We broadly define the neoclassical macro model to include all approaches accepting the Walrasian paradigm (especially in its temporary equilibrium version, from Hicks’ Value and Capital to Lucas’s works). We suggest that, despite its limitations, the model singles out some essential aspects of economic reality, such as self-interest and competitive behaviour. For this reason, it can play a useful role in our stability analysis. It is important to note that our aim here is not to provide a survey of the model’s main analytical building blocks. That we shall do in later chapters dealing with interpretations of the NE. Our main focus here is on the determinants of the notion of instantaneous equilibrium underlying the neoclassical model.
The key causal factors
The key causal forces underlying the notion of instantaneous equilibrium in neoclassical theory are referred to as ‘deep parameters’ and include preferences, technology and resource endowments in general. These are the ultimate determinants of the system of relative prices that assure consistency in agents’ plans in all markets. This overall picture underlies both standard micro and macroeconomics. In the Walrasian approach, it also serves as the basis for studying the dynamic behaviour of the economy. The price adjustment mechanism guarantees that equilibrium will prevail in the long run, no matter what shocks or changes in the parameters occur, thanks to a number of assumptions, such as those of stability and rational expectations.
As already noted, the complexity approach calls into question this basic scheme. In view of the dynamic properties of the real-world economy (e.g. increasing returns, path- dependence, continuous change in preferences and technologies), it drops the assumption of stability, asserting that there is no guarantee for the attainment of anything like a state of long-run equilibrium. Dropping the concept of ‘equilibrium over time’ obviously has drastic consequences on standard macroeconomics: it disallows the formulation of the basic macroeconomic laws, based on the constant conjunction of events, such as the quantity theory of money asserting that in the long run an increase in the quantity of money is associated with inflation.
For this reason, the complexity approach advocates purging the neoclassical model of the notion of general equilibrium. To be more precise, it suggests getting rid of the unwarranted generalizing tendency implied by the stability postulate, whereby equilibrium is not seen as merely temporary but as a lasting feature of both reality and of the standard model. What is left of the model without stability? This is an important question that the SFA does not pose. In our view, what remains is evidence of causal
mechanisms that are real but that do not uniquely determine actual outcomes; strictly speaking, standard macro models can only indicate ‘tendencies’ as opposed to ‘universal laws’. While universal laws are supported by empirical evidence, tendencies may fail to show up in observed data and may thus survive the possible lack of stability in real-world economies.
The gap between pure theory and actual phenomena
This claim calls for some justification. What sort of tendencies does the neoclassical model capture? To what extent do they influence the final outcome? To answer these questions, it is useful to recall that awareness of the gap between actual phenomena and the laws of economic theory is nothing new. Ever since the foundation of political economy as an autonomous science, economists have tried to explain this gap in terms of the lack of stability in real-world economies. Mill, for example, believed that it was due to the operation of countervailing forces and disturbing factors. In his view, the established laws of political economy
provided an accurate account of how specific causal factors operated, but they were not universal laws. Rather, they represent statements of tendencies. But since these tendencies were subject to numerous
‘disturbances’ or ‘interfering causes’ which cannot all be specified in advance, then ceteris paribus clauses that allow for these disturbances will play a crucial role in the formulation of these tendency ‘laws’. Economics explores the implications of these established laws, but given the influences of the disturbing causes, these implications will not always be realized.1
(Boylan and O’Gorman 1995:11) But many other prominent theorists have acknowledged the limitations of standard theory. One of them, Carl Menger, is a particularly relevant example for our purposes because of his philosophical stance, to which we will turn in the discussion concerning the status of standard economic theory.2 Menger was a realist and essentialist. In line with Aristotelian views, he regarded entities as identifiable in terms of a few distinct characteristics that represent their essence. On these grounds,
he maintained, in an Aristotelian manner, that the attempt to understand and explain real economic phenomena must reach behind the superficial appearances and attempt to understand the underlying essences. Further, the chosen concepts should represent that which is typical and exclude the superficial and accidental in the phenomenon under scrutiny.
(Hodgson 2001:80) Menger’s approach was based on two key principles: the so-called ‘method of isolation’, whereby it was possible to isolate the essential aspect of the phenomenon and to disregard the incidental and the attempt to break down the essential reality into its simple,
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typical and most enduring components (e.g. Lawson 1997:113–27; Hodgson 2001:82).
For Menger, the fundamental unit of analysis and the enduring theoretical foundation for economics was the economizing individual. By this he meant that economics should focus on the particular aspect of human life concerning ‘the manifestation of self-interest in the efforts of economic humans aimed at the provision of their human needs’ (Menger 1885, quoted in Hodgson 2001:82). While admitting the possibility of other motives, including ‘public spirit’ and ‘love of one’s fellow man’, Menger simply ‘consigned the study and incorporation of these other motives to other social sciences’ (ibid.). According to him, based on the premise that individuals act on self-interest alone, it is possible to derive all ‘exact laws’ of pure economic theory and to seek to explain national and institutional phenomena in terms of the purposeful individuals within them. The fact that these laws capture only one aspect of the actual motives of behaviour and phenomena explains why they do not emerge in strict event regularities in the social realm:
Theoretical research seeks to ascertain the simplest elements of everything real, elements which must be thought of as strictly typical just because they are the simplest. It strives for the establishment of these elements…without considering whether these in reality are present as independent phenomena…in their full purity. In this manner theoretical research…arrives at results…which, to be sure, must not be tested by full empirical reality (for the empirical forms here under discussion, e.g.
absolutely pure oxygen, pure alcohol, pure gold, a person pursuing only economic aims, etc, exist in part only in our ideas). However, these results correspond to the specific task of the exact orientation of theoretical research and are the necessary laws and presupposition for obtaining exact laws.
(Menger 1985, quoted in Lawson 1997:115–6, emphasis in the original) Further significant examples of awareness of the distinction between laws of pure theory and actual phenomena can be cited. For instance, both Robbins in the thirties and Hahn in recent times are of the ‘view that the supposed empirically grounded propositions of economics are all formulated only at a very general level’ (Lawson 1997:96) and ‘doubt whether concrete quantitative laws of economics can be practically derived’ (ibid.).
According to Robbins, this is partly because there are usually a large number of determinants of economic phenomena, and partly because ‘certain factors, especially individual valuations and technical conditions, will be changing over time’ (ibid.).
Friedman’s attempt to overcome the gap
Issues concerning the congruity of theory and real phenomena have not stood in the way of standard macroeconomists willing to derive straightforward policy conclusions from their models. Friedman, for example, has tried to reconcile the dictums of neoclassical theory with empirical evidence by recurring to ‘as if’ or instrumentalist strategies. In particular, in his famous methodological contribution of 1953, Friedman calls attention to
the predictive success of economic theory, rather than to the realism of its assumptions or their explanatory power. In his view, real economic agents can be regarded as if they were performing the necessary calculations to maximize their profit or utility. The fact that they do not actually behave in this way does not really matter, he says, because ‘the only relevant test of the validity of a hypothesis is comparison of its predictions with experience’ (Friedman 1953:8–9). In Friedman’s view, neoclassical theory is successful from this standpoint, and he alludes to the ‘repeated failure of its implications to be contradicted’ (ibid.: 22).
However, as several have noted (e.g. Maki 1986, 1992; Hausman 1992:163), Friedman’s methodological stance is often contradictory or inconsistent; in certain aspects it is even in line with scientific realism. Boylan and Gorman point out that
‘Friedman…continues to be all things to all methodologists. His piece has…other dimensions, namely that of scientific realism…’ (1995:115). This realist dimension is expressly stated by Friedman, who regards, for example, any scientific theory, ‘as a body of substantive hypothesis designed to abstract essential features of complex reality’
(Friedman 1953:7). In line with the essentialist view, he seeks the hidden structures or essences of reality:
A fundamental hypothesis of science is that appearances are deceptive and that there is a way of looking at or interpreting or organizing the evidence that will reveal superficially disconnected and diverse phenomena to be manifestations of a more fundamental and relatively simple structure.
(ibid.: 33)3
Friedman’s point is that the neoclassical model is false only at the descriptive level, and that it actually does capture the essence of what is going on in the economy. In particular the maximization axiom, while descriptively false, nonetheless reveals the essence of the economic behaviour of agents. For instance, according to this view, ‘business firms are really, ultimately, at rock bottom, nothing but maximizers as characterized by neoclassical theory’ (also Mäki 1992; Boylan and O’Gorman 1995:127).
It should be noted, however, that although it justifies the neoclassical assumptions of rationality and perfect competition, Friedman’s approach does not by itself guarantee the empirical success of his theory; it does not guarantee, for example, that laws such as the quantity theory of money are actually validated by econometric tests. Indeed, as many have recognized and as appears to have become even truer in the present NE, the simple fact is that ‘significant invariant event regularities…have yet to be uncovered in economics… Econometricians continually puzzle over why it is that estimated relationships repeatedly break down’ (Lawson 1997:70).
On these grounds, one can conclude that a plausible interpretation of standard macroeconomic theory, such as that implied by Friedman’s monetarism, provides an aggregate representation of the invisible-hand view according to which the simple forces of self-interest and competition bring about an optimal outcome for the economy as a whole. The strong assumptions of rationality and perfect competition that underlie monetarism are not arbitrary or ‘false’, but seek to capture the essence of key real-world causal mechanisms, such as self-interest and competition.4 From this standpoint, despite differences in analytical and methodological style, neoclassical theory can be seen to
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express some of the key features of the conception of classical political economists, such as Adam Smith or even Marx. The neoclassical approach is unique in that it seeks to achieve reductionist explanations, on the grounds of those strong assumptions, to account for all phenomena and all layers of economic reality (i.e. micro and macroeconomics), including actual observable outcomes. However, the lack of stability in real-world economies continues to preclude the realization of this goal. The mechanisms of self- interest and competition that the neoclassical refer to can, therefore, only give rise to tendencies rather than to ‘universal laws’.