US economics in the age of neo-liberalism

The neo-liberal age dawned with the election of Margaret Thatcher in Britain in 1979 and Ronald Reagan as US President in the following year. It took another decade for the high inflation of the 1970s to be brought under control, ushering in a period of faster growth, some­what lower unemployment and very much lower inflation that came to be known as the ‘Great Moderation' of 1992—2007.

In microeconomics, the rise of Walrasian equilibrium modelling had culminated in the canonical General Competitive Analysis (1971) by Arrow and the Cambridge (UK) theorist Frank Hahn. Very soon, however, the entire general equilibrium project was undermined by the demonstration, by Debreu and two colleagues, the American Hugo Sonnenschein (b. 1940) and the Yale-trained Argentinian Rolf Mantel (1935—99), that almost nothing could be said a priori about the excess demand functions that were generated by such models, and therefore there was no reason to expect the existence of a unique equilibrium. The Debreu-Mantel- Sonnenschein theorem, sometimes described as the ‘anything goes theorem', was so influential that by the end of the 1980s general equilibrium models had been quietly abandoned by the great majority of US microeconomists, just as (ironically) they were being incorporated into the core of macroeconomic theory. General equilibrium was rapidly replaced by game theory as the principal theoretical framework for the analysis of microeconomic problems. It shared the most important characteristics of Walrasian modelling, above all the assumptions of methodo­logical individualism, instrumental rationality and certainty-equivalence, so that goals and constraints were known, at least probabilistically, and the standard procedures of constrained maximisation could be applied.

The range of problems to which neoclassical microeconomics appeared to offer solutions was steadily expanding. Under the leadership of the Chicago theorist Gary Becker (1930—2014), economists now invaded what had previously been considered the domain of the other social sciences, which (it was claimed) were being driven out of the occupied terrain by the irresistible advance of the new ‘economics imperialism'. Thus neoclassical economic modelling was applied to education (via the concept of ‘human capital'), political behaviour (in ‘public choice' theory), crime (since the criminal could be seen as a rational, utility-maximising entrepreneur) and the family (with the popular metaphor of the ‘marriage market' being taken literally and femin­ists being enraged by the idealisation of male domestic tyranny). In this way, inter-disciplinary cooperation gave way to invasion tactics. But the imperialists were often fiercely resisted, and with considerable success; neoclassical models were indeed sometimes used in political science, sociology, anthropology and social psychology, but only on the disciplinary fringes.

Perhaps the most important new field for the employment of neoclassical modelling techniques was provided by financial theory, which proved to have extremely large and wide- ranging real-world applications. Without the Capital Asset Pricing Model developed by Fischer Black (1938-95), Harry Markowitz (b. 1927), Merton Miller (1923-2000), William Sharpe (b. 1934) and others, there would have been no explosive growth of the market for financial derivatives, and without the Efficient Market Hypothesis articulated by Eugene Fama (b. 1939) the New Deal regulatory structure would not have been dismantled in the 1980s and 1990s to permit the explosive and very largely unregulated growth of those markets. Thus main­stream microeconomics played an important part in constituting the new economic world of financialised neo-liberalism.

The political context was, as always, extremely important.

Economics imperialism now extended its reach from the academic journals into popular culture and ideology. Chicago was again at the centre of this movement, with the best-selling book by Milton Friedman and his wife, Rose Friedman (1910-2009), Free to Choose (1980), being used as the basis for an influential television series promoting neo-liberal ideas. This is the epoch when ‘economics goes to the movies', and also to the television studios. Galbraith's ‘Age of Uncertainty', televised in 1977, presented the history of economics from a broadly social demo­cratic, Keynesian perspective, but it was much less influential than the Friedmans' programmes, which were made in reaction to it. It was not long before the first successful Hollywood film was made starring an economist. This was Ron Howard's A Beautiful Mind (2001), featuring the brilliant but deeply troubled game theorist John Nash (b. 1928), whose eponymous theorem was one of the most influential products of the post-von Neumann era in game theory. Nine years later, Charles Ferguson's Inside Job (2010) took a much less sympathetic look at the prominent macroeconomic theorists who had given a clean bill of health to the Icelandic banking system just before what, with hindsight, was its inevitable collapse. Back in 1872 Marx had already described those responsible as ‘hired prize-fighters of the bourgeoisie'.

Macroeconomic theory had changed dramatically since the heyday of US Keynesianism.

These developments in macroeconomic policy were accompanied (and indeed largely caused) by a radical shift in macroeconomic theory, and in the methodological arguments used to justify this shift. Monetarism had always been rather light on theory, with the Quantity Theory defended mainly on empirical grounds: the velocity of circulation was roughly constant, Friedman claimed, and in the Equation of Exchange (MV = PT) causation ran principally (though not exclusively) from left to right, so that changes in the money stock (M) caused changes in the price level (P). Friedman also claimed, correctly, to have something in common with Keynes, since both men did their macroeconomics from the top down, not from the bottom up.

The second generation of Chicago monetarists, led by Robert Lucas (b. 1937), did it the other way round, insisting on the provision of ‘microfoundations’ for macroeconomic theory.

As already noted, the macroeconomists of the neo-liberal era took up general equilibrium modelling just as it was being discarded by their colleagues in microeconomics. The new Dynamic Stochastic General Equilibrium (DSGE) models focussed on individual consumers of a very particular type: representative agents with rational expectations, who maximised lifetime utility in an economic environment that was characterised by random shocks. By the 1990s these RARE microfoundations were very widely accepted by mainstream macroeconomists, including many of those who described themselves as ‘New Keynesians’. The New Classicals saw unemployment as voluntary in nature, since it resulted from the free decisions of rational individuals who had chosen leisure in preference to paid employment. The New Keynesians, like Paul Krugman (b. 1953) and Joseph Stiglitz (b. 1942), argued instead that labour and product markets were imperfect, so that prices and money wages tended to be sticky downwards. Involuntary unem­ployment was the most important consequence of the asymmetries in information that gave rise to imperfect markets. There were good reasons why profit-maximising employers might not offer work to unemployed people who were prepared to undercut their existing workforce.

These arguments constituted an important element of the New Neoclassical Synthesis that had emerged by the late 1990s. Post Keynesian critics like Davidson and Minsky always maintained that this was a travesty of Keynes, who had maintained in chapter 19 of the General Theory that downward flexibility in prices and wages should be discouraged. The great majority of New Classicals and New Keynesians, however, now agreed on the need for RARE microfoundations, accepted the Taylor Rule as the basis for macroeconomic policy, and at least implicitly rejected Keynes’s irreducibly macroeconomic principle of effective demand.

Thus the insights of Post Keynesians like Davidson and Minsky were marginalised, along with the contributions of other heterodox economists from the Institutionalist and radical-Marxist traditions. It became increasingly difficult for non-mainstream economists to publish in the leading journals, and their own students were less and less likely to find employment in the leading universities. Some formerly heterodox economics departments were besieged and overrun by the mainstream — Rutgers in the mid-1980s, Notre Dame 20 years later — leaving only a handful of institutions still offering heterodox PhD programmes. By 2014 only the New School in New York City, the University of Massachusetts at Amherst, the Levy Institute of Bard College at Annandale-on-Hudson in New York and the University of Kansas City-Missouri remained. Individuals could still find jobs in less prestigious state universities and in liberal arts colleges, but at the expense of heavy teaching loads and limited access (if any) to research funding (Lee, 2009, chs. 4—5). The ‘second crisis of economic theory' that Joan Robinson had foreshadowed back in 1971 had not worked out as she had hoped.

By the beginning of the new century, however, some observers were pointing to an entirely new phase in the evolution of American economics, with emerging research paradigms that posed a real challenge to neoclassical theory. The former mainstream, they claimed, was now fragmenting. The new research programmes included evolutionary economics, behavioural economics, evolutionary game theory, behavioural game theory, experimental economics, neuroeconomics and agent-based complexity economics (Colander et al., 2004). The last-named provides a good case study. Complexity economics is a branch of the science of complexity, centred on the Santa Fe Institute and largely financed by Citibank. Its fundamental conception is of an economic system dominated by evolutionary processes of change that are adaptive and self-organising and that generate non-linearities, path dependence, emergent properties that cannot be reduced to their component parts, and increasing returns to scale. Complexity economics only became possible with advances in information technology that allowed the numerical simulation of dynamic equation systems for which analytical solutions could be obtained.

These developments not only represented a new pluralism in American economics, it was argued, but also provided clear evidence of reverse imperialism, with economics importing new ideas, techniques and research agendas from biology, neuroscience and cognitive psychology. In the process, the new ‘dissenters', or ‘heterodox mainstreamers', were abandoning much of the intellectual apparatus of the old mainstream. They recognised that individuals are socially embedded, not atomistic; accepted that economic processes are evolutionary rather than mechanical; and acknowledged that individuals and socio-economic structures are mutually dependent, so that the quest for ‘microfoundations' was bound to fail. Thus critics from the old heterodox schools were becoming increasingly irrelevant in their continuing attacks on what was now a straw man.

The heterodox economists, however, maintained that the new ideas were being absorbed into mainstream theory in ways that ensured that no threat was posed to its core tenets. A process of ‘bastardization' was under way, similar to that which had accompanied the incorporation of Keynes's macroeconomics into the mainstream of American economics in the 1940s. This could be seen in all the new streams of thought, perhaps most clearly in the case of behavioural economics. Here the ‘old behaviourism' of Herbert Simon (1916—2001) had been edged aside by the ‘new behaviourism' of Daniel Kahneman (b. 1934) and Amos Tversky (1937—96), which was essentially individualistic and carried the comforting implication that in many cases economic agents needed only to be ‘nudged' in the right direction for something approaching the instrumentally rational behaviour postulated by traditional neoclassical theory to be obtained.

Increasing concern is at last being shown over the growth of inequality in income and wealth that has occurred in the United States since the 1970s, and which has had a social and political no less than an economic impact. This has been recognised by mainstream economists like Stiglitz, in The Price of Inequality (2012), and Jeffrey Sachs, in The Price of Civilization (2011). But it has not been adequately explained by mainstream theory, since narratives that focus exclusively on the consequences of labour-saving technical change are not convincing. Changes in social and (especially) political power are a crucial part of the explanation for the growth in inequality, which suggests that there may well be some mileage left in the (old) Institutionalism and in radical and Marxian political economy. This conclusion is reinforced by the after­math of the Global Financial Crisis, which only failed to repeat the catastrophe of the Great Depression because of the adoption of old-fashioned Keynesian stimulus measures, in the United States and elsewhere. Although there was a short-lived increase in interest in Post Keynesian and Marxian ideas after 2007, and the work of Hyman Minsky was often cited, there seems to have been little or no reduction in the influence of the core ideas of mainstream economic theory (Mirowski, 2013).

To conclude: the course of economics in the United States has been influenced by factors both internal and external to the discipline. Most important among the internal influences after 1945 was the strong commitment to formal modelling, which reinforced the tendency towards economics imperialism but also provoked criticism of the economists’ inappropriate ‘scientism’ — mindless imitation of the methods of the natural sciences — and, even more pejoratively, of their ‘physics envy’. The external influences included the pervasive American exceptionalism that had been a common element in all the social sciences from the earliest days and included a strong anti-socialist orientation that was strengthened after 1945 by the onset of the Cold War. For much of the twentieth century, academic economics in the United States had very close links to both business and the state, providing practical instruments and techniques for use by government, corporations and courts of law (Fourcade, 2009). It relied on four sets of patrons: universities, governments, business and foundations (Goodwin in Morgan and Rutherford, 1998). While the academy was never merely a creature of the other three patrons, it was never entirely independent of them, either. What the future holds for economics in the United States will of course be decided by its academic practitioners, but their decisions will be conditioned and constrained, as they always have been, by outside political and financial interests.