Why do Neo-classical economic models often fail to explain Japan’s economic miracle.
Two points are extremely important.
- The determinism
- The non-linearity
Determinism is a philosophical concept asserting that every event is caused by preceding events. In other words, the future state of something is dictated by its current state. This idea underscores that future event are governed by previously established rules and laws, highlighting the dynamic nature of everything due to the principle of cause and effect.
Determinism fits well with the idea that every action causes a reaction, meaning everything happens because something else triggered it. However, determinism also suggests that we can predict future events with absolute certainty. This idea conflicts with many neo-classical economic models, which often incorporate uncertainty and the unpredictability of future events.
Here is a quick look
First, in Neo-classical framework, many models adhere to determinism, meaning that a defined set of initial conditions reliably produces a singular, predictable outcome in economics. If we know the current status, rules of the model produce certain results determined by the process of the models.
For instance,
- The law of demand states that when the price of ice cream drops, people will always respond by buying more. It’s a fundamental principle that highlights the predictable relationship between price and consumer behaviour
- If we know the interests rates today given the expenditures, famous IS-LM model predicts increased investments when interest rates are lower. (but why ?)
- On the other hand, by plugging the capital and labour stock, the production function will determine the future value of production.
This says that feeding today’s status into model will give a certain deterministic outcome in the future because economics is in the deterministic universe.
This problem stems from the principles and assumptions of the Neo-classical models. For instance, by assuming that firms and consumers do consistently maximize utility, the resulting demand function often doesn’t align with real-world. For instance, when interest rates, the price of money, are low, investors tend to borrow more because they all face a downward-sloping demand curve. This has made these model a predictable decision-making process which guarantee that today’s conditions will shape the future.
However, the most important aspect is that realistic economy is non-deterministic. As a result, the real-world demand curve may get any shape depending upon the other changing conditions.
I intentionally avoided using the term that contrasts with deterministic models, namely stochastic models. It is pretty important that economics typically incorporate interconnected complexity rather than randomness. Nothing is based on the probability in economics. Interconnected complexity means that outputs recycle as inputs, transforming the overall outlook.
For instance, after the economic bubbles burst in Japan in the 1990s, the Bank of Japan drastically lowered interest rates from 8 percent during the peak of the bubble to near zero by 1995. According to neo-classical economics, lower interest rates should have spurred increased borrowing due to a downward-sloping demand curve. However, in a surprising turn, the entire corporate sector focused on paying down debt rather than taking on more loans, even amidst historically low interest rates. The demand curve for debt was not downward slopping. This unexpected behaviour challenged traditional economic theories, which had not anticipated such a scenario occurring.
The reason was that many corporations in Japan had heavily invested in real estate. When property prices sharply declined, these firms faced substantial losses. To stabilize their financial positions, instead of borrowing more, they actively reduced their debt levels. This unexpected shift continued for a decade, from the mid-1990s to around 2005, as companies focused on repairing their balance sheets rather than expanding through borrowing, marking a significant departure from conventional economic expectations. Essentially, equity holders’ collective decisions shape the relationship between interest rates and investments.
This situation underscored a key contradiction with neo-classical economic theory, which assumes a deterministic relationship between actions and outcomes. When firms, faced with financial challenges after the real estate downturn, chose to decrease their debt burdens instead of borrowing more, it disrupted the expected pattern. This interconnection of economic decisions introduced uncertainty, challenging the ability to predict outcomes with certainty as traditionally assumed in economic models. This is known as interconnected complexity.
Secondly, In economics, cause and effect is inherently non-linear. This means that when you give an input, such as a policy impact or interest rate, the resulting changes or the output in the economy are not proportional to the input. Small adjustments can lead to significant, sometimes unforeseen outcomes, while larger changes might have minimal impact.
For example, this is the same reason why there is a notable disparity in exchange rate volatility between periods of lower and higher foreign reserve levels. Exchange rate depreciations are much larger when foreign assets are lower and smaller when there are enough reserves in place.
On the other hand, even slight shifts in financial markets can cascade into substantial impacts, like prompting widespread selling of stocks. This illustrates how even small developments can propagate through the market, influencing investor behaviour and broader economic trends.
As a concluding remark, in science, the presence of just one observation that goes against a theoretical hypothesis can dismantle the foundation of that original hypothesis. This emphasizes the need to regularly scrutinize our models to ensure their alignment with real-world scenarios. The Japanese Lost Decade and the 2008 financial crisis are stark examples of how Neo-classical economic models did not foresee the unfolding realities they were supposed to predict.
In the world of economics, the debate over what constitutes a ‘correct’ prediction frequently surfaces. As a final thought, I’ll leave you with a compelling quote from a celebrated mathematician
All stable processes we shall predict. All unstable processes we shall control
-John von Neumann-
Article by P. M Amila Dissanayake