Economyths: Ten Ways Economics Gets It Wrong [Hardcover]

The book 'Economyths' by David Orrell is a mythbuster with an attack on the neoclassical economic theory. A timely rejection given the current economic crisis. Neoclassical economics did not just fail to warn us for the economic crisis since 2007. It is a cause of it. The emphasis on efficiency made business and politicians underinvest in safeguards: too few safeguards in our financial system, and not enough support of the environment. Its emphasis on equilibrium took away awareness of the vulnerability of the connected economic systems in which we live. The individualism that is its methodological basis and world view made neoclassical economics ignore the importance of social networks. It neglects power. The steeper income inequality becomes, the harder it becomes for people at the bottom of the income pyramid to climb the social ladder of success. Neoclassical economics ignores income inequality, has nothing to say about power, and overlooks social mobility or rather the lack of it.
The tools of neoclassical economics created the foundations for the financial crisis of 2007. The deregulation, the new financial innovations, the efficient market hypothesis, and the risk pricing tools of the asset pricing model enabled banks to develop new financial activities that raised their profits and bonuses. But that also ignored systemic risk. And the systemic risk caused the financial economic crisis. When for US house-owners with a sub-prime mortgage their low initial teaser rates expired, they could not pony up the higher interest rates. This set in motion a cascading failure that spread through industries and countries and that currently in 2012 wreaks euro-land.
Orrell identifies the weaknesses of neoclassical economics item by item, one item per chapter. He shows assumptions that facts of the ground and critical studies have disproved. He points to alternative views that better fit how the economy works. Neoclassical economics needs alternatives: it is part of the problem, it has the wrong policy suggestions built-in, and it fails to see where the capitalist market economy is failing the citizens.
The neoclassical failure begin with the heart of the capitalist system: share prices. It predicts share price movements that fluctuate within a narrow band around the mean. The reality is considerably more volatile, it shows up extreme shocks, way beyond what the model is capable of explaining. The explanation of causes of the extreme volatility of share prices reveals characteristics of the capitalist system that need to be the core of an alternative view.
A really smart thing in the book is that Orrell revisits the founders of neoclassical economic theory, These people, notably Jevons, Walras and Pareto, were from bookish mathematical types. They were active in their world with a keen eye for failures and problems. They knew the economy failed many people and wrote extensively about that, besides being active in addressing problems. Especially Pareto comes out as an interesting person and a visionary. His ideas founded neoclassical theory, but can also still be foundations for an alternative view. Pareto studied income and wealth inequality. He knew power is an important force in a society, the society has elites, that the relationship between elite's and the mass of the population is problematic, that social mobility of outsiders into the elite can be blocked, and that a society may be unstable as a result. These are valuable insights that Orrell feels should be central to alternative theories.
Most chapters of Orrell's book do two things: they add a further plank to the critique on neoclassical theory and they suggest a building block for an alternative theory. An example is that GDP measures economic activity, which is not the same as happiness. Except of course, when neoclassical conditions of perfect competition and information transparency hold. Which they don't. So happiness should be explicitly measured by developing new indexes. It is an obvious point, but an alternative view needs new measurements, and a new measurement on happiness or economic performance is clearly a key element.
What are the elements of an alternative view? This part of Orrell's book is sketchy. There is a synthesis in the final chapter, but it is a sketch and not a new theory. The elements of a new view are there, but the synthesis into a working machinery is not. The question this raises for me is: are all these concerns that come from this critique on neoclassical consistent with each other? Can these be reconciled with each other in one overall perspective? Issues with income inequality, gender and discrimination (in chapters 6 and 7) are both examples of diversity. They surely can be combined in an overall theme of complexity and diversity. Topics of economic crises and sustainability (in chapters 3 and 8) are both about the need for economic agents to consider external consequences of their actions. Self-interest does not do, certainly not with large players like banks that are too big to fail (the aspect of diversity again). There surely is the perspective than an analysis of complex adaptive systems, with diverse agents, and systems consisting of sub-systems, can capture the elements discussed in this book and brought out in critique of neoclassical economics. The example in the book is the financial market consisting of large too-big-to-fail banks, with external consequences for the rest of the economy. This degree of connectedness led to systemic risk, which the neoclassical analytical tools of the banks ignored. To our cost and their shame. Well, at least to our cost.
Perhaps the absence of a full swinging synthesis in the book is not bad. As reader, I felt that I benefit from seeing the contours of a new view. As the author notes to his defense, destroying the old is surely an important service towards building the new. On the other hand, the best critique is an alternative view. The reason that the alternative view is so hard to articulate is that it needs to be multidisciplinary. Only economics will not do. The alternative view needs to include power, inequality, social relationships, happiness, complexity, and emergence through bottom up processes. These call for integrating insights from sociology, psychology, and a few other disciplines. Even mathematics and physics, the bugbears that ushered in neoclassical economics as a derivative, need to be included. There is a reason that THE book of the emergent complex adaptive systems view does not yet exist. It may exceed the intellectual capabilities of a single person. Having said that, Orrell's book is full of important insights, reasonable viewpoints, smart observations, deep study, and, in addition, devastating wisecracks.
A key insight I get from the book is that economists use their mathematical models and their access to data to make precise predictions. This makes their models useful for decision makers. It suggests a precision and reliability that these predictions can not live up to. They make economics useful for vested interests seeking to defend decisions and outcomes. Instead, Orrell suggests that economists should analyze how prone systems are to shocks. With modern tools based on complex adaptive systems and social network analysis, it becomes possible to explore how robust or vulnerable a system is. This Orrell believes is much more valuable information than to know (if that is the word) how much economic growth this year will bring, or how much profit growth the company expects for the coming quarter. We will never know how much growth to have next quarter, but at least we could know whether our system has vulnerabilities so we can fix those before the big one comes.
Orrell criticizes neoclassical economics for being an academic handmaiden to business and political interests of the mainstream. It consults them and provides them with innovative theoretical tools upon which they can build new business models. It does not just analyze the mainstream, it is part of it and keeps it going. This suggests the thought that the alternative view should have a different position in the world. Less attached to vested interests, more open to contacts with alternative stakeholders, the ones hurt by globalization, crises, and rising income inequalities. How does such a scientific community look like? Is it like neoclassical economics nicely tucked away in comfy economics and business departments of universities? But this time in different departments, like sociology and psychology? Or are these very different people with very different lives, connected in different ways to the current world. Perhaps, like the neoclassical pioneers of the nineteenth century, activists in shaping a better world? Orrell does not address the question. Making the alternative view hanging in mid air, as far as the question is concerned which people are supposed to develop and instruct the alternative view.

Author David Orrell gets it right exactly where mainstream economics gets it wrong, from the mathematics to the environment. Already on page 5 he lists the 10 myths, then devotes one chapter to each myth: "The economy can be described by economic laws; The economy is made up of independent individuals; The economy is stable; Economic risk can be easily managed using statistics; The economy is rational and efficient; The economy is gender-neutral; The economy is fair; Economic growth will make us happy; Economic growth is always good."

Orrell is a champion of the complex systems approach to economics. He cites agent-based models as a promising approach to capturing the non-linearity and chaos that is intrinsic to real-world economics (p. 24): "Agent based models have been used to reproduce the boom/bust behavior of markets, and have found many other applications in areas from transportation to cancer therapy." He advises economists to forget about "predicting", except for isolated "pockets of predictability", to focus on scenarios, and qualitative and comparative behavior instead.

He lists 4 properties of "robust networks" that economics should emphasize but doesn't (pp. 40-43): Modularity, Redundancy, Diversity, and Controlled Shut Down. Incidentally you can find some good examples of failures in economic networks in "Cornered - The New Monopoly Capitalism and the Economics of Destruction" by Barry Lynn.

Orrell demolishes economic "efficiency, stability, rationality", showing how 19th century attempts by Walras, Jevons, Pareto and others to emulate Newtonian mechanics failed to due to the oversimplification required. Unfortunately they also failed to take note of Maxwell's classic 1876 paper "On Governors" (used by steam engines) which analyzed how negative feedback could be used to control instability, or how positive feedback would generate instability.

Later Orrell takes on the normal distribution and shows how power law distributions and fractal phenomena are a better match for many economic data sets. Then he goes after the Arrow-Debreu equilibrium model and Milton Friedman, saying right up front that "The aim of models should be not to predict the unpredictable but to help design the financial system so that it is more robust".

From there Orrell goes on to characterize mainstream economics as highly masculine in its formulation (preferring abstract models to real-world concerns), unfair (inequality arises naturally in a deregulated economy), focused on growth (growth is unsustainable and GDP is a bad indicator of true economic health, the ecological footprint is ignored), portrayed as a closed system (the actual economy is open to the environment and resources so that "scale and timing and the flow of energy" are critical).

In the end, David Orrell calls for a totally new economics, saying that (p. 238): "We're living in a bubble...We have a line of credit with the rest of the planet, and it's flashing red." Right on!

Orrell demonstrates that neo-classical economics, the basic economics still taught in our universities is rubbish. Exposes the rotten heart of economics--charlatanry wearing the trappings of science and speaking its language while violating the most basic scientific discipline--confirming that its central models conform to empirical data--behavior in the real world. As widely publicized and used by banks, governments, and other financial institutions, neo-classical economics is an ideology that pretends to be a science--a fraud on the public.

Economists use the language and tools of science, but systematically violate scientific method. A scientific fundamental is that a theory is only good as long as it fits observation. If the data does not conform to the theory, the theory gets thrown out. Economic theory consistently deviates from market behavior, but instead of replacing such theory, economists ignore spikes and disasters that they do not understand.

Strongly recommended to anyone who prefers not to waste his money following advice from an economist!

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