The difference between a simplifying assumption and a fantasy

Why Neoclassical economists make fantastical assumptions

I’m taking a break from the current “Meme that is destroying Western civilisation” series, to consider something that some people have expressed curiosity about: why do economists continue believing fallacies about money and banking, if the proof that they are fallacies is so obvious?

A personal anecdote might help here.

I presented my model of Minsky’s Financial Instability Hypothesis at a conference of the Western Economic Association in 2011 (it took the adjective “Western” to extremes by being held in Brisbane, Australia).

This was three years after the “Global Financial Crisis”, which Americans call “the Great Recession”. Only a handful of economists warned of before it happened (Bezemer 2009a; Bezemer 2009b), and I was one of them—see “Keen, Roubini and Baker win Revere Award for Economics” (Fullbrook 2010).

You might think that mainstream economists would have been very chastened by their failure to anticipate the biggest—and worst—economic event since WWII. Some were, but the majority simply ignored that failure.

I went to one session where a recent PhD graduate was enthusiastically outlining his DSGE (“Dynamic Stochastic General Equilibrium”) model, which assumed, as usual, that people have a Neoclassical macroeconomic model in their heads which enables them to accurately predict the future. That’s what the assumption of “rational expectations”, which is critical to modern Neoclassical macroeconomics, actually means. This is how the concept was first defined in 1961:

expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory… we call such expectations "rational." (Muth 1961, p. 316)

I call such assumptions “batshit crazy”—this is assuming, not only that all humans have the capacity for accurate prophecy, but also that Neoclassical models are accurate descriptions of reality. But these assumptions were enthusiastically adopted by Neoclassicals, since it gave them a way to argue against interventionist government economic policies.

As this young man outlined his particular way of defining rationality as being Nostradamus, I thought to myself that it would be fun if he turned up to my session. Sure enough, he did—and he sat in the front row.

As I outlined Minsky’s theory, I could see him getting more and more agitated.

Finally, he couldn’t restrain himself, and in the middle of my talk he blurted out “But, but, but, you’re assuming people are idiots!”

“Well, did you predict the Great Recession?”, I asked him. He simply said “No”.

 “In that case, by your own definition, you’re an idiot”, I replied. “Why shouldn’t I model the world as consisting of people like you?”

After my session, he followed me out of the room, and shouted from behind me “But we have to make some simplifying assumptions!” As I walked away, I said over my shoulder “Mate, you have to learn the difference between a simplifying assumption and a fantasy”.

Neoclassical economists have lost the capacity to distinguish simplifying assumptions from fantasies, because Neoclassical theory abounds in fantasies that are needed to gloss over its many logical contradictions and empirical fallacies. But in fact, it’s easy to distinguish between the two.

A simplifying assumption is something that makes it easier to build a model, but which doesn’t make a huge difference to your results. For example, conventional wisdom in the 16^th century was that heavy objects fell faster than light ones. When Galileo disproved this by dropping two lead balls of different weights from the Leaning Tower of Pisa, he made the simplifying assumption that air resistance didn’t make a big difference to the experiment—which, at the height of the Tower, is true. If some pedant had insisted that the experiment was invalid because he hadn’t dropped the balls in a vacuum, then a vastly more complicated experiment would still have yielded the same result.

The assumption that people can accurately predict the future is not a “simplifying assumption”: it is a fantasy. If your theory relies on it, then your theory is false. Neoclassical economists can’t see this, because their entire paradigm is full of such assumptions.

Given that inbuilt desire to show the market system as self-correcting, they’re not interested in exploring reality to see whether their assumptions are really fantasies rather than simplifying assumptions. For example, it’s easy to show, as I’ll do in a future “meme” post, that banks can only lend out reserves if all loans are in the form of cash. But Neoclassical economists continue to assume that banks lend out reserves, because that way they can blame the government for bouts of inflation and financial crises, rather than blaming the market system.

There is, therefore, no point in arguing with a Neoclassical about how the monetary system works—or anything else, for that matter. They’re not interested in challenging their assumptions, but rather in preserving them from criticism. This is the major reason why I now argue that young people who are interested in economics shouldn’t study economics at University. Learn system dynamics instead, learn the history of economic thought from iconoclasts like me (Keen 2011) or John Blatt (Blatt 1983), and apply that knowledge to economic systems. A University degree in economics will just fill your head with fantasies that you’ll spend the rest of your life either trying to clear out of your head, or believing—in which case, you will become part of the problem.

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Bezemer, D. J. 2009a. ''No one saw this coming' – or did they?', Centre for Economic Policy Research (CEPR). https://voxeu.org/article/no-one-saw-coming-or-did-they.

Bezemer, Dirk J. 2009b. "“No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models." In. Groningen, The Netherlands: Faculty of Economics University of Groningen.

Blatt, John M. 1983. Dynamic economic systems: a post-Keynesian approach (Routledge: New York).

Fullbrook, Edward. 2010. "Keen, Roubini and Baker win Revere Award for Economics." In Real World Economics Review Blog, edited by Edward Fullbrook. New York: Real World Economics Review.

Keen, Steve. 2011. Debunking economics: The naked emperor dethroned? (Zed Books: London).

Muth, John F. 1961. 'Rational Expectations and the Theory of Price Movements', Econometrica, 29: 315-35.