especially the general equilib-rium doctrine. In this section, we try to see whether the more heterodox versions are open to similar criticisms. It would be dif-ficult to agree upon an exact definition of modern mainstream economics, for there are several schools of thought running con-currently such as new classical economics, supply side economics,
SPECIAL ARTICLEmarch 22, 2008 EPW Economic & Political Weekly84new Keynesian economics, post Keynesian economics, neo-Keynesian economics, neo-Austrian economics, etc.18 Of these schools, the new classical may be viewed as a direct descendant of the neoclassical economics of Walras, Jevons and Marshall, the neo-Keynesian school (somewhat out of disfavour now) evolved out of the IS-LM neoclassical synthesis and hence, retains some affinity with neoclassical economics proper, the new Key-nesian school with its emphasis on microfoundations differs from the new classical school only in its assumption of sticky wages and prices, whereas supply side economics in spite of its essentially amorphous nature may also be classified under the neoclassical rubric because of its strong belief in Say’s law of mar-kets. Modern mainstream economics, empirically analyses fea-tures of these various approaches in an eclectic fusion via what is called dynamic general stochastic equilibrium (DGSE) modelling. An essential feature of the DGSE approach is a belief in the so-called simplicity postulate of Jeffreys-Wrinch (see Section 6 for a fuller discussion). Thus, our critique of modern mainstream economics (or the DGSE approach) is somewhat diffused, and limited to the common features shared by these four somewhat heterogeneous schools. All the various viewpoints subsumed under modern main-stream economics inhere two of the core features of orthodox neoclassical economics, viz, greed and rationality,19 and hence, the criticisms directed at these aspects in the previous section carry over. They differ from the orthodox viewpoint however in admitting the possibility of persistent disequilibrium and ration-ing (as for example in the new Keynesian school) and in being far more open to empirical verification. Their attitude to empirical verification (as expressed in their writings) seems to reflect what we have called asUSP-2 (see Section 1), and if this were in fact the case, there would be little to complain about. Unfortunately, the breach between precept and practice is quite distinctive. There is a great deal of econometric work but this is mainly confined to deriving parameter estimates within a given framework and to testing hypotheses. But for true progress in any science what is required is hypothesis discovery. Inductive generalisations have sometimes led to the discovery of new hypotheses in the biomed-ical sciences20 but because of the heavy reliance on microfounda-tions in some of the mainstream economic theories, the working of this process is not given full play. Early scepticism about the use of empirical methods in economics is exemplified in the following quote from Robbins (1935), No doubt there is a sense in which it can be argued that every random sample of the universe is the result of determinate causes. But there is no reason to suppose that the study of a random sample of random samples is likely to yield generalisations of any significance.The logic of this viewpoint drives Robbins to downplay the importance of statistical methods in economics. For example he concedes that empirical studies such as Mitchell’sBusiness Cyclesmay be useful in suggesting problems to be solved, but “it is theory and theory alone which is capable of supplying the solution” [Robbins 1935, p 120]. The famous Koopmans-Vining controversy [Koopmans 1947, 1949 and Vining 1949] finds Koopmans maintaining fact finding as “a waste of time” if not guided by theory. Such an attitude then denies any place to the finding of any empirical regularities, which cannot be explained in terms of the existing microfounda-tions. This is undeniably a philosophically ambivalent position. The role of empirical regularities in the development of new theories can never be overemphasised. Kepler’s laws of planetary motion were discovered before Newton’s theory of gravitation furnished their theoretical basis and the father of evolutionary biology Charles Darwin revealed how he “worked on true Baconian principles and without any theory, collected facts on a wholesale scale” [quoted in Karl Pearson 1892].The issue has been discussed at length in Hadamard’s (1945) book wherein he underlines the importance for hypothesis dis-covery of a third type of inference, viz, reductive inference,which has been defined by Peirce (1892) as “...studying facts and devis-ing generalisations to explain them”. Zellner (2007) shows how the principle of reductive inference (in economics) leads to a focusing on unusual and surprising facts, rather than discarding these as outliers. There are other features of the reductive approach such as (i) observing behaviour in unusual historical epochs or in different cultures; (ii) studying limiting behaviour of existing theories; and (iii) assigning a greater role in theory building to insights from economic experiments and econometric simulations. Zellner and several others [Min 1992; Zellner and Israilevich 2005] have devoted much attention to operationalis-ing the reductive approach by devising appropriate statistical techniques such as structural econometric modelling time series analysis, data-based analyis, etc. However one can hardly claim that these approaches have had any substantive impact on main-stream economic thinking. It should be emphasised that the DGSE approach, on a super-ficial examination seems very much in the spirit of USP-2, and as such methodologically unexceptionable. However, there is in evi-dence a pronounced reluctance in the DGSE approach to modify or discard the microfoundations of their theory, even when con-fronted with continuous rejection of the (theoretically expected) conclusions by the empirical evidence. Thus, in terms of method-ology, the preferred method is inductive with very little scope for the reductive approach. This leads researchers in this tradition to focus on hypothesis validation rather than hypothesis discovery. This is contrary to the spirit of the USP-2 in which hypothesis rejection should invariably lead people to the search for new hypotheses and assumptions. In the natural sciences like physics as well as in many imperfect sciences such as medicine, theories are being continuously modified when confronted with experi-mental failures. Thus, in spite of its use of a great deal of eclecti-cism, the DGSE approach is neither ideology nor value neutral as often claimed; only these features remain implicit rather than being highlighted explicitly (for example, the focus placed on the microfoundations, on price determination, on the efficiency of markets, and commensurately the neglect of issues such as inequality, distribution, justice, etc).5 Enamourment with Neoclassical ThinkingHow does one then explain the survival and even flourishing of a doctrine (viz, neoclassical economics in both its orthodox and less restrictive versions) resting on such insecure intellectual
SPECIAL ARTICLEEconomic & Political Weekly EPW march 22, 200885foundations? The real reasons why neoclassical economics reignssupreme and unchallenged in the world today have nothing to do with the soundness of its methodological position. Instead, they are to be located in exogenous factors. Firstly, it provides a seemingly infallible justification for the operation of free markets (see below).Secondly, it subtly confuses the issues of economic freedom and political liberty. An oft quoted remark of Milton Friedman is to the effect that “Underlying most arguments against the free market is a lack of belief in freedom itself”. The process by which western political economists have come to view the connexion between capitalism and democracy as irrevocable, is fairly evi-dent. Both share the common philosophy of “free will of the indi-vidual, imperfectability of human beings, primacy of private val-ues and property…the suspicion of government or any other agglomeration of power” [Weitzman 1993, p 314]. From this, the conclusion seems inevitable that there is a natural isomorphism between the philosophies of democracy and capitalism, and nei-ther can flourish in the absence of the other, without generating significant social turmoil. In recent years, however, researchers have approached the issues with a more open mind, which assumes additional significance in the wake of the cataclysmic events culminating in the fall of Soviet communism. Their major premise is that the attitudes supporting democracy are conceptu-ally distinct from those favouring markets [Shiller et al 1991]. Once it is recognised that the values at the basis of democracy and markets are distinct, then the irrevocable causal connection between the two, that is central to Schumpeter, Hayek and Friedman is no more automatic [see Bagchi 1995].Thirdly, it is one economic doctrine, which lends itself easily to the use of a fair degree of sophisticated mathematics. This use of symbols often deludes neoclassicals into believing that they have rendered the subject of economics “scientific”. But as the famous mathematicianSchwartz(1986) remarks, mathematics often tends to “dress scientific brilliancies and scientific absurdities alike in the impressive uniform of formulae and theorems. Unfortunately, however, an absurdity in uniform is far more persuasive than an absurdity unclad”. In an important contribu-tion Velupillai (2005) draws attention to one hitherto neglected aspect of the use of mathematics in economics. Of the various schools of mathematical reasoning in existence today (such as the platonists, intuitionists, Hilbertian formalism, bourbakists, etc) mainstream economists have worked (perhaps unknow-ingly) in the formalist tradition. Velupillai (op cit) argues that much of modern orthodox general equilibrium theory is cru-cially conditioned on this approach. Several propositions, including the two well known welfare economics theorems may have to be considerably modified if one followed a different mathematical school of thought such as (for example) the constructivist[Scarf 1990]. Lastly, it may be added that the collapse of the Soviet type economies, and the emergence of US hegemony has been heralded as a triumph of the market philosophy underlying neoclassical economic policies.The intellectual pre-eminence that neoclassical economics has acquired in the last few years has had a corresponding impact on the way development issues have been viewed. The older politico-economy perspective has disappeared, as also the recog-nition that problems of less developed countries (LDCs) are of a fundamentally different genre from the problems of growth in western societies. To this belief that neoclassical economics is universal (widely prevalent among large sections of the Indian intelligentsia) is attributable the fact that the subject of Indian Economics (interpreted either as a study of the basic institutional characteristics of the Indian economy or as a study of economic theories relevant for the specific Indian context) now survives only as an exotic species. As a matter of fact, the spirit of inde-pendent thinking that characterised the writings of 19th century nationalists such as Dadabhai Naoroji and Mahadev Govind Rande, and of their intellectual heirs such as A K Dasgupta, D R Gadgil, V K R V Rao, Amlan Datta, V M Dandekar, and others, has virtually disappeared from the current generation of Indian economists. The neoclassical paradigm of development economics traces a benevolent causal (in the sense of nomological necessity) link from the existence of free markets to high growth rates inLDCs and emerging market economies (EMEs). But this causation can-not be supported unless each link in the following chain of deduc-tive arguments is validated: (1) a policy of free markets leads to an optimal static allocation of resources; (2) any move towards free markets is welfare improving; (3) a series of static optima can be strung together to yield a dynamic optimum for the econ-omy; and (4) the resultant optimal path does not run up against resource constraints.Debatable PropositionsEach of these propositions is highly debatable and the main points of the controversy are too well known in the literature to merit any but the briefest discussion. The first proposition is often claimed as following from the first and second welfare economics theorems. Apart from some of the methodological criticisms noted above about the general validity of the theorems, what modern reform advocacy seems to forget (rather conveniently) is that the theorems are about perfect competition and not about ownership of enterprises.21 The refutation of the second proposi-tion forms the substance of the so-called “second-best theory” of Lipsey and Lancaster (1956), which to date holds its own. The last two points are rather technical but the general thrust of the liter-ature in this area is that in the absence of perfect foresight and a complete set of futures markets, a competitive market allocation may not be able to achieve intertemporal efficiency and dynamic consistency.22 The extended discussion is intended to underscore two vital but neglected points, viz (i) that neoclassical conclusions hold under the strictest of assumptions and extremely restrictive boundary conditions; and (ii) the case for market-oriented reforms rides on an extremely cavalier interpretation of neoclassical tenets, extrapolating them well beyond their legiti-mate contexts. Thus, an intellectually honest position would be to maintain that whether freer markets will promote growth or otherwise is essentially an empirical issue to be determined by rigorous data analysis. This point seems obvious to the layman.
SPECIAL ARTICLEmarch 22, 2008 EPW Economic & Political Weekly86However, multilateral think tanks, government advisers and policymakers inLDCs and EMEs very often seem to proceed as if the “benevolent link” alluded to above was a settled issue, beyond any theoretical doubt, when in fact the issue is far more com-plicated and the benevolence or otherwise of the link between freer markets and economic development (and social welfare in general) is crucially conditioned by the institutions and historical circumstances of each individual country.23It is indeed true that in the Asian region, in the past three decades, nations with market-friendly policies do seem to have fared much better on many economic indicators than nations with socialistic orientations, especially on growth rates. On the African continent, by contrast, reforms have hardly achieved much (with the exception of South Africa), at best perpetuating the status quo. Thus, the empirical experience clearly points out that whereas selective and well-planned liberalisation of marketscan produce beneficial results on certain occasions, a blind foolhardy rush in the direction of markets is beset with some dangers and not always desirable. Several important issues need sorting out, even if one agrees on the necessity of reforms, and even the most basic list of such issues, would minimally include the following: (i) the pace at which reforms should be introduced; (ii) the sequencing of reforms; (iii) the political feasi-bility and social justice aspects of reforms; (iv) the revised role of important state institutions (like the central bank and planning commissions) and the public sector generally; (v) the likely strains on the federal polity in the wake of reforms; (vi) the rec-onciliation of affirmative action policies with market principles; and (vii) above all the issue of whether and to what extent mar-kets should be allowed to evolve naturally and to what extent their development must be supervised and guided by the state itself. Certainly on these details, in an ideal scenario, each coun-try would work out its own road map, using nationally available expertise (ie, economists and other social scientists thoroughly familiar with local conditions). Instead what has happened is the emergence of a uniform reforms blueprint prepared under the aegis of multilateral institutions, based on the so-called Washington Consensus (and its several avatars), which is designed as a standard sized hat “to fit all heads”.It must be conceded that in the early years of liberalisation in India, some serious thinking seemed to have been evident in guiding the economy in a particular direction. The current frenzy of privatisation, financial liberalisation and opening up to multi-nationals which has been witnessed in recent years in India, hardly bears the impression of a carefully thought out long-term strategy guided by national interest, but seems a hastily put up patchwork quilt, with at least one eye on what will be acceptable to the International Monetary Fund and the World Bank. Such higgledy-piggledy reforms marching to the tune of Orwellian chant of “markets good, state bad; public sector bad, private sector good” in the business media represent a triumph of short-termism and political brinksmanship over careful and dis-passionate economic thinking and seem to be thrusting India onto a dangerous trajectory with growing interpersonal and regional inequality, rising social tensions and above all macro-economic instability.6 ConclusionsThis paper has striven to carefully examine on a methodological basis the claims made on behalf of neoclassical economics. There are strong reasons to dispute its theoretical conclusions and even more so its practical implications. It is in this context that one realises the importance of the relativist approach of Dasgupta (especially evident in his Epochs) which underlined the rationale for a distinctive approach to Indian economic prob-lems. In the past a relativist approach emphasised an inter-disciplinary focus incorporating the verstehen element (dis-cussed above) and using a methodology which closely parallels the modern hermeneutic school, of which McCloskey (1983) may be taken as a leading proponent. Such a view might be properly called as the unity of social sciences approach, in con-trast to the unity of sciences approach discussed earlier. How-ever, McCloskey and others in the tradition veer to a somewhat extreme position by concerning themselves exclusively with the intuitive and rhetorical aspects of economics, arguing that these are all that matter.24 An alternate and promising approach, which breaks away from many of the limitations of neoclassical economics, while not dis-carding the essence of the scientific approach is the emerging dis-cipline of complexity modelling. This recognises that what Lesk (2000) says about biology lacking “the magnificent compression of the physical sciences” holds with even greater force for eco-nomics. Discarding therefore mathematical formalism as the pre-ferred mode of analysis, it adopts the approach of mathematical constructivism. The complexity approach is a refutation of the Jeffreys-Wrinch simplicity postulate [Jeffreys 1939], which asserts that “the simpler laws have the greater prior probability” and owes its mathematical foundations to Kolmogorov’s (1933) complexity notion. Let me state in brief why complexity modelling appears an attractive alternative to current mainstream economics. Firstly,the approach recognises that economics is too complex to be studied from micro-foundations alone. Secondly, it eschews a common (universal) set of basic micro-foundation assumptions, arguing instead that micro-foundations have to be contextualised within institutional structures. Thirdly, it departs from the principle of parsimony of assumptions, which often tend to straitjacket behavioural and institutional assump-tions. Finally, it abandons an exclusively deductive-formalist approach in favour of a more eclectic approach in which deductive, inductive and reductive modes of inference are com-bined with applied mathematics and statistics. The entire spirit of complexity modelling is constructivist and computational. Both in its theory and policy aspects it strongly advocates an understand of the specific different circumstances prevailing ineach community (including not only institutional dif-ferencesbut also cultural differences in attitudes to rationality, entrepreneurship etc).25 I hope that the economics profession in India will overcome itstraditional intellectual dependency on western mainstream economics, and imbibe a little bit of the spirit of free inquiry and critical appraisal of dogmas, that characterised both A K Dasgupta’s life and work.
SPECIAL ARTICLEEconomic & Political Weekly EPW march 22, 200887Notes 1 The two phrases are borrowed from Solow (1997) and Colander (2005) respectively. 2 Hicks (1979) provides interesting illustrations of the transition through these three stages. He sub-sumes the first two stages under the appellation old causality, with the two literary classics – Milton’s Paradise Lostand Pope’sEssay on Man serving as moral exemplifications of this principle. The philosophical basis for the transition to the new causality (our third stage) was laid by Gibbon’s Decline and Fall of the Roman Empire, wherein the concept of natural cause is intro-duced in direct contrast to the older moral view ofcause as seeking “to justify the ways of God to men”. 3 The verstehen point of view can be illustrated by a simple analogy. The explanation of an economic phenomenon like globalisation or a sociological phenomenon like racial discrimination cannot be reduced to a few basic causal factors, as can be done in explaining natural phenomena like eclipses, tides or earthquakes. In other words social phenomena lack (to use Lesk’s (2001) popu-lar phrase) “the magnificent compression of the physical sciences”. 4 The word “adequate” in the above quote admits of two interpretations. At a basic level, it may be interpreted as “goodness of fit” or “data-congru-ence” [to use a term popularised by Hendry 1993]. At a deeper level, it may be related to the Jeffreys-Wrinch Simplicity Postulate [Jeffreys 1931] which asserts that “The set of all possible forms of scien-tific laws is finite or enumerable and their initial ie, a priori) probabilities form the terms of a con-vergent series of sum”. Jeffreys (1939) further elaborates the postulate by adding the proviso that “the simpler laws have the greater prior prob-ability” Kolmogorov’s (1933) complexity notion (developed independently) looks at the obverse side of the problem, albeit from a more mathe-matical angle. The modern theory of simplicity working on these early percursors, is formalised in the Solomonoff-Levin distribution [Solomonoff 1964] and the minimum description length prin-ciple of Rissanen (1983, 1987). Several extensions of these ideas as well as some applications to eco-nomics are discussed in Zellner et al (2001). 5 While this is certainly true of Jevons who “built the essentials of his teaching from bricks of his own manufacture” [Schumpeter 1954, p 826] and to a large extent of Walras, it would be somewhat debatable in the case of Menger whose 1871 work Grundsatze der Volkuirtschaftslehre (English translation 1950) bears a heavy imprint of Smith and Ricardo. 6 Dasgupta’s position on this issue is not universally accepted. Schumpeter for example, maintains that “Mill’s and Marashall’s cases are similar in that for reasons of their own, commendable or not, they stressed Ricardian influences unduly at the expense of others. From Marshall’sPrinciples, Ricardianism can be removed without being missed at all” [Schumpeter 1954, p 529]. But we do not wish to go into this controversy at the moment. 7 The usage here is as in Veblen-Dasgupta (above).8 Schumpeter’s charge of Edgeworth failing to grasp Walras’ technical language is puzzling, when one considers that both Edgeworth and Marshall were mathematicians of a higher order than Walras (a fact conceded by Walras himself (in his letter to Edgeworth dated August 10, 1988). 9 There is a long history to the analysis of norma-tive and behavioural aspects of utility theory.10The six gradings are malevolent envy, non-cooperative egoism, cooperative egoism, partial altruism, complete altruism and extreme altruism. 11 On this see Bair (2003). 12 As a matter of fact Hahn (1982) puts in a charac-teristic vitriolic comment “The neo-Ricardians …have demonstrated that capital aggregation is theoretically unsound. Fine…The result has no bearing on the mainstream of neoclassical theory simply because it does not use aggregates. It has a bearing on the vulgar theories of the textbooks”. 13 A more recent perspective on this aspect may be had from Caballero (1992). 14 In this connection, it is interesting to observe that Wald (1936) had correctly observed that “there is a statistical probability that from the assumption that [WARP] holds for every household, the valid-ity of [WARP] for the market follows”. In other words WARP at the micro level can lead to WARP at the macro level. The later neoclassicals conven-iently interpreted the can as will. 15 This attitude really traces itself back to the cele-brated position of Friedman (1953) in which he argued that all that was needed of assumptions was that they are sufficiently good approximations for the purpose at hand, ie, for predictions. In other words, assumptions need not be empirically verified as long as they yield good predictions. His emphasis on predictions really puts Friedman in (what we have described as) the less orthodox ver-sion of neoclassical economics. Nevertheless this so-called F-twist runs through much of orthodox neo classical economics, even though prediction is assigned a very nominal role therein. 16 Blaug (1998) is even more explicit in his condem-nation of this tendency “Economics has increas-ingly become an intellectual game played for its own sake and not for its practical consequences for understanding the economic world…. Eco-nomics was once condemned as a ‘dismal science’ but the ‘dismal science of yesterday was a lot less dismal than the soporific scholasticism of today’.” 17 This is not to deny that attempts have been made to devote attention to these issues in the literature see for example Aumann’s (1974) notion of pre-play communication, Kreps’(1990) incorporation of bounded rationality and Sugden’s (1986) notion of unintended consequences.18 The various schools are discussed and compared in Snowdon et al (1994).19New Keynesianism however admits market imperfections (like monopolistic competition) and also informational imperfections like asym-metric information and moral hazard.20Landsteiner’s discovery of blood groups or Mendel’s discovery of the laws of heredity are instances which immediately come to mind. 21 In the latest revised edition of his well known book Little (2002) makes this amply clear “The laissez-faire model, given enough assumptions, could bring about the ‘optimum’ distribution of resources, as well as the socialist ‘blueprint’. The socialist blueprint model is ‘superior’ at the logi-cal level in that it requires fewer postulates. It does not require the postulate of either a rising cost curve, or a perfectly elastic demand curve”.22 A very selective list of the vast literature in this area would include Koopmans (1967), Lutz (1993), Dreze and Stern (1990), Dasgupta and Maler (2000). 23 The force of this statement becomes evident, when we review the varied Latin American expe-rience. Chile by all accounts, is usually rated as the most successful reformer in the region. Over a six-year period beginning 1987, approximately 1.5 million people emerged from the poverty trap, with the proportion of people below the poverty line declining from 46.6 per cent to 30 per cent. Simultaneously, unemployment was drastically curtailed from 10.8 per cent in 1987 to about 5.3 per cent in 1992 [Barrera 1998]. The Argentine story, marks a sharp contrast, however. Here, ever since the inception of liberalisation in 1975, income inequality and poverty have markedly deteriorated. The poorest 30 per cent of the popu-lation received 11.4 per cent of the national income in 1975 but only 8.9 per cent in 1993. Cor-respondingly, the share of the richest decile rose from 46.6 per cent to 51.6 per cent [Starr 1999]. The Mexican case also replicates several key aspects of the Argentine case [Lustig 1992]. 24 It is important to note that the original propo-nents of verstehen, who viewed it (correctly in my opinion) as an essential complement to erklären, carefully avoided this pitfall. 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