The Long-Running Critique of Neoclassical Economics and its Limited Relevance to Policy

Notwithstanding its dominance as an economic policy tool, neoclassical economics has been the subject of devastating criticism from leading economists directed at its scientific standing, its lack of methodological rigour, its lack of empirical testing, its unnatural fascination with mathematical formalism, the grossly unrealistic and normative nature of its assumptions and the irrelevance of its conclusions for policy analysis. Even Alfred Marshall (1842–1924), an astute mathematician and leading microeconomist, expressed considerable reservations about the use of mathematics in economics. Hayek, a member of the Austrian school and an opponent of neoclassical economics, complained in 1945 that:

[M]any of the current disputes with regard to both economic theory and economic policy have their common origin in a misconception about the nature of the economic problem of society. This misconception in turn is due to an erroneous transfer to social phenomena of the habits of thought we have developed in dealing with the phenomena of nature.[5]

He went on to criticise the scientific standing of economics in his Nobel Prize acceptance speech in 1974, warning us that market processes were so complex that the knowledge of them by economists was incomplete and virtually impossible to measure.

While in the physical sciences it is generally assumed, probably with good reason, that any important factor which determines the observed events will itself be directly observable and measurable, in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process…will hardly ever be fully known or measurable.[6]

Hayek also warns us against a strong tendency in the social disciplines to focus exclusively on factors that are measurable—arbitrarily excluding factors that are not measurable. One important policy consequence of this focus on the easily measurable is the current obsession with growth in national production to the detriment of better measures of human welfare. The focus on growth in production has helped blind economists to the broader criticism of the capitalist system and its effects from the environmental and anti-globalism movements and from Marxists. Nevertheless—and somewhat inconsistently—Hayek remains the darling of economic fundamentalists because of his advocacy of a minimalist state arising primarily from his fear of political tyranny. This inconsistency reflects the inconsistency between the two primary sources of economic fundamentalism: libertarian political philosophy and neoclassical economics.

Similarly, another Nobel Prize-winning economist, Wassily Leontief, told us in 1983:

Not having been subject from the outset to the harsh discipline of systematic fact finding…economists developed a nearly irresistible predilection for deductive reasoning. As a matter of fact, many entered the field after specialising in pure or applied mathematics. Page after page of professional economic journals are filled with mathematical formulas leading the reader from sets of more or less plausible but entirely arbitrary assumptions to precisely stated but irrelevant theoretical conclusions.[7]

In fact, Leontief made numerous attacks on the poverty of a priori theorising in economics, and on the neglect of adequate statistical work.

Similarly, in his Nobel Prize lecture in 1991, Ronald Coase criticised in particular what he saw as the narrow focus in economics on market-price determination—a criticism that is relevant particularly to the fundamental theorems of welfare economics. Coase claimed:

The concentration on the determination of prices has led to a narrowing of focus which has had as a result the neglect of other aspects of the economic system. Sometimes, indeed, it seems as though economists conceive of their subject as being concerned only with the pricing system and that anything outside this is considered as no part of their business. What is studied is a system which lives in the minds of economists but not on earth. I have called the result ‘blackboard economics’. The firm and the market appear by name but they lack any substance. The firm in mainstream economic theory has often been described as a ‘black box’. And so it is. This is very extraordinary given that most resources in a modern economic system are employed within firms, with how these resources are used dependent on administrative decisions and not directly on the operation of a market. Consequently, the efficiency of the economic system depends to a very considerable extent on how these organisations conduct their affairs, particularly, of course, the modern corporation. Even more surprising, given their interest in the pricing system, is the neglect of the market or more specifically the institutional arrangements which govern the process of exchange. As these institutional arrangements determine to a large extent what is produced, what we have is a very incomplete theory.[8]

More recently, Coase confirmed: ‘Economics, over the years, has become more and more abstract and divorced from events in the real world. Economists, by and large, do not study the workings of the actual economic system. They theorise about it.’[9]

Of course, Coase is too kind to neoclassical economics: because neoclassical economics largely ignores the role of the corporation, it does not have an adequate account of price formation. Ironically, Coase can also be accused of the above sins. Despite recent discussion of transaction costs, moral hazards and information asymmetries, mainstream economics on the whole makes do with a primitive reductionist view of the firm, ignoring the vast differences in their sizes and disparate goals, assuming that they are profit maximisers. Apart from recent contributions from new institutionalists—a movement within neoclassical economics focusing on transaction costs—this view largely ignores the internal organisation of firms, the practical difficulties of coordination and assumes that they are run as if they had a single owner. It is assumed that firms choose between different inputs in a manner analogous to consumer choice.[10] This simply lacks credibility.

In the same spirit, leading contemporary economic methodologist Mark Blaug told us in 1997:

Modern economics is sick. Economics has increasingly become an intellectual game played for its own sake and not for its practical consequences for understanding the economic world. Economists have converted the subject matter into a sort of social mathematics in which analytical rigour is everything and practical relevance is nothing…Economics was once condemned as ‘the dismal science’ but the dismal science of yesterday was a lot less dismal than the soporific scholasticism of today.[11]

In short, the conceptual foundation of neoclassical economics and economic fundamentalism is a shambles. If it were not for its institutional momentum and ideological usefulness it would long ago have been abandoned.

The consequence for Blaug is that we now understand less of how real markets work than did Smith or even Leon Walras (1834–1910). Consistent with Leontief and Coase, he suggests that the real trouble is a belief among economists—going back to Ricardo—that economics is essentially a deductive science in which economic behaviour is inferred on the basis of some assumptions about motivations and some stylised facts about prevailing institutions, suppressing the temptation to ask whether these are realistic assumptions or accurately chosen facts. Contemporary economic teaching and the associated textbooks reinforce this focus. Whereas economics consists of a plurality of conversations, most of today’s textbooks are dogmatic, one-dimensional and neoclassical, crowding out other and more fruitful forms of analysis.[12]