Pluralism is the enemy of science. At any given time, science deals only with a single most correct theory in any particular domain, not with multiple incorrect theories. There is a huge difference between evaluating many new ideas and the uncritical tolerance of many inconsistent ideas, which is what economic pluralism really is. Economists usually criticize each other privately and avoid open confrontation in public, giving a misleading impression of the unity of economics. The global financial crisis (GFC) has been seen (e.g. Economist, 2009) as a failure of the dismal science of economics, because mainstream economics is assumed to be science, with all its mathematical models and statistical analyses.
But mainstream economics is not science – it only pretends to be – which is why it failed. The heterodoxy of the fringe has been using the disrepute of “economic science”, which is actually scientism (Hayek, 1974), to revive the failed economic philosophies of the past in a move back to pluralism (Fullbrook, 2008). Future economic education will then be to teach more of past failed theories which have not been properly buried. This development would increase cognitive dissonance.
Cognitive dissonance is so great in economics that heterodox economists seem not to recognize that pluralism need not be revived, because it has never gone away. Economics is pluralist. Many different economic schools (e.g. Heilbroner, 1998) have continued to survive and even thrive judging by the books and the large number of articles published in many different economic journals – too many in fact. Neoclassical economics has had greater influence in recent decades because its computer models seem more relevant in the information age; they provide policy makers with new technological tools for decision-making.
To assume that neoclassical economics alone is responsible for economic policy and alone responsible for the GFC is further evidence of cognitive dissonance. For example, Fullbrook (2008, p.6) attributes the shortcomings of economics to “the lack of pluralism”, in that “the problem is not neoclassical economics itself, but its monopoly position”. In recent decades, particularly before the GFC, because neoclassical economics got most attention and research funding in universities, many academics assumed that it was the neoclassical economic policy of “neoliberalism” which alone caused the GFC, without looking at the facts, as will be done in this post.
Actually, economics is pluralist and economic policy in the real world is not monopolist, but pluralist. Economics is not science, partly because it is pluralist. Resource allocation in most economies uses many different methods inspired over time by different economic theories of the market and the government. The influences of different economic theories are captured in various economic policy legislation enacted over decades, as will be discussed below for the US economy.
It is pluralism – an unresolved melange of conflicting theories – which leads to cognitive dissonance, which is responsible for policy flip-flops over decades and a “trained incapacity” to recognize facts. For example, many heterodox economists associate neoclassical economics with extreme capitalism to which they attribute rising wealth inequality in the United States and other countries (Piketty, 2014). Below, this assumption will be shown to be empirically false.
But the empirical data over the decades show (see below) that the US economy has become progressively less capitalist, and more socialist, with the government taking a larger and larger share of the economy. It is assumed popularly that bigger government leads to social equality. It will be shown that the rising wealth inequality in the United States is due less to capitalism than to creeping socialism – with a surprising twist of how this has happened. Far from neoclassical economics having a monopolist or even dominant position in theory or in policy, market-based ideas actually have had only partial influence in the US government – the rhetoric is not the reality.
Politicians and policy makers are mostly pragmatic people who have been elected or selected based on their political bias and they are always looking for new ideas to differentiate themselves from their opposition and to promote their political agendas. It is precisely the pluralism of economic ideas from academic scribblers which has led to the policy pluralism in existence today, as Keynes (1936, p.383) noted famously:
The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else.
Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.
The ideas of economists are powerful, but unscientific. Practical men do not bother with the pedantry of logic or science – they are interested in using whatever fits their purpose. Ideas are tools to be used and discarded according to circumstances. Academic scribblers are too happy to supply an abundance of arbitrary ideas for which they feel no responsibility – it is caveat emptor to journal editors and publishers. Consistency and coherence in the actions of practical men and in their consequences are of little concern, as the history of economic policy legislation shows (see below).
Real-world economies are based on variable mixtures of policies inspired by many conflicting theories – for example, free-market capitalism, Keynesian socialism and monetarism all play their part in US economic performance of the past eight decades. The table below shows some formal legislation influenced by those ideas.
It is unnecessary to repeat tediously what is already known about the history of the above mentioned legislation, except to show that they have their basis in economic pluralism and that they are substantially the causes of the crisis today. Those legislation enabled and obliged the government and its agencies to control and manage more and more of the US economy, even as they are motivated by changing ideas which may be mutually inconsistent – including, paradoxically, deregulation by an interventionist government.
Early last century, classical economics of free-market capitalism prevailed in the US in stark contrast to socialism and communism elsewhere, particularly in the Soviet Union. The 1929 stock market crash and the Great Depression appeared to confirm the Marxist warning that capitalism is inherently unstable. A raft of legislation was introduced in the 1930s to regulate the financial markets. Particularly noteworthy was the Banking Act (1933) which included the Glass-Steagall Act, essentially forbidding commercial banks from undertaking investment banking or financial speculation.
Keynes (1936) had another explanation for economic instability, not based on class exploitation by capitalists, but based on the uncertainty and irrationality of investors, leading to inadequate macroeconomic demand which, he suggested, the government should manage. Keynesian economics is based on the assumption that the government should ensure economic growth and employment by stimulating consumption demand through fiscal and monetary policy.
The influence of Keynesian economics after the Second World War (WW2) was evident in the Employment Act (1946), which made the US federal government responsible for economic stability and employment. However, to ensure the labour market has greater wage flexibility according to the principles of classical economics, the Taft-Hartley Act (1947) was legislated to limit the ability of trade unions to go on strikes, “to promote the full flow of commerce”.
The size of US government, measured by total government expenditure relative to its gross domestic product (GDP), increased from 20 percent to 30 percent by 1970. By the early 1970s, it was clear that there was a structural gap between government income and expenditure to fund the needs of a welfare state (see the chart below). The quantity theory of money, also called monetarism (Friedman, 1970), suggested that inflation can be controlled by the money supply. Since inflation was thought to be linked tightly to employment through the Phillips curve relationship (Phillips, 1958), money supply can be therefore used to control employment through inflation.
But the post-war gold standard constrained the growth of the money supply and therefore limited government control on welfare, warfare, inflation and employment. The gold standard was abandoned by Nixon in August 1971 by suspending “temporarily” the convertibility of the US dollar to gold at $35 per ounce. As Greenspan (1966) noted:
The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit…In the absence of the gold standard, there is no way to protect savings from confiscation through inflation.
Since 1971, the US monetary system, by extension through the Bretton-Woods agreement, has operated a global monetary system based on the US dollar, a purely fiat currency, which the former French Finance Minister (later President), Valery Giscard d’Estaing, called an “exorbitant privilege”. Agreement with the Saudi royal family to price their oil in US dollars had created a petro-dollar hegemony lasting to today.
The ensuing high inflation of the 1970s together with high unemployment was the stagflation phenomenon inexplicable by Keynesian economics, in a refutation of which Lucas and Sargent (1978) said:
… our intent is to establish that the difficulties are fatal: that modern macroeconomic models are of no value in guiding policy and that this condition will not be remedied by modifications along any line which is currently being pursued.
The assumed tight trade-off between inflation and employment (Phillips curve) proved to be a factual fallacy which required new legislation to enable government policy to uncouple them and to allow monetary authorities to choose between priorities and evils. The Full Employment and Balanced Growth Act (1978), also called the Humphrey-Hawkins Act, enabled Paul Volcker to apply his shock therapy to curb high inflation, regardless of its assumed impact on employment.
By 1981, Keynesian economic fallacy was widely recognized when Reagan declared in his inaugural presidential address:
In the present crisis, the government is not the solution to our problem. The government is the problem.
This saw more policy attention being paid to government budgeting in legislation such as Tax Equity and Fiscal Responsibility Act 1982 and Tax Reform Act 1986. The intention was to curb the ever rising tax receipts and government expenditure, in order to reduce the economic impact of government.
The chart below shows that the Reagan government succeeded largely in stabilizing current tax receipts from its citizens, but not current expenditure. Unless stated otherwise, the data used in this post are published by the US Bureau of Economic Analysis (BEA). In this case, the data from BEA Table 3.1 are used in the chart below.
As is well-known, the failure of the Reagan government (1981-1989) to reign in expenditure led to persistently large budget deficits, to the delight of some Keynesian economists. The size of government measured by total government expenditure to GDP continued to increase, indicating creeping socialism. The empirical data also dispel the heterodox myth that recent economic woes were caused by neoclassical economics or neoliberalism dismantling the socialism and welfare state of the 1950s and 1960s – the era of nostalgic Keynesianism which never ceased.
Cognitive dissonance remained unrecognized when economists made superficial attempts to unify fundamentally contradictory theories through neoclassical synthesis or New Keynesian economics, where microeconomics of market equilibrium was used to analyze the macroeconomics of government policy. The undesirability of government intervention in markets in neoclassical economics was to be reconciled with the desirability of government management in Keynesian economics.
Ironically, large and persistent budget deficits from Keynesian intervention were facilitated by privatization of government enterprises, which was influenced by the belief that those enterprises could benefit from the market efficiency preached through neoclassical economics.
Neoclassical economics argued for less government interference in markets, but by default, left macroeconomics to Keynesians. The ability to run government budget deficits in the modern economy was facilitated by financialization which allows debt creation with minimal constraint from real economic factors of production. Keynesian economics was made possible by financialization, with its origins in neoclassical economics.
Innovations in financial derivatives created the illusion that risk management is a science like physics, and led to “light touch” regulation and deregulation in financial services. In 1986, on taking up the chairmanship of the US Federal Reserve, Greenspan was relieved to find his “libertarian opposition to most regulation” was shared by his staff when he recalled (2007, p.373):
What I had not known about was the staff’s free-market orientation, which I now discovered characterized even the Division of Bank Supervision and Regulation.
The free markets of neoclassical economics were not the same as the highly intermediated markets in financial services – the vital differences were ignored. Financialization and deregulation led to the creation of new debt securities and an explosive growth of debt in the Greenspan era and subsequent eras when continual monetary stimulus of Keynesian and monetarist theories was maintained.
Not only did the debt growth fuel increasing leverage in the stock markets and their bubbles, there were also constant streams of initial public offerings (IPOs) from the privatization of the government enterprises, often benefiting insiders. Neoclassical faith in markets was behind the deregulation of the labour market and the privatization of many government enterprises, providing income streams from asset sales to fund additional spending from government budget deficits (see Figure below).
The first inkling of the financialization fallacy came in October 1987 when the innovation of “portfolio insurance” materially contributed to the stock market crash. The reaction was to consider the event as an unpredictable exogenous shock and the remedy was Executive Order 12631 Working Group on Financial Markets (1988), a legislation which allows the government to intervene and stabilize financial markets through the creation of the “Plunge Protection Team”. This government intervention would be consistent with the Keynesian economic view of irrational investors causing market dysfunction. But this would contradict the neoclassical view of free-market efficiency.
In practice, governments treat markets as efficient by deregulating them, but intervene when they fail, as a policy compromise between conflicting economic theories, reflecting economic pluralism. Financial scandals in the 1990s such as Gibson Greeting, Orange County, Metallgesellschaft, Barings, Long-Term Capital Management (LTCM), Enron, etc. were largely brushed off as accidents in neoclassical economics, not indicative of any serious flaws of financialization.
Confidence in financialization was formally legislated in the Gramm-Leach-Bliley Act (1999), which repealed the Glass-Steagall restrictions. Certainty in risk management through derivatives was legislated in the Commodity Futures Modernization Act (2000), which deregulated the over-the-counter (OTC) derivatives markets. These acts in the new century were votes of confidence of the booming stock markets and rapidly growing economies at the time, delightful to neoclassical and Keynesian economists alike.
Of course, the boom soon turned to bust, in the collapse of the so-called dotcom bubble. The efficient markets of neoclassical economics had to be rescued by government intervention with easy monetary policy of Keynesian and monetarist economics. But the easy monetary policy, coupled with financial innovations in mortgage securitization, led several years later to housing bubbles in many countries, many of which have collapsed since 2008, creating the Great Recession.
Again, the economic slump was seen to require Keynesian action, with the government intervening by reducing official interest rates to the lowest level rationally possible – zero. In case this monetary measure was insufficient, old-fashioned fiscal pump priming was legislated through the American Recovery and Reinvestment Act (2009), which was the Congress-approved Obama stimulus package worth $787 billion.
The combination of Keynesian government intervention and neoclassical market-deregulation and financialization continues to this day, with monetary easing directly through increasing the quantity of official currency – called “quantitative easing”. Direct manipulation of the quantity of money has to be added to the price manipulation of money, with interest rates having reached zero-bound. These measures are further supplemented by market management of the “Plunge Protection Team” whenever efficient markets fail to be efficient by collapsing. Government management of free-markets is an oxymoron enabled by economic pluralism.
This post, showing the influence of pluralism, forms the first part of a research paper where the second part shows how cognitive dissonance of pluralism leads to a policy of creeping American socialism, which is largely unrecognized.