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Monday, April 02, 2007

Do Economists Need Engineers?

Sometimes I post things I don't fully agree with. Though I agree in spirit with the idea that economic systems should be made robust, this essay is more interventionist than I am comfortable with, and, as you might expect, I don't fully agree with the negative characterization of economists.

This is from a much longer article in The American Prospect:

Why Economists Can't See the Economy, by Barry C. Lynn, American Prospect (alt. link):

The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to avoid being deceived by economists. -- Joan Robinson, Cambridge University

On page one of The Wealth of Nations, Adam Smith illustrates the central principle of his economics with an example taken from, in his words, a "very trifling manufacture": the making of pins. Smith goes to some effort to describe the process. "One man draws out the wire," he writes, "another straights it, a third cuts it... In all, Smith counts 18 different "operations," then estimates that such specialization boosts productivity at least 240 times over what the same number of men, each working alone, could accomplish.

Smith's pin factory has served economists ever since as an organizing vision of what economics should work toward. ... And due to the immense influence of economics within our society, this vision has come to shape how we view our world and organize the industries on which we all rely. America's promotion of free trade, at the most simple level, is just the vision of the pin factory supersized into national policy. ...

Look closely at today's global production system and you will see shockingly high degrees of specialization, in terms of both geography and ownership. More and more activities take place in only one or a few places on earth, and within one or a few companies. This is especially true in electronics...

For America, this is a big problem. As Adam Smith understood 230 years ago, decisions on how to divide the tasks necessary to produce pins are based not merely on questions of efficiency but also of engineering. ... Americans would never ask an economist to design a suspension bridge or a new jetliner, though we wisely insist that engineers give the economists a seat at their table. Yet when it came time to design the most amazingly complex system ever devised by human beings--the global production machine--we relied only on principles that spring from the mind of the economist. We did not insist that economists offer the engineers a single stool at the table...

Our brand-new global factory does look awfully efficient. But it is an efficiency purchased through the destruction of all flexibility, and hence sustainability. What we should be fretting about now is what happens when, one day soon, we awake to find that war, revolution, disease, or natural disaster has cut us off ...; what happens when, for want of access to one or a few of the links that make up the global assembly line as a whole, our entire industrial system breaks--pins, electronics, pharmaceuticals, food, and all.

One of the more fascinating academic exercises in America these days is to sit down with an industrialist to discuss the growing brittleness of our production systems, then raise the exact same points with an economist.

The industrialist grasps the idea of fragility immediately, and often offers up fresh tales of production shutdowns and close calls. Indeed, industrial fragility has quietly emerged as perhaps the single biggest operational concern of business today, reflected in a boom in programs to study supply chain risk...

The economist, by contrast, just as swiftly rejects the idea of such fragility outright. Why? Because no industrialist, the economist will declare, would ever take such a risk. Industrialists who say that market pressures force them to take too much risk are simply seeking protection. They are selfish, or lazy.

To understand why economists will so audaciously dismiss ...[warnings of fragility] it helps to look at how ... today's global production system differs from the ... previous production system. Because to the extent that economists' thinking is based on the real world, it is the world that existed in mid-20th-century America.

Through most of our nation's history, ... industrial activity was doubly "compartmentalized." Production took place within discrete, vertically integrated firms, located within a largely self-reliant nation. This isolation of production--inside a box inside another box--made it relatively easy to identify risk and contain disaster. ...

Over the last generation, however, Americans busted open both these boxes. We merged our national industrial system with the industrial systems of many other nations, in the process we know as globalization. At the same time, we encouraged our vertically integrated firms to blend their operations together, through outright merger and through ... "outsourcing." Add these two processes together, and the result is a single, global, networked system of production marked by extreme and growing specialization of activity. More and more, certain things are made, and certain services located, only in certain places.

In theory, there is absolutely nothing wrong with a networked system of production. ... The catch is to understand that networks are not safe by nature, but by design. A network will organize into dispersed compartments that isolate risk only if humans program it to do so.

This is what we did with the Internet... This is true also of the global monetary system, which is compartmentalized by currency and regulated by central banks. Indeed, this is true of all complex systems built by humans. Sometimes by initial design, sometimes after a period of trial and error, human beings act to make a system resilient and flexible by building in some redundancy and compartmentalization. Human beings come to realize that a system can become too specialized, too efficient, to be really safe.

This is not, however, the path we have taken with our global production system. Over the past two decades, we have destroyed the old compartments and kept the engineers from building new ones. ...

Now let's consider how the most basic theory of economics compares with what exists in today's real world.

The most fundamental assumption of mainstream economics today is that the natural state of an economy is perfect competition among many small actors. The average marketplace is viewed as free, open, and politically neutral. For our purposes, this theory is especially important because it allows economists to assume away the exercise of power within the economy, and hence any need to understand the effects of how power is exercised...

Until recently ... there were still many real-world examples of open markets comprising small actors such as farmers, storekeepers, and garage owners. Economists could continue to claim that their theory was valid in the real world...

Such competition, though, is less and less the case in any major American marketplace. The radical changes in antitrust law imposed in the early 1980s by the Reagan administration unleashed forces that played out in the enclosure of many previously open markets. ... In market after market, private monopoly has returned...

Over the last 25 years, this concentration of the economy has resulted in the emergence of an entirely new hierarchy of power...

And so, every day, the divide between economist and engineer grows wider. The economist--reclining upon the ancient verities--remains supremely confident that the system is structured to identify and isolate risk, and to punish those people and firms who take too much risk. The engineer--who acts in the real world, ... grows ever more fearful.

Economists did not always live in the clouds. ...

Even after the academy began to emphasize the use of mathematics, it was by no means clear that economists would one day find themselves so completely divorced from the world. On the contrary, many in the profession seemed, in the early 1930s, to be developing the tools necessary to muck around in the real world... To understand what economics is now, take a moment to look at one of the more important pathways economics did not take.

In 1932, Adolf Berle ... at Columbia ... teamed up with Gardiner Means ... at Harvard ... to write The Modern Corporation and Private Property. This book showed that just a few firms dominated the U.S. economy... A year later, another Harvard economist, Edward Chamberlin, published The Theory of Monopolistic Competition, and the Cambridge economist Joan Robinson published The Economics of Imperfect Competition. Together, these works showed how such large firms hugely distorted basic market functions. At a time when the Depression had shattered the old certainties of laissez-faire economics, the effect of the near-simultaneous appearance of these three volumes was sensational, both within economics and among the general public.

For many economists, the works promised a future in which they would study and model the power of large firms and trace the effects of these concentrations of power on such factors as pricing and employment. This approach implied that markets are, at least indirectly, the products of law acting on or through the corporation and other institutions. It also implied that the concentration of economic power, especially through a public institution like the corporation, transformed the affected marketplace into a largely if not entirely political realm.

For mainstream economics, these works added up to nothing less than a direct challenge, from some of the most gifted economists and legal scholars of the era, to the core theory of economic dynamics: that all markets are perfectly competitive and perfectly neutral. ...

There are many reasons why this movement, often called "Institutionalism," did not become the branch along which the mainstream of economic thinking flowed. One was simple politics. Conservatives inside and outside economics rose in opposition to the new ideas, which, after all, did savor more than a little of Marxist analyses of "monopoly capitalism."...

A second reason was war. As the United States prepared to fight Germany and Japan, even many left-wing economists felt compelled to work more harmoniously with the nation's industrialists.

A third reason, and what proved perhaps the most damaging one over the long run, was the emergence of Keynesian economics, which swiftly attracted many of the economists most enamored of Institutionalism, including the young John Kenneth Galbraith. ...

Yet even without a platform within the academy, Institutionalism remained very much alive. It survived in law, especially in the philosophy and practice of antitrust. ...

What ultimately killed off Institutionalism was the rise of the Chicago School of economics, organized loosely around Friedman's political writings, in the 1960s and '70s. ... Rather than illuminate the political nature of market relationships, their aim was to push the politician entirely out of the realms of business and finance, and to push "market concepts" into the realm of politics.

Unlike the Institutionalists, moreover, the Chicago School was highly organized and very well funded. In public, members repeated ad nauseam their mantra that markets are perfect, and for that matter perfectly wise--which meant that politicians should never interfere... From behind this rhetorical cloud, in both Democratic and Republican administrations since the mid-1970s, members of the school oversaw the radical rewriting of the three main pillars of American economic regulation--the laws governing trade, competition, and the corporation--in ways that steered power and profit upward rather than down. ...

Mainstream economics today ... has degenerated into a purely materialistic and atomistic philosophy, fixed monomaniacally on the pursuit of efficiency as measured by the manufacture of objects... Mainstream economics today strives ... to replace the responsibility of the individual citizen to pursue ethical outcomes through politics with abject worship of an automatic mechanistic "market," which is really just a sham for private directorship of the political economy by the immensely rich.

Just how dangerous such a materialistic and deterministic way of thinking can be when applied to the real world is clear if we consider what ... radical globalists conclude from the fact that we have scattered our pin factories and all of our other factories across the face of the earth. Their line of reasoning is beautifully simple.

Once human beings understand that our production system is so specialized geographically that it will stop working in the absence of any one of a number of major industrial regions, all rational people and right-thinking nations will naturally avoid any actions that might disturb the functioning of the system. The inescapable ... result of making our industrial system fantastically fragile, they conclude, is a world of peace and harmony forever more. If anything, the more precarious the system, the more secure the peace.

To accept this global-market utopianism ultimately amounts to accepting the economist not merely as the engineer of our global industrial system but also as the engineer of an entirely new human nature. ...

[T]here is a wiser course, one that requires no radical shift in our politics. On the contrary, it requires merely a return to our nation's traditional approach to organizing government among human beings, which is to assume that human nature is deeply and irretrievably flawed, and that the best way to control such flaws is through the construction of carefully calibrated, interlocking, counterbalancing, and ever-evolving political institutions. ...

Most immediately, it requires recognizing that the average American economist is not fit to understand, let alone design, the complex networks of our 21st-century economy in ways that result in the most minimal amounts of redundancy, resiliency, flexibility, and survivability, and that we'd better act fast to put someone on the job who can. It requires doing just what Adam Smith would surely do: Turn the task back over to the engineer.

There is lots to disagree with here starting with the basic premise that "economists' thinking is based on the ... world that existed in mid-20th-century America," i.e. that we do not understand that individual steps in the production process are now outsourced to a much greater degree than in the past, etc. -- I think we get that.

And modern macro models do not assume perfectly competitive foundation as asserted. In these models price-setting behavior is important and since perfectly competitive firms are price-takers, monopolistically competitive firms are the atomistic unit (and the degree of market power can be varied parametrically). Thus, they are in the spirit of the Chamberlin and Robinson models cited above.

But rather than going through a point by point rebuttal of the many things I disagree with, I think I'll go in a different direction and recommend Hal Varian's "Avoiding the pitfalls when economics shifts from science to engineering" as evidence that economists are thinking about the issues raised in the essay.

    Posted by on Monday, April 2, 2007 at 12:06 AM in Economics | Permalink  TrackBack (0)  Comments (32)

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