Noble laureate Edmund S Phelps’ article, “The three revolutions economics needs”, was featured in one of The Edge’s January 2019 publications. Echoing others within the profession, Phelps stressed the inability of modern mainstream economics to deal with the challenges posed by a world of constant change.
In the article, he suggested three vital economic revolutions. First, he argued that economists had neglected lessons on the imperfect knowledge in economic theory as identified by Frank Knight and John Maynard Keynes. Second, he mentioned the importance of imperfect information in relation to inflation of wages and unemployment. Finally, in my opinion, Phelps invited the economic world to explore a theory of economic dynamism as described by political economist Joseph Schumpeter.
His suggestions were truly a trigger and stimulant debates that would push the discipline in the right direction. I hope that such debates would find a good arena in Malaysia and in the rest of the region; indeed, the points raised by the article are not only useful in a theoretical economic conversation, but they are very important for the development of political economy.
The point to be made here is that Phelps’ three revolutions can reside together in the so-called market process tradition as developed, along an evolutionary path started in the 1870s by the Austrian School of Economics, and by its commitment to a subjectivist agenda rooted in the analysis of purposeful human action unfolding in real time and in its unintended consequences. In 1949, Austrian economist Ludwig von Mises explained that at the root of economics, we find human action and that “human action is purposeful behaviour. Or as we say: Action is will put into operation and transformed into an agency, is aiming at ends and goals, is the ego’s meaningful response to stimuli and to the conditions of its environment”.
Such a vision stresses the importance of having a purpose based on interactions in reality before allocating scarce resources to certain goals. Such choices, if rooted in reality and not in fictional hypothesis, are characterised by limited — or imperfect — information, dispersed into individual minds.
The information also needs to be communicated via human interaction, and then interpreted (thus digested as knowledge) by the agents that define plans and actions as a result of such interpretational processes. This chain of interaction-communication-interpretation-action is never at rest. Therefore, imperfect knowledge and information, as suggested by Phelps, evolves but never becomes perfect.
Taking into account real humans, in fact, means to consider their situation of radical uncertainty. This fact is linked to another point emphasised by the Austrian School of Economics about the importance of considering action and interaction in real time, not time as a series of points on a line, but as a necessary vehicle for novelty (change) and experience.
The dynamic nature of the economic system, suggested by Schumpeter, consists precisely in the fact that all those actions at the core of economic analysis should happen in time. A static economic analysis is a contradiction. The essence of economics is analysing the intended and unintended consequences of human action and interaction; it is only realistic to assume that such actions are characterised by genuine uncertainty rooted in the flow of time. It goes without saying that dynamic change is the only constant element in such a scenario.
Before, I mentioned that such considerations can be important also for informing policy. Having taken (a limited) part in the Malaysian policy debate, I have had a chance to note how it is characterised by a certain degree of “obsession” for the collection of data. It is normal, and appropriate, to consider data as important. However, what can we demand of data?
Too frequent is the temptation that data collection and interpolation can generate models able to determine, in advance, the future and exact dynamics of demand and supply behaviour. If we honestly recognise the depth of Phelps’ insights, and move forward in appreciating the contributions of the market process tradition, we will be forced to realise that if information is imperfect, if knowledge is the imperfect and subjective interpretation of information, and if the economic system (the market process unfolding in time) is dynamic and, therefore, ever-changing, econometric modelling has very limited significance. Such importance, moreover, decreases the more the time frame under consideration increases, as the flow of time is a constant source for novelty.
In conclusion, Phelps’ revolutions, and the way I believe they are already incorporated into Austrian economics, are very important if we want to make economics meaningful again. But they also teach a lesson in humility to policymakers and experts — in a dynamic scenario that is characterised by changing (and yet imperfect) knowledge and information, central planning has little chance of success.
Decentralised interaction, on the other hand, unfolds the market process as an action of mutual discovery, which gradually can show the emergence of patterns in mutual coordination.
Carmelo Ferlito is senior fellow at the Institute for Democracy and Economic Affairs (IDEAS)