“Economics is haunted by more fallacies than any other study known to man.” – Henry Hazlitt
Dr. Arvind Subramanian (DAS) is a well-noted economist. He is now the chief economic adviser to the Narendra Modi government. His evocation is anticipated to add heave to a government that is weak in economic thinking. There is also far-flung hope that Dr. Subramanian in the finance ministry and Dr. Raghuram Rajan in the Reserve Bank of India will be the avant-garde of a new generation of economic mandarins to replace the previous generation that maneuvered India from a closed economy to so-called open economy after 1980.
Like Dr. Rajan, DAS is also a bold economist who openly condemns the BJP-government attitude towards black money issue. Recently, he made the circles to ponder over the causes of black money. He has also called for less government interventionism, rate cuts, etc. to steer pure growth of Indian economy. But, sadly speaking, his armchair seems to depend on some form of “determinism”. This determinism is implicit in the “behavioral approach” to psychology and is illustrated in experiments on animals. The famous work of Pavlov in Russia has obviously influenced the entire communist concept of planning, the conviction being that the same principles which are applied to the lives of animals can be applied to the lives of men. Collective terms like “society,” “community,” “nation,” “class,” and “us” constitutes his economic thinking. The important thing to remember is that they are abstractions, figments of the imagination, not living, breathing, thinking, and acting entities. The fallacy involved here is presuming that a collective is, in fact, a living, breathing, thinking, and acting entity. The good economist recognizes that the only living, breathing, thinking, and acting entity is the individual. The source of all human action is the individual. Others may acquiesce in one’s action or even participate, but everything which occurs as a consequence can be traced to particular, identifiable individuals. So, is he really a good economist?
Dr. Subramanian has revisited the theme of robust institutions in many subsequent papers. He has pointed out to four main functions of institutions:
1) Institutions create markets by protecting property rights, upholding rule of law and protecting contracts.
2) Institutions regulate and/or substitute markets in the case of market failures or because of overarching societal goals such as reducing inequality, for example by supporting primary education or promoting financial inclusion.
3) Institutions stabilize markets by promoting economic stability through central banks or fiscal rules that limit deficits.
4) Institutions legitimize markets by providing a social safety net as well as mechanisms to reduce conflicts; democracy is the best meta-institution for these tasks.
Following is my systematic elenchus of his institutionalism theory posited above:
1) Institutions do not create markets. They distort the markets, in fact. They are ultimately the wings of government, so it cannot be vouched that institutions create markets and this is due to the parasitical-pathological behavior of the government. The health of the government is inherently dependent upon interventionism and this is how the governments destroy wealth through institutions. Institutions moderated by the government also enjoy zero incentives to protect the property rights and thus the road to socialism is gradually installed.
Private ownership of the means of production is the fundamental institution of the market economy. It is the institution the presence of which characterizes the market economy as such. Where it is absent, there is no question of a market economy. Ownership means full control of the services that can be derived from a good. This catallactic notion of ownership and property rights is not to be confused with the legal definition of ownership and property rights as stated in the laws of various countries. It was the idea of legislators and courts to define the legal concept of property in such a way as to give to the proprietor full protection by the governmental apparatus of coercion and compulsion, and to prevent anybody from encroaching upon his rights. As far as this purpose was adequately realized, the legal concept of property rights corresponded to the catallactic concept.
However, nowadays there are tendencies to abolish the institution of private property by a change in the laws determining the scope of the actions that the proprietor is entitled to undertake with regard to the things that are his property. While retaining the term private property, these reforms aim at the substitution of public ownership for private ownership. This tendency is the characteristic mark of the plans of various schools of Christian socialism and of nationalist socialism.
2) Ludwig von Mises demonstrated the importance of distinguishing between value-free economic analysis of how to attain ends in and normative discussion of what ends we should attain. It is, however, important to also distinguish between those with genuine concerns of this kind and those who instead only appear to have them. Economists Kenneth Arrow and Harold Demsetz had an exchange several years ago that deserves some attention. Arrow contended that free-enterprise economies underinvest in research and invention because of risk. Arrow also asserted that an “ideal socialist economy” would supply such information free of charge, thus separating the use of and the reward for producing such information. In the late ’60s, Demsetz penned a devastating critique of Arrow’s arguments on information, and of the “market failure” literature in general. To Demsetz, markets fall short of perfection, but so does government. To point to market imperfections as proof of the need for government intervention, he said, is to indulge in the “Nirvana Fallacy,” whereby we compare allegedly imperfect real markets to imaginary governmental institutions that lack even the smallest imperfection.
Now, a vast literature exists on the imperfections of government in allocating resources. Yet, many economists still recommend government intervention to correct market failures, often without also considering the possibility of government failure. There is nothing inherently wrong with attempts to establish ends for us to aim at in economic matters. Those who desire more government simply for its own sake, however, should at least be honest about their intentions. Instead of pretending to be concerned with efficiency, DAS, Dr. Rajan and others like him should admit that are advocates of particular ends rather than analysts of different means. If their ideological convictions for government have merit, then they should be anxious to explain them. If their beliefs lack merit, then they should accept this graciously. In either case, it is clear that all too many economists are not interested in an open and honest debate over these issues. Instead, they use deceptive rhetoric about market failure to hide their true agenda: the expansion and empowerment of the state.
3) First of all, existence of “central banking system” is detrimental to the financial health of India. They do not print sound money and instead propagate fractional reserve system. After the decline of former socialist countries and under the influence of the apparent prosperity in most market economies during the Great Moderation, most economists recognized the importance of markets and private property for long-term economic prosperity. But markets and private property generate prosperity because only in such an order can monetary calculation facilitate rational economic planning. But for monetary calculation to operate in a way most consistent with consumer sovereignty, calculation and prices must be embedded is a sound monetary system. As expressed by Salerno, in his research paper “ Money: Sound and Unsound.”:
While there is now a basic recognition by economists that rational allocation of resources necessitates institutional reforms that return resources to private hands and restore genuine markets for productive inputs, there is no such comprehension of the importance of sound money to the processes of economic calculation.
Salerno continues: “Sound money, then is simply one which does not lead to systematic falsification of or nullification of economic calculation.” Economic calculation requires money prices, but for calculation to most adequately achieve the goal of solving the economic problem, the money prices used for calculation must reflect the valuations of producers/consumers that are based on their individually unique preferences, knowledge, and resources. Sound money then is money whose purchasing power and quantity are determined by consumers’ and producers’ valuations, preferences, knowledge, and resources — that is, a market-determined commodity money absent government intervention. As expressed by Mises:
Economic calculation does not require monetary stability in the sense in which this term is used by champions of the stabilization movement. The fact that rigidity in the monetary unit’s purchasing power is unthinkable and unrealizable does not impair the methods of economic calculation. What economic calculation requires is a monetary system whose functioning is not sabotaged by government interference. The endeavors to expand the quantity of money in circulation either in order to increase the government’s capacity to spend or in order to bring about a temporary lowering of the rate of interest disintegrate all currency matters and derange economic calculation.
4) Former Austrian economist Bryan Caplan asserts that economists are habitually disappointed by what governments do. Dictatorships are the worst offenders, featuring a rogue’s gallery of impoverishing policies from farm collectivization to backyard steel mills to expulsions of minority merchant classes. But democracies also frequently pursue policies—like protectionism and price controls—that every introductory economics textbook concludes are a costly burden upon the general public. How is this possible? How can majoritarian politics durably sustain policies harmful to majority interests?
The most popular way to resolve this puzzle is to blame special interests for undermining the democratic process. Protectionism hurts most people, but the minority which benefits lobbies heavily on its behalf. The main problem with this account, however, is that public opinion research—not to mention everyday conversation—routinely finds that the policies that economists do not like are popular. The plot thickens. Before going back to the drawing board to come up with a new explanation, it is a good idea to at least investigate whether anyone in the history of economics has already grappled with these difficulties. It turns out that two economists—one French, the other Austrian—worked out a rather sophisticated account long ago. The first is Frédéric Bastiat, writing in the mid-19th century. The second is Ludwig von Mises, who published most of his relevant work a little less than a century later. One striking feature of the Bastiat-Mises view is that politicians are actually tightly constrained by public opinion. On their account, democratic competition keeps elected officials in line; if they deviate from majority preferences, they lose elections and their jobs. Bastiat affirms that “[P]ublic opinion, whether enlightened or misguided, is nonetheless mistress of the world.” Vestigial departures from democratic principles in contemporary France do not impress him: “Political power, the law-making ability, the enforcement of the law, have all passed, virtually, if not yet completely in fact, into the hands of the people, along with universal suffrage.” His assessment of modern democracy would probably be even less qualified.
Mises elaborates on Bastiat’s point, freely comparing politicians to businessmen. Both face intense competitive pressure:
A statesman can succeed only insofar as his plans are adjusted to the climate of opinion of his time, that is to the ideas that have got hold of his fellows’ minds. He can become a leader only if he is prepared to guide people along the paths they want to walk and toward the goal they want to attain. A statesman who antagonizes public opinion is doomed to failure… [T]he politician must give the people what they wish to get, very much as a businessman must supply the customers with the things they wish to acquire.
The last sentence is especially striking because Mises has boundless confidence in the propensity of entrepreneurs to serve consumer interests:
In the capitalist system of society’s economic organization the entrepreneurs determine the course of production. In the performance of this function they are unconditionally and totally subject to the sovereignty of the buying public, the consumers. If they fail to produce in the cheapest and best possible way the commodities which the consumers are asking for most urgently, they suffer losses and are finally eliminated from their entrepreneurial position.
In modern terminology, neither Bastiat nor Mises worries much about democracy’s “principal-agent” problem, its ability to match voters’ wishes and leaders’ actions. How then can they share others economists’ judgment that democracies frequently select policies contrary to majority interests? The answer is that they question the wisdom of public opinion. According to Bastiat and Mises, systematically mistaken economic beliefs—or, as Bastiat terms them, “sophisms,” are widespread. To take his most famous example, Bastiat accuses the public of “broken window” thinking—ignoring opportunity costs. Its members favor wasteful government programs because they fail to consider the alternative uses of wasted resources. They want a large military in peacetime because they implicitly assume that there is nothing else for discharged soldiers to do. They favor fruitless public works projects to “create jobs,” not realizing that the taxes required to fund these projects destroy as many jobs as they create. Bastiat similarly argues that democracies adopt protectionism because the majority mistakenly thinks that imports are bad for the economy: “Protectionism is too popular for its adherents to be regarded as insincere. If the majority had faith in free trade, we should have free trade.” Unfortunately, popular views remain influential even if they are wrong, or positively confused. “When one of these fundamental errors… becomes firmly established as a conventional judgment, unquestionably accepted and agreed to by everybody, it tends to proceed from theory to practice, from thought to action.”
When Bastiat rails against popular “sophisms,” he is often misinterpreted as merely an economic educator. But his point is much deeper. He is not just describing the public’s errors, and urging the economics profession to correct them. He is also asserting that until those errors are corrected, they will influence policy in destructive directions. In other words, Bastiat is laying out a descriptive theory of how real-world politics works: The further the average citizen’s views are from the truth, the lower the quality of policy. Or as Mises explains:
Democracy guarantees a system of government in accordance with the wishes and plans of the majority. But it cannot prevent majorities from falling victim to erroneous ideas and from adopting inappropriate policies which not only fail to realize the ends aimed at but result in disaster.
Bastiat anticipated the rise of socialism, but Mises actually lived through it. It is therefore unsurprising that Mises above all lamented the public’s tendency to underrate the economic benefits of the free market and overrate the economic benefits of government ownership. Thus, in the conclusion of his Socialism, he bluntly states that:
The world inclines to Socialism because the great majority of people want it. They want it because they believe that Socialism will guarantee a higher standard of welfare. The loss of this conviction would signify the end of Socialism.
Mises also highlights more specific economic misconceptions, and links them to narrower policies. Like Bastiat, he blames protectionism on the simple-minded but popular view that imports are bad: “The ultimate foundation of modern protectionism and of the striving for economic autarky of each country is to be found in this mistaken belief that they are the best means to make every citizen, or at least the immense majority of them, richer.” Mises similarly observes, in a passage highly relevant to permanent high unemployment in modern Europe’s heavily regulated labor markets, that the average citizen fails to connect the dots: “Public opinion fails to realize that the real cause for the permanent and large unemployment is to be sought in the wage policy of the trade unions and in the assistance granted to such policy by the government.”
How original is the Bastiat-Mises explanation for poor economic policies? Modern economists often discuss voters’ “rational ignorance”—not bothering to learn about problems that they as individuals can do little to change. But Bastiat and Mises deviate from the usual story in two interesting ways. For one thing, most economists focus on voters’ lack of incentive to learn about the details of policy: Which industry is getting what kind of government help, who is doing what to whom. This counterfactually assumes that state intervention is unpopular to begin with. To come to terms with the facts, it is necessary to home in on more elementary errors, as Bastiat and Mises repeatedly do. Protectionism exists because the electorate thinks it is a good idea, not because they do not know exactly which industries are benefiting. Bastiat and Mises also recognize, as few modern economists do, that it is often implausible to see the public’s errors as mundane ignorance. If the electorate merely knew little about economics, its members should essentially be agnostic on the subject. In practice, however, they often enthusiastically support protectionism, labor market regulation, and other misguided policies in spite of their lack of study.
Economics is simply not physics, chemistry, or mathematics. It is the study of human action, and humans are not programmed robots. Yes, certain immutable laws of nature do indeed exist, but one of them is that humans are—each and every one of them inner-motivated, creative, self-interested organisms. They range from docile to irascible, meek to daring, complacent to ambitious, smart to not-so-smart. As Adam Smith pointed out more than two hundred years ago, “In the great chessboard of human society, every piece has a principle of motion of its own, altogether different from that which the legislature might choose to impose upon it.”