January 31, 2016

Economists cannot do the simple math of profit — better keep them out of politics

Comment on ‘Paul Krugman, Bernie Sanders, and the Experts’

Blog-Reference and Blog-Reference and Blog-Reference on Feb 3

Economists are supposed to be experts on the economy. So it is quite natural to think that they know what profit is; after all, this is the pivotal phenomenon of their subject matter. Yet, this is definitely not the case. And this means that economists give economic policy advice without having a true understanding of the market economy. This holds for Walrasians, Keynesians, Marxians, and Austrians.

This is not to say, of course, that economists know nothing. In fact they know some easy to grasp practical, institutional or historical details. This, though, is not what science is all about. When the task is to explain how the universe works and the astronomer goes on describing in great detail how his kitchen works then one is inclined to think that this expert is a moron.

The situation is analogous in economics. You have much expert talk about whether the Fed should or should not lower the interest rate but all these guys have no idea of how the market system works because they have not figured out since Econ 101 what the crucial difference between profit and income is.

All this is by no means new or some hidden secret of the profession. Every economist knows, or can know because it is in the Palgrave Dictionary, that “A satisfactory theory of profits is still elusive.” (Desai, 2008, p. 10)

So, the simple fact is that economists do not know what profit is, and this means that they do not know how the market system works, and this in turn means, that their economic policy advice has no sound scientific foundation.

When economists talk about the economy this is storytelling decorated with some charts of crossing curves and exemplified with some actual numbers. It looks more scientific than tea leaves reading but, clearly, an economic model that is based on nonentities and inconsistent concepts is not different in principle from a cup of tea leaves.

The fact of the matter is that economists are incompetent scientists who fail already at the level of elementary math. This assertion, of course, needs a formal proof.

This is the set of premises to start with (each step of the argument can be checked on the back of an envelope by inserting arbitrary numbers for L, W, R):
(0) The objectively given and most elementary configuration of the (world-) economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm.
(i) Yw=WL wage income Yw is equal to wage rate W times working hours. L,
(ii) O=RL output O is equal to productivity R times working hours L,
(iii) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.

These premises are certain, true, and primary, and therefore satisfy all methodological requirements. The set of premises is minimal, that is, it cannot be reduced further, only expanded. The set contains no nonentities like maximization or equilibrium and no normative assertions. For the graphical representation see here.

At any given level of employment L, the wage income Yw that is generated in the consolidated business sector follows by multiplication with the wage rate W. On the real side, output O follows by multiplication with the productivity R. Finally, the price P follows as the dependent variable under the conditions of budget balancing, i.e. C=Yw and market clearing, i.e. X=O. Note that the ray in the southeastern quadrant is not a linear production function; the ray tracks any underlying production function. Note also that the wage rate W is an average if the individual wage rates are different among the employees, which is normally the case.

Under the conditions of market clearing and budget balancing in each period the price is derived as P=W/R (1), i.e. the market clearing price is always equal to unit wage costs. This is the most elementary form of the Law of Supply and Demand.

If the wage rate W is lowered, the market clearing price P falls. If the number of working hours L is increased the price remains constant, provided productivity R does not change. If productivity decreases the price P rises. If productivity increases the price falls. In any case, labor gets the whole product, the real wage W/P is invariably equal to the productivity R according to (1), and profit for the business sector as a whole is zero. All changes in the system are reflected by the market clearing price. The most elementary economy is reproducible for an indefinite number of periods. For the inclusion of money see (2014).

To define a reproducible minimal economy and to make its properties absolutely transparent has been the first step. With the second step the conditions of market clearing and budget balancing have to be lifted. This produces the phenomena of inventory changes (O-X>0 or <0) and of saving/dissaving (Yw-C>0 or <0) and of profit/loss (C-Yw>0 or <0).

One has three logical cases for the household sector Yw-C=Sm>0, <0, =0, that is, the household sector either saves Sm>0, dissaves Sm<0, or balances the budget Sm=0.

One has three logical cases for the business sector C-Yw=Qm>0, <0, =0, that is, the business sector either makes a profit Qm>0, a loss Qm<0, or breaks even Qm=0.

The balances of the two sectors add up to zero Sm+Qm=0. This follows directly from the definition of saving/dissaving Sm and profit/loss Qm.

This gives one the most elementary version of the profit law: profit is positive if the households dissave (increase debt/decrease financial assets) and negative if the households save. So profit for the economy as a whole has nothing to do with productivity, the wage rate, or risk or any other of the usual explanations which stem from the observation of a single firm among many others. In fact, exactly here is where error/mistake comes in because what is true for a single firm is not true for the economy as a whole. This logical blunder is well-known as fallacy of composition.

In science, there is no need at all to believe in anything. Science is not about credibility or expert opinion or whether the scientist is simpatico, but alone about proof, that is, logical and empirical consistency.

Imagine a simple experiment for the ongoing election campaigns. Ask every economist who comes along with a proposal of how to fix the economy about his underlying model. Check what this model says about profit. Admit only those economists to public discussion whose profit theory is correct — the silence will be deafening.

Egmont Kakarot-Handtke


References
Desai, M. (2008). Profit and Profit Theory. In S. N. Durlauf, and L. E. Blume (Eds.), The New Palgrave Dictionary of Economics Online, pages 1–11. Palgrave Macmillan, 2nd edition. URL
Kakarot-Handtke, E. (2014). Economics for Economists. SSRN Working Paper Series, 2517242: 1–29. URL

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REPLY  comment on anne of Jan 31

I summarized “The fact of the matter is that economists are incompetent scientists who fail already at the level of elementary math. Because of this their economic policy advice has no sound scientific foundation.” This summary is based on the shortest possible formal proof.

You say “Beyond this confusing criticism I have no idea what the essay is about and suggest a clear and simple summary. Unless a clear and simple summary is set down, I at least will never again read a sentence by this writer.”

This makes my point that economists (including anne) cannot grasp an elementary proof, much less formulate a consistent economic theory/model.

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REPLY  comment on anne of Jan 31

(i) You know pretty well that it is a silly game to ask for a two-line summary of an argument that rectifies the conceptual foundations of economics.

(ii) It is well known that it takes more words to correct/explain a faulty proposition than to make one. To say ‘the sun goes up’ is short and immediately convincing, to explain why this is an optical illusion takes a whole book at minimum.

(iii) Marginalism had more than 140 years and a lot of manpower to fully develop an axiomatically ill-founded approach [“most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point” (Krugman)]. Fairness alone demands that you grant more than a two-liner for the refutation of entrenched neoclassical junk.*

(iv) To demand a catchy summary and then to complain that a lot has been left out which unfortunately makes the argument incomprehensible is an outworn catch-22.

(v) If you need more information for understanding new economics you will surely find it. If you “will never again read a sentence by this writer” that is perfectly in order and the inalienable privilege of all irredeemable proto-scientific economists.

* See ‘Economists and methodology: the horror of all horrors

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REPLY  comment on anne of Jan 31 on Feb 1

(i) My post has been cut off in the middle. For the intact text see here.

(ii) My key point is “So, the simple fact is, that economists do not know what profit is, and this means that they do not know how the market system works, and this in turn means, that their economic policy advice has no sound scientific foundation.”

(iii) I give a formal proof for the known fact that profit theory is false since Adam Smith (2014). Every intelligent non-economist can check this proof.*

(iv) From this proof follows: neither you nor any of the expert-economists you quote/defend/support has realized until this very day that their underlying model is logically and empirically defective and therefore unacceptable (2015).

(v) Now you ask me “Again and finally, discuss a single tangible economic problem with feeble me and I will bother reading another line. Structural change in the Chinese economy? Growth in India? Dependence on commodity exports in Africa? I am waiting.”

(vi) Clearly, there is no point in discussing these issues with an economist who cannot tell the difference between profit and income. But it would be a good idea to inform yourself first about the correct employment theory.** Then we can together answer the question why the Fed’s 2 percent inflation target is the most stupid idea so-called expert-economists ever came up with.

(vii) Incompetent economists are a menace to their fellow citizens.


References
Kakarot-Handtke, E. (2014). The Profit Theory is False Since Adam Smith. What About the True Distribution Theory? SSRN Working Paper Series, 2511741: 1–23. URL
Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working Paper Series, 2624350: 1–40. URL

* See the post ‘How the intelligent non-economist can refute every economist hands down
** See the post ‘How to save the economy from storytelling economists

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REPLY  comment on anne of Feb 1 on Feb 2, summary of the correct employment equation

The price mechanism does not work as standard economics imagines. As a matter of fact, overall employment increases if the average wage rate increases relative to average price and productivity. This gives one the lever to improve the employment situation all over the world and to fend off deflation without rising debt and without artificial capacity growth. To increase the average price relative to the average wage rate and productivity increases unemployment. This is current Fed policy.

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REPLY comment on Ken Zimmerman of Feb 4

You say: “If scientists didn’t believe there was something to observe, there are ways to do those observations that will help the scientist understand the observed, and that all the work of observing would lead to better understanding why would they waste the time doing it? Science itself is just one big belief, on big faith.”

You are a bit behind the curve as far as the relationship between theory and observation is concerned. And, worse, you have not yet gotten the fundamental distinction between belief (= religion) and knowledge (= science).

What commonsensers and naive empiricists have never understood is that science starts where their myopic common sense ends. Here is the classical example.

Roughly speaking, Aristotle put the Law of Motion thus: every body moves to his natural place of rest. Then he took a stone and threw it skywards. The stone came down some meters away. Never in the history of mankind had a law better been empirically tested and confirmed without exception.

Against this, Galileo said, roughly, every body moves in a straight line until eternity. An empirical proof could not be given until space flight was possible.

Nevertheless, this counter-intuitive assertion reappears as the first axiom of motion in Newton’s Principia. (Axiomata Sive Leges Motus, Wikipedia)

And this is what Galileo told naive empiricists and commonsensers and brain-dead realists about the essence of science: “I shall never be able to express strongly enough my admiration for the greatness of mind of these men who conceived this [heliocentric] hypothesis and held it to be true. In violent opposition to the evidence of their own senses and by sheer force of intellect, they preferred what reason told them to that which sense experience plainly showed them ... I repeat, there is no limit to my astonishment when I reflect how Aristarchus and Copernicus were able to let conquer sense, and in defiance of sense make reason the mistress of their belief.” (quoted in Popper, 1994, p. 84)

The only thing scientists believe in is formal and empirical proof. Economics is a failed science. It has been logically and empirically refuted. There is no such thing as an economic expert. Peer review does not work in economics because author and reviewer share the same false belief (2013).


References
Kakarot-Handtke, E. (2013). Confused Confusers: How to Stop Thinking Like an Economist and Start Thinking Like a Scientist. SSRN Working Paper Series, 2207598: 1–16. URL
Popper, K. R. (1994). The Myth of the Framework. In Defence of Science and Rationality., chapter Science: Problems, Aims, Responsibilities, pages 82–111. London, New York, NY: Routledge.

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REPLY comment on Norman L. Roth on Feb 4

You certainly have to take Georgescu-Roegen off the list because he and I are of one mind: “Knight lamented that there are many members of the economic profession who are ‘mathematicians first and economists afterwards.’ The situation since Knights time has become much worse. There are endeavors that now pass for the most desirable kind of economic contributions although they are just plain mathematical exercises, not only without any economic substance but also without mathematical value. Their authors are not something first and something else afterwards; they are neither mathematicians nor economists.” (Georgescu-Roegen, 1979, p. 317)

So, yes, I think and even prove that economists are “incompetent scientists who fail at the level of elementary math.” *


References
Georgescu-Roegen, N. (1979). Methods in Economic Science. Journal of Economic Issues, 13(2): 317–328. URL

* See also ‘How the intelligent non-economist can refute every economist hands down

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REPLY  comment on Ken Zimmerman of Feb 5

In methodology, there is the distinction between the context of discovery and the context of justification. What Kuhn and others have put forth was a sociology/history of how major paradigm shifts have happened. Mirowski did the same in the field of economics, e.g. (2009). With rare exceptions, though, economic methodology has entirely degenerated to storytelling and gossiping “Much of the work in methodology over the last ten years has thus consisted of methodological analysis of what economists do and how they argue.” (Dow, 1997, p. 78)

The context of discovery appeals very much to so-called social scientists. This is because the only way they can understand the world is in the form of a narrative, i.e. Galileo said the earth moves, the Pope did not like it, he mobilized the Inquisition, Galileo was put on trial, he did not recant, after his conviction he said the historical words ‘Eppur si muove’. This is the stuff Hollywood then makes a sitcom of.

With regard to the context of justification Kuhn stated: “First, a theory should be accurate within its domain, that is, consequences deducible from a theory should be in demonstrated agreement with the results of existing experiments and observations. (quoted in Redman, 1993, p. 3)

This is pretty much in accordance with what I said, isn’t it?

The unbridgeable difference between genuine scientists and so-called social scientists is that the former seek a clear decision between true or false while the latter are happy with storytelling in the vast realm between true/false where “nothing is clear and everything is possible.” (Keynes, 1973, p. 292).*

To see the crucial point it suffices to compare the scientist Newton and the economist Adam Smith: “But he [A. Smith] had no such ambitions; in fact he disliked whatever went beyond plain common sense. He never moved above the heads of even the dullest readers. He led them on gently, encouraging them by trivialities and homely observations, making them feel comfortable all along.” (Schumpeter, 1994, p. 185)

Economics never moved above the heads of the dullest readers until this day.

References
Dow, S. C. (1997). Mainstream Economic Methodology. Cambridge Journal of Economics, 21: 73–93.
Keynes, J. M. (1973). The General Theory of Employment Interest and Money. The Collected Writings of John Maynard Keynes Vol. VII. London, Basingstoke: Macmillan.
Mirowski, P., and Plehwe, D. (2009). The Road From Mont Pelerin. The Making of the Neoliberal Thought Collective. Cambridge, MA, London: Harvard University Press.
Redman, D. A. (1993). Economics and the Philosophy of Science. New York, NY, Oxford: Oxford University Press.
Schumpeter, J. A. (1994). History of Economic Analysis. New York, NY: Oxford University Press.

* See ‘Economics as fool’s paradise

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REPLY comment on Ken Zimmerman of Feb 6

Economics claims to be a science: “Starting with Adam Smith’s history of astronomy, the main theorists of classical economics sought to capture the essence of the scientific method in order to employ in the sphere of economic research.” (Mirowski, 1995, p. 198)

What is the essence of science? “Research is in fact a continuous discussion of the consistency of theories: formal consistency insofar as the discussion relates to the logical cohesion of what is asserted in joint theories; material consistency insofar as the agreement of observations with theories is concerned.” (Klant, 1994, p. 31)

In more than 200 years economists have not produced much of scientific value but very much of silly storytelling.

In view of obvious scientific failure, economists have to make up their minds: (i) to stick to storytelling and to voluntarily get out of science, or (ii), to comply with the methodology and ethics of science and to come up eventually with the true theory of how the economy works.

As Eichner put it more specifically: “Economics as a discipline therefore has a choice: It can retain the neoclassical core of its theory or, alternatively, it can one day become a science. It cannot have it both ways.” (1983, p. 518)

Make no mistake, when the dust is settled and the history of science becomes written neither an orthodox nor a heterodox economist of the last 200 years will appear in the index under the heading Scientists.


References
Eichner, A. S. (1983). Why Economics Is Not Yet a Science. Journal of Economic Issues, 17(2): 507–520. URL
Klant, J. J. (1994). The Nature of Economic Thought. Aldershot, Brookfield, VT: Edward Elgar.
Mirowski, P. (1995). More Heat than Light. Cambridge: Cambridge University Press.

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REPLY  comment on Jon Cloke of Feb 6

Entertainment is about like/dislike, science is about true/false.

The problem with Krugman is that his economic policy arguments have no sound theoretical foundation. He, for example, uses still IS-LM or a variant thereof. Because the IS-LM model is provable false since Keynes/Hicks this is a reliable indicator of logical incompetence (2014).

Whatever Krugman argues for or against is his personal opinion. Having disqualified himself, he has no legitimacy to speak in the name of science.

References
Kakarot-Handtke, E. (2014). Mr. Keynes, Prof. Krugman, IS-LM, and the End of Economics as We Know It. SSRN Working Paper Series, 2392856: 1–19. URL