Examining the failure of economic thinking

Mark Thoma is spot on in this passionate assessment of what ails the modern economic system,

"It's distribution, not production that has failed us over the last 30 or 40 years. We produce far more than we ever have, and we will continue to increase our ability to squeeze more and more out of the resources we have. We have the ability to produce enough stuff. But the distribution of the things we produce has been tilted toward the top. Instead of wages rising with productivity as our textbooks say they should, wages have stagnated and the rewards have gone elsewhere. Thus, while the pessimism of the past was about production not being able to keep up with population - many classical economists looked forward to a long-run outcome of a dismal, stationary state with most people struggling at subsistence wages - the pessimism of the present is driven largely by a failure of distribution. The haves get more and more, and the have nots get less and less even though overall output is rising... Pessimism about breaking through the wealth and power structures that stand in the way of change is understandable, as is the desire of the winners in our increasingly two-tiered society to keep the focus on growth rather than distribution."

The remarkable achievements of the past few decades - rapid advances in information and communication technology, spectacular economic growth in emerging Asia etc - is confirmation of the fact that markets have allocated scarce resources very efficiently. But the growing evidence of failures and sufferings across the world is ample proof that market systems have failed to ensure fairness in allocation of these resources.

Fortunately, many of these market failures are the inevitable consequence of the process of efficient allocation of scarce resources and they can be atleast partially mitigated by appropriate public policy interventions and through formal and informal social and political institutions. Progressive taxation, social safety nets, subsidies and concessions, and institutionalized regulatory restraints are some of the commonplace policy options used to address such failures in distribution or achieve fairness in allocation. Political parties in democracies, social interest groups, trade unions etc have played significant role in creating an environment that promotes fairness in allocation.

Traditionally, governments have intervened, often very aggressively, with such policies to address failures in the fair distribution of resources. The vibrancy of social and political institutions have also played a major role in containing the excesses emerging from the dynamics of untrammelled free market. However, the disruptive socio-economic changes of the past couple of decades have unleashed forces which have considerably undermined the tenuous balance between efficiency and fairness.

As the concentration of economic power and resultant widening of economic inequality has accelerated spectacularly in recent years, many of these traditional checks and balances have either been dismantled wholesale or their strength considerably eroded. Across the world, thanks to the spectacular growth of financial market incomes, the past few years have seen the emergence of a class of uber-rich elite, whose economic power has found reflection in the traditional political institutions. In other words, economic power has spawned political power.

This has had two fold impact. It has loosened the restraints put by social and political institutions. More worryingly, these changes have seriously undermined the resolve of governments at all levels to step in to rectify market failures. A false consciousness has been sought to be created that the big winners are the beneficiaries of a competitive merit race, and the outcome is a reflection of the natural order of things. Such explanations brush under the carpet the ovarian lottery that increasingly defines a major chunk of life's outcomes.

The strong opposition, not only in the West but also in many emerging economies, to increasing taxes on even the richest, withdrawing concessions to corporate groups, stronger regulation of financial markets, and expanding the role of government, even if only to provide basic social safety cushions to those most affected by economic shocks, is a reflection of this changing dynamics of social and political power.

Unfortunately, as a profession, economics has failed to either anticipate or do anything meaningful to highlight the implications of this failure. It has been too concerned with studying "efficient allocation of scarce resources" that it appears to have forgotten that the sustainability of this allocation depends on it being fair.

I am inclined to believe that this skewedness in focus among economists is attributable to two factors - limitations of mathematical models and ideological bias. Modern macroeconomic research is heavily dictated by mathematical formalism. However, unlike issues of efficiency (which is essentially a maximization problem, subject to certain constraints), those of fairness in distribution is not easily amenable to mathematical modelling. Fairness involves the exercise of human judgement, in some form or other, to bring about a desired final state of the system.

Then there are the ideological biases of economists, most of whom work in free-market democracies. Unlike the ideal systems of modern economic theories, the real world is full of imperfections, where the ideal world assumptions do not hold. In the circumstances, fairness demands interventions that seek to re-distribute resources and thereby correct the business as usual state of affairs in the system. But such remedial interventions, more often than not, go contrary to the ideological principles that underpin the theoretical foundations of these economists.

Update 1 (2/10/2011)

Mark Thoma argues that there is a need to revisit the socio-economic and political power balance, but is not sure how it will happen. He writes,

"Congress has no interest in doing so, things are quite lucrative as they are. Unions used to have a voice, but they have been all but eliminated as a political force. The press could serve as the gatekeeper, but too many outlets are controlled by the very interests that the press needs to take on and this gives them the ability to cloud most any issue. Presidential leadership could make a difference, and Obama’s election brought hope for change, but this president does not seem inclined to take a strong stand on behalf of the working class...

Another option is that the working class itself will say enough is enough and demand change. There was a time when I would have scoffed at the idea of a mass revolt against entrenched political interests and the incivility that comes with it. We aren’t there yet – there’s still time for change – but the signs of unrest are growing and if we continue along a two-tiered path that ignores the needs of such a large proportion of society, it can no longer be ruled out."