Posts Tagged ‘neoclassical’

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Lots of folks have been asking me about the significance of the so-called Nobel Prize in economics that was awarded yesterday to Richard Thaler.

They’re interested because they’ve read or heard about the large catalog of exceptions to the usual neoclassical rule of rational decision-making that has been compiled by Thaler and other behavioral economists.

One of my favorites is the “ultimatum game,” in which a player proposes an allocation of an endowment (say $5) and the second player can accept or reject the proposal. If the proposal is accepted, both players get paid according to the proposal; if the proposal is rejected, both players get nothing. What Thaler and his coauthors found is that most of the second players would reject proposals that would give them less than 25 percent of the endowment—even though, rationally, they’d be better off with even one penny in the initial offer. In other words, many individuals are willing to pay a cost (i.e., get nothing) in order to punish individuals who make an “unfair” proposal to them. Such a notion of fairness is anathema to the kind of self-interested, rational decision-making that is central to neoclassical economic theory.

Other exceptions include the “endowment effect” (for the tendency of individuals to value items more just because they own them), the theory of “mental accounting” (according to which individuals can overcome cognitive limitations by simplifying the economic environment in systematic ways, such as using separate funds for different household expenditures), the planner-doer model (in which individuals are both myopic doers for short-term decisions and farsighted planners for decisions that have long-run implications), and so on—all of which have implications for a wide variety of economic behavior and institutions, from consumption to financial markets.

So, what is the significance of Thaler’s approach economics?

As I see it, there are three stories that can be told about behavioral economics. The first one is the official story, as told by the Nobel committee, which starts from the proposition that “economics involves understanding human behaviour in economic decision-making situations and in markets.” But, since “people are complicated beings,” and even though the neoclassical model “provided solutions to important and complicated economic problems,” Thaler’s work (alone and with his coauthors) has contributed to expanding and refining economic analysis by considering psychological traits that systematically influence economic decisions—thus creating a “a flourishing area of research” and providing “economists with a richer set of analytical and experimental tools for understanding and predicting human behavior.”

A second story is provided by Yahya Madra (in Contending Economic Theories, with Richard Wolff and Stephen Resnick): behavioral economics forms part of what he calls “late neoclassical theory” that both poses critical questions about neoclassical homo economicus and threatens to overrun the limits of neoclassical theory by offering “a completely new vision of how to specify the economic behavior of individuals.” Thus,

Based on its psychological explorations, behavioral economics confronts a choice: will it remain a research field that merely catalogs various shortcomings of the traditional neoclassical model and account of human behavior or will it break from neoclassical theory to formulate a new theory of human behavior?

A third story stems from a recognition that behavioral economics challenges some aspects of neoclassical economics—by pointing out many of the ways individuals are guided by forms of decisionmaking that violate the rule of self-interested rationality presumed by traditional neoclassical economists—and yet remains within the strictures of neoclassical economics—by focusing on individual behavior and using rational decision-making as the goal.

Thus, Thaler’s work and the work of most behavioral economists focuses on the limits to individual rationality and not on the perverse incentives and structures that plague contemporary capitalism. There’s no mention of the ways wealthy individuals and large corporations, precisely because of their high incomes and profits, are able to make individually rational decisions that—as in the crash of 2007-08—have negative social ramifications for everyone else. Nor is there a discussion of the different kinds of rationalities that are implicit in different ways of organizing the economy. As I wrote back in 2011, “is there a difference between how capitalists (who appropriate the surplus for doing nothing) and workers (who actually produce the surplus) might decide to distribute the surplus to others?”

Moreover, while behavioral economics have compiled a long list of exceptions to neoclassical rationality, they still use the neoclassical ideal as the horizon of their work. This can be seen in what is probably the best known of Thaler’s writings (with coauthor Cass Sunstein), the idea of “libertarian paternalism.” According to this view, “beneficial changes in behavior can be achieved by minimally invasive policies that nudge people to make the right decisions for themselves.” Thus, for example, Thaler proposed changing the default option in defined-contribution pension plans from having to actively sign up for the plan (which leads to suboptimal outcomes) to automatically joining the plan at some default savings rate and in some default investment strategy (which approximates rational decision-making).

The problem is, there’s no discussion of the idea that workers would benefit from an alternative to defined-contribution plans—whether defined-benefit plans or the expansion of Social Security. It’s all about taking the institutional structure as given and “nudging” individuals, via the appropriate design of mechanisms, to make the kinds of rational decisions that are presumed within neoclassical economics.

Paraphrasing that nineteenth-century critic of political economy, we can say that economic decision-making appears, at first sight, a very trivial thing, and easily understood. Its analysis shows that it is, in reality, a very queer thing, abounding in metaphysical subtleties and theological niceties. We might credit Thaler and other behavioral economists, then, for having taken a first step in challenging the traditional neoclassical account of rational decision-making. But they stop far short of examining the perverse incentives that are built into the current economic system or the alternative rationalities that could serve as the basis for a different way of organizing economic and social life. And, in terms of economic theory, they appear not to be able to imagine another way of thinking about the economy, as a process without an individual subject.

However, taking any of those steps would never be recognized with a Nobel Prize in economics.

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By now, everyone knows that Joel Osteen, the Prosperity Gospel preacher in Houston’s Lakewood Church, initially refused to open the doors to shelter the victims of Tropical Storm Harvey.

That’s certainly a good reason for people to hate Osteen.

Kate Bowler [ht: ji], the author of Blessed: A History of the American Prosperity Gospel, offers three other reasons for hating Osteen:

#1—Osteen represents the Christian 1 percent

From aerial views of his jaw-dropping mansion to the cut of his navy suits, he always looks like a man with a good reason to be smiling. He is a wealthy man who unapologetically preaches that God has blessed him, with the added bonus that God can bless anyone else, too. The promise of the prosperity gospel is that it has found a formula that guarantees that God always blesses the righteous with health, wealth and happiness. For that reason, churchgoers love to see their preachers thrive as living embodiments of their own message. But the inequality that makes Osteen an inspiration is also what makes him an uncomfortable representation of the deep chasms in the land of opportunity between the haves and the have-nots. When the floodwaters rise, no one wants to see him float by on his yacht, as evidenced by the Christian satire website the Babylon Bee’s shot Tuesday at Osteen: “Joel Osteen Sails Luxury Yacht Through Flooded Houston To Pass Out Copies Of ‘Your Best Life Now.’ ”

#2—There is a lingering controversy around prosperity megachurches and their charitable giving

When a church that places enormous theological weight on tithes and offerings is not a leader in charitable giving, the most obvious question is about who is the primary beneficiary of the prosperity gospel? The everyman or the man at the front?

#3—The Prosperity Gospel’s answer to the question about evil in the world is not unlike the one offered by neoclassical economics

Its central claim — “Everyone can be prosperous!”—contains its own conundrum. How do you explain the persistence of suffering? It might be easier to say to someone undergoing a divorce that there is something redemptive about the lessons they learned, but what about a child with cancer? This week, the prosperity gospel came face-to-face with its own theological limits. It was unable to answer the lingering questions around what theologians call “natural evil.” There is a natural curiosity about how someone like Osteen will react in the face of indiscriminate disaster. Is God separating the sheep from the goats? Will only the houses of the ungodly be flooded? The prosperity gospel has not every found a robust way to address tragedy when their own theology touts that “Everything Happens for a Reason.”

For neoclassical economists, everything happens—good and evil, both prosperity and poverty—because of people’s choices.

I have offered my own reasons for questioning the Prosperity Gospel—what I have called the American Hustle—and yet for taking it seriously—especially in terms of support for Donald Trump.

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There’s nothing that gets mainstream economists going like a proposal to raise workers’ wages.

Except the idea of raising workers’ wages in other countries.

Then you’re screwing with both wages and international trade. And mainstream thinkers just won’t allow that.

That’s why Eduardo Porter considers the AFL-CIO’s proposal that the North American Free Trade Agreement guarantee that “all workers — regardless of sector — have the right to receive wages sufficient for them to afford, in the region of the signatory country where the worker resides, a decent standard of living for the worker and her or his family” a “fairly loopy idea.”

As I see it, the only thing loopy about the proposal is the idea that the Trump administration would actually take it seriously.

Then there’s MIT’s David Autor:

Stipulating that countries must pay above-market wages when producing export goods for the U.S. feels like outrageous economic imperialism.

And finally Harvard’s Dani Rodrik, according to whom the idea of a living wage

is very difficult to define and can be harmful to employment if enforced too strictly.

So, there you have it: according to mainstream economists, attempting to raise workers’ wages, especially wages in Mexico and elsewhere, is “loopy,” an example of “economic imperialism,” and “harmful to employment” if actually enforced.

Now, to be clear, as I showed earlier this year, workers on both sides of the border have lost out, and their losses are mostly not due to NAFTA. The wage share of national income was declining in both the United States and Mexico before the free-trade agreement was implemented—and it’s continued its slide since then.

Why then are mainstream economists so opposed to raising Mexican workers’ wages—which, after all, is merely an example of leveling-up as against a race-to-the-bottom?

It’s because mainstream economists actually believe workers are paid according to their productivity. They get what they’re worth. In other words, “just deserts.”

But that’s the problem: there’s nothing necessarily just about the prices set in markets, whether for labor power or any another commodity. Raising workers’ wages above current rates—on both sides of the border—represents a different kind of economic justice. It may not be neoclassical justice, which is the only thing Porter, Autor, Rodrik, and other mainstream economists recognize.

It’s a justice based on the idea that workers lose out when they’re paid a wage but create more value than what they receive in the form of wages. They produce a surplus, which their employers appropriate. Both their Mexican employers and their U.S. employers.

Raising workers’ wages would mean there would be somewhat less surplus available to their employers in the form of profits. And that’s a kind of economic justice mainstream economists simply won’t accept.

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We’ve all heard it at one time or another.

Why is the price of gasoline so high? Mainstream economists respond, “it’s the market.” Or if you think you deserve a pay raise, the answer again is, “go get another offer and we’ll see if you’re worth it according to ‘the market’.”

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And then there’s CEO pay, which last year was 271 times the average pay of workers. Ah, it’s what “the market” has determined the appropriate compensation to be.

“The market” explains everything—and, of course nothing.

Chris Dillow argues that invoking “the market” (e.g., to explain the gender disparities in pay for BBC broadcasters) serves to hide from view the role of power.

Talk of the “market” is therefore what Georg Lukacs called reification – the process whereby “a relation between people takes on the character of a thing and thus acquires a ‘phantom objectivity.’” It obfuscates the fact that wages are set by the power of one person over another. Such obfuscation serves a profoundly ideological function; it effaces the fact that the capitalist economy is based upon power relationships.

Not even neoclassical economists stop with references to the “the market.” That’s just the first step of the explanation. The next step is to analyze “the market” in terms of its ultimate—given or exogenous—factors determining supply and demand. Their story is that “the market” can finally be reduced to and explained by preferences, resource endowments, and technology. In other words, according to neoclassical economists, market prices—whether for gasoline, workers’ pay, and CEO compensation—reflect consumer preferences, households’ endowments, and human know-how, all of which are considered to be prior to and independent of the economy.

That’s the way formal neoclassical economics works. But mainstream economists are also content to let the myth of “the market” persist in the minds of their students and the proverbial person in the street because it protects markets from what they consider to be unwarranted regulation and intervention. “The market” is turned into an abstract entity that merely reflects human nature. And if anyone wants to change the results—to change, for example, the price of gasoline, workers’ wages, or CEO compensation—they face the daunting task of changing human nature.

But there’s another side to the myth of “the market.” It becomes symbolic of an entire system gone awry—and which therefore can be criticized and replaced.

Instead of “the market,” we might refer to individual markets—not just to markets for gasoline, workers’ ability to labor, or CEOs’ skills but to markets for different kinds of gasoline, different groups of workers, or CEOs in different industries. Or, alternatively, we might invoke the different roles producers, consumers, workers, corporate executives, government officials, and so on play in determining market outcomes. All of those individual markets and market participants might then be regulated to produce different outcomes.

But if it’s “the market” that is to blame, then it’s the entire system—not one or another market or market participant—that needs to be radically transformed.

If mainstream economists defend and celebrate “the market,” critics of market outcomes—of which there are many—can then move to a more systemic assessment, to become critics of the economy as a whole.

And once that happens, critics can then imagine and begin to create a different economic system, one that is not governed by “the market.” Such an alternative system might have markets, lots of different kinds of markets. But it would have a different logic, a different way of operating, with very different outcomes.

Such an alternative economy exists on the other side, beyond the myth of “the market.”

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Mainstream economists have been taking quite a beating in recent years. They failed, in the first instance, with respect to the spectacular crash of 2007-08. Not only did they not predict the crash, they didn’t even include the possibility of such an event in their models. Nor, of course, did they have much to offer in terms of explanations of why it occurred or appropriate policies once it did happen.

More recently, the advice of mainstream economists has been questioned and subsequently ignored—for example, in the Brexit vote and the support for Donald Trump’s attacks on free trade during the U.S. presidential campaign. And, of course, mainstream economists’ commitment to free markets has been held responsible for delaying effective solutions to a wide variety of other economic and social problems, from climate change and healthcare to minimum wages and inequality.

All of those criticisms—and more—are richly deserved.

So, I am generally sympathetic to John Rapley’s attack on the “economic priesthood.”

Although Britain has an established church, few of us today pay it much mind. We follow an even more powerful religion, around which we have oriented our lives: economics. Think about it. Economics offers a comprehensive doctrine with a moral code promising adherents salvation in this world; an ideology so compelling that the faithful remake whole societies to conform to its demands. It has its gnostics, mystics and magicians who conjure money out of thin air, using spells such as “derivative” or “structured investment vehicle”. And, like the old religions it has displaced, it has its prophets, reformists, moralists and above all, its high priests who uphold orthodoxy in the face of heresy.

Over time, successive economists slid into the role we had removed from the churchmen: giving us guidance on how to reach a promised land of material abundance and endless contentment.

However, in my view, there are three problems in Rapley’s discussion of contemporary economics.

First, Rapley refers to economics as if there were only one approach. Much of what he writes does in fact pertain to mainstream economics. But there are many other approaches and theories within economics that cannot be accused of the same problems and mistakes.

Rapley’s not alone in this. Many commentators, both inside and outside the discipline of economics, refer to economics in the singular—as if it comprised only one set of approaches and theories. What they overlook or forget it about are all the ways of doing and thinking about economics—Marxian, radical, feminist, post Keynesian, ecological, institutionalist, and so on—that represent significant criticisms of and departures from mainstream economics.

In Rapley’s language, mainstream neoclassical and Keynesian economists have long served as the high priests of economists but there are many others—heretics of one sort or another—who have degrees in economics and work as economists but whose views, methods, and policies diverge substantially from the teachings of mainstream economics.

Second, Rapley counterposes the religion of mainstream economics from what he considers to be “real” science—of the sort practiced in physics, chemistry, biology, and so on. But here we encounter a second problem: a fantasy of how those other sciences work.

The progress of science is generally linear. As new research confirms or replaces existing theories, one generation builds upon the next.

That’s certainly the positivist view of science, perhaps best represented in Paul Samuelson’s declaration that “Funeral by funeral, economics does make progress.” But in recent decades, the history and philosophy of science have moved on—both challenging the linear view of science and providing alternative narratives. I’m thinking, for example, of Thomas Kuhn’s “scientific revolutions,” Paul Feyerabend’s critique of falsificationism, Michel Foucault’s “epistemes,” and Richard Rorty’s antifoundationalism. All of them, in different ways, disrupt the idea that the natural sciences develop in a smooth, linear manner.

So, it’s not that science is science and economics falls short. It’s that science itself does not fit the mold that traditionally had been cast for it.

My third and final point is that Rapley, with a powerful metaphor of a priesthood, doesn’t do enough with it. Yes, he correctly understands that mainstream economists often behave like priests, by “deducing laws from premises deemed eternal and beyond question” and so on. But historically priests served another role—by celebrating and sanctifying the existing social order.

Religious priests occupied exactly that role under feudalism: they developed and disseminated a discourse according to which the natural order consisted of lords at the top and serfs at the bottom, each of whom received their just deserts. Much the same was true under slavery, which was deemed acceptable within church teachings and perhaps even an opportunity to liberate slaves from their savage-like ways. (And, in both cases, if those at the bottom were dissatisfied with their lot in life, they would have to exercise patience and await the afterlife.)

Economic priests operate in which the same way today, celebrating an economic system based on private property and free markets as the natural order, in which everyone benefits when the masses of people are forced to have the freedom to sell their ability to work to a small group of employers at the top. And there simply is no alternative, at least in this world.

So, on that score, contemporary mainstream economists do operate like a priesthood, producing and disseminating a narrative—in the classroom, research journals, and the public sphere—according to which the existing economic system is the only effective way of solving the problem of scarcity. The continued existence of that economic system then serves to justify the priesthood and its teachings.

However, just as with other priesthoods and economic systems, today there are plenty of economic heretics, who hold beliefs that run counter to established dogma. Their goal is not to take over the existing religion, or even set up an alternative religion, but to create the economic and social conditions within which their own preferred theories no longer have any relevance.

Today’s economic heretics are thus the ultimate grave-diggers.

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When I ask my students that question, they don’t really have an answer. That’s because, like much of the rest of the U.S. population, they don’t have much experience with unions, either directly or indirectly—not when the union membership rate has fallen to below 11 percent nationwide and is only 6.4 percent in the private sector.

And if you pose that question to neoclassical economists, the response is: labor unions cause unemployment, by setting a wage rate that exceeds the equilibrium price for labor. According to the neoclassical story,

while union workers (“insiders”) may benefit, unemployed non-union workers (“outsiders”) lose out. So, their overall conclusion is, unions ultimately hurt workers and cause increased inequality. Unions should therefore be discouraged.

For my students who have taken a course in mainstream economics, that’s pretty much the only answer that will be offered to them.*

But what if we look back to the heyday of unions—to the period that begins during the first Great Depression (when the Wagner Act was passed and unionization rates once again began to rise) and extends through the 1950s?

According to a new study by Brantly Callaway and William J. Collins, who utilize a novel dataset compiled from archival records of a survey of male workers in five non-Southern cities conducted in 1951, unions played an important role in reducing inequality, especially at the bottom of the wage scale.

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Thus, for example, at the 10th percentile, union workers earned 20.3 log points more than comparable non-union workers—while the difference at the median was smaller and, at the 80th, the difference turns negative.

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For less-educated workers (those with less than a high-school education), the premium at the bottom was similar (at 19.1 log points) but the advantage persisted across all percentiles. And the union wage premium was relatively large, and it remained so, throughout the Black income distribution. The clear indication is that the emergence of industrial unions after 1935, which sought to unionize production workers along industry rather than craft lines, opened more better-paying union job opportunities for both less-educated and Black workers.

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Callaway and Collins also conduct some counterfactual estimations concerning wage inequality, by looking at what would happen if union workers had been paid according to the non-union wage schedule. Their Table 4 (Panel A), shows that in terms of all measures—overall inequality (the difference between the 80th percentile and the 10th percentile), lower-tail inequality (the difference between the 50th percentile and the 10th percentile), and upper-tail inequality (the difference between the 80th percentile and 50th percentile)—inequality is significantly higher in the counterfactual “no union” scenario than in reality. In other words, the overall wage distribution was considerably narrower in 1950 than it would have been if union members had been paid like non-union members with similar characteristics.

As I see it, there are two lessons that can be drawn from the Callaway and Collins study. First, in terms of U.S. history, unions played a significant role in mitigating the effects of competition among workers, both raising workers’ wages and reducing inequality among workers. Second, with respect to economic theory, their research shows that simple supply-and-demand stories (which neoclassical economists use to attempt to explain inequality in terms of skills and levels of education) are profoundly misleading precisely because they leave out institutions.

One of the most important institutions in the postwar period in the United States, when economic inequality was much lower than today, were labor unions.

 

*If students were exposed to something other than neoclassical economics, they’d learn that unions do many other things, including helping non-union workers, through: (1) the threat of unionization (nonunion employers worried about a possible unionization drive may match union pay scales to reduce the demand for organization), (2) the ripple effect (like minimum-wage increases, union wage rates for production workers can lead to increases in wages for those above them, e.g., their managers), and (3) the moral economy (unions help institute norms of fairness regarding pay, benefits, and worker treatment that can extend beyond the unionized core of the workforce). They might also learn that, historically and by examining the experience in other countries, unions have often defended and promoted the larger interests of workers—in their enterprises (by demanding a say in decisions about such things as safety and jobs), nationally (by contributing time and money to political parties and campaigns), and internationally (by cooperating with and assisting unionization efforts in other countries).

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I’m often asked—by students and readers of this blog—why I include Keynesian economics, alongside neoclassical economics, within mainstream economic theory.

The major reason I do so is because the mainstream debate within the discipline of economics is mostly confined within limits defined by neoclassical economics and Keynesian economics—between (as I explained last year), the conservative invisible hand of free markets and the more liberal visible hand of government intervention.

It’s basically what most students of economics are exposed to their in their micro and macro courses:

At the microeconomic level, capitalism (or, as liberals generally refer to it, the market system) has the potential of achieving an efficient allocation of resources. As for the macroeconomy, capitalism is capable of providing stable growth and full employment. Capitalism, therefore, promises the best possible outcomes both for individuals and for the economy as a whole.

Now, while conservative mainstream economists believe that efficiency, growth, and full employment stem from allowing markets to operate freely, liberal mainstream economists argue that markets are often imperfect and therefore the only way to achieve (or at least approximate) those goals is to intervene in and regulate markets. Those are the terms of the mainstream debate in economics, from the origins of modern economic discourse in the late-eighteenth century right on down to the present.

Keynesian economics was, of course, born as a critique of neoclassical economics, in the midst of the First Great Depression, when the allocation of resources was anything but efficient and capitalism provided neither stable growth nor full employment. Far from it!

Keynes introduced new ideas into economic discourse, emphasizing the role of economic and social structures (such as collective bargaining and, from later Keynesians, imperfect competition), mass psychology (especially with respect to investors and stock-market speculators), and fundamental uncertainty (it was impossible to make rational decisions in the face of an unknown—and unknowable—future).

However, as recent essays by Michael Roberts and Chris Dillow remind us, Keynesian economics has severe shortcomings.

While I think Roberts begins by overstating his case (I, for one, am not convinced that “Keynes is the economic hero of those wanting to change the world”), he does convincingly argue that Keynes’s economic prescriptions are based on a fallacy:

The long depression continues not because there is too much capital keeping down the return (‘marginal efficiency’) of capital relative to the rate of interest on money.  There is not too much investment (business investment rates are low) and interest rates are near zero or even negative. The long depression is the result of too low profitability and so not enough investment, thus keeping down productivity growth.  Low real wages and low productivity are the cost of ‘full employment’, contrary to all the ideas of Keynesian economics.  Too much investment has not caused low profitability, but low profitability has caused too little investment.

Dillow, for his part, explains that Keynes “was largely silent about three related issues: class, power and profits, or least he dismissed them lightly.” In a sense, then,

Keynesianism was profoundly conservative. In believing that technocratic governments could provide workers with decent wages and full employment, Keynesianism did away with the need for industrial democracy: one of the achievements of Keynes was to eclipse movements such as guild socialism. It wasn’t Keynes himself who said “the man in Whitehall knows best” but one of his disciples, Douglas Jay – and that encapsulated a key part of Keynesian ideology, its belief in top-down management.

Populism, of course, is a backlash against just this. That slogan “take back control” and the dismissal of experts represent a rejection of Keynesianism; the baby of decent macroeconomic policy is being thrown out with the bathwater of elitism. It’s far from clear that Keynesianism has the intellectual or political resources to fight back.

In my view, neither neoclassical nor Keynesian economics turns out to have the intellectual or political resources to effectively respond to the issues that motivate and resonate within contemporary populism. If anything, they have served to create the problems that have brought right-wing nationalist populism to the fore.

For good reason, both wings of mainstream economics have ceased to be persuasive.