Economic Theory and Social Reality



This essay illustrates that economic theory is relevant, when corrected by government. It is also prescriptive for the U.S. elections of 2012.


The Economist magazine described the economy as a “marvelous machine.” Economics is the most rigorous of all the social sciences. It is therefore useful to investigate how its science corresponds to social reality. In an election year, we also investigate how economics applies to government, history, and politics.


Classical economics assumes that the individual, seeking to increase his welfare in the markets, acts in an optimal manner. There are three main assumptions underlying classical economics:

1)      All agents are price-takers, meaning that in a competitive world of both individuals and small producers, neither can affect the price of a commodity.

2)      There are no externalities that allow an individual or a producer to impose his costs onto others.

3)      All market participants have perfect information when they make their decisions. 

Pareto efficiency is the end result of an economy governed by classical economics. It is the analytical confirmation of Adam Smith’s “invisible hand”; markets lead to the efficient allocation of resources. It is the equilibrium result after all individual consumers have maximized their utility by making exchanges, their preferences revealed by markets.

At Pareto optimality, along curve CD, it is impossible to make one person better off without making another person worse off (because in markets all have incentives to increase their individual welfares). It is a minimal notion of efficiency, because it makes no statement whatsoever about what income distribution is socially desirable. Many sets of income distributions are efficient along the Pareto curve. 



To cite well-known objections to the above:

1)      Perfectly competitive markets: Many competitive markets self-destruct because markets favor size, if the environment doesn’t change.

2)      No externalities: To cite Justice Scalia’s recent analogy of health insurance to broccoli, health insurance is not a consumer purchase like broccoli. If a person doesn’t buy health insurance, he could end up in a hospital emergency room where he is treated at a cost to others. Health insurance is more like a vegetable like in, “Eat your vegetables.”

3)      Perfect Information: The violation of this assumption is obvious to investors. People have different amounts of it and process it in different ways, thus there is no such thing as “perfect information.” As a result the social outcome of the market will be Pareto inefficient, Stiglitz (1991).

We have started with the classical economic model to illustrate that classical economics is an insufficient description of economic reality. The crucial missing actor, and this has always been true, is government. Government is necessary to correct the classical model: to make markets more competitive and inclusive, make sure that agents bear the full cost of their activities and provide the regulatory institutions to decrease market uncertainties. If classical economics held, and certainly if it does not, it is necessary for government to affect income distribution. The issue of income distribution is a perfect pivot point to discuss a new book on political economics by MIT economist Daron Acemoglu and Harvard political scientist James Robinson titled, “Why Nations Fail” (2012) 1. It is the most coherent discussion of political economics and (if you are interested) the history of the world in the last four hundred years that we have ever encountered; highly recommended.   

What came first, the chicken or the egg? In the 19th century, Karl Marx argued that the means of production determined the political superstructure of society. In their new book, the authors carefully and convincingly argue the opposite. It is the political arrangements of society that determine the structure of the economy. Their argument begins by defining inclusive political institutions, “…political institutions that are sufficiently centralized and pluralistic...When either of these conditions fails, we refer to the institutions as extractive…” 2 Acemoglu and Robinson then draw a critical relationship between a society’s political and economic institutions:

There is a strong synergy between economic and political institutions. Extractive political institutions concentrate power in the hands of a narrow elite and place few constraints on the exercise of this power.

Economic institutions are then often structured by this elite to extract resources from the rest of society. Extractive economic institutions thus naturally accompany extractive political institutions. In fact, they must inherently depend on extractive political institutions for their survival. Inclusive political institutions, vesting power broadly, would tend to uproot economic institutions that expropriate the resource of the many, erect entry barriers, and suppress the functioning of markets so that only a few benefit. 3


With this definition, the authors then examine a large number of extractive political regimes, notably contrasting Spain and England’s colonizations of the Americas.


In 1492, Columbus sailed the ocean blue and discovered the Americas. In 1519, Spanish expansion and colonization began in earnest with the Mexican invasion of Hernán Cortés who conquered the Aztec empire with a few hundred soldiers after capturing the Aztec emperor Moctezuma. How did he do this? There was more to this than guns, horses, and alliances with dissident tribes. The Spanish developed a direct and brutal strategy they were to apply throughout the Americas. They would capture and kill the indigenous leader and then force the highly organized Indian societies to render them food and treasure, using existing methods of taxation, tribute, and forced labor.

In 1521, Cortés organized the indigenous population into encomiendas, headed by the ecomiendero, who ran a system of forced labor. In 1531, Francisco Pizarro set about conquering the Inca Empire.3a  Then in 1545, a local discovered a mountain of silver in Bolivia. To mine that silver, the Spanish needed many miners and forced the indigenous population into new towns called reducciones, facilitating the exploitation of their labor by the Spanish crown.

The authors write, “Though these institutions generated a lot of wealth for the Spanish Crown and made the conquistadors and descendents very rich, they also turned Latin America into the most unequal continent in the world and sapped much of its economic potential (our note: also Spain’s, which then suffered from the ‘oil curse’).” 4

In U.S. grade schools, students are taught that North America was settled by adventurous colonists, and welcomed by the Indians. In fact, England’s colonization of Northern America began inauspiciously. By the time they had finished the civil War of the Roses and routed the Spanish Armada in 1588, the Spanish had already taken the most “desirable” portions of the Americas. 5 The English were left with only North America, with its low density of poor Indian tribes. The Virginia Company of London founded the colony of Jamestown in 1607 upon the extractive model of Spanish colonization; but their leader, the practical Captain John Smith, soon realized that the colony needed a supply-side economic model and asked the Company to send him, “…thirty carpenters, husbandmen, gardeners, fishermen…  ”.  6

Applying cool reasoning, the Virginia Company decided that if the indigenous peoples could not be exploited, perhaps the colonists (who were also shareholders) could be. Jamestown thus evolved into a company town under martial law, with execution the first resort. The problem was, new opportunities always beckoned in the New World; the settlers could always run away. In 1618, after twelve long years, the company finally capitulated, granting a settler and members of his family fifty acres of land each. In 1619, a General Assembly gave all adult men a say in the colony’s laws and institutions, “…the only option for an economically viable colony was to create institutions that gave the colonists incentives to invest and to work hard.” 7 Thus began democracy in America. In Maryland and the Carolinas the English also tried to set up, “an elitist, hierarchical society based on control by a landed elite,” 8 but their attempts failed for the same reason they did in Jamestown, too many opportunities beckoned. 8a

By the 1720s, all the thirteen colonies of what was to become the United States had similar structures of government. In all cases there was a governor, and an assembly based on a franchise of male property holders…political rights were very broad compared with contemporary societies elsewhere. It was these assemblies that coalesced to form the First Continental Congress in 1774, the prelude to the independence of the United States….This created problems for the English colonial government. 9

The rest is history.


To return to economics, arguing in terms of the corrected classical model, the reason for government to influence income distribution along the Pareto curve is to preserve society’s middle-class democracy, and therefore its political and economic inclusiveness. The U.S. has been successful because its government and society are inclusive, rather than extractive, effectively dealing people into the economic system. For example, by creating a strong system of public education.

Why value inclusiveness? Like diversity, inclusiveness is not just a nice idea. Acemoglu and Robinson argue that political and therefore economic inclusiveness are valuable because it allows Schumpeter’s “creative destruction” and therefore sustainable growth.

The main deterrent to political and economic inclusiveness is the fear of creative destruction that change brings. New technologies obsolete existing skills, machinery, and social arrangements. The authors write, “The process of economic growth and the inclusive institutions on which it is based creates losers as well as winners in the political arena and the economic marketplace.” 10 People do not like their livelihoods to be creatively destroyed.  “Growth …moves forward only if not blocked by the economic losers who anticipate that their economic privileges will be lost and by the political losers who fear their political power will be eroded....Who the winners of this conflict are has fundamental implications for a nation’s economic trajectory. If the groups standing against growth are the winners, they can successfully block economic growth, and the economy will stagnate.” 11

The authors then cite many examples of examples of extractive economic and political systems ranging from the agricultural marketing monopolies in the developing world to the aristocracies of the Austro-Hungarian and Russian empires. 

Why did the industrial revolution, and thus supercharged economic growth, first happen in England? We have earlier noted how in 1619, the Virginia General Assembly took over governance from the Virginia Company. The ability of the settlers to readily self-organize lay back to English history and culture. It wasn’t just a matter of economic incentives. 12 According to Ertman (1997):


It was during the greatest of…conflicts, the Hundred Years War (1337-1453), that the distinctive English pattern of “shared rule  between a strong sophisticated central government and self-confident shire communities represented in Parliament made its first, precocious appearance. These shire communities, through their chosen delegates, successively claimed the right not only to approve new taxes, but also to participate in any modification of the ‘common law’ which they had helped to create in the shire and hundred courts. 13

In England, the balance between parliamentary and royal power fluctuated until a 1689 agreement between the new Protestant monarch, William of Orange, and parliament resulted in the world’s first modern state and reformed public finances. 14 The principle of parliamentary oversight was established, constraints were placed on the power of the monarch, and a broad coalition of commercial landowners, businessmen, and media exerted considerable influence on the way the state functioned. Crucial were enforced property rights; the abolition of royal monopolies; patents for new ideas like the steam engine, the spinning frame, and steamships; law and order and the rule of law. These innovations protected “creative destruction.” The authors then describe a virtuous circle where, “…inclusive political institutions support and are supported by inclusive economic institutions.” 15

This discussion illustrates:

1)      Government is necessary to insure the efficient functioning of free markets and to redistribute income, thus maintaining a middle-class democracy.

2)      An inclusive political order is necessary for an inclusive economic order that is capable of “creative destruction,” therefore sustained growth.

3)      The ideal of very limited government and low taxes is only tangentially related to economic growth, if at all. It is an exceedingly narrow and therefore inaccurate view of economic reality. There are many factors that cause growth, including those provided by government.

4) This analysis allows us to ask a further question, also raised by Stiglitz (2012) and Sean Harkin (2013). Does the present economic system produce more inequality than basic incentives require?





The 2012 elections should clearly decide how to restore sustainable economic growth to the U.S. economy. The real long-term growth of the U.S. economy can be calculated as follows:


              Economic Growth = population growth + productivity growth 

                                                 (1%/yr)                       (2%/yr)  


emphasizing: Δ Productivity = GDP/ Δ employment



In a time of slow economic growth and globalization, we would restate that equation as:


              Economic Growth = technological change + productivity growth


The role of government is to set the long-term environment by appropriate trade policies and to make long-term investments in public education, scientific research, training, and relevant infrastructure. The role of private businesses is to make things happen in the shorter-term, by causing specific technological change or increased productivity.

We think it is much more important for the U.S. to renew its economy and increase employment by technological change. The U.S. needs new ways of doing things, or it will stagnate. 


Theoretical economics is a science, therefore crucially dependent upon the ceteris paribus assumption, all other conditions being equal (in the laboratory). In complex human societies, that assumption is never true. In real situations, there are also many other major factors (or at least different conditions) to consider. This makes practical government an art rather than a Platonic science. Consider an article in the 7/23/12 Business Week.

Estonia is a small Baltic country with a population of 1.3MM people. It is a model of European austerity. Before the Financial Crisis of 2008, it suffered from its own real estate boom. Between 2004 and 2008, private debt increased from 10 percent to 100 percent of GDP, as banks in neighboring Sweden and Finland began to compete by selling mortgages for new houses. “As debt flowed into the country, workers left manufacturing for more lucrative jobs in construction.” 

When the country’s real estate markets crashed in 2009, Estonia’s government did not devalue its currency or borrow money. It imposed austerity:

“…froze pensions, lowered state salaries by about 10% and raised the value-added tax by 2 percent. The gross domestic product dropped more than 14 percent that year (our note: the U.S. GDP dropped by 3.5 percent).” Nobel prizewinner, Paul Krugman, recently “…took on what he called ‘the poster child for austerity defenders.’…he graphed real GDP from the height of the boom to the first quarter of this year to show that, even after a recovery, the economy is still almost 10 percent below its peak in 2007. (our note: the comparable U.S. figure is growth of approximately +2.1 percent). ‘This,’ he wrote, ‘…is what passes for economic triumph?’”

When visiting Estonia, the Business Week reporter encountered only two people who did not know about what Krugman had written about their recovery. The reason for this is Estonia’s president (who grew up in New Jersey) felt that the economist had offended the country’s honor. Issues of honor aside, was Krugman right? During hard times requiring adjustments, does the formula for austerity apply to all – to the U.S., England, Italy, Spain, Ireland, and Greece? It applied to Estonia, which is “…a small country with an open economy and little capital, foreign direct investment is everything.” To attract foreign investment, the country could only offer low labor costs. Furthermore, “Large countries have the luxury of a discretionary currency policy. Small countries have a credibility problem no matter what they do.” Krugman was right for the U.S. and maybe England.

Seeking to keep its labor costs under control, Estonia chose austerity.*  The U.S. needs less to reduce its high average labor costs. It needs technological advantages in order to justify its presently high labor costs and its standard of living. The real risk is continuing to argue about the nature of the state, not achieving a political consensus and a plan for reform.

 * As did the Asian countries during the Financial Crisis of 1997; this is the standard IMF formula.


The 8/6/12 Business Week writes:

The (present fiscal crisis) was built into the Bush tax cuts a decade ago.

In early 2001, Paul O’Neill, the new secretary of the Treasury for a new president, began work on a plan for radical tax reform….He presented a 5-inch- thick binder of research to a senior White House Official. “Don’t ever let that see the light of day,” O’Neill says he was told. George W. Bush didn’t want to deliver tax reform. He wanted to deliver the tax cuts he’d promised as a candidate.

He did in 2001 and then again in 2003. But the kinds of cuts he’d promised-large ones-would create unsustainable deficits after 10 years, the Congressional Budget Office projected. So they were designed to expire in a decade, at least on paper. It was “baloney,” says O’Neill, who publicly supported them at the time. Republicans never intended to let the cuts lapse. “It was put in there so they could make a fiscal claim that it wouldn’t damage us. It had nothing to do with reality.”

It’s now more than 10 years later, and Bush’s tax cuts are with us - adding to the debt, exactly as predicted.












Government policy motivated by ideology, having nothing to do with reality, will lead to problems – because the reasons for that policy will be wrong. Present calls for more tax cuts are plucked out of the thin air of ideology with the myopia of narrow economic interest, not properly understood. It’s time to bite the bullet and elect a consensus that can really deal with the deficit in a well-planned way. The article continues, “In 2001, the Pew Research Center found that 37 percent of Americans preferred to use the (then) surplus to fund Social Security and Medicare, 23 percent for domestic spending, and only 19 percent for a tax cut.” Americans are practical.