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The Invisible Hand Doesn't Help Any More

by Holger Rogall Wednesday, Feb. 15, 2012 at 5:08 AM

Neoclassicism starts from the assumpti8ons that people always act rationally and market processes always lead to optimal results on account of the price mechanism. The market fails. Its view of the person as Homo oeconomicus must be replaced by the Homo cooperativus.


The Invisible Hand and Market Failure

By Holger Rogall

[This article published in: Die Bruecke zur Welt, December 3, 2011 is translated from the German on the Internet, http://www.nachhaltige-oekonomie.de/images/stories/pdf_startseite/StZ_Rogall_Essay_031211.pdf.]

Economics. Adam Smith and the neoclassical economy are not right any more. The market fails. Its view of the person as Homo oeconomicus and the derived models do not help solve the current and future problems of humanity. Instead we need a new sustainable economy.

The basis of traditional economics, neoclassicism, arose in the second half of the 19th century. It tries to explain complex ways of acting of humans and businesses. On principle, it starts from the assumption that people always act rationally and market processes always lead to optimal results on account of the price mechanism. But today it is proven that the ideas of neoclassicism are unrealistic or out-of-touch with reality and their advice necessarily leads to crises.

Criticism of neoclassicism begins with its basic assumptions. The neoclassical view of the person as Homo oeconomicus characterizes the person as a constantly selfish being who acts rationally. If this human type had ever been true, it would have died out in the Stone Age. The men would have made themselves safe with the endangering approach of wild animals while defenseless women and infants would have been devoured.

Neoclassical theory doesn’t know any psychological factors like anxieties and hopes, the influence of advertising or social conflicts. This theory assumes that businesses in a dawning economic crisis automatically lower interests and wages, invest and hire new employees. While that sounds logical, it doesn’t happen since businesses fear consumers will buy fewer products in the crisis. Economists like John Maynard Keynes and Reinhard Seiten showed people often decide irrationally and emotionally. As a result, markets fail and crises arise.

The Nobel Prize winner Ronald Coase criticizes the economy as a theoretical system suspended in the air with hardly any relation to what happens in the real world. If one asks why they assume persons act totally rationally, one often hears the amazing answer from economists: “because we could not otherwise use our models.” Thus models are used for economic forecasts and action recommendations whose presuppositions are wrong. Therefore the conclusions must also be false.

This is not only an academic dispute. For thirty years, state controls on financial- and economic markets were systematically dismantled because of these models. The textbooks promised that people (including bank- and fund-managers) act according to rational expectations. Actually they are ready to take (excessively) high risks and speculate. The abolition of state controls and rejection of a transaction tax that could have restrained the waves of speculation led to the present global financial- and economic crisis. Without massive state action, this could flow into a global depression – comparable to the world economic crisis of the 1930s.

Thus the first necessary reform step is application of a view of the person that corresponds more to reality. Economists should acknowledge that people seldom act rationally or always to their best interests. Therefore sustainable economics proposes the Homo cooperatives. It starts both from the selfish and from the idealist potentials of the person. This means rejecting many simple models and making new efforts to explain the real economic courses.

The second reform step involves the market ideology. Liberal economists believe the whole supply of goods of an economy should only be determined by the market since the price mechanism ensures the optimal distribution of workers, resources, capital and goods. In the neoclassical theory, all the costs and benefits of economic acts are included in the individual calculation and thus determine the right price of goods. A balance always occurs. In the long term, an over-exploitation of natural resources and unacceptable imbalances like mass unemployment do not appear in neoclassical theory.

Today many economists still believe in these self-healing- and controlling powers of the market. This hope is usually vain. Inaction often intensifies problems. The daily market failure in central economic areas is really obvious. For example, the still relatively low prices for crude oil do not show that no oil will be available in a few decades. They also hardly reflect that burnt oil releases greenhouse gases which lead directly to uncontrollable floods and aridity reducing harvest yields.

If the current oil price included these costs, no car today could consume more than a half gallon of gasoline for seventy miles. Solar or wind current could be considerably more inexpensive than current from fossil power plants. Since all oil producers and traders do not need to directly calculate environmental consequences, the price mechanisms do not halt the negative consequences of oil consumption.

In his book “In Free Fall” published in 2010, the Nobel Prize winner Joseph Stiglitz concludes “the assumption that markets are efficient has no scientific basis.” Therefore a sustainable economics should not treat market failure as a rare exceptional situation but as a regular case. Sustainable economics should abandon the idea of the self-healing powers of the market and the goal of a pure market economy and include other factors in its analysis and prognosis.

This leads to the third reform step. Nearly all educated people know that today’s form of producing and consuming exceeds the limits of nature’s carrying capacity and that unbridled markets cannot solve this problem. The economy must turn to the question what a sustainable economic system would look like that rests on principles of generational justice, precaution and performance and no longer on profit-maximization that is not future-friendly. The goal is a social-ecological market economy that ensures adequately high standards for all people and for future generations.

Economists have the essential task of developing the political-legal instruments necessary for the sustainable reorganization of the global economy. Covering our total energy needs from renewable energy and reducing resource consumption at least eighty percent are central.

In addition we must abandon the growth paradigm of the traditional economy according to which material production and economic growth should increase infinitely in ou8r finite world with scarce resources. This growth paradigm has to be replaced by a sustainability paradigm that makes possible further economic development only within the natural limits and sets justice higher than the optimal market outcome.

The economy’s need for reform is recognized. The building-blocks for a new praxis-oriented economics exist. In 2000, economics students in France brought an Internet petition to the public in which they decried the mathematization and unrealistic out-of-touch nature of economics. More than eighty economics professors joined forces internationally in the Netzwerk Nachhaltige Okonomie (Sustainable Economy Network) and urge development of sustainable economics. They are working on the economic foundations for a global framework that prevents social-ecological dumping and makes possible fair worldwide trade.

The time for action has come. In twenty years, the world will find itself in different power structures. Whether today’s threshold countries will act more responsibly toward humanity than the old is uncertain.
The author Holger Rogall is an economics professor at the Berlin Academy for Economy and Law and initiator of the international Sustainable Economics Network. He pleads for a rejection of the neoclassical paradigm that in his view hardly considers social and ecological problems arising out of economic interactions.

Economic theory

Neoclassicism continued the ideas of the Scot Adam Smith (1723-1790). Its assumptions dominate economics today. Neoclassicism starts from a selfishly acting individual and his preferences. Assuming a functioning market, supply and demand are balanced through the prices. Smith called this “the invisible hand.” For that reason, the state should not meddle in the economy.


Video: John Kenneth Galbraith, 2008, 52 min

Hild, Thorsten, “The Rule of Supply-Side Economists,” January 2012

Konicz, Tomasz, “The Crisis Explained,” December 2011

Lansley, Stewart, “Managed v. Market Capitalism,” January 2012

Mosler, Volkhart, “Capitalism Criticism 2.0,” November 2008

Reuter, Norbert, “Stagnation as a Trend,” 2009

Schulze, Ingo, “Capitalism Doesn’t Need Democracy,” January 2012

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