Posted on 24 February 2021 by Steve Keen, Patreon.com/Steve Keen OverviewMany armies have followed a triumphant march into Russia with an ignominious withdrawal. Orthodox economics is merely the latest invader to succumb to this dismal tradition. But this theory did more damage to the Russian Bear than most military invaders, according to Steve Keen, author of Debunking Economics (Debunking Economics: the naked emperor of the social sciences - Zed Books [US/UK] & Pluto Press).Please share this article - Go to very top of page, right hand side, for social media buttons.Neoliberals were jubilant at the fall of the Berlin Wall. Not only had capitalism proved superior to communism, but the economic theory of the market economy had, it seemed, proved superior to Marxism. A task of
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posted on 24 February 2021
by Steve Keen, Patreon.com/Steve Keen
Many armies have followed a triumphant march into Russia with an ignominious withdrawal. Orthodox economics is merely the latest invader to succumb to this dismal tradition. But this theory did more damage to the Russian Bear than most military invaders, according to Steve Keen, author of Debunking Economics (Debunking Economics: the naked emperor of the social sciences - Zed Books [US/UK] & Pluto Press).
Please share this article - Go to very top of page, right hand side, for social media buttons.
Neoliberals were jubilant at the fall of the Berlin Wall. Not only had capitalism proved superior to communism, but the economic theory of the market economy had, it seemed, proved superior to Marxism. A task of transition did lie at "the end of history" - though not from capitalism to communism as Marx had expected, but from state socialism back to the market economy.
Such a transition was clearly necessary. In addition to the clear political and humanitarian failures of centralized Soviet regimes, economic growth under central planning had failed to maintain its initial promise. Once impressive performances gave way to stagnant economies producing dated goods, whereas the market economies of the West had grown more rapidly (if unevenly), and with far greater product innovation.
As the most prominent intellectual advocates for the free market over central planning, neoclassical economists presented themselves as the authorities for how this transition should occur. Above all else, they endorsed haste. In a typical statement, Murray Wolfson argued that
market systems are much more stable than most people who have been brought up in a command economy can imagine. The flexibility of market systems permits them to absorb a great deal of abuse and error that a rigidly planned system cannot endure. (Wolfson 1992, "Transition from a command economy: rational expectations and cold turkey", Contemporary Policy Issues, Vol. 10, April: p. 42). 
The terms "abuse" and "error" were unfortunately prophetic - for the rapid transition imposed a great deal of abuse and error on the peoples of Eastern Europe. A decade later, incomes have collapsed, unemployment is at Great Depression levels, poverty is endemic. The transition has in general been not from Socialist to Capitalist, but from Socialist to Third World.
Wolfson is far from being a leading light of neoliberal economics. But his arguments in favour of a rapid transition are indicative of the naivety of those whom Joseph Stiglitz would eventually blame for abetting the theft and destruction of Russia's wealth. Their key failing was a simplistic belief in the ability of market economies - even proto-market economies - to rapidly achieve equilibrium. This led them to recommend haste in the transition, and especially in privatization of state assets - a haste which effectively handed over state assets to those in a position to move quickly, the old Party appartachiks and organized crime.
Reading these pro-haste papers one decade after the transition debacle, one can take little comfort in realizing how different the outcome of this rapid transition was to the expectations economists held:
"Even though we favour rapid privatization, we doubt that privatization will produce immediate, large increases in productivity... Nonetheless, we believe that in order to enjoy these enormous long-term gains, it is necessary to proceed rapidly and comprehensively on creating a privately-owned, corporate-based economy in Eastern Europe" (Lipton & Sachs 1990: "Privatization in Eastern Europe: the case of Poland", Brookings Papers on Economic Activity, 2: 1990, p. 295)
"The motivation for comprehensiveness and speed in introducing the reforms is clear cut. Such an approach vastly cuts the uncertainties facing the public with regard to the new 'rules of the game' in the economy. Rather than creating a lot of turmoil, uncertainty, internal inconsistencies, and political resistance, through a gradual introduction of new measures, the goal is to set in place clear incentives for the new economic system as rapidly as possible. As one wit has put it, if the British were to shift from left-hand-side drive to right-hand-side drive, should they do it gradually … say, by just shifting the trucks over to the other side of the road in the first round?" (Sachs, 1992. "The economic transformation of Eastern Europe: the case of Poland", The American Economist, Vol. 36 No. 2: p. 5) 
It might be thought that, since speed was such a key aspect of the recommendations economists gave for the transition, they must have modeled the impact of slow versus fast transitions and shown that the latter were, in model terms at least, superior. But in fact the models economists took their guidance from completely ignored time: they were equilibrium models that presumed the system could rapidly move to a new equilibrium once disturbed.
The period of transition coincided with the peak influence of the concept of "rational expectations" in economic theory. This theory argues that a market economy is inhabited by "rational agents" who have, by some presumably evolutionary or iterative learning process, developed complete knowledge of the workings of the market economy and who can therefore confidently predict the future (at the very least, they know what will happen in response to any policy change by the government). The workings of the market economy happen to coincide with the behavior of a conventional neoclassical model, so that the economy is always in full employment equilibrium.
When this theory is put into a mathematical model, it results in a dynamic system known as a "saddle", because the system dynamics are shaped like a horse's saddle.
In conventional dynamic modeling, a saddle is an unstable system: the odds of the system being stable are the same as the odds of dropping a ball on to a real saddle and having it come to rest on the saddle, rather than falling off it. But if you were so lucky as to drop the ball precisely onto the saddle's ridge, and it stayed on that ridge, it would ride up and down it for quite a while until it finally came to rest.
In rational expectations modeling, the saddle system that sensible dynamic models would say is unstable becomes stable but cyclical. The "rational agents" of the models all know the precise shape of the saddle, and jump onto its crest instantly from wherever they may have been displaced by a government policy change. Then the economy cycles up and down the ridge of the saddle, eventually coming to rest in full employment equilibrium once more. This is how devotees of rational expectations explain cycles, given their belief in the inherent equilibrium-seeking nature of a market economy: the system cycles up and down the sole stable path until coming to rest until it is once again disturbed.
These perspectives on individual behavior, the formation of expectations, and the behavior of a market economy, are dubious enough in their own right. Rational expectations "logic" is truly worthy of the moniker 'autistic', since it is based on a proposition that, if properly handled, negates its own predictions. This is the proposition that, as Muth put it:
Information is scarce, and the economic system generally does not waste it. (John Muth, "Rational Expectations and the Theory of Price Movements": ) 
Since in neoclassical economics, scarcity is the basis of value, then information should according to this theory have a cost. If it has a cost, then agents should economize on its use - they will not use "all available information" but only the subset of information that they can afford, given their preferences for knowledge. Therefore individual agents will not know the full character of the economy, and most will certainly not know its "stable manifold". Rational agents therefore cannot be expected to jump immediately to the equilibrium path of the economy unless they are irrational enough to expend the enormous amount of revenue that would be necessary to buy all the scarce information.
The foundations of "rational expectations" economics are thus internally inconsistent, and the fact that they were taken seriously in the first place is a clear sign of how truly autistic economic theory has become.
But if it was autistic to give this theory credence in the West, how much more so was it to apply this model to the behavior of people in an economic system in transition between central planning and market capitalism?
How can the "agents" in a transitional system develop a mental model of a market economy with which they predict the future behavior of the actual economy, if they have not previously lived in a market economy? Are we to presume instead that people can instantly develop the understanding of something as complex as a market economy - and are we to grace this belief with the adjective "rational"?
Lest this seem an overly harsh rhetorical flourish, consider the following discussion of how fast the transition should be from Wolfson's 1992 paper. He begins with a statement that a sensible person might expect would lead towards the conclusion that people must be given time to learn how to react to market signals:
"Indeed, when government actions become so large that their effect on prices causes wide divergence from individual choices, one cannot determine what those choices would have been. As a result, no reliable guidelines exist for government choice. Even with the best of intentions, unlimited collective choice destroys the very information base for rational decisions." (Wolfson 1992: 37). 
But instead, he immediately follows up this apparently sensible statement with the following proposition:
Central planners seemingly should at once resign their posts and close their offices. Their departure simply would signal the market to move immediately to equilibrium." (Wolfson 1992: 37) 
What market? But oblivious to logical contradictions, he elaborates:
"For example, suppose the government were planning a gradual transition from a regime of administered prices to market prices to take place a year from now. What would happen 364 days hence? Obviously, people would refuse to make any but the most urgent transactions at the old prices, or an illegal market would immediately jump to the new prices. Those individuals who would have to sell their goods and services at a lower price on day 365 would find no legal customers on day 364. Similarly, those who would receive higher prices at day 364 would not sell legally on day 363, 362, 361, and so on. The economy would either come to a complete stop or would legally or illegally anticipate the future. In the face of rational and reasonably knowledgeable economic agents, delay invites disaster." (Wolfson 1992: 37) 
"Rational and reasonably knowledgeable economic agents"? Where did they come from, and how did they acquire so profound a knowledge of the market system they have not as yet lived in that they can predict its behavior (and prices in it a year into the future) before they experience it? Yet presuming their existence and their intimate knowledge of the behavior of an economic system that does not yet exist, Wolfson advises that
A rational expectations conclusion is that quitting communism Cold Turkey is the only way to get from A to B. In practice, governments must make the national currency convertible and allow it to float on legal as well as black markets, abolish the system of subsidies and direct plans and quotas, close plants that cannot compete, come quickly to a privatization of industry even if some inequities result, strictly control the money supply, and allow goods and services to find their own price on national and international markets. (Wolfson 1992: 39; Wolfson does qualify his arguments with some concessions to reality, but in the end his recommendations are all for speed on the basis of a belief in the self-adjusting properties of the market economy) 
While there were significant differences in how the program of transition was implemented, in general this rapid and complete exposure of the once relatively closed economies of the East to the West was the rule. Away from the fantasies of rational expectations economics, what this rapid exposure to international competition did was give ex-socialist consumers instant access to Western goods, and expose Eastern European factories to open competition with their Western counterparts.
As Janos Kornai details so well [4, 5], the soft budget constraints of the Soviet system had resulted in "cashed up" consumers on the one hand, and technologically backward and shortage-afflicted factories on the other. The consumer financial surpluses, accumulated during the long wait between placing orders for consumer durables under the Soviet system and actually receiving the goods, were rapidly dissipated on Western consumer goods. The Eastern businesses, now forced to compete with technologically far superior Western firms, were rapidly destroyed, throwing their workers into unemployment. With accumulated buying power dissipated and freely floating currencies, exchange rates collapsed - for example, Romania's Lei has gone from about 1,000 to the US dollar in 1993 to 32,000 to the dollar today.
A sensible dynamic analysis of the plight of the ex-socialist economies - one that really did take time into account - would have predicted this outcome from a too rapid transition. Even if the technological advantages of the market system over Soviet-style industrialization had amounted to just a one percentage difference per annum in productivity, the forty five year period of socialism would have given market economy firms a 55 per cent cost advantage over their socialist counterparts. And of course, the product development aspect of technological innovation had made far greater differences than this merely quantitative measure of costs - Western firms would have decimated socialist ones on product quality alone, even without a cost advantage.
A time-based analysis would therefore have supported a gradual transition, with substantial aid as well to assist Eastern factories to introduce modern production technology and process control methods. It should also have been obvious that for a market economy to develop, one needs the minimum distributive systems of a market: systems of wholesale and retail distribution, respect for written contracts, systems for consumer protection, laws of exchange - all things which take a substantial time to put in to place.
With the obscene haste with which the actual transition was implemented, the only non-market systems that could rapidly develop were those that were already in place in the preceding socialist system - the systems of organized crime that had always been there to lubricate the wheels of the shortage-afflicted Soviet system, just as market intrusions once permeated the feudal systems out of which capitalism itself evolved in Europe.
It is of course too late now to suggest any alternative path from socialism to the market for these no longer socialist economies. The new transition they must make is from a de-industrialized Third World state back to a developed one, and that transition will clearly take time.
 Wolfson, M. 1992 Transition from a Command Economy: Rational Expectations and Cold Turkey. Contemporary Economic Policy
 Sachs, J. 1992 The economic transformation of Eastern Europe: the case of Poland. Economics of Planning
25, 5-19. (doi:10.1007/BF00366287).
 Muth, J.F. 1961 Rational Expectations and the Theory of Price Movements. Econometrica
 Kornai, J. 1979 Resource-Constrained versus Demand-Constrained Systems. Econometrica
 Kornai, J. 1980 'Hard' and 'Soft' Budget Constraint. Acta Oeconomica
25, 231-245. (doi:http://www.akademiai.com/content/119704/).
This article appeared on Patreon 30 January 2021.
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Caption photo taken from The Night Bivouac of Napoleon's Army during retreat from Russia in 1812, Wikipedia, by Vasily Vereshchagin, Oil on canvas. Historical Museum, Moscow, Russia. Public Domain Mark 1.0. Full image below.
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