The global financial crisis and the science of economics

One of the underlying causes of the current global financial crisis is the notion that the results of standard economic theory can be considered to be scientific. If so, how can any policymaker ignore economic theory when forming economic policy? It is for this reason that the phrase "economic rationalism" had become prominent in the Australian economic policy debate of the 1980s and onwards.

In the wake of the current crisis many have, appropriately enough, questioned the scientific credentials of economic theory. Those who do so have been correct to denigrate the Efficient Markets Hypothesis of neo-classical economic theory, which underpins neoliberal policy prescriptions. The EMH is based on the theory of rational expectations which assumes that free markets are mechanical systems that exhibit law like behaviour. Rational expectations, in turn, was based on an instrumentally rational or Homo economicus conception of human economic behaviour.

That the GFC demonstrates that the EMH is false has now led to the rise of the view that economics does not, but more importantly cannot, constitute a proper science. I will dispute this claim and will submit that economics can in fact be a science.

But, first, some background.

The scientific enterprise is encapsulated by the philosophy or, perhaps better still the broader "attitude", of naturalism. In this view all that can be said to exist is natural, in some undefined sense. Supernatural entities, such as God or "the force" or something, should not be invoked in order to explain the world.

There are two types of naturalism, what we might call "philosophical naturalism" and "methodological naturalism". Philosophical naturalism is very much tied up with the doctrine of "materialism" or "physicalism". On this view everything that is real is in some sense physical.

Methodological naturalism by contrast is not concerned with the ultimate nature of reality, but rather, is a methodological thesis that asserts that the surest approach to theoretical knowledge is via the norms and techniques of science.

Philosophical naturalism cannot be reasonably defended. At the earliest stages of the scientific revolution philosophical naturalism was very much akin to the mechanical philosophy of Rene Descartes. However, by developing the universal law of gravitation Isaac Newton fundamentally undermined the mechanical philosophy. He did not really explain gravitation; famously declaring in the Principia "hypothesis non fingo" (I frame no hypothesis).

All that remained was what Albert Einstein in a different context was later to call "spooky action at a distance". By invoking Newton rational expectations theorists only reveal their ignorance of the underlying issues.

In a real sense we still do not know what gravitation is, hence the search for a quantum theory of gravity. We do not know what space and time, or better still, space-time is. We don’t know whence comes mass, although perhaps the Large Hadron Collider at CERN will experimentally confirm the Higgs Mechanism. Most matter is in fact "dark matter" and that remains a mystery.

Even worse by far most of the universe consists of "dark energy" that accounts for the process that underpins the existence of a cosmological constant. This energy is called "dark" because nobody knows what it is.

Lacking any hard and fast definition of the physical or of the ontological philosophical naturalism is not rationally defensible, we may thereby conclude.

Science basically is synonymous with methodological naturalism. This should not be equated with some hard and fast conception of "the scientific method". No such method exists. Nonetheless, science is not an irrational or arational pursuit given that there is a crucial difference between the context of discovery and the context of justification. The philosophy of science itself should be a science, further discussion of which is left aside here.

Science concerns itself with uncovering internally consistent and empirically well grounded theories that seek to explain the natural world.

Commitment to reason and rationality in economics has not been a prominent feature of the discipline. To illustrate this let me dust off an old macroeconomics text book of mine, which provides an IS-LM model of the Australian economy. There is an interesting section on economic thought, with an especially fascinating part thereof devoted to an analysis of post-Keynesian economics.

Post-Keynesians are very much in the minority in the field of macroeconomic theory. This is intriguing, for when the standard neo-classical economists spun elaborate webs about the efficient nature of markets, the application of the financial instability hypothesis of post-Keynesian theory predicted something basically synonymous with the current global financial crisis. The most noted post-Keynesian in this regard was Hyman Minsky.

That should tell us something about the supposed scientific credentials of standard theory. We are told that we are "all Keynesians now", however in reality few of us are post-Keynesians, Brand Rudd included.

Neo-classical economics is basically an ideological discipline. As I have stated previously, the fundamental axiom of economic theory, which underpins all the celebrated theorems, is: if we make the rich happy wonderful things will happen. Think for instance of what we call in Australia "tax reform".

Tax reform basically means skewing income tax cuts towards the top tax rate while broadening the tax base towards consumption, which of course is regressive. By the same token we must cut corporate taxes so that we can remain "internationally competitive". Brand Rudd, alongside his newly found best mate Ken Henry, has placed cutting corporate tax at the centrepiece of the Henry tax review.

We are told that this is best for economic efficiency. It is easy to see the prime axiom in operation here. Notice, furthermore, that this is couched within a fiscal policy that is directed towards maintaining budget surpluses. We make the rich happy while broadening the tax base towards the poor and, wholla, great things will happen.

Standard economic theory tells us we must do this. This conclusion is made because of the prime axiom that underpins the overall theoretical structure.

Any economic theory that seeks to undercover laws that are supposed to hold in any economy is a form of positivism. In the social sciences positivism is associated with the search for laws that supposedly apply in the social world. The problem here is that the social world largely is the world of the contingent rather than of the necessary. Because of this, large scale macro social laws, economic laws included (post-Keynesian as well), do not exist.

The critiques of the scientific pretensions of economic theory are correct when they point this out. However, economics can be a science. Essentially a scientific theory of economics would be a theory of the mind, or better still, of the cognitive.

Human economic behaviour must follow on from some essential property of human nature. Whatever that property may be, surely it must be mentalist. Indeed humans are not the only species that exhibit economic behaviour or actual economic systems. Insects such as ants have economic systems, which even exhibit class structure. The economic systems created seem very rigid and must thereby be based on an innate genetic endowment. We assume that this genetic endowment is based on mental structure, rather than in the legs or digestive system of ants.

Their economic systems are natural but their ultimate explanation involves understanding the initial cognitive and genetic state.

Put in these terms for humans we have two possible approaches before us: that of empiricism and that of rationalism.

Empiricism we associate with the blank slate or tabula rasa theory of the mind of John Locke. However, Locke's view is extreme. Empiricism, basically, has come to mean that the mind consists of a central rational faculty based on inductive reasoning. Rationalism, by contrast, is a theory that posits that the mind is composed of innate structures, faculties, organs or "modules" that are domain specific and unique, for instance we have the faculties of vision and language.

The cognitive revolution in the sciences strongly suggests that the rationalist view is correct. If so we must also have a faculty or module of social cognition.

The rational expectations hypothesis or Homo economicus assumptions of economic theory are heavily associated with empiricism. Here we would have a central faculty of inductive reasoning that accounts for instrumental rationality and from this central faculty we can go and build-up a theory of human economics based upon "rational" behaviour.

We know that this picture is false. Indeed, it is the results of experimental behavioural economics that tells us this. Experimental economists have demonstrated that reciprocity plays a crucial role in human economic behaviour. There are two key experiments that underpin this, namely the Ultimatum Game and the Public Goods game. These experiments show that the notion of Homo economicus is false.

Human economic behaviour is explicable by way of a dedicated social faculty. Understanding how such a module works is also an empirical question and one ultimately for the cognitive sciences. It is the behavioural economists, who seek to uncover universals in human economic behaviour through experiment, who are best able to contribute to the development of a cognitive theory of economics from within the discipline as it is currently configured.

Plainly human economic systems are not genetically determined, for instance we do not have a capitalism gene. However, the range of systems that humans can form would be innately determined. Unlike with ants, human economic systems have varied over time. Our innate mental structure must involve a strong element of creativity which must be based on some innate system of rules and representations.

Our cognitive theory of economics would be a theory concerned with uncovering this innate structure. Whatever that cognitive theory may be it would be that theory that constitutes a scientific theory of economics. I do not see why such a theory is not a priori impossible for us to formulate.

Let us call this "bioeconomics".

We might note that the same conclusions would apply to other disciplines such as political theory, moral theory and social theory more broadly. There is such a thing as "biopolitics" already, but this is mostly nonsense for it merely consists of the application of pop evolutionary psychology to political problems.

If what I have said here about standard economic theory is correct it might well be the case that our dominant economic categories are in some fundamental sense unnatural. A self-operating free market economy is a "stark utopia" and whenever implemented has led to collapse amid much suffering, for instance during the radical neoliberal reforms implemented in Russia during the 1990s.

A free market society might be unstable precisely because such a society is one that humans are unable to form through free choice. We already have good grounds for believing that Marxist central planning is also a non-human economic system, for its stability, such as it was, basically was achieved through force and violence.

A truly natural economic system would be a system that does not depend upon the state for its stability. Industrial civilisation has not yet constructed such a system, but I rather suspect that such a system would exhibit a very high level of industrial democracy.