Don’t say that the reality is defective because it does not fit the theory – interview with Andrew Sheng

The linear and symmetric approach of neoclassical economics is elegant, intuitive and very attractive, especially to those in power. However, the global financial crisis showed clearly that we are facing a huge paradigm blindness and therefore a paradigm crisis – said Andrew Sheng, Distinguished Fellow of Asia Global Institute, a Hong Kong-based global think tank in its interview given to Economania. According to him, we need to change the system of education completely, as competition of ideas and models comes from diversity. He says that if the theory is wrong, we must change the theory and admit that this is not the reality which is considered defective if it does not fit the theory. In his opinion the Beijing Consensus is a Western fiction, as the Chinese “theory” is simply a process of experimentation and decision-making under uncertainty.

Andrew Sheng was invited as a panelist to the Lamfalussy lectures 2019 and gave a lecture entitled „The Great Transformation 2.0 – how we should use Polanyi’s thinking as the bridge between the East and the West in the 21st century?” the 13th February 2019 at the Institute of Geography, Geoeconomy and Sustainable Development (Corvinus University of Budapest).

Kolozsi Pál (KP): One of your central theses is that the old neo-classical paradigm does not work anymore. How did you arrive to that conclusion? What are the visible signs of that paradigm-crisis?

Andrew Sheng (AS): The neo-classical paradigm has certain blind spots that is very dangerous if ignored. The two obvious ones are social inequality and climate change, both assumed to be taken care of by politics. So, the reductionist model used in neo-classical has both theoretical weaknesses, as well as uses. First, the DSGE models used in central bank and policy formulation do not even contain money in their forecasts, as reported by Professor Lord Mervyn King, former Governor of the Bank of England. This is because financial assets and liabilities are netted out in models of the real economy, but the financial tail can easily wag the real dog.

We also know that because the neoclassical model is laissez faire in approach, it assumed that the system is self-regulated and would revert to equilibrium if disturbed by exogenous shocks. It completely ignored endogenous shocks. This is a huge logical error. If the economic system is complete, there can be no exogenous shocks.  If it is partial, then of course there are exogenous (to the partial system), but then your model is incomplete – but it assumes that it is complete. The 2007 global financial crisis showed that the financial system has endogenous conditions that can create very large shocks.

These reductionist market models also forget about the institutional structures, including the fact that not only does the market have self-order (as Hayek observed), but in practice, large bureaucracies in either government, firms or non-government organisations also have self-order. This means that institutions have their own interests, different from their owners or managers. If you do not factor these into consideration, your models and policy conclusions are going to be very wrong in their outcomes.

The best example of institution-blindness is their explanation of China’s remarkable growth, which was managed by the Chinese bureaucracy. Of course, the state used the market forces very well, because they learned to mimic the market prices where the state is uncertain where to move. The institution also learned how to engender competition between firms (including state-owned enterprises), cities and provinces, in order to push innovation and efficiency gains.

KP: Why do you think that actually the biggest risk is paradigm risk?

AS: I have observed from pilots that those who believe in black-boxes die by such black-boxes. This means that those who rely on instruments, rather than looking for themselves what the skies look like, will suffer the consequences. A person who has rosy-tinted glasses will always see the world in rosy pink. Hence, if our paradigms are wrong, we will get to wrong conclusions and policy prescriptions. The sad part is that even a dead clock is right twice a day!

For example, most trained economists and policymakers today assume that current problems are “bumps in the road”. We get back to normal by some slight fine-tuning. That is huge paradigm blindness. What if the bumps are structural, fractal and fundamental – the whole road has been washed away by climate change natural disaster, the country is in revolution or there will be huge inward or outward migration because of climate change or technology or invasion? The most dangerous fool is the one who is certain, complacent and wrong.

ShengBWAndrew Sheng

KP: According to your lectures, one of the leading alternatives of Hayek’s neoliberal order is Karl Polanyi’s approach. What are the key ingredients and the fundamental differences of these philisophical schools?

AS: Polanyi went to the heart of the logic of the neoclassical model, which is whether you can separate the economics from the social. His fundamental point is that the market is embedded in society, even as society is embedded in nature. You cannot separate them artificially. Therefore, to assume that economics and the market can trade land, labour and capital as if they are rational and would self-regulate is a logical flaw – fiction! But of course, doctors believed for 400 years that bleeding would cure patients, so it is not surprising that neoclassical economists believed that free markets would self-correct.

I must admit that I was a believer, and if the majority believed in the same thing, there is a self-fulfilling prophecy. When things go wrong, it is not the theory that is wrong, it is the bad execution of policy, or the policymakers did not understand the market well enough! The shaman cannot be wholly wrong – that would challenge their credibility.  Sounds familiar?

It is easy to criticise, but not easy to give credible and concrete alternatives. Polanyi was instinctively and logically right, but to find the right balance between state and market is very difficult, so he did not point the right way.  My conclusion is that there is no one-size-fit-all model or solution – each society will have to seek its own balance. For example, the Kingdom of Bhutan does not believe in GDP – it seeks the happiness of its citizens.  That is Bhutan’s right to do so.  From diversity comes competition of ideas and models, so the system as a whole adapts.

Taken to its extreme, the neoclassical school became pseudo-science, where the assumptions become self-evident truths.  As you know, theories will be refuted when new evidence show that these theories are defective. The neo-classical is a big school that covers many different views, and the most theoretical have become cardinals that preach to the converted, ignoring the fact that reality has moved away from their paradigm. It took the rise of the periphery economies in Europe to convince the Catholic Church that the Reformation was real, and the church adapted accordingly. The neoclassical school adapted to the Keynesian challenge by absorbing it into quantitative terms. The philosophy of Keynes was interventionist – the market will not clear when there is inadequate aggregate demand. When Keynesian economics was over-applied, the neoclassical came back with a vengeance, arguing that you should not only cut back fiscally, but also in terms of regulation in almost every field. That gave monopolists and the elite a chance to capture the system, not just politically, but also intellectually and ideologically. The rich became richer.

KP: The development of economics has always been related to the evolution of natural sciences, essentially physics. It is true however that mainstream economics remained closely linked to the perfectionist, mechanical, linear view of classical physics, and the quantum-revolution is not really reflected in economics. In your opinion, what would be the value added of the quantum concept’s integration in economics?

AS: The neoclassical linear, symmetric approach is elegant, intuitive and very attractive, especially to those in power. No one needs to do anything, because the free market enables one to achieve many riches.  But this actually completely contravenes the pre-Modern period in which man must live with nature and with other men, so there are limits to human self-interest and markets. When we move to complex, non-linear paradigms, the alternatives are so many, so heterodox and complicated that most people are confused. So many remain attracted to the old model as the most comforting, even if it is wrong.

The quantum revolution actually goes back to relational, probabilistic and evolutionary models of change that even physicists do not quite understand, but the theory works in many circumstances. For example, quantum computing is now able to make complex computations faster and more comprehensive than classical computers (using binary maths). This enables AI solutions that changes the tools of human decision-making, which means that the economics and social behaviour also changes.

Quantum finance is an obvious area of potential break-through, because money is information, and quantum mechanics is very much information-based. The marginal cost of monetary creation is zero, which is why crypto-scientists are able to produce crypto-currencies, just as central banks create money through quantitative easing. The concept of entanglement is very useful in understanding how derivatives are related to their underlying asset. Ponzi-scheme operators use this to create liabilities (which holders believe are assets) whilst they steal the underlying asset. Even if the asset is totally destroyed, those who hold the liability may still try to trade this off to the next “client”. We have only just begun to explore this aspect of quantum finance.

KP: Ten years after the beginning of the crisis there is still a debate concerning the future and the evolution of economics. In your opinion, what would be the most important steps to take concerning the teaching, the publication possibilities, the academia etc. in that context?

AS: I have come to realise that human institutions behave very differently from individuals, with their own complex self-order. To posit a rational agent whose collective behaviour is like that of additive individuals is itself a logical error. The assumption of perfect information exists only in the minds of non-thinking theorists. To deduce from that assumption that there is “perfect or optimal solutions” to all problems of the economy (even though you concede that not all markets are complete or perfect) is the height of sophistry. But if a whole religious order believes such sophistry, then it will fight all challengers. This is because there is complete self-interest as those who are high priests control the journals, the curriculum and the textbooks, even at the school levels. So how can they admit that they are wrong?

In the natural sciences, it is easier. In the social sciences, you can never replicate the same social experiment twice – exactly like quantum experiments, the answers will vary probabilistically. Hence, the Neo-classical economists will say that they are not totally disproven. Brazilian philosopher/economist Roberto Unger correctly recognise that we need to change the system of education completely. We are in the midst of changing the school curriculum because of Artificial intelligence changing the nature of work and therefore the nature of education. One day, quantum thinking will be taught in schools, not only at graduate school levels. They say that Chinese language is difficult, but one fifth of mankind speak and read Chinese, and also learn other languages at the same time. So, there is no reason why quantum cannot be learnt. The maths are difficult, but the concepts are not as hard as the physicists try to show.

KP: As a Chinese economist with an educational and professional background in Europe and the US, how do you see the differences between the Western and Chinese approaches concerning science, technology and development? What can be the consequences deriving from these differences in the long run?

AS: After nearly 50 years of working in economics, finance and policy formulation, including regulation, I have come to realise that you must be completely honest in your assessment between theory and practice. If the theory is wrong, change the theory – don’t say that the reality is defective because it does not fit the theory. Ask why and where the theory is wrong. The Chinese succeeded where the Soviet planners failed, by learning to mimic the market. Where the Chinese have not succeeded is to explain how their theory or practice works. I think the Western idea that there is a Beijing Consensus, like there existed a Washington Consensus is a Western fiction of how the Chinese work. The Chinese “theory” is a process of experimentation and decision-making under uncertainty, not a full-fledged theory along Western lines, with assumptions and basic principles. I guess the process is an algorithm that one applies if it has been proven to work with practice, since processes can be adjusted and adapted over time.

The advantage of the Chinese system is that there is scale – one fifth of mankind, so allowing different experimentations would yield diverse results to be tested, and the one that works well would be pushed. The central government manages system stability, but allows experimentation at the local and lower levels. Because the education system prefers STEM (science, technology, engineering and mathematics) training, the Chinese workers are much more practical than theoretical.  Once you have scale, you have economies of scale that enables cost efficiencies that can be enjoyed at the global level. If mistakes are made, then the system will adapt very quickly to change. But as the system becomes larger and more complex, it is difficult to predict whether the existing model can still hold. This is why the structural reforms in the Chinese system are so difficult to achieve.

KP: In your opinion what can or should be the new paradigm? What could be the first steps to take from the current insular and segmented „supply-chain economy” to an inclusive „knowledge-economy”?  

AS: The danger of the “global supply chain” thinking is that if you adhere to one standard, you gain efficiency, but if that one standard is wrong, then the system can go wrong along the whole system through contagion. I don’t think there will be one paradigm, because just as quantum physics replaced classical physics, there are many variants and interpretations. It just so happens that because economists are all trained at the classical maths and models, they were “lagged” in evolving quantum economics. You can see the rapid adoption of quantum thinking in biology, mathematics and technology (information sciences, cryptology etc). Diversity is the spice of life. We are living in a truly exciting and yet dangerous era.  Almost all fields have been challenged to their core – religion, ethics, politics, by the rise of new technologies, but we need to go back to basics – what we are here for? To make more money?  Or to live peacefully and harmoniously with other people and with nature?  And if so, what ethics and values matter more? I think that one day, Adam Smith the moral philosopher will be remember more than Adam Smith the free market economist.

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