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Real Economies and the Illusions of Abstraction

Posted on Thursday, November 4th, 2010 at 10:41 am by Hazel Henderson

The yawning gap between the real world and the discipline and profession of economics has never been wider. The ever-increasing abstractions in finance and its models based on "efficient markets" and "rational actors": capital asset pricing, Value-at-Risk, Black-Scholes Options Pricing, have been awarded most of the Bank of Sweden prizes since they were founded in the 1960s and foisted onto the Nobel Prize Committee. Most of these abstract models, based on misuse of mathematics, contributed to the financial crises of 2007-2008. Now, the family of Alfred Nobel, led by lawyer Peter Nobel, has disassociated itself from the Bank of Sweden Prize in Economics In Memory of Alfred Nobel.[1] They point out that Nobel never would have approved of a prize in economics since it is not a science – and would have disapproved even more that most of the prizes were given to Western, neoclassical economists using mathematized, abstract models – far from Nobel's wider concerns.

Nowhere is this abstraction more devastating than in the mathematical compounding of interest rates on borrowed money, now sinking individuals, companies and nations in unrepayable debt as explored in lawyer Ellen Brown's Web of Debt (2007).

In The Politics of the Solar Age (1981, 1988), I warned that compound interest violated the Second Law of Thermodynamics:

"Much confusion arises because economics inappropriately analogizes from some of these models from the physical, social, and biological realms. For example, the best example of a "runaway" can be found in the hypothetical model that economists have imposed on the real world: compounded interest. Here, they have set up an a priori, positive feedback system (based on the value system of private property and its accumulation), in which the interest earned on a fixed quantity of money (capital) will be compounded and the next calculation of interest added on cumulatively. But this "runaway" accumulation process bears no relationship to the real world – only to the value system. However, it has profound real-world effects if enough people believe it is legitimate and employ lawyers, courts, etc., to enforce it!" (p. 228)

I also pointed out that Frederick Soddy, Nobel laureate in chemistry, decided that economists' dangerous drift into pseudo-scientific abstraction must be halted before they destroyed industrial societies, because their uninformed ideas contravened the first and second laws of thermodynamics. (p. 225)

The mathematical fantasy that money is wealth and can reproduce itself is revealed again in the US housing and foreclosure crisis. Money is a useful information system for tracking our use of nature's resources and scoring the games we humans play, but it gradually became mistakenly equated with the real wealth of nations. Similarly, too often economists and politicians describe money flows in economies as analogous to the human body's circulatory system. Yet human blood's hemoglobin cells do not charge money or interest for the life-giving oxygen they deliver to every other cell in our bodies.

Charging interest for lending money was frowned on by our ancestors and considered a sin in Christian, Judaic as well as Islamic and other religious traditions. This view survives today in Sharia finance where lending at interest is shunned in favor of requiring the investor or creditor to share risks of any enterprise with the entrepreneur.

Generations of scholars since Aristotle's treatises on "just prices" have examined the myths and human experiments in creating money and systems of exchange, from mutual fund manager Stephen Zarlenga's The Lost Science of Money (2002) and Prof. Margrit Kennedy's Interest and Inflation Free Money (1995) to lawyer Ellen Brown's Web of Debt (2007). In my Creating Alternative Futures (1978), I posed the question: Is there any such thing as profit without some equal, unrecorded debt entry in some social or environmental ledger or passed on to future generations? My answer was "yes," provided all costs of production were internalized and thermodynamic, not economic, measures of efficiency were calculated.

The mismatch is between the real-world economies, where real people grow food, make shoes, clothes, shelter and tools in real factories, versus the human mind's tendencies toward abstraction. Understanding the real world in which we live requires us to recognize patterns and to abstract reality into mental models. The map is not the territory, as we have been reminded by many epistemologists. The danger is that we routinize our perception through these models, forgetting the need for constant updating and course-correcting as conditions change around us. Thus our mental models are memes that crystallize into habits, dogmas and outdated theories such as those in conventional economics and finance. These led to collective illusions: about "efficient markets," "humans as rational actors" and the lure of "compound interest" that still guide the decisions of too many asset managers. New models of triple bottom line accounting for environmental, social and governance (ESG) have been adopted by responsible investors and institutional investors, including those engaged with the UN Principles of Responsible Investment, managing $22 trillion in assets. The current US mortgage and foreclosure mess provides a new teachable moment where we can re-examine the obsolete beliefs still at the core of economics and now refuted by physicists, thermodynamics, endocrinologists, brain and behavioral scientists.[2]

Read the full, original post at Seeking Alpha.

Hazel Henderson is the author of Ethical Markets, available now.

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