Neorational Keynesonomics

What is valued and how do we value it?  This is a question humans asked and attempted to answer long before the classical school of economics was born with Smith’s Wealth of Nations. Aristotle believed that value was intrinsic to an object, a property of its underlying substance.  While David Hume would reject this claim to powerful effect in the mid-1700’s, the field of economics would not fully shake itself free of this conception until the late-19th century.  The labor theory of value, elaborated and utilized tenaciously by Karl Marx in his attacks against capitalism, was not merely some communist delusion; it was the basis of the classical economists’ explanation of prices, which were thought merely to fluctuate around a commodity’s “real” value - the amount of labor accumulated in the commodity.  This came from the immediate physical labor of the worker, but also from the machinery (itself built by labor) that was used in the production process.  The money fetched by the commodity, then, was thought to be distributed according to the labor each member of the production process could mobilize.  Thus did the capitalists, mobilizing labor through their tools and machines, get their piece in the form of profits, the workers get their piece in the form of wages, and so forth. 

This conception of value was problematic, in that it consistently failed to predict the buyer’s willingness to pay for an item given what it was worth.  A paradigm shift took place, its intellectual roots in David Hume’s work in which he argued that their was nothing intrinsic to any object (including humans); rather, knowledge was based on the juxtaposition of things and their qualities, and thus so was value.  This in mind either explicitly or implicitly, late-19th century economists became less interested in the real “worth” of an object and more in how buyers and sellers seemed to value items in relation to one another.  This was the groundwork of the so-called marginal revolution, which suggested that people were not interested in the “real” value of a commodity - that is, it’s value in terms of labor - but rather in the extra utility (revenue) that purchasing (producing and selling) one more unit of the commodity would provide to the buyer (producer), relative to the costs of acquiring (making) it.  When theses costs and benefits are in equilibrium, no more units will be bought or sold.  Value becomes linked to notions of scarcity and unlimited wants, and the tensions between the two is worked out in markets.  This is the basis for supply and demand analysis, and it also clarifies market entrance and exit on both sides of the exchange.  Along with the help of a few simplifying assumptions, it comprises the foundations of what we now call neoclassical economics.

These assumptions, as discussed in the article, are threefold:
1) People have rational preferences among outcomes.
2) Individuals maximize utility and firms maximize profits.
3) People act independently on the basis of full and relevant information.

Neoclassical economics atomizes the individual so that her decisions come down to the solutions to one or two simple equations, and when economists aggregate those decisions they can develop workable theories of markets for just about anything one can conceive - from Playstation 3’s and the labor used to build them to marriage partners.  It was the mathematization of economics, as the author of this article discusses, that gained it acceptance as something on par with physics as a science.  The insatiable appetite for that which satisfied notions of modernism - the idea that the world can only benefit from progress and development technologically, intellectually, morally, and so on (and that the ‘modern’ society embodies those ideas) - encouraged these developments and made them concrete.  Once neoclassical, mainstream economics gained recognition as a science, it became extremely difficult to challenge in the countries that most esteem this label, such as the UK and USA. In these bastions of economic thought, it is the neoclassical conception of economics that students are taught, to the exclusion of alternative approaches, such as Marxian, Austrian, neo-institutional, and so on.  For the most part, neoclassical economics does not abdicate authority to these heterodox groups when it fails to explain certain phenomena, but rather borrows from them and implements their ideas as necessary and in such a way as satisfies the neoclassical notions of optimization.  

In neoclassical economics, outcomes are considered best in the Pareto-efficient sense when “any other allocation of goods and services would leave someone better off,” meaning that if someone were to take an equilibrium defined by a well-functioning market and redistribute the resultant allocation, the total utility experienced at equilibrium would be less than the one produced by the unfettered machinations of the “invisible hand.”  Much of the frustration that spawns alternative schools of economic thought arises from disagreement with the mainstream’s fundamental assumptions as outlined above.  In my opinion, the resilience of the mainstream seems to arise from two factors.  First, it aligns quite readily with how westerners buy and large tend to think of themselves and others.  We often see ourselves as rational, autonomous individuals that make the decisions that are most satisfying to us given the outcomes we expect, and as we are the ones most often under study in economics, we are prone to impute such assumptions into our analyses.  Second, evidence that goes against the assumptions is often and easily construed in a way that it is made to fit the framework.  Notions of “incomplete information”, “bounded rationality”, and cultural peculiarities can be modeled or otherwise understood with a fair degree of accuracy using probability distributions, cognitive neuroscience, or careful study of the subject and subsequent retooling of the fundamental decision equations.  Neoclassical economics is notoriously flexible as an analytical framework, is able to maintain an acceptable level of clarity even after some relaxation of its assumptions, and on these facts turns its continued support and utility as the main school of thought in economics.

This article is short and easily understood, but some may question the author’s objectivity as a commentator on such important information (though certainly not as an economist); his judgment in calling detractors from the mainstream “kooks” or “antiscientific” is not only a gloss - it is outright wrong.  Except to the extent that adherents often downplay these alternative views, however, there is nothing “wrong” with neoclassical economics.  In any event, the idea of value in economics has some very deep and fascinating roots that one can learn in any class or book on the history of economic thought. 

Reference:  Weintraub, E. Roy, “Neoclassical Economics”, The Concise Encyclopedia of Economics. Liberty Fund, Inc. Ed. David R. Henderson. Library of Economics and Liberty. 18 January 2008. <http://www.econlib.org/library/Enc/NeoclassicalEconomics.html>.

Irving Fisher was one of the most prolific economists of the 20th century, both because of the magnitude of his contribution and his ability to relate his ideas to readers with a comprehensible and pithy writing style.  Says the author of the article “…graduate economics students, who to this day still study [Fisher’s Theory of Interest, one of his most important works], often find that they can read - and understand - half the book in one sitting.” 

According to the article, Fisher’s contributions to economics lie in his work on money and interest, and also in his sensible use of mathematics to sharpen his analysis.  In the book just mentioned, Fisher’s Theory of Interest, he fleshed out what continues to be the mainstream conception of interest rates - that they are indexes “‘of a community’s preference for a dollar of present [income] over a dollar of future income.’”  Furthermore, the value of capital is the income it produces - net of initial costs and depreciation - vis a vis the interest rate.  Finally, with respect to interest rates, Fisher was the first to make a clear distinction between the real and nominal interest rates and to show that the former was equal to the latter less inflation.  All of these notions are central to how economists conceptualize interest and the relationship between capital and income.

Fisher was also one of the first to construct and utilize price indices, and no doubt this was empirically useful in his work on the quantity theory of money, laying the groundwork that allowed the monetarists like Friedman and his ilk to interrogate Keynesianism to near-revolutionary effect in the 1960s.  The equation of exchange is a very useful identity, formulated by Fisher, that can be used to ‘check the math’ on a variety of statements about economic policy effects.  It states that MV = PT, where M is the stock of money, V the velocity (or circulation rate) of money, P is the price level, and T is the total volume of transactions (we now use y instead of T, where y is stands for real income).  If any one variable is changed, at least one of the others must change to maintain the equality. 

From the author’s description, Fisher was something of a jack-of-all-trades and a man of many firsts.  He earned the first PhD in economics from Yale before the ivy league school even had an economics program.  He had a somewhat dubious social agenda, being a supporter of eugenics, Prohibition, and “peace.”  He also lost some face when, during the Great Depression, he insisted that recovery was imminent for several years.  (Incidentally, Fisher himself lost a great deal of wealth in the crash of 1929). 

Overall, the article was interesting but too much of a gloss to glean too much information.  I was, however, intrigued by the suggestion that he was a good writer, and since Fisher’s work is older, it is generally available for free on the internet.  For instance, you may find Fisher’s Theory of Interest here.

 Source:  “Biography of Irving Fisher.”  The Concise Enyclopedia of Economics.  Liberty Fund, Inc. Ed.  David R. Henderson.  Library of Economics and Liberty. 18 January, 2008.  http://www.econlib.org/library/Enc/bios/Fisher.html