Toward a New Classical Economics

Writing over at Hackernoon, Arnold Kling writes about a need to “overthrow neoclassical economics.”

Kling’s article rings of truth.  A lot of neoclassical economics, as it is taught and practiced, does tend to simply treat “labor” and “capital” as blobs and ignores the individual believes and attitudes of individuals.  People are reduced to “representative agents” or mere resource-allocators in the standard neoclassical framework.  Firms are treated as mere input-output machines that run by blobs of homogenous things known as “capital” and “labor.”

Kling proposes to insert the ideas of cultural evolution into economics, a proposal I am sympathetic to.  And, at one time, economists took this factor into account.  Adam Smith, David Ricardo, Frederic Bastiat, and many other of the classical economists knew you had to take into account people’s attitudes, desires, sympathies, etc and they acted on these.  Adam Smith’s Theory of Moral Sentiments is a proto-economic book and he discusses at length how our sympathies and morals, shaped and shaping those around us, affect our behavior.  Frederic Bastiat, in The Law and That Which is Seen and That Which is Unseen discuss the role of institutions and how people react to those institutional frameworks if they deviate from their moral foundations.

In a sense, Kling is correct.  We need to overthrow neoclassical economics.  I’d like to see it return, at least insofar as the assumptions concerning homo economicus goes, to its classical roots.

Does Heaven Have an Economy?

Short answer: no.

Long answer: Heaven has no need for an economy.  Economics looks at scarcity and how humans interact to deal with the problems arising from scarce resources:  Exchange and production, collective action solutions (like firms or governments), rights, institutions, etc.  Things like preferences, budget constraints, opportunity costs, knowledge, etc are all under consideration by the economist.

Heaven is a post-scarcity place.  God is omniscient, which means there are no knowledge problems.  God is omnipotent, which means any resources needed (if any) can be instantly created.  God and Heaven exist outside of the temporal universe, which means problems relating to future knowledge are eliminated.  There are no economic problems in Heaven, and thus no need for an economy.

I bring this up not for some theological discussion on the nature of Heaven, but rather to point out a mistake many policy pundits (even with economic training) make when they discuss economics: they assume away the economic problem.

The most common form assuming away the economic problem takes is assuming in supply and demand curves.  We see this all the time: free trade discussions, market failure discussions, labor market discussions, etc.  Economists and policymakers and pundits just assume away the knowledge problem, forgetting that the very curves the need to make their policies are generated by the very process (market process) they are seeking to disrupt!

Another example, exemplified by this paper, exists in assuming away individualism.  Much of the economic problem (and its subsequent solutions) exist because people are individuals, with their own dreams and desires.  In more technical terms, they have preferences.  If we assume a “representative agent” or assume “identical preferences,” we assume away a major part of the economic problem, which is how we arrive at conclusions that make no economic sense.

The point is this: a lot of these assumptions tend to lead to conclusions economists generally oppose.  The reasoning is simple: If you assume away economic problems, of course economic methods are going to become pointless.

The Logical Impossibility of Absolute Rights

There is an important implication of my post from yesterday (or, perhaps more accurately, I should say this post as important implications that lead to yesterday’s post): universally absolute rights are logically impossible.

We tend to hear arguments by libertarians and anarcho-capitalists that certain rights, namely property rights, are absolute (for example, see Murray Rothbard’s article here).  No one can prevent us from doing what we want with our property (including our bodies) or enjoying our property as we see fit.  While on the surface, this seems reasonable, it is a logically impossible thing to enforce.

Let’s consider an example, similar to the one I gave yesterday.  Two neighbors have an abutting piece of land.  One neighbor, Joe, has a pool and a nice backyard he enjoys lounging in.  However, one thing he does not like is the smell of smoke and the sound of loud noises.  These things reduce the enjoyment of his property.  The other neighbor, Bob, has a backyard as well, but he likes to sometimes hold barbeques, bonfires, and parties.  When he does this, he generates noise and smoke that inevitably flow over to Joe’s yard.  In other words, Joe’s “stuff” is being messed with.

If both parties have absolute property rights, how can this situation be resolved?  If Joe cannot request, require, or negotiate some end to Bob’s activities, his ability to enjoy his property as he sees fit is diminished by Bob’s actions.  Likewise, if Joe’s ability to enjoy his property is maintained, then Bob’s enjoyment of his property must necessarily be reduced by reducing or eliminating his barbeques, bonfires, and parties.  Either way, someone‘s property right is not absolute.  Something has to give.

It is important to note there is no necessary need for state intervention here.  Joe and Bob can (and likely will, absent major costs) find some mutually beneficial arrangement.  But that arrangement must result is someone’s rights being attenuated.  If one of them has an absolute right, the other cannot.

The question should not be whether some rights are absolute or not.  Absolute rights are a logical impossibility.  Rather, the question should be how to resolve conflicts that inevitably arise when rights collide.  If libertarians cannot address these conflicts, then we necessarily secede the argument of conflict resolution to the statists.  By insisting on absolute rights, a logical impossibility, we state outright libertarianism has no place in the real world as it cannot resolve conflicts.  This has to end.

Coase, Smith, Justice, and Liberty

The Smithian and classically liberal conception of justice, as explained by Dr. Dan Klein, is, to put it succinctly: don’t mess with other people’s stuff.  The flipside of justice, liberty, is consequently other people not messing with your stuff.  On the surface, this seems like a rather simple ethical basis.  The rule is very clear: if you mess with other people’s stuff, you are committing an injustice and violating their liberty.  But an ethical rule is not valued in its simplicity, but rather its robustness to the real world.

While Smith does regard justice as a sacred virtue, he does carve out exceptions to its enforcement.  There may be times when the strict rules of justice may not or cannot be enforced without a detriment to overall liberty.  In these cases, someone’s stuff has to be messed with.  While this statement may be jarring to the classical liberal, let’s consider an example from modern law and economics.

Let’s consider Ronald Coase’s famous example of the farmer and the rancher.  The farmer raises crops on his land.  The rancher grazes cows nearby.  The rancher’s cows sometimes, accidentally, graze the farmer’s crops that are too close to the fence, either the crops hang over the fence for the cows to eat or the cows stick their heads through the fence (that is, the farmer’s “stuff” is being messed with).  However, if there are restrictions on where the cows can graze, then those restrictions are messing with the rancher’s “stuff” (they are limiting the rancher’s use of his cows).  So now we have a conflict: the use of each person’s “stuff” may conflict with each other, resulting in mutual messing with each other’s stuff.

Who is in the right?  Who is in the wrong?  A simple appeal to the rules of justice cannot solve this: the farmer’s crops are being messed with, yes, but so are the rancher’s cows.  Some rule would be required to address this matter.  That rule would, necessarily, violate the strict rules of justice.

Let’s take, for example, a rule that the farmer has the property right to his crops and any damage must be compensated to him by the rancher.  The rancher’s “stuff” is now being messed with.  He’d need to figure out some way to corral the cows, or limit their grazing, or negotiate some kind of bargain with the farmer…some solution would be acquired.  However, this bargain would constitute a “messing” with the rancher’s stuff since he now has to alter his behavior beyond what he ordinarily would have chosen to do.  Some use of his property is now beyond his control.  We can make a similar argument by giving the property right to the rancher, or even if we say “caveat emptor” and say any crops that spill over the fence can be eaten and any cow over the fence can be shooed away.

While one person’s individual liberty may be decreased (ie, someone is messing with his stuff), overall liberty may increase (ie, there is generally less messing with stuff).  Rules, laws, customs, etc are necessary because they create reliability.  If we reasonably believe a given rule will be enforced, then we can act in a given manner.  If I believe my ownership of my car will be enforced should someone steal it, I am more likely to buy a car.  If I do not believe the ownership would be enforced, I’d be less likely to purchase a car (and/or spend more resources to ensure it doesn’t get stolen).  Just as stable rules can grow the economic pie, stable rules can grow the liberty pie.  Rules that develop to make virtues like justice predictable by all and create stability that allows exchange, production, and general improvement to flourish.  Without predictable rules, the concept of justice may simply become ad hoc and something of a Hobbesian jungle may arise as the costs of production/protection rise and the costs of predation fall.

Some libertarians/anarcho-capitalists get nervous about the implications of Smith’s comments regarding sacrificing individual liberty for overall liberty.  The primary concern I hear is such an argument can be used for an expansion of the state into all manner of things.  While a naive interpretation of Smith could justify such an expansion, I think a closer reading of Smith, especially in the context of his overall writings, suggests that the “overall liberty” criteria are a conflict resolution tool rather than a “behavioral control” tool.

Today’s Quote of the Day…

…is from Page 145 of Adam Smith’s classic 1776 work The Wealth of Nations (Liberty Fund Edition):

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary.

The first line of this quote is one of the most famous of all of Smith.  But the conversation usually ends there (typically with an erroneous claim that Smith would support antitrust legislation).  The immediately-following sentences provide deep insight into Smith’s classical liberalness as well as the dilemma we all face in the trade-off between liberty and security.

Smith also here has a discussion on incentives.  The law should not render associations between producers (ie trade groups, cartels, etc) necessary.  While Smith is discussing in the context of labor regulations and business regulations here, that discussion can be easily extended into the realm of what we now call Public Choice.  When government can hand out favors, firms will try to capture those favors.  They may even form associations to pool resources to increase the likelihood of capture (eg a Chamber of Commerce).

The foresight of Adam Smith, and his continued applicability to modern economics is astounding.

Adam Smith was More Preceptive Than We Give Him Credit For

My previous post sported a quotation from Adam Smith’s Wealth of Nations.  As I was going through that section again, I noticed the editor’s footnote I had overlooked last time.  It pointed me to Book IV, Chapter IX of the Wealth of Nations where Smith makes the following argument (Pages 680-681):

Except with Japan, the Chinese carry on, themselves, and in their bottoms, little or no foreign trade; and it is only into one or two ports of their kingdom that they even admit the ships of foreign nations.  Foreign trade, therefore, is, in China, every way confined within a much narrower circle than that to which it would naturally extend itself, if more freedom was allowed to it, either in their own ships, of in those of foreign nations.

The perfection of manufacturing industry, it must be remembered, depends altogether upon the division of labour; and the degree to which the division of labour can be introduced into any manufacture, is necessarily regulated, it has
already been shown, by the extent of the market.  But the great extent of the empire of China, the vast multitude of its inhabitants, the variety of climate, and consequently of productions in its different provinces, and the easy communication by means of water carriage between the greater part of them, render the home market of that country of so great extent, as to be alone sufficient to support very great manufactures, and to admit of very considerable subdivisions of labour. The home market of China is, perhaps, in extent, not much inferior to the market of all the different countries of Europe put together.  A more extensive foreign trade, however, which to this great home market added the foreign market of all the rest of the world; especially if any considerable part of this trade was carried on in Chinese ships; could scarce fail to increase very much the manufactures of China, and to improve very much the productive powers of its manufacturing industry, as by a more extensive navigation, the Chinese would naturally learn the art of using and constructing themselves all the different machines made use of in other countries, as well as q the other improvements of art and industry which are practised in all the different parts of the world. Upon their present plan they have little opportunity of improving themselves by the example of any other nation; except that of the Japanese.

The tl;dr version: Smith argued (along the lines of the QOD) that China, under their current regime of laws and institutions, has maxed out their ability to grow.  China has a great ability to manufacture, and yet a poorer than Europe.  Why?  Smith predicts that it is because of their disdain for foreign trade.  If they were to open their markets to foreign trade, China would become considerably more wealthy.

We are blessed, in the 21st Century, to be able to test Smith’s hypothesis.

Prior to the 1970’s and 1980’s, China was very much anti-foreign trade.  The desire to be self-sufficient and reject all “Western” influences was strong (eg the Great Leap Forward) and China was abjectly poor.  In 1981, approximately 81% of China’s population lived in extreme poverty (less than $1.25 a day).  Their economy was stagnant.

However, beginning in the 1980s and accelerating in the 2000’s, China opened itself up to international trade.  According to the Economic Freedom of the Word report, China dramatically reduced tariffs and more moderately reduced non-tariff barriers to trade between 1980 and 2015 (most recent data).  Coincidently, China’s growth skyrocketed.  After hovering around 0% for the 60’s and 70’s, China started to grow consistently at 8+%.  Poverty fell to about 12% by 2010.  China’s average standard of living (as measured by GDP per capita) while still quite low, is quickly converging to the world average.

Adam Smith appears to have been quite right.

On a related note, this paper from the Journal of Legal Studies (gated) is another example of the percipient nature of Adam Smith

Today’s Quote of the Day…

…comes from page 111-112 Adam Smith’s 1776 masterpiece, An Inquiry into the Nature and Causes of the Wealth of Nations:

But perhaps no country has ever yet arrived at this degree of opulence. China seems to have been long stationary, and had probably long ago acquired that full complement of riches which is consistent with the nature of its laws and institutions. But this complement may be much inferior to what, with other laws and institutions, the nature of its soil, climate, and situation might admit of. A country which neglects or despises foreign commerce, and which admits the vessels of foreign nations into one or two of its ports only, cannot transact the same quantity of business which it might do with different lawsand institutions. In a country too, where, though the rich or the owners of large capitals enjoy a good deal of security, the poor or the owners of small capitals enjoy scarce any, but are liable, under the pretence of justice, to be pillaged and plundered at any time by the inferior mandarines, the quantity of stock employed in all the different branches of business transacted within it, can never be equal to what the nature and extent of that business might admit. In every different branch, the oppression of the poor must establish the monopoly of the rich, who, by engrossing the whole trade to themselves, will be able to make very large profits.

JMM:  The nature of the institutions and the legislation that is enforced in a given country has a lot to do with the potential growth of the economy.  Institutions and legislation that protect and expand the scope of markets, in other words, institutions and legislation that allow human cooperation to flourish, will bring opulence.  Conversely, those that reduce the scope of markets will bring stagnation.