Sunday, May 8, 2016

Is Classical Theory Irrelevant?

For the last 70 years, macroeconomics has become so entrenched within a demand-side framework that arguments that don’t operate within that paradigm are often derided as irrelevant.

A couple weeks ago I wrote a piece explaining classical business cycle theory and its denial of demand deficiency. Someone from a prominent think tank (not my former employer) messaged me, asserting that although he agreed classical theory is routinely misunderstood, he didn’t understand why it mattered:
It seems to me that the piece is really about …the fact that goods will command some price in the market - that demand for them will never literally reach zero – [which] is not a terribly interesting finding … and I would really like a clear explanation of why this matters...
Given the difficulty of discarding the macroeconomic lens that has prevailed since the 1930s, this misunderstanding and subsequent dismissal of the argument isn’t surprising. Virtually all modern theory is rooted in an “aggregate demand” paradigm—that is, demand management is understood as the key to a well-run economy. This is true for “Monetarists,” “Keynesians,” and even many free market variations, where disagreement has been reduced to whose model best achieves that end.

Classical theory, however, rejects not merely the dominant models, but the framework itself. It provides an entirely different one through which to model the economy. The key to its framework is not that “goods command some price in the market,” which, as economist Steve Kates instructs, ignores that the economy is made up of entrepreneurs attempting to find buyers who don’t simply cover some but all of the costs of production. Rather, the point is understanding that the economy begins and ends with production, which determines the level of demand. As I stressed, when production increases, purchasing power—or “demand”—rises; when production diminishes, demand shrinks. The key, then, is to coordinate the structure of production—supply and demand. Economic fluctuations result from the discoordination of the two.

The implications of this paradigm are enormous. Many of our current policies, such as food stamps, minimum wage laws, infrastructure spending, and various welfare and green energy programs, are justified at least partly by arguing that spending will help the economy. But the classical framework suggests these policies are useless at best and destructive at worst, and that boosting the economy requires encouraging production—entrepreneurialism, risk-taking—by peeling back disincentives such as high tax rates and regulatory burdens.

But given the gravity of asking the vast majority of the economics community to accept that its fancy models, sophisticated math equations and strongly held worldviews may be utterly mistaken, it’s no wonder they often dismiss the relevancy of classical theory. But reversals in economic orthodoxy are not impossible. It happened in the 1930s. Let’s hope it might happen again.

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