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  • Writer's pictureSergio Focardi

In a nutshell: Why does classical economic theory need an overhaul? And how should it happen?

In some previous posts and in some articles I have expressed criticisms of mainstream economic theory. I have also proposed several new strategies to arrive at an empirically valid economic theory that can be used to make predictions and to make economic policy decisions. In this post I would like to summarize criticisms and solutions to classical economics. The tone of the post is informal, geared towards an audience of non-specialists, and therefore does not include rigorous but complicated mathematical deductions. Let us begin withthe diagnosis ofthe problematic aspects of classical theory. Then I will suggest possible changes.

1. Goods and services are heterogeneous and there is no aggregate measure of their quantities

The first thing to observe is the impossibility of formulating a theory of the quantity of output, and therefore of real growth, based on observables. This seems a trivial observation, it seems obvious that we can't significantly add up the amount of bananas, with the amount of cruises, with the amount of cars and so on.

Yet macroeconomic models insist on modeling the amount of output. They do this by making extreme assumptions such as assuming that an economy produces only one commodity. Theoretical solutions have also been tried by constructing indices. An index replaces a quantity with its percentage change. Example. We cannot estimate the sum of bananas and cruises but we can consider the percentage of growth in consumption of bananas and cruises. Percentages are pure numbers and can be aggregated. It seems like a brilliant solution but it has a problem: what weight do we associate with each percentage? We cannot directly compare quantities and therefore weights are arbitrary. Therefore, the first conclusion is as follows:

We cannot create macroeconomic models of the amount of output because that quantity does not exist.

2. Nominal and real GDP and inflation

Of course we can consider characteristics of goods and services other than quantities. For example we can consider their price. This strategy seems to provide the final solution, in the sense that we cannot determine the percentage of output growth but we can determine the percentage of growth of its value. But unfortunately even in this case we encounter problems. Prices are relative prices only. In other words, at all times prices are defined up to a multiplicative constant. The question we have to ask ourselves is how we can calculate this multiplicative constant. What causes the total value of transactions to change from one period to another?

Economists have separated nominal GDP growth, that is, GDP calculated at current prices, as the product of two factors: one factor is the real growth of the economy, the other factor is the eventual growth of the price level, called inflation. But both of these concepts, real GDP and inflation are problematic as we are now discussing.

The concept of inflation is very old. There are many documented cases of price growth starting with those that occurred in Egypt around 2000 BC. In general, these cases of inflation are linked to predominantly agricultural economies characterized by a very limited and static supply of products and services. Inflation is defined as the rise in the price level. If there are only a few products and if the increase in prices is approximately the same for all products then inflation is a well-defined concept.

But if both prices and quantities sold change in various directions, how do we attribute the weights to form the average of the percentage changes? There are so many possible indices. Not only that, but it has been shown that there are not even criteria that all good indices must meet. But there are even more serious problems because in modern economies products and services change qualitatively in any reasonable period of observation. Not only that, but due to innovation some products and services cease to exist and new products are placed on the market.

The final conclusion is that we cannot establish an index of price change. There is no single way to calculate a price level and its percentage change when prices and quantities change in all directions and when there is a process of rapid qualitative innovation, both technological and symbolic, and when products are subject to rapid osolescence and are quickly replaced by other products.

Inflation is not a true observable. Inflation is a theoretical term that must be defined within the theory. (this is a critical point to which we will return)

3. Qualitative improvements are calculated as inflation

In practice, in all modern economies, inflation is calculated from the Consumer Price Index (CPI). The idea is simple. It is not possible to calculate the price fluctuation indexfor the whole economy. Then we calculate it only on a representative and static basket of goods. The inflation thus calculated is extended to the whole economy.

The price change index assumes that the products in the basket remain unchanged. Consequently, qualitative changes are not considered (hedonics have limited applicability). Price changes resulting from qualitative changes are calculated as inflation. For example, in the period 1950-2020 the American nominal GDP per capita grew by 36 times which are factored in 4 times real growth and 9 times nominal growth. These figures seem clearly misleading when we consider the level of innovation in the 70 years from 1950 to 2020.

Inflation is overestimated and real growth underestimated

4. Money is not taken into account by macroeconomics

Macroeconomics tends to model the real economy and considers money a transparent superstructure. The reality is different. Money is created with credit. When banks lend, and therefore increase the mass of money that exists, they create purchasing power. This fact has two consequences. The first is that credit, and therefore the creation of money, is potentially destabilizing. In fact, credit can create purchasing power in excess of the debtor's ability to repay the debt. Hyman Mishkin described the destabilizing power of credit. The second is that credit creates the possibility of monetary profits and therefore the possibility of accumulating excess capital of real capital.

5. Modern economies are segmented into sub-economies that move at different speeds

Modern capitalistic economies are segmented into different segments that grow exponentially at different rates. For this reason, not only do social inequalities continue to grow, but capital accumulation is growing faster than the average speed of the economy. This is a condition that leads to crises.

The segmentation of the economy is not taken into account by economic policies that continue to make decisions as if the economy were a homogeneous entity. This can lead to harmful decisions. For example, raising interest rates to counter inflation can be a very negative maneuver. Another example is unemployment and underemployment, which are structural phenomena linked to the segmentation of the economy and do not have simple relations with GDP.

Having summarily described the criticisms that I believe can be made of economic theory, I would now like to describe what could be done to make economic theory more scientific and decision-making more effective. It must be said right away that it is a very challenging change because it must change at the same time economic theory and practice, both well rooted both in academic structures and in decision-making processes.

Together with some co-authors I described the fundamental lines of a new economic theory as a function of the green transition in the article Frank J. Fabozzi, Sergio Focardi, Linda Ponta, Manon Rivoire, Davide Mazza, "The Economic Theory of Qualitative Green Growth", Structural Change and Economic Dynamics, March 2022.

The fundamental points are as follows.

1. Economic theory must follow the scientific method

First of all, economic theory must follow the scientific method. This implies not only adhering to a discipline of empirical verification, but, above all, following a rigorous process of formation of concepts. The basic point is that scientific concepts and variables are linked globally to empirical observations. Scientific theories are conceptual constructions that respond globally to empirical verification. Concepts such as temperature are not directly observable. However they enter the formulation of thermodynamics as theoretical concepts and are observed through processes that include the entire physical theory.

In economics this means that we can only define a monetary macroeconomic theory in which concepts such as output, capital, and inflation are theoretical terms related to monetary or other observables throughout the theory. There can be no intuitive terms in economic theory but only theoretical terms related to observable throughout the theory.

2. Economic theory must include qualitative terms

Qualitative terms are not terms related to perceptions of well-being or other perceptions by economic agents. Qualitative terms are terms defined in terms of complexity. Measures of complexity are an essential element of a modern economic vision. The basic idea is to consider modern economies as complex evolutionary systems.

This is not the only possible formulation of economic models. For example, it is possible to formulate multi-agent models of the economy. It should be noted that economic theory is not the study of laws of nature. Economic theory is the study of the behavior of a human artifact the economy. In particular, we study capitalistic economies. Other economic and social structures are possible and, presumably, require different types of analysis

3. Economic models

The economic models we propose are Stock Flow Consistent models following the ideas of Winne Godley and Marc Lavoie. In the simplest formulation they include monetary variables and abstract variables that represent the real economy. Inflation is calculated by dividing products and services into two categories: simple products and complex products. Simple products are products with low complexity while complex products are products that have a high complexity index according to the Product Complexity Index of Hidalgo and Hausman. It is stipulated that inflation is zero for high-complexity products while it is calculated by the usual methods for low-complexity products. More complex versions of these models explicitly include segmentations of the economy.

4. What is the fundamental difference of these models?

The fundamental difference of these models compared to classical theory is the ability to consider complexity and qualitative elements. The practical difference is this: considering the qualitative aspects of the economy, the real growth of modern economies is much higher than the "official" growth, and inflation is much lower. Modern economies are segmented with different growths for different segments.

5. What can change bring about?

The green transition is the driving force that can produce change. Governments and companies will quickly be faced with a problem of resource scarcity. They will therefore have the choice between driving a ruinous economic degrowth with an explosion of social inequalities or trying to steer the transition to a qualitative economy. At that point the theoretical change will impose itself.

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