/The Neoclassical Economic Dogma: Part 2

The Neoclassical Economic Dogma: Part 2

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Neoclassical Solutions to the Market Failures: the Liberal View  Liberal neoclassical economists share a faith in the goodness of markets with their libertarian counterparts, but the liberal faith is tempered by an understanding that market failures can seriously undermine the “social welfare.” Their solution to market failures is a more activist government. It is important to note here that liberals are not radicals; they do not aim to overthrow existing social arrangements. They make the same identity between market economyand capitalism as do the libertarians and believe that capitalism is far superior to any alternative mode of production.

A good way to contrast the two groups of neoclassical economists is to run through each of the market failures again. Liberals are not in principle opposed to the public production of goods and services the market will not provide. For example, they generally support public education. They point out that the social security system, administered by the federal government, is operated in an extremely efficient manner, with administrative costs of about 1 percent. In the liberal view, there is no inherent reason why private production of social goods and services is superior to direct public production. They might point to the defense contractor scandals: private defense contractors bilked the government out of many millions of dollars.

Liberals are more concerned about the problem of inequality than are the libertarians. Liberals ask how equality of opportunity, one of the bedrock goals of modern capitalist economies, can be maintained if there is great wealth and income inequality. It is perfectly legitimate for the government to use its power to redistribute at least income, to give those with the smallest share of the economic pie a little larger slice. This might be done by progressive taxes and progressive spending, government outlays which benefit the poor more than the rich. Such expenditures might include subsidized health care, free school lunches, and subsidized schooling. Liberals would also be inclined to support a decent minimum wage and a strong labor movement, the latter seen as a “countervailing power” to that of large corporations.

Regulatory laws are not necessarily anathema to liberals. Environmental laws, strictly enforced, are seen as superior to pollution rights schemes by many liberals. Laws are also needed to prevent the most predatory practices of businesses and protect consumers, borrowers, investors, the elderly, the sick, and the young.

The problem of involuntary unemployment shows the greatest divide between liberals and libertarians. In fact, the liberal neoclassical perspective was developed in large part as a response to the Great Depression. When the economies of the major capitalist countries failed to rebound as the most respected neoclassical economists of the day believed they would, a large rift developed within mainstream economics. Until the Great Depression, nearly all neoclassical economists were what I have been calling libertarian neoclassicals. However, the inability of economists to adequately explain one of the most significant episodes in the history of market economies led some of them to speculate that something was wrong with the accepted economic wisdom. The need to find answers was made more acute by the growing anger of workers and the poor, matched by new interest in the radical ideas of Karl Marx.

John Maynard Keynes

A group of economists at Cambridge University in England, led by John Maynard Keynes, began to put forward arguments today associated with modern liberalism. In the mid-1930s, Keynes was already a famous economist and public intellectual. Interestingly, he had not studied economics at university, although he had been tutored by friend of his father, himself a noted economist. He was also a homosexual, and some biographers have speculated that his double outsider status, untrained as an economist and a member of a despised minority, helped him to develop unorthodox economic insights.

Keynes’ upheaval of neoclassical orthodoxy is laid out in his magnum opus, The General Theory of Employment, Interest and Money, published in 1937. In this dense and much-interpreted book, Keynes argued that full employment was not a natural state of affairs in a capitalist economy. If the economy suffered a shock that spawned a depression, market forces might act in a perverse way and deepen the downturn in output and employment rather than putting the economy back on the path toward full employment as Keynes’ neoclassical predecessors had argued. Keynes’ ideas are complex and not easily put into a few words, but the main idea is straightforward. When the economy goes into a slump, business (and consumers, too, although Keynes s focus is on investment) managers and owners might become so pessimistic about the profitability of prospective investment spending (and consumers about consumer spending) that they will not spend money no matter how low interest rates fall.

Businesses will not hire workers no matter how low wages fall, and consumers will not raise their spending no matter how low prices fall. Thus, the increase in investment and consumer spending necessary for an economic recovery does not transpire, and the economy stays in a slump, trapped as it were by the fears of investors and consumers about the future. Whatever money investors and consumers have beyond that needed for essential maintenance and consumption will be hoarded and not spent. Keynesians say that this is precisely what is happening in Japan today.

Keynes was not a radical; he strongly endorsed capitalism and was a foe of socialism. He believed that his theory provided a way out for capitalist economies stuck in depressions. It is a fairly simple notion actually. The problem in a depression is not enough spending, or, as the economist would put it, insufficient aggregate demand for newly produced output. Put another way, in a slump, the amount of money saved by businesses and consumers is larger than the amount businesses are willing to invest. If allowed to persist, this situation will give rise to a decline in both output and saving. The solution is for the state (the government) to take away some of the private sector’s savings and make public investments (spend the money itself). The government could get private savings through taxation or borrowing. If taxation is used, the taxes must be levied on those with relatively high incomes, since the well-to-do can pay the taxes out of money they would otherwise have saved. Taxes could also be levied on corporate profits, since it is the hoarding of these profits that is one of the sources of the insufficient spending in the first place. If borrowing is employed, the government will issue bonds and sell these to the public, banks, and other businesses. The government bonds might appear to be a wise use of unspent savings, because they yield interest and, at least for an advanced capitalist economy, are relatively safe.

Once a government has collected money through progressive taxation and/or borrowing, it must spend the money. It could transfer the money directly to the unemployed and the poor, who will immediately spend the money and stimulate businesses to produce more output and hire more labor to meet the higher demand. Or, better, the state could make public investments, such as in public housing, infrastructure, health care, and many other socially useful projects. Not only would these public investments put people directly to work (either employed directly by the government or by private contractors), but they would also generate much needed spending on output. The improvement in the economy s performance, primed by the government’s initiatives, would then create an environment conducive to optimistic expectations about the future of the economy, and this would spur private investment and consumer spending. The upturn would feed on itself until full employment was achieved and the downturn was over.

The Second World War seemed to vindicate Keynes’ theory. Governments everywhere in the advanced capitalist world sharply raised taxes and issued bonds. They used the proceeds to finance the war. Military spending increased enormously, as did the investment spending needed to produce war materials. Governments, themselves, built entire factories to make the planes, tanks, and guns needed to prosecute the war. Amazingly, unemployment soon disappeared; in the United States, the Great Depression was but a memory by 1943. Labor shortages replaced surpluses; everyone who wanted a job could easily get one. After the Second World War, Keynesianism became part of economic orthodoxy. Capitalist nations like Sweden utilized the Keynesian techniques of progressive taxation and public investment and employment to achieve extremely high average standards of living. In no rich capitalist economy did government spending and tax revenues fall back to their prewar levels. Governments also implemented automatic tax and spending mechanisms so that downturns would be immediately counteracted without any conscious policies. Unemployment compensation, for example, automatically helped to maintain consumer spending when workers lost their jobs during a slump. So too did progressive taxation; as incomes fell in a recession, tax payments fell faster, thus helping to stabilize consumers’ disposable incomes.

Liberal economists often combined their Keynesian economics with the promotion of policies aimed at reducing inequality, such as higher minimum wages, poverty programs, and support for unions. Not only were these seen as just programs; they also stimulated spending and employment. This was so because poorer persons would spend all of any increase in incomes they received, whereas the rich would save part of theirs.

The period between the end of the Second World War and the end of the 1960s was the heyday of Keynesianism. There were differences of opinion about how the government should spend the money it raised from taxes and debt. In the United States, military spending dominated, giving rise to the term “military Keynesianism.” Other Keynesians decried the growth of military spending, contending that such spending might give the economy a one-time boost but would not raise the long-term productiveness of the economy. One of Keynes’ disciples, Joan Robinson, called what the United States was doing “bastard Keynesianism.” Strictly speaking, however, it does not matter what the government spends its on. All that matters is that it spend it and use its taxation, debt, and spending policies to manage the macro economy.

Monetary and Fiscal Policy


Two types of macro economic policy are available to governments trying to stabilize their economies, that is, keep their outputs high or make them higher if the economy has slumped. Libertarian economists say that a government can rely solely upon monetary policy. Monetary policy aims at regulating the availability of credit. This policy is overseen in the United States and in most other rich capitalist countries by a relatively autonomous monetary authority. This authority controls a nation’s central bank, which is not a normal bank but one that regulates the commercial banks with which most persons and businesses normally deal. In the United States, the central banking system is called the federal reserve system, and the central banks are called federal reserve banks. The banks are located around the country, with the most important one in New York City, the country’s financial center. The agency charged with operating the central banking system is called the Board of Governors. There are seven governors, appointed by the President for overlapping terms of fourteen years. One of the seven is made chair, also by the President. Today the chair is Alan Greenspan [note: today, of course it is Ben Bernanke], the world ‘s most powerful central banker. The federal reserve has a number of tools it can use to make credit more or less available. In a slump, it would want to make more available, so it would do things that would put downward pressure on interest rates. Lower interest rates would encourage businesses and consumers to borrow and spend more money, and the increased spending would, in turn, lead firms to produce more output and hire more workers. The actual ways in which the federal reserve puts pressure on interest rates are complicated, but the basics are not overly difficult to grasp. Commercial banks (Chase Manhattan, Wells Fargo, etc.) that join the federal reserve system (membership confers considerable advantages to banks: they can borrow money from their federal reserve bank; they can get expert advise from federal reserve economists; and the federal reserve clears their checks) must keep a fraction of their deposits on reserve at their federal reserve bank. Mellon Bank in Pittsburgh, Pennsylvania, for example, must keep its required reserves in the federal reserve bank in Cleveland, Ohio. The reserve fraction, known as the reserve ratio, is set by the Board of Governors. Money on reserve cannot be loaned out by the commercial bank. So, the Board could encourage borrowing by lowering this ration, giving the banks more money to lend out and forcing them to lower interest rates to get prospective borrowers to actually borrow money.

Banks can also borrow money from their federal reserve banks. The interest rate on these loans is called the discount rate (because the asset the commercial bank puts up as collateral for the loan is discounted, that is, the interest is taken out in advance). The discount rate is set by the Board of Governors. A lower rate sends a signal to the financial community that the federal reserve wants to stimulate the economy. A third tool of monetary policy is open market operations. The federal reserve banks own large quantities of federal government bonds, bonds issued to pay for past government spending. These old bonds are frequently bought and sold, just like stocks. Federal reserve buying or selling of old bonds is called open market operations. In a recession, the Board of Governors would order the federal reserve banks to buy old bonds. The money used to pay for these bonds comes from the reserves deposited by member banks, the interest received by federal reserve banks on their own bond holdings, and the newly-printed money made by the U.S. Mint, which is deposited in the federal reserve banks. When the money enters the private sector, some of it will be spent, directly stimulating the economy. Some of the money will become deposits in banks, and the banks will try to lend this money out, lowering their interest rates to do so. Readers should understand that the central bank does not itself set interest rates, except for the discount rate. But what it does puts pressure on market interest rates. For example, commercial banks loan money to one another on a daily basis. The interest rate on these overnight loans is called the federal funds rate, and it is one of the first to change when the central bank makes a move. Another commonly reported interest rate is the prime rate. This is simply the interest rate the nation’s largest banks charge their biggest customers. It is, therefore, the lowest of all market loan rates. If the federal reserve is trying to stimulate the economy, you will see these interest rates falling. The central bank has still greater powers. It can serve as a “lender of last resort,” making money available to corporations facing extreme financial distress, to brokerage firms unable to get money from clients who have bought stocks on credit, even other countries in economic distress. The central bank is the society’s ultimate source of “liquidity,” that is, of cash needed in emergencies. [Note: This past year, the Fed has written whole new chapters in its role of provider of liquidity, greatly expanding its repertoire of liquidity-expanding activities.]

Libertarian economists believe that if any government policy is needed to stabilize the economy, monetary policy is all that is needed. Liberals, however, are less sanguine about central bank policy. First, they point out that in a severe downturn, monetary policy may be completely ineffective, as argued by Keynes in the 1930s. If businesses and consumers become so pessimistic about the future that they seek safety above all else, they will not borrow and spend no matter how much interest rates decline. In this case, the government must execute fiscal policy—its control over taxes, debt, and spending—to increase spending, output, and employment. In other words, monetary policy works only indirectly to energize the economy. What might be necessary is a direct stimulus in the form of public investment financed by either progressive taxes or bond sales. Second, liberals note the inherent conservatism of central bankers. The federal reserve system in the United States operates with considerable autonomy; it does not need either Congressional approval or funding for what it does. Yet, this independence, combined with the fact that those who serve on the Board of Governors or as reserve bank officers invariably come from the business community or are academics sympathetic to the business perspective, ensure that monetary policy will have a bias toward controlling inflation rather than reducing unemployment. Banks, the society’s primary creditors, hate inflation because rising prices make their customers  loan repayments worth less in terms of purchasing power than the money loaned out in the first place. The central banking authorities, arising as they do from the banking and business community, are much more comfortable pursuing a contractionary economic policy, one which pressures interest rates up to reduce spending and weaken inflationary pressures. Therefore, monetary policy cannot be trusted to stimulate the economy enough during an economic contraction.

The Triumph of the Libertarians


Today, liberal neoclassical economics is in disarray, and the libertarians dominate the mainstream of economics. The libertarian explanation of this is that the increasing globalization of capital, fueled by the electronic revolution, has made Keynesianism irrelevant. In addition, the liberal economic project, with its insistence on large-scale government intervention into the economy, was profoundly wasteful and undemocratic.

Globalization has rendered the Keynesian economic stabilization remedies useless. Suppose, for example, that a government decides to strongly stimulate a national economy through government spending, progressive taxation, and low interest rates. The greater interconnection among national economies, through trade in goods and services as well as various kinds of money flows, greatly reduces the expansionary effects of such a program. First, as incomes increase, so too do imports, moving spending out of the country and lowering the increase in domestic demand. The increase in imports tends to create a deficit in the country’s balance of trade (exports minus imports), and this, in turn, puts downward pressure on the national currency’s exchange rate. That is, if the United States imports more than it exports, the demand for dollars relative to other currencies falls, and this makes the dollar worth less in terms of other currencies. It now takes more dollars to buy yen or euros than before. This raises the price of imports, and in countries which are import dependent, inflation becomes a problem.

Second, rich individuals will begin to move their funds out of the country seeking lower taxes and higher interest rates. The same might be true for domestic businesses. Third, currency speculators, sensing a decline in the exchange value of the currency, might begin to speculate in the currency. They can do this by borrowing dollars (if we are talking about the United States) and selling them. This further drives the exchange value of the currency down and worsens inflation. The speculators will then buy the dollars back at a lower exchange value at some time in the future, pay back their debt to the lender of the dollars, richer by the fall in the exchange value.

Now the country is faced with inflation and capital flight. To combat the inflation and to get money flowing back into the country, the central banking authorities engage in actions which push interest rates up. This may reduce the inflation, but it will curtail consumption and investment spending, counteracting the effects of the expansionary fiscal policy. The government will also face strong pressure to reduce the progressivity of the tax structure. In the end, market forces conspire to defeat the good intentions of the Keynesians. The libertarians take all of this to mean that a government cannot really expand the economy through fiscal policy. In the face of Keynesianism’s failure, libertarians recommend that the best thing to do is rely upon the markets’ tendency to generate socially desirable outcomes. The entire Keynesian experiment left capitalist governments with bloated public bureaucracies and wasteful public spending projects. High taxation served as a strong disincentive to hard work and investment, slowing down the growth rate of the economy. Large budget deficits meant that governments were competing with private businesses for loans (deficits mean that a government has issued bonds to pay its bills), driving up interest rates and further depressing private investment. The same was true for the myriad government rules and regulations, which only compelled businesses to devote precious resources to satisfying the bureaucrats.Libertarians believe that the Keynesian experiments were monumental mistakes, attempts to defy the logic of the market and subvert its beneficence. They had some short-term good effects, but over the long run they caused capitalist economies to become much more inefficient, and, therefore, in the long-run, hurt those they aimed to help. Now globalization has forced a rethinking of Keynesianism and a welcome return to the old time religion of the marketplace.

The turn away from Keynes and toward the market is today called neoliberalism. It is nothing more than what I have called libertarian neoclassical economics. The use of the word “liberal” in neoliberalism refers to the nineteenth century usage of liberal, which then meant what today is called libertarian. Neoliberalism reflects the belief that nations should pursue economic policies first enunciated by Adam Smith, David Ricardo, John Stuart Mill, and all of their heirs apparent in the neoclassical pantheon.

Before we turn at last to the neoclassical analysis of the data we have examined in Chapters, Two, Three, and Four, let us see exactly what neoliberalism means in terms of what countries should do in terms of their economies. An exceptionally clear summary can be found in journalist, Thomas Friedman’s much-publicized book, The Lexus and the Olive Tree:

. . . a country must either adopt, or be seen as moving toward, the following golden rules: making the private sector the primary engine of its economic growth, maintaining a low rate of inflation and price stability, shrinking the size of its state bureaucracy, maintaining as close to a balanced budget as possible, if not a surplus, eliminating and lowering tariffs on imported goods, removing restrictions on foreign investment, getting rid of quotas and domestic monopolies, increasing exports, privatizing state-owned industries and utilities, deregulating capital markets, making its currency convertible, opening its industries, stock and bond markets to direct foreign ownership and investment, deregulating its economy to promote as much domestic competition as possible, eliminating government corruption, subsidies and kickbacks as possible, opening its banking and telecommunications systems to private ownership and competition, and allowing its citizens to choose from an array of competing pension options and foreign-run pension and mutual funds.

Inequality and Work in the Global Economy: Neoclassical Explanations


How do neoclassical economists explain the inequality, underemployment, low wages, and overwork that plague so much of the world? Let us take each subject in turn.

Inequalities Among Nations

Why are there rich countries and poor countries? This question implies a more fundamental one: Why are some countries poor? What is missing in them that is present in the rich countries? The neoclassical answer to this question has various strands. Since neoclassical economists see capitalist economies as much more productive than any prior economic system, they contend that one reason why some countries are poor is that they are as yet insufficiently capitalist. We saw in Chapter Four that 40 percent of the world’s workforce is still in agriculture. In the poorest nations, much of this agriculture is relatively primitive, labor-intensive farming. This agriculture is inherently inefficient; a large outlay of hard labor is necessary just to feed rural families. There is little surplus to feed urban dwellers, much less trade with other countries.

What is true for agriculture is true of much of the rest of the poor economies. The main problem is low productivity. What makes an economy productive, capable of raising its output with fewer inputs, is capital. Poor countries are poor, the neoclassical economist tells us, because they lack capital. Without capital, the cannot use modern capitalist techniques of production and must resort instead to highly labor intensive work processes. Capital is not just machinery and modern technology, however. It is also a trained and skilled workforce. Poor countries lack what the neoclassical economist calls “human capital.” Poorly educated and trained workers are bound to be relatively unproductive.

The poverty of a nation, deriving from the lack of capital, in turn impoverishes the government, which cannot perform certain vital functions, such as maintaining the law and order necessary for smoothly operating markets. People unable to support themselves adequately otherwise will try to use the government for their own advancement. Thus poor countries show a marked proclivity for public corruption, and this makes the economy still less productive, as valuable resources are stolen or used to support a swollen state bureaucracy.

A look at the rich countries reinforces the neoclassical arguments. In all of the rich countries, almost all economic activity goes through markets and is subject to competitive market discipline. Only the efficient survive in such markets. Agriculture takes up a tiny fraction of the labor force, and farming is ultra modern, with the ubiquitous use of sophisticated machinery and equipment. As a consequence, agriculture is extremely productive, producing a large surplus over basic consumption needs, both for rural communities and the nation as a whole. The labor displaced from agriculture provides workers for industry, and capitalist competition soon develops industry, providing a surplus of labor for work in the service sectors now dominant in all rich capitalist countries. The states of rich countries have sufficient resources, because incomes are high, to finance infrastructure and the institutions necessary to make the economic system still more efficient. Workers are highly educated and trained to be ever more productive.

The chance to move up the economic ladder—absent in poor countries—keeps workers on their toes, working hard, and making their economies productive. In the rich countries, fully developed markets create an environment in which prosperity feeds on itself. Wealth creates opportunities, the seizing of which creates more wealth: a virtuous circle of growth, opportunities (realizable through market competition), growth.

What does the neoclassical economic advisor recommend to the poor nations? First and foremost, a poor nation must attract the requisite capital. Since the rich countries have the capital, the poor countries must obtain capital from them. This means opening up domestic economies to foreign capital. Any barriers to foreign capital, such as rules which limit foreign ownership or access to domestic currency, must be eliminated. Strong government structures must be put in place to guarantee the safety of foreign (and domestic) capital. Capital must be assured that it will not be nationalized or otherwise expropriated, and it must be certain that it will get to keep whatever profits it makes, minus a fair share for domestic taxes. Capitalists must not be forced to pay bribes to operate. Tariffs on foreign products must be speedily eliminated, so that cheaper foreign goods can get into the country and benefit domestic consumers.

To make economic progress, a country must be willing to specialize in those goods for which it has a relative cost advantage. In poor countries, labor is cheap, so specialization can begin in those areas where foreign capital is looking for relatively cheap labor. In addition, many poor countries are especially suited for the production of certain agricultural commodities and minerals. Foreign capital should have access to the land and mines (through purchase on the market, of course). These enterprises could then hire the abundant labor to help produce crops and minerals for export. The foreign exchange earned from the exports could finance imports of other necessary capital equipment. As these sectors develop, they will naturally become more modern and capital intensive, freeing labor for production of manufacturing goods in urban areas. Then a similar process will occur there, and eventually production will shift to services as the poor country comes more and more to resemble the rich nations.

Poor countries can be helped along through foreign aid from rich countries and loans, perhaps on favorable terms, from multinational agencies like the World Bank and the International Monetary Fund. These can help governments to build the infrastructure necessary for efficient market operations, from roads and dams to modern financial markets. Along with taxes from rising wage incomes and business profits, loans can help nations to build modern state bureaucracies, uncorrupted and responsive to democratic processes. Money can be spent for education and training, so that workers can take advantage of the growing demand for skilled labor that neoclassical economists assume accompanies economic growth.

If poor nations actively encourage the development of markets, open up their economies to foreign capital, and build modern state structures, the neoclassical theory predicts that over time there will be a convergence between per capita incomes in the poor and rich nations. The demand for labor in the poor countries will be relatively greater than the demand for labor in the rich countries, and this will cause wages in the poor nations to rise relative to wages in the rich nations. The relatively greater investment in the poor countries, attracted initially by the high rates of return, will cause the poor nations’ economies to grow relatively more rapidly than the rich ones. This means a convergence of GDPs per capita, assuming that population growth is not larger in the poor countries. This should not be the case, however, since higher economic growth rates will discourage large family size as they have in the rich countries. In addition, some persons will emigrate from the poor countries, attracted by higher wages, and this will further reduce population growth.

Inequalities and Poverty Within Nations

The various types of inequalities among people within nations that we studied in the last two chapters are analyzed by neoclassical economists in much the same way as the inequalities among nations. The same is true for poverty. We must note at the outset that neoclassical economists take the initial distribution of wealth in a capitalist economy as a given. They do not analyze how historically this initial distribution came to be what it was, although they admit that wealth inequality will, in and of itself, generate income inequality. Implicit in their analysis of income and wage inequality and poverty is the notion that wealth inequality is the result of different maximizing decisions made by the participants in the marketplace. For example, those with high wealth must be persons who have had a stronger propensity to save large shares of their incomes, using the savings to purchase income-bearing assets like stocks and bonds. Or, they must have had a higher tolerance for risk and used their savings to start businesses. Naturally, to maintain the argument that there is a fundamental equality between the participants in the market, each person must have roughly the same chance to save money, purchase assets, and take risks.

If we set aside questions of wealth distribution, we can explain the neoclassical analysis of income distribution and poverty in a straightforward manner. According to the theory, the owners of the means of production are rewarded —that is, receive a price in the market—in proportion to their productivity. Consider workers ranked in order of their productivity to a prospective employer. Each will, other things equal, add some amount of output to the firm’s total output, and, at the market price for the product, this added output will add an amount of extra revenue to the firm s total intake of money from sale of the product. The firm, if it is a profit maximizer, will hire workers as long as the amount they add to revenue (their productiveness) is greater than the amount they to the firm’s cost (their wage). The last worker hired will have a productiveness just about equal to the worker’s wage. It follows from this analysis that if one group of workers has a productiveness greater than that of another group of workers, the first group will receive a higher wage than the first group. Inequality in wages is simply a matter of unequal productivities. It also follows that the surest route to higher wages is greater productiveness.

Just as labor is productive and the market dictates that labor will be rewarded according to the level of its roductivity, so too is capital productive and the market dictates that its owners will be rewarded according to its productivity. The high incomes of some of the owners of capital are due, therefore, to the great productivity of the capital they have put into the market place. If financier, George Soros, gets a yearly income of one billion dollars, it is because of the great productiveness of his capital, which he has risked on the market.

Poverty and unemployment receive exactly the same treatment in neoclassical economics as does inequality. The only difference is that the willingness of workers to supply their labor enters into the discussion as well as the employers  demand for labor. People are unemployed, according to the neoclassical economist for one or both of two reasons. They may not be productive enough to be hired at the lowest wage rate they will accept. If I will not work for a wage rate less than $5.00, but I add a maximum of $4.50 per hour to an employer’s revenue, I will not be hired. It could be said either that I am not productive enough to be hired or that I am asking for too high a wage rate. Another way to put this second point is to say that at the going wage rate, I have a preference for not working (leisure) which outweighs my preference for the goods and services I could purchase with the income from working. The conclusion of all of this is simple: I am unemployed, but this unemployment is voluntary. I choose to be unemployed.

Likewise, I choose to be poor. So, some unemployment and poverty are due to insufficient productivity, but this is just another way of saying that the unemployed and the poor are insisting on a wage rate that is too high. The solution that flows from the neoclassical analysis of inequality, poverty, and unemployment is for the society to implement policies that will raise the productivity of those at the bottom of the income and wealth distributions, the poor, and the unemployed. Policies which should be avoided are those that will encourage people not to work or that will price them out of the labor market. Minimum wage laws should be avoided, since their inevitable effect will be to price less productive workers out of the market. Similarly, welfare programs which pay people without demanding that they also work should be avoided. These will just encourage people with higher leisure preferences not to work and therefore not gain the job experience so critical to becoming more productive. Unemployment compensation and disability programs should not be overly generous for the same reason: they discourage work effort.

Education and training should be promoted, because these are seen as productivity enhancers. Neoclassical economists have noted the strong positive between earnings and education and training. This must mean that education and training improve worker productivity, since it is productivity that primarily determines income. Mandatory schooling, a focus on training for work in the schools, scholarships and low-interest loans for higher education, subsidies to employers for hiring less productive workers and training them, workfare programs in which those who receive welfare subsidies must work to get them—all of these, the neoclassical economist argues, can reduce inequality, poverty, and unemployment. If economic difficulties are caused by an economic downturn, monetary policy will be sufficient to get the economy back on track again.

What I have just offered as the neoclassical solutions to problems of inequality, poverty, and unemployment speaks primarily to the libertarian neoclassical position, far and away the predominant way of thinking among neoclassical. Two points must be added. First, the vast majority of libertarians are not concerned about inequality. They say that inequality is the price we pay for capitalism’s fantastic productivity. What must be done is to strengthen the markets which are the source of this productivity. If an economy grows rapidly, all boats will rise, including those of the poor and unemployed. Why worry that a few persons are extraordinarily wealthy, as long as the majority of people experience rising incomes. Equality is the real problem: too much of it stifles productivity by denying the creative the rewards to their creativity.

Second, liberal economists are in basic agreement with their libertarian colleagues on these issues. They might still argue that some fiscal policy will be needed to end a severe economic downturn. They might say that too much inequality cannot be tolerated, so it is good to have some progressiveness in the tax structure and some concentration on the poor and unemployed in government spending programs. They might favor a higher minimum wage on the empirical grounds that most studies show relatively small job loss when the minimum wage has been increased in the past. They might also favor subsidization of things like health care for the very poor, because decent health is a prerequisite for productive labor.

Testing the Neoclassical Predictions


The neoclassical theory is the intellectual foundation of neoliberalism. If poor countries follow the neoliberal program outlined by Thomas Friedman above, they will, according to the neoclassical economists, someday become rich countries. If poor persons make appropriate investments in their human capital, ? they will become richer persons. The same is true for those who are unemployed or underemployed. People work long hours largely because they choose to do so. When people acquire skills, employers will be compelled to create enough skilled jobs to match the higher demand for them. If, once people do the things necessary to improve their economic circumstances, they want to build up their wealth, they will start to save part of their income and use this saving to obtain wealth.

Although it is not always easy to devise tests of the neoclassical predictions, for reasons described in Chapter One, the evidence from tests which have been done does not conform to their hypotheses. Let us look at several examples. If markets are competitive, if nations specialize in areas where they have a comparative advantage, and if capital is free to move around the world without restraints, neoclassical economists argue that poor economies should grow more rapidly than rich ones. There should be a gradual convergence of per capital Gross Domestic Products. The evidence here is completely contrary to the neoclassical theory. We have already seen that the per capita GDPs of rich and poor nations have been diverging since at least the end of the nineteenth century. With very few exceptions, the original rich capitalist countries are still rich, and the countries initially colonized and molded to shape the needs of the rich nations are still poor. It would take a kind of mindless optimism to believe that the countries in sub-Saharan Africa are going to become rich, no matter how “free” they make their economies and no matter how far into the future we make our projections. The reasonably optimistic assumptions made for India in the example in Chapter Two show a GDP convergence with the United States twelve generations from now! The neoclassical economist could contest the data on divergence by saying that the poor nations had not made their economies sufficiently reliant on “free” markets. That is, in the comparisons between rich and poor countries, other things have not been held constant so that the comparison is an objective one. Had the poor nations done what they should have done, their growth rates would have been much greater, and there would have been convergence of per capita GDPs. This is a common tactic used by neoclassical economists. It is trotted out every time neoclassical expectations are not confirmed by actual events. Since it is difficult to imagine that any economy could be structured exactly according to the neoclassical assumptions, it is always possible for the economists to say that events do not really contradict the theory’s predictions. This becomes a kind of quasi-religious argument. There is always at least one of god’s rules that imperfect humans have violated, and this transgression can be used to “explain” why human beings have come to ruin.

It is possible to use recent history to provide a test of the convergence hypothesis. Between 1980 and the present, most of the world’s poor nations have introduced much of the neoliberal regimen of open markets, deregulation, privatization, austere public budgets, and encouragement of foreign investment. According to neoclassical theory, such a long period of neoliberal reforms should have brought about high GDP growth rates. Exactly the opposite was the case, as shown in Table 5.1. The growth rate of per capita GDP in the developing countries (what I have called the poor countries) was much lower between 1980 and 1998 than it was in the earlier period, 1960-1969. In fact, the growth rate was zero! While growth rates also slowed in the rich countries, they were still much higher than in the poor countries, and the amount of the decline was not as large. Therefore, per capita GDPs continued to diverge. The evidence

Table 5.1
Median Average Annual Per Capita Income Growth Rates (a), OECD and Developing Countries
                                                                                              1960-1979    1980-1998
OECD (b)                                                                                3.4                    1.8

Developing Countries(c)                                           2.5                    0.0

aThe numbers shown in this chart represent median values for average annual per capita income of countries over the years indicated. The median value is the point at which half of all countries in the group are above the average growth rate indicated while half are below.

bThese are the leading industrial economies in Europe, plus the United States, Japan, Canada, Australia and New Zealand.

cDeveloping countries here encompasses all developing countries, including China and ex-Communist states in Eastern Europe and Central Asia.


Source: This table is taken from The Editors, The New Face of Capitalism, Monthly Review 53 (April 2002): 3.

against convergence is so overwhelming that neoclassical economists have begun to tweak their models so that, under certain assumptions, even competitively organized economies might diverge.25 When theorists resort to such devices, however, they are admitting that their basic model is inadequate. And it is always the basic model that informs the public policies promoted in the name of the theory. It needs to be stressed that the poor countries which most fully embraced neoliberal programs were the most likely to suffer severe financial crises. There are many examples here Thailand in the late 1990s and Argentina in 2001 and 2002 come immediately to mind. Both economies experienced rapid GDP growth  though not development in the sense of a widely shared general increase in social welfare  and were christened by mainstream economists as the latest economic miracle. When Thailand opened up its economy, doing all of the things Mr. Friedman tells us poor nations must do, foreign money literally flew into the country, attracted by low wages, high interest rates, and eager borrowers. Stock market and real estate booms ensued, and all sorts of businesses began operations, often in newly-constructed buildings. But then, Japanese banks raised their interest rates, and investors began to realize that the boom had played itself out. Money began to leave the country as fast as it had entered. As the Thai currency, the baht, was sold to purchase dollars and yen, it fell in value. Stocks and real estate were sold and the money sent out of Thailand. Speculators went to work, selling short, and this drove the prices of everything inexorably downward. As the value of the currency sank, the price of imports, upon which the country was dependent (it was following the export model of economic growth, ignoring production for domestic markets), rose dramatically, badly hurting ordinary Thais. As construction ground to a halt and business in general went into a slump, unemployment and misery mounted. Neoclassical apologists began to say that the Thai government was corrupt. It practiced “crony capitalism,” and was therefore not a true model of neoliberalism. No wonder the economy failed.

Reality also dealt a serious blow to neoclassical economics with respect to the North American Free Trade Agreement (NAFTA). This treaty, supported by virtually all neoclassical economists, was supposed to raise the living conditions of workers in all three treaty nations: Canada, the United States, and Canada. Yet, research shows that NAFTA s promises have not been realized. Research done by economists at the Economic Policy Institute in the United States indicates that NAFTA is partly responsible for growing inequality in all three signatory countries. NAFTA has caused significant job loss in high-wage manufacturing industries in the United States. This by itself lowers average wage rates in the United States, but it also lowers wages by increasing the supply of labor seeking employment in the already low-wage service sector. We have already noted the treaty’s devastating impact on Mexican peasants. I am not aware of any study showing that NAFTA raised the per capita GDP growth rate of any of the three nations. In fact, right after passage of NAFTA, the Mexican economy went into a tailspin.

If the neoclassical theory fares poorly in explaining inequality among nations, its performance is strikingly bad in unraveling the causes of inequality, poverty, wages, and underemployment within countries. According to the theory, inequality in income is simply the monetary reflection of inequality in productivity. This notion can be challenged on both theoretical and empirical grounds. Although capital in the form of machinery, buildings, and equipment is productive, in the sense that, other things equal, the more capital per worker, the more output is produced, the ownership of capital is not a productive act. Therefore, income from the ownership of the nonhuman means of production cannot be justified on the grounds that the means of production are productive. A significant fraction of the nonhuman means of production become the private property of individuals through inheritance, and in these cases the argument that the inheritors are productive is particularly ridiculous. Neoclassical economists do not seem to be capable of the realization that if Bill Gates went into a coma, he would still collect billions of dollars of income every year, despite the fact that whatever productivity he once had had was now reduced to zero. It is ownership that generates income not productivity.

The neoclassical explanation of wage inequality is likewise suspect. If we say that wages reflect productivity, we must be able to measure the productivity of individual workers. This, however, is for the most part impossible. The output of many workers, particularly those in the burgeoning service sector, cannot be measured in any meaningful way. What output does a teacher produce? A policeman? A doctor or nurse? In industrial settings, work is not an individual process; it involves the necessary cooperation of large groups of workers. The productivity of an individual worker is a meaningless concept.

But even if we use indirect measures of productivity, such as years of schooling and years of experience, and hold these constant across samples of workers, we find that wages are still unequal. Workers can do exactly the same kind of work and have equal productivity (as measured indirectly) and still earn different wages. All workers know of situations in their own workplaces in which one worker works harder and with greater diligence in the same job and gets less pay than another.

The most damaging studies for the neoclassical wage analysis have been those dealing with wages by race and gender. Nearly all studies show that equally situated black and white workers do not earn the same pay; black workers always make less. The same is true for women; no matter how many factors we hold constant, women earn less than men. Neoclassical economists have devised several ingenious theories to explain racial and gender differences. Nobel award winner, Gary Becker, has hypothesized that some employers have a “taste for discrimination,” that is, these employers are willing to pay—by making lower profits—to satisfy this taste, which leads them to pay black workers who are as productive as whites less money. But what Becker does not seem to be able to explain is why some nondiscriminating employers would not then hire black workers at a wage less than their productiveness, lower their product prices, and drive their racist rivals out of business.

The neoclassical theory predicts that equally productive workers will make equal wages. This is manifestly not the case. If we look at workers across the world and observe the astronomical differences in wages among workers, this prediction looks increasingly preposterous. The Mexican workers making car engines for General Motors or Ford are as productive as their Detroit counterparts, but the pay of the former is a small fraction of that of the latter. On a macroeconomic level, there is no direct connection between productivity and wages. In the United States, for example, productivity in the economy as a whole rose steadily between 1973 and 1998. Yet, median compensation (compensation equals wages plus benefits) fell in real terms throughout most of this period. If productivity is the major wage determinant, these trends are very difficult to explain.

There have been many other, indirect, tests of the neoclassical explanations of labor market outcomes. We have already noted the minimum wage studies by Card and Krueger. Contrary to the prediction of the neoclassical theory, a government increase in the minimum wage does not lead to losses of employment, at least not in the United States. Instead, an increased minimum wage has ordinarily been associated with increases in employment, as well as some reductions in poverty and income inequality. There is also some evidence that so-called “living wage” laws, enacted by local governments in the United States to provide certain employees with a wage that will keep a family above the poverty level of income, have not caused any job losses.

The neoclassical theory predicts that rising wages will cause unemployment. This can be explained neoclassically in two ways. First, as wages rise, insufficiently productive workers will be priced out of the labor market. Employers will be forced to cut back employment or risk losing money. Second, if we consider two parts of a country, one with a low and one with a high unemployment rate, we could argue as follows. Suppose that a worker living in the low unemployment area is contemplating moving to the high unemployment area. He or she will require a higher wage to move, since in the new location the risk of unemployment is higher.

Two British economists put this hypothesis to the test in an exhaustive study involving millions of wage and  nemployment observations worldwide. What they found was that, other things equal, the relationship between wage rates and unemployment is inverse. High unemployment rates are associated with low wage rates and not vice versa as the theory predicts. Unemployment may be due to many things, but it does not appear that high wages are one of them.

Finally, neoclassicals have always argued that some unemployment and poverty are voluntary, the result of high leisure preferences among some persons. Again, the empirical evidence for this is weak. In the United States, the federal government conducted an income transfer experiment in the 1970s. Two groups of families were selected in a number of Eastern cities. One group was given an income subsidy each month for three years, and the other group was not. Using statistical techniques to hold other variables constant, researchers studied the labor market behavior of the two groups. Neoclassical theory predicts that the families receiving the subsidy would be more likely to drop out of the labor force or reduce their hours of work. This was not the case, especially for Black and Hispanic men, who actually increased their labor market activities. The wives in the families did reduce their labor market activities, but they substituted greater child care and more schooling for this. The behavior of both wives and husbands in this study hardly fit the neoclassical stereotype of leisure-seeking poor people, loafing more because they get money from the government.



Neoclassical economics is the economics of the isolated individual. Social outcomes are hypothesized to be the results of all of the maximizing decisions of buyers and sellers in the marketplace. In this theory the individual is prior to society, so it is not necessary to ask what effects social circumstances might have on individual behavior. Society is never to blame for anything in this theory, precisely because it is not in any sense outside of and acting upon the individual.

It is no wonder the theory does not test well when it comes to inequality among nations, inequality within countries, poverty, underemployment, and overwork—the subjects of this book. How a nation’s economy performs has everything to do with the position it holds within the ranks of the world’s nations. The extremely poor nations of sub-Saharan Africa have been forcibly underdeveloped by the rich nations for centuries. Unless this relationship, one of imperialism, changes, there cannot be much hope that these nations will develop, regardless of what their governments decide to do. Certainly, if they pursue neoliberalism, they just reinforce the conditions that got them into such a fix in the first place.

Similarly, those at the bottom of the income distribution, those who are poor, those without wealth, those who are underemployed, those who are overworked—none of these people are likely to improve their circumstances much through individual maximizing actions. Nor will we be able to explain their conditions by looking at individual maximizing behavior. Their difficulties are structural; they find themselves locked into a set of structures beyond their individual control. To say that the thousands of people living and working in the garbage dumps outside Manila in the Philippines have made a set of poor maximizing choices is to say nothing at all. To say that they should get more schooling is naive beyond words. To say that they are unproductive is equally unhelpful. To say that they are voluntarily underemployed is preposterous on its face. To say that they will be helped if the government embraces neoliberalism is simply wrong; their plight and the plight of most of the world’s poor have worsened precisely as their leaders have opened their economies to foreign capital.

While libertarians rule the neoclassical roost, there are still some liberal economists who have taken issue with the libertarians. They do not believe that all unemployment and poverty are voluntary; they still hold to Keynes’ view that unemployment is, for the most part, involuntary. Aggressive fiscal policies are needed to combat this unemployment, and various types of capital controls (see the last chapter for more on these) must be put in place so that the expansionary impact of fiscal policy can be realized.

Another group of liberal economists have pretty much abandoned strict neoclassical arguments and concentrated upon empirical investigations. Good examples are the minimum wage studies of Card and Krueger and the wage/unemployment rate studies of Oswald and Blanchflower. U.S. economists Richard Freeman and James Medoff have done important empirical work on the real world effects of unions on wages, employment, prices, and equality. Their conclusions are much more sympathetic to unions that is the neoclassical theory itself.

While the liberal economists are to be applauded, it is important to understand that only another theory, better able to explain the economic world, can supplant the neoclassical theory. And, for reasons made clear in Chapter One, only a strong social movement aimed at radically altering the societies which gave rise to neoclassical economics can ensure that a new theory will have a chance to survive.

Suggested Readings


A good overview of the history of economic thinking is still Robert Heilbroner’s The Worldly Philosophers, 7th Revised Edition (New York: Touchstone Books, 1999). The basic neoclassical model of labor markets is presented, along with summaries of empirical research, in Ronald Ehrenberg and Robert Smith, Modern Labor Economics: Theory and Public Policy, 7th Edition (New York: Addison Wesley Publishing, 2000). A classic popularly written defense of libertarian neoclassical economics is Milton and Rose Friedman, Free to Choose: A Personal (New York: Harcourt Brace Jovanovich, 1980). A positive account of neoliberalism is Thomas Friedman, The Lexus and the Olive Tree (New York: Farrar Strauss & Giroux, 1999). A A best-selling textbook today, for which the author was paid the largest advance ever paid for a textbook, is N. Gregory Mankiw’s Principles of Economics (Fort Worth, TX: South-Western College Publishing, 1998).

Addendum: Summers Infamous Memo


Lawrence Summers is the president of Harvard University.[Note: Now, of course, he is one of President Obama’s top economic advisors] A well-respected and very neoclassical economist, he served as President Clinton s Secretary of Treasury and before that as chief economist at the World Bank. In 1991 he issued a memorandum concerning industrial pollution.[Note: one of his staff economists, Lance Pritchett, actually drafted the memo]. In it he said, Shouldn’t the World Bank be encouraging more migration of dirty industries to the third world? His argument is a classic example of neoclassical reasoning. We know that industrial pollution causes sickness and death. This sickness and death have costs, which can be measured by the foregone earnings of those who get sick (and cannot work) and those who die.

Obviously foregone earnings will be higher in rich countries, where wages (and therefore productivity) are higher, than they will be in poor countries, where the opposite is the case. Since the loss in rich countries outweighs the loss in poor countries, the world will gain if polluting industries are moved to poor countries. In addition, since some poor nations have more pristine environments (because they have less pollution-generating industry), the initial pollution from industries will do relatively less environmental damage than it would in environments already heavily polluted. A little bit of smoke in clean air will hardly be noticed, whereas more smoke in dirty air might be the straw that broke the camel s back. Finally, pollution will cause cancer and other diseases which might only affect people in their old age. In poor countries life expectancies are low, so people won’t live long enough to get the diseases, again good reason to encourage the building of polluting industrial facilities in poor countries.

Nowhere in Summer s memo does he point out how it is that the poor countries came to be poor. The fact that much of the rich countries wealth was simply the result of the force and violence wreaked by the rich nations upon the poor countries does not enter into his analysis. This is not his concern. He just takes the conditions of the poor countries as a given. Then his marginal analysis of costs and benefits appears impeccable in its logic. A poor life is indeed worth less than a rich one. If he were to see the plight of the poor countries as the consequence of deliberate actions taken by the rich nations, of the money in the rich man s pocket as intimately connected to the emptiness of the poor person’s pocket, he could not have written his memo. Instead he would have had to talk about debts and reparations.