To Apply to Economics Methods of Analysis Drawn from Physics Was Itself an Unscientific Procedure

Not all economists were carried away by the tide of equilibrium theory which swept through the profession in the second half of the twentieth century. A tiny handful of dissenters, known as Austrians because they followed the teachings of the late nineteenth-century Austrian economist Carl Menger, refused to accept equilibrium theory. One of their leading members, Friedrich von Hayek, wrote a series of articles during the Second World War which questioned the foundations of equilibrium theory. He pointed out that to apply unthinkingly to a social science like economics, which dealt with the behaviour of human beings, methods of analysis drawn from physics, which dealt with inanimate objects, was itself an unscientific procedure. He warned that it was particularly foolish to suppose that future economic events could be predicted as if the economic system behaved like a machine.

—David Simpson, Rethinking Economic Behaviour: How the Economy Really Works (Houndmills, UK: Macmillan Press, 2000), 23-24.

 

The Method of Reasoning Employed by the Neoclassical School Is Essentially the Same As That Followed by Ricardo

The method of reasoning employed by the neoclassical school is essentially the same as the procedure followed by Ricardo as described by Schumpeter:

This is the method of analysis which proceeds by excluding as many variables as possible. Then, for the rest, piling one simplifying assumption upon another until, having really settled everything by these assumptions, he [Ricardo] was left with only a few aggregative variables between which, given these assumptions, he set up simple one-way relations so that in the end, the desired results emerged almost as tautologies.⁴

Nevertheless, it was hailed by almost all professional economists as being a triumph for economic theory when in 1964 it was shown that, given specified endowments of resources, technology and consumer preferences, a system of competitive markets could in a logical sense be proved to exist. This triumph was only slightly marred by the fact that its proponents themselves were divided on its interpretation. Since it was recognised that the result had been achieved by making such drastic simplifications and such sweeping exclusions as were not remotely attainable in practice, did it mean that a real world market economy could work, or did it mean that it could not work?

__________

⁴Schumpeter continued: ‘The habit of applying results of this character to the solution of practical problems we shall call “The Ricardian Vice”’.

—David Simpson, Rethinking Economic Behaviour: How the Economy Really Works (Houndmills, UK: Macmillan Press, 2000), 16-17, 213n4.

Equilibrium Theory Might Be Appropriate for a Planned or a Primitive Economy, But Is Not Appropriate for a Modern Market Economy

Equilibrium theory might well be appropriate for a planned economy, or perhaps for a very primitive subsistence economy, where little changes, and one year is much like the next. But it is quite unhelpful in understanding how a modern market economy works. Some of the most important elements of the contemporary economy, such as institutions, entrepreneurship and profits, are missing, while some extreme assumptions which contradict experience, such as perfect knowledge, optimising behaviour and constant returns to scale, have been introduced into the theory in order to achieve predictability. The justification of equilibrium theory therefore rests not on its explanatory power but on its predictive ability. On this point the evidence is overwhelming. All surveys of forecasting accuracy come to the same conclusion: economic forecasts based on equilibrium theory perform no better than naive forecasts which assume that next year’s values will be the same as this year’s.

—David Simpson, introduction to Rethinking Economic Behaviour: How the Economy Really Works (Houndmills, UK: Macmillan Press, 2000), 3.