Realism in economics and physics: the issue of averages

Most Austrians tend to say that the problem with the modern mainstream of economic science is that they use the standards of intellectual inquiry that are dominant in physics. The mainstream economists are thus guilty of what Hayek (if I am not mistaken) called ‘physics envy’.

According to those Austrians, mathematical modelers attempt to make unrealistic models of reality and then test them, like physicists do. But do physicists (at least classical physicists from whose work much of the modern mathematical methods in economics were borrowed) really do what they are charged with?

Let us take the theory from which the indifference curves were borrowed, the isotherms of the Carnot cycle of thermodynamics. Now, of course the theory makes a somewhat unrealistic assumption that the reservoir that is used to maintain the temperature constant throughout the experiment is infinite. But I think the infiniteness can be thought of as a harmless approximation in measurement.

Another retort would be to say that the thermodynamic description of the Carnot cyckle utilizes averages like say macroeconomics does. In particular, temperature is nothing but certain average of the kinetic energy of the molecules inside the closed system multiplied by a constant. Why then not say that physicists are as unrealistic as macroeconomists who utilize the constructs like price levels?

The answer is that not all averages are made equal. It is possible to average over the same units. And in physics speed is kinetic energy is kinetic energy, regardless of the object.*

Kinetic energy is an objective mathematical dimension that can indeed be averaged. But what about price. Is price really a measure like speed is? The answer is an obvious no. The prices are not actually 2$ and 3$, they are 2$/banana and 3$/orange. Dollars are thus not units of some measure of a good. They are just units of money. Averaging over such units does not give a price, it gives the average amount of units of money that changed hands which, however subtle this idea might be, is a wholly different thing from price.

Thus, the stake can be turned against mainstream economists. The creators of thermodynamics did not do the unrealistic modeling, they stayed faithful to the elements of the world which they were describing. So should economists.

*A question may be asked how we can know it. There is clearly no experiment that could prove this idea. Thus the hypothetico-deductive conception of physics is clearly wanting. Classical physics at bottom is clearly based on fundamental bits of experience but not on experiments.

Labor market power from the Austrian perspective

Daniel Kuehn wrote a post about the effects of minimum wage laws in the context of market power and fixed costs. He presents the issue of market power as if it were unambiguous. I would like to raise a brief Austrian dissent.

The question of market power is probably one where the contrast between the mainstream and the Austrian approaches is starkest. From an Austrian standpoint there is no way to objectively measure the marginal product of an employee and compare it with the salary.

But a more important point is that there are strong dynamic mechanisms that will push employers toward paying employees in accordance with how much value they add, although of course this convergence isn’t going to be perfect. In particular, there is an opportunity for potential competitors to discover that certain employees are underpaid and to lure them away from their current employers. This will induce current employers to keep salaries close to the marginal product level.

Another mechanism arises from the fact that it is in entrepreneurs’ own interest to try to pay employees as close to the marginal product as possible because if they do not do that it will falsify their profit calculations.

Neither of the points I mentioned can be captured by mainstream models, no matter how sophisticated mathematically. And the upshot is that it is not at all clear that employers will exercise whatever the market power they might have in particular hiring transactions.

Free will can be physically grounded

One popular philosophical argument in favor of religion and the existence of souls (substance dualism) is the argument based on the impossibility of accepting at the same time the existence of personhood as we ordinarily think of it and the physical grounding of the mind.

The problem that gives rise to the argument is that we know that what we experience as our free choices seems to have actual physical effects in that electric signals are sent down the nerves. But then the question becomes how these supposedly free choices (that can’t be purely physical because they wouldn’t in that case be free) may have physical consequences but be grounded in physical phenomena but at the same time not be reducible to them. It is the combination of these three features that makes the grounding of free will in physicalism problematic. Physicists claim that physical phenomena are deterministic from which they deduce that the phenomena that are not reducible to physical phenomena may not have physical effects, unless some supernatural mechanism is at work. So it seems that one may not have freedom of choice and physical grounding at the same time.

It seems that the argument is damning until we ask the same question about chemical phenomena that also have physical effects.

There is a good case to be made that chemical phenomena are not reducible to the micro-physical ones (see, e. g. this article by the Nobel Prize winning chemist Roald Hoffmann). Yet, clearly, many chemical phenomena have physical effects and are at the same time grounded in physical phenomena (or, in the language of the modern philosophy, supervene on them). There is nothing that would make mental phenomena like choices in principle different in this sense. Thus, the dichotomy between the physical grounding of the mind and the existence of free will seems to be a false one.

We don’t Owe it to Ourselves

Richard Ebeling’s post over at ThinkMarkets has reminded me about one very dangerous meme that is even shared by many professional economists, including Lawrence Klein to whom Ebeling’s post is devoted. This meme is that public debt is something that “we owe to ourselves” and thus it presents no significant problem.

This is one of the many cases where people fall victim to what may be called money fetishism. Of course in purely monetary terms there is no problem with public debt because it is possible for the government in the end to print as much money as possible even if taxes are not sufficient to cover the public debt obligations.

This is true but it disregards the sheer magnitude of public debts, especially of its lion’s share constituted by pension and health care promises to the future retirees.  Monetary fetishism here obscures a very important point: the pension and health care claims are ultimately claims not for money but for real goods. When people retire and thus cease to work they reduce productivity of the economy.  At the same time the promises to them imply that the productivity of the economy may not fall significantly after their retirement. Thus, the only way to provide for their retirement is for them to increase the productivity of the economy prior to their retirement by improving the economy’s capital and getting a share in this improvement.

The pension and public medical “insurance” systems that are used in most of the countries are based on the so-called pay-as-you-go model where most if not all of the money taken from the current employees have for a long time not been invested but instead just redistributed to the (then) current retirees. This means that the increases in productivity of the economy over the lifetimes of current employees will almost definitely be insufficient to provide them with the lifestyles that they expect after retirement, unless the innovations of 3D printing, nano- and biotechnologies lift the debt boat. No amount of monetary sophistry may change this basic fact which is not dependent on money at all.