• Sergio Focardi

What damage can modern economies suffer as a result of inadequate economic theories?

Wrong theories can produce serious damage. For example, the De Havilland Comet aircraft was the first commercial jet aircraft. The Comet made its first scheduled flight in 1952 between London and Johannesburg via Rome and in 1958 was the first commercial jet aircraft to make a transatlantic flight.


But the Comet suffered a series of serious accidents. The reason for these accidents was the fatigue of metal a phenomenon at that time not well known. The Comet was withdrawn from service and redesigned. The Comet accidents are an example of accidents that occurred due to inadequate theoretical knowledge.


Mainstream economic theory suffers from fundamental inadequacies. Decisions made on the basis of mainstream theory can therefore be suboptimal and possibly harmful. But first of all let's remember the main inadequacies of mainstream theory. The fundamental problem of economic theory is its inability to recognize that modern economies are complex adaptive systems. Mainstream economic theory was developed at times when economies evolved slowly and did not have the complexity that characterizes modern economies. In particular, mainstream economic theory has the following weaknesses:


  1. Mainstream theory uses a concept of inflation that does not fit into modern evolutionary economies. In fact, inflation is conceived as an increase in prices. But given the heterogeneity and rapid evolution of products and services, we can roughly estimate the change in prices only over short periods of the order of one or two years. Over longer periods, inflation is a theoretical term that does not represent price increases.

  2. Real economic growth cannot be estimated for the same reasons. We can't calculate the amount of output because we can't aggregate heterogeneous products and services that are constantly changing.

  3. We can only calculate the value of the output, the nominal GDP. But to compare GDP at different times would require a different concept of inflation. Today the real GDP is calculated by discounting the nominal GDP with the price change index. But in this way innovation, qualitative improvements in products and services are neglected.

  4. As a result, the concept of economic growth completely neglects qualitative growth. Real GDP growth completely ignores fundamental qualitative growth in modern economies.

  5. The role of money is not appreciated in economic or mainstream theories.

  6. Modern economies are dual systems, formed by sub-economies that grow at different speeds

  7. In addition, for financial reasons, the value of capital grows much faster than the value of the economy creating situations of imbalance


Let us now discuss how these inadequacies can lead to economic damage. We will look at three cases in particular: economic growth, inflation, and productivity.


Economic growth

The concept of economic growth adopted today in the political-economic decision-making process is vague and ambiguous. In fact, it is impossible to define a concept of quantitative output growth due to the heterogeneity and innovation of products and services. The growth of the real Gross Domestic Product (GDP) is then used. Real GDP is nominal GDP discounted by a factor that represents inflation. But the interpretation of this number is unclear.


As discussed in previous posts and in some articles, inflation should represent the increase in the prices of goods and services that remain stable and do not change. But in advanced modern economies few products remain stable. What is calculated as inflation over medium to long periods is a theoretical term that is difficult to interpret because price changes due to qualitative factors are partly calculated as inflation.


Today, qualitative growth is not considered true growth. A nation can show a growing GDP but, at the same time, see its complexity ranking fall. For example, let's look at the evolution of the ranking of Economic Complexity Indexes (ECIs) calculated by OEC (Observatory Of Complexity):"


https://oec.world/en/rankings/eci/hs6/hs96.


In the period 2000-2020 Italy lost 6 positions going from the thirteenth to the nineteenth position, despite its real per capita GDP has remained almost constant, albeit with considerable fluctuations. On the other hand, Slovenia also moves from seventeenth to twelfth position with a constant real per capita GDP.


The Economic Complexity Index – ECI – is a measure of a nation's capabilities that contribute to its competitiveness. In the period 2000-2020 Italy lost competitiveness because it did not invest in the creation of knowledge and skills. By contrast, Slovenia has invested in research and its competitiveness, as measured by its economic complexity index, has improved.


Governments make decisions about the economy using a measure of growth that does not take qualitative growth into account. This can lead to erroneous industrial policy decisions. For opportunistic reasons, governments may neglect the knowledge and complexity aspect in favor of decisions that may lead to growth in the short term but undermine the nation's future competitiveness.


Neglecting qualitative growth is always a mistake but it is a particularly serious mistake in the present situation. Indeed, the green transition will require economic growth to be decoupled from the use of natural resources and therefore will require increasing complexity.


Productivity

The inability to consider qualitative growth as true growth has other economic consequences. For example, it has been observed that labour productivity growth has declined since the 1990s despite the contribution of information technology and automation. This seems strange in a world characterized by an increasing use of automation. But it is impossible to evaluate productivity directly as an amount of output. As discussed in posts and articles, the physical amount of output is not an observable quantity due to heterogeneity and innovation of products and services.


There are several definitions of productivity that depend on the industry and the factors considered. The most widely used measure of productivity in relation to a nation is the ratio of real GDP to the number of hours worked. The first observation to be made is that this measure of productivity is not realistically applicable to inherently dual economies. Modern economies concentrate the production of high value-added goods and services in smaller and smaller segments of the population while ever larger segments are employed in low-value-added labour. Productivity as real GDP divided by the number of hours worked makes no sense in the presence of a strong heterogeneity of the workforce.


The second observation concerns the measure of real GDP. The functional value of modern economies is increasingly linked to the complexity of the economy not to the quantity of objects produced. But real GDP does not measure the complexity of an economy. Therefore, the ratio (real GDP)/(number of hours worked) is not a good indicator of the efficiency of an economy. Raising productivity may imply investment in productions incompatible with the green transition.


Decisions to raise productivity can actually produce a worsening of a country's know-how and therefore of its competitiveness at the international level. This is because a government might take an industrial policy decisions which tend to expand the economy without increasing its complexity and therefore its know-how. The same happens with labor policies that intend to grow the economy by increasing the number of hours worked instead of the quality of work.


Of course, making decisions in favor of complexity is not easy because it requires a cultural change that appreciates quality. Above all, it requires a more equitable distribution of wealth and profits. Qualitative growth requires a population that is able to appreciate quality and to be able to afford it. This implies a more egalitarian economy.


Inflation

If inflation, measured with current methods, begins to increase and reaches high levels of the order of 6-8% immediately central banks put in place actions to contain inflation. Typically, these actions consist of raising interest rates to slow economic growth so as to increase unemployment and allow the economy to absorb demand growth without producing inflation.

Raising interest rates to slow down the economy, raise unemployment, and eventually produce a real recession does not seem like a socially viable strategy for reducing inflation.


And in fact in the modern world it is not. First of all, as we have discussed in posts and articles, given the measurement of inflation carried out today, a fast qualitative growth is most likely interpreted as inflation. At the base we have a theoretical problem whereby an increase in economic complexity is interpreted as inflation.


As a result of the qualitative growth of the economy, households experience inflation. The answer should not be to contain household demand in such a way as to reduce price increases but a wage policy that adjusts wages to a qualitatively richer and therefore more expensive economy. But this brings us back to the previous point, an economy that grows qualitatively must make everyone grow and not increase inequalities.


But this is not the only problem. Part of the inflation recorded by households is the result of speculative phenomena. In the absence of an organized response from workers, companies raise prices to increase profits. This is the interpretation of inflation that was originally proposed by Michal Kalecki and that is now taken up by several authors such as Mario Seccareccia and economists from the Federal Reserve, David Ratner and Jae Sim, who have supported a Kaleckian view of inflation in a recent working paper.


Empirically it is found that the Phillips curve, a curve that expresses the relationship between inflation and unemployment, is now flat. This means that a large rise in interest rates is needed to produce an appreciable change in inflation at the expense of a large increase in unemployment.


The new economic theories recognize that inflation is a social phenomenon due to the conflict between workers and companies over prices and wages. Inflation must not be cured by creating a recession but by producing a richer and more egalitarian economy.


In summary

The three preceding points highlight how theoretical errors due to lack of understanding of the evolutionary and complex character of modern economies lead to harmful consequences for economies. These harmful consequences are not evenly distributed. The poorest social classes with less social power are the most affected. Avoiding these consequences would require a rethinking of economic goals and the acceptance of a society much more egalitarian than the present one.


Major changes towards a society that is both qualitatively more sophisticated and more egalitarian are unlikely to take place as a result of an endogenous push towards better social justice. The change, if there is change, is probably related to the green transition. Faced with environmental problems that are becoming catastrophic, there are two possible answers: one is degrowth, which in practice means the impoverishment of the masses and a growing domination of the elites. The other is qualitative change, with the formation of more sophisticated and more egalitarian economies.


It is very difficult to predict today which attitude will prevail. The signals are not good. While we are beginning to ask the large masses of the population for energy savings and consideration for waste, we are witnessing elite consumption that is really not friendly to the environment: colossal yachts, cars capable of exceeding 400 km per hour, and even space tourism. And on the international background, the war has also reappeared in regions that were considered "civilized" and therefore immune from the violence of war.


We can say, albeit with some hesitation, that human history, over long periods, is a history of progress. We could also apply these considerations to the present times. Even with ups and downs, the improvement of technological capabilities and the improvement of the cultural level of the population should lead to social improvement. But we must understand that any mistakes now can prove catastrophic. We are changing the climate and influencing biological phenomena on a large scale. We must rapidly develop the awareness that there is no room for error.

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