How the Economy Came to Resemble the Model

Business Economics, Jan, 2000 by Alan S. Blinder

A CONVERGENCE OF FORCES IS DRIVING ECONOMIES AND THEIR INDIVIDUAL ACTORS CLOSER TO THE CLASSICAL MICROECONOMIC MODEL--A TREND TO BE RECKONED WITH IN BUSINESS PLANNING.

Over the years, economists have spent much effort to modify the capitalist, perfect-competition, profit-maximizing model of classical microeconomics to fit reality. Thus, it is ironic that in recent times reality has been approaching the classical model. This is due only in part to the persuasive talents of economists, and not all of this change is necessarily an improvement. Among the factors contributing to the reversion to the classical model are the failure of socialism, alignment of managerial and shareholder interests, focus on shareholder value, decline of labor union power, changes in financial markets, global competition, and changes in regulatory practices.

George Stigler (1976, p. 351) wrote that "economists exert a minor and scarcely detectable influence on the societies in which they live." I don't believe that is true any longer. In fact, I want to make--and then defend-- an audacious claim that directly contradicts Stigler. Since he wrote those words, real-world economies, including ours, have changed in a number of ways that bring them into closer alignment with the pristine model envisioned by economic theory. In this curious sense, life has come to imitate art.

But this essay is not meant as a piece of boosterism for economic theory. The arguments of economists, persuasive as they may have been, were not necessarily the main reason for the changes in real economies. Nor were all these changes unambiguously for the better. Nor do I claim that every previous discrepancy between the real world and the model has been resolved in the model's favor. However, I do perceive a general pattern, and it is an ironic one. One might have assumed that economists would have to adjust their models to fit reality, rather than the other way around. That's certainly the way it works in the natural sciences. Germs did not change their behavior to accommodate Pasteur's theory, nor was Mercury's orbit perturbed so that Einstein wouldn't be. But economists appear to have bent reality (at least somewhat) to fit their models. That's quite a feat.

The Fall of Socialism

I begin with the most obvious, and certainly the most important, change that falls under this rubric: the replacement of socialism by capitalism in almost all the formerly socialist countries. No other victory of the model is nearly so fundamental. But, because it is so obvious, I will deal with it only briefly.

Received economic theory is, of course, a theory of capitalism. Our models envision owners of capital who hire workers, pay them a wage, and keep the residual (positive or negative) for themselves. Workers do not hire capital at a fixed rental rate. But other systems of organizing production are imaginable. Back in the l930s, there was a lively intellectual debate on the possibility of "market socialism," examining (among other things) whether a socialist system could replicate or even surpass the virtues of the invisible hand, despite public ownership of capital. [1] I claim no great expertise on that debate. But I think a bowdlerized version of the outcome was that market socialism could indeed mimic the achievements of capitalism in the realm of static efficiency--at least at the level of pure theory, but that market socialism would find capital formation and allocation problematic, and would founder badly when it came to risk-taking and entrepreneurship.

The latter proved true, of course. Socialist economies found themselves noticeably short of "high rollers" and more or less incapable of coping with Schumpeterian "creative destruction." They were, instead, bureaucratic and ossified. In fact, the competition between capitalism and socialism proved to be even more lopsided in practice than it was in principle. Real-world versions of socialism in Eastern Europe and elsewhere fell vastly short of Lange's market socialist ideal and thus failed to come close to matching capitalism--even on the comparatively "easy" criterion of static efficiency. One main reason was that communist governments granted far too little freedom of choice to individuals and managers--this freedom of choice being just as central to Lange's arguments as it had been to Adam Smith's 160 years earlier.

In any event, the verdict of history is in. Leaving aside the extreme (and dysfunctional) regimes in North Korea and Cuba, there are now essentially no socialist countries left on Earth. Score one for the economic model. It would be presumptuous to claim that economic theory played much of a role in ending the Cold War, but economic reality--specifically, the abject failure of the Soviet economic system--certainly did. In any case, the world economy clearly took a giant step closer to the economists' model.

The Trend Toward Privatization

In many ways, the choice between pure socialism and pure capitalism is much too stark. All real economies have always blended privately owned and publicly owned assets. The genuine public-private ownership issue is quantitative: Where shall society draw the line?