By Denis Hay
Mainstream economics is flawed. Discover why neoclassical economics fails and how alternative models offer real-world solutions.
Picture this: It’s 2006, and mainstream economists confidently declare that markets are stable, inflation is under control, and the economy is self-regulating. Then, within two years, the worst financial crisis since the Great Depression erupts. Millions lose their jobs, homes, and savings. How did economists get it so wrong?
Steve Keen, one of the few economists who predicted the crash, argues that neoclassical economics’ fundamental assumptions are flawed. In this article, we’ll explore why neoclassical economics misleads policymakers, businesses, and the public and how alternative economic models can offer better solutions.
Neoclassical economics assumes that individuals make rational decisions to maximise their utility. This notion, rooted in the “calculus of hedonism,” paints consumers as predictable decision-makers. However, real-world behaviour often contradicts this theory.
For example, during the 2008 crisis, millions of homeowners took on unsustainable subprime mortgages. Were they acting rationally? Behavioural economics suggests that biases, misinformation, and emotional factors drive decisions more than pure rationality.
The neoclassical model assumes markets are perfectly competitive, meaning numerous small firms compete without individual pricing power. Yet, large corporations dominate industries, manipulate prices, and influence government policy.
Take Australia’s supermarket duopoly – Coles and Woolworths – which collectively control over 65% of the grocery market. This market concentration defies the assumption that competition always leads to efficiency and fair pricing.
The classic supply and demand model suggests that prices adjust automatically to balance markets. However, this fails in the face of speculation and financial manipulation.
Consider Australia’s housing market: Despite supply outpacing demand in some areas, prices are still unaffordable due to speculative investments, tax incentives like negative gearing, and foreign capital inflows. Neoclassical models do not account for such distortions.
Neoclassical economics posits that wages reflect productivity, implying that economic inequality is justified. However, wealth concentration often results from inherited privilege, corporate lobbying, and financial speculation rather than individual merit.
Australia’s wealthiest 1% owns more than 22% of the country’s total wealth, while wages for the bottom 50% have stagnated. This reality contradicts the neoclassical claim that free markets fairly distribute income. (Myth of meritocracy).
Before the 2008 crisis, neoclassical economists confidently proclaimed that financial markets were stable due to the Efficient Markets Hypothesis(EMH). However, the crisis revealed deep flaws in this assumption.
Keen argues that mainstream economists ignored warning signs, such as rising private debt and excessive financial speculation. By not acknowledging the role of debt in economic instability, neoclassical models left policymakers blind to impending disaster.
Neoclassical models ignore private debt, assuming that borrowing and lending balance out eventually. However, debt-fuelled asset bubbles are a key driver of financial crashes.
Keen’s research shows that economic downturns become inevitable when private debt grows faster than GDP. Australia’s household debt-to-GDP ratio, one of the highest globally, poses a significant risk if left unaddressed.
Hyman Minsky’s Financial Instability Hypothesis suggests that capitalist economies naturally evolve from stability to instability as speculative borrowing increases. Unlike neoclassical models, Minsky’s framework explains why financial crises are recurring features of capitalism.
During economic booms, businesses and individuals take on excessive debt, believing the good times will last forever. When reality hits, defaults surge, triggering a financial crisis. This model better explains past crashes and offers a framework for preventing future ones.
Unlike mainstream economists, Keen argues that banks do not merely lend out savings but create money through credit issuance. This contradicts the outdated ‘money multiplier’ theory taught in most economics courses.
By recognising the fundamental role of money creation, policymakers can implement better strategies to manage financial stability, such as regulating speculative lending and implementing debt jubilees.
Neoclassical theory suggests that stock prices reflect companies’ intrinsic value. However, history shows that speculation, herd behaviour, and algorithm-driven trading fuel the market crashes.
The 1929, 1987, and 2008 crashes followed periods of speculative mania, proving that markets are not inherently rational. Accepting this reality allows for stronger regulatory policies to mitigate risk.
The global economy cannot afford another crisis caused by flawed economic models. Economists must embrace real-world complexity and move beyond the neoclassical obsession with equilibrium.
Alternative schools, such as post-Keynesian economics, Modern Monetary Theory (MMT), and complexity economics, offer more realistic frameworks for understanding and managing economic systems.
Countries like Norway and Germany implement policies that challenge neoclassical assumptions. Public banking, state-owned enterprises, and strong financial regulations have helped them support economic stability while avoiding excessive corporate influence.
State-Owned Enterprises (SOEs): Norway maintains significant state ownership in various sectors, including natural resources and energy. The government holds substantial stakes in publicly listed companies, reflecting a model where the state plays a pivotal role in the economy.
Financial Regulations: Norway’s financial system is characterised by robust regulatory frameworks that ensure stability. The country’s financial institutions are subject to stringent oversight, contributing to a resilient financial environment.
State-Owned Enterprises: Germany has a presence of SOEs across various sectors, including infrastructure and financial services. These enterprises operate under governance structures aimed at balancing commercial objectives with public policy goals.
Financial Regulations: Germany is part of the European Banking Union, adhering to a single rulebook that governs financial institutions across the EU. This framework includes directives on capital requirements and bank recovery, ensuring a stable financial system.
Public Banking: Germany’s financial landscape includes public banking institutions, such as the KfW (Kreditanstalt für Wiederaufbau), a government-owned development bank that plays a significant role in financing projects aligned with public policy objectives.
Australia can learn from these models by prioritising financial stability over deregulation and speculation.
For decades, neoclassical economics has shaped policies that serve corporate interests while neglecting financial stability and social well-being. The 2008 crisis exposed its fundamental flaws, yet its theories still dominate university curricula and political decision-making.
To build a fairer and more stable economy, we must reject outdated economic models and adopt frameworks grounded in reality. By learning from alternative approaches, we can create policies that help all Australians, not just the wealthy elite.
Q1: What is the biggest flaw in neoclassical economics?
A: The biggest flaw is its assumption that markets are self-regulating and always lead to the best outcomes. This ignores financial instability, speculation, and debt-driven crises.
Q2: What alternative economic models exist?
A: Post-Keynesian economics, Modern Monetary Theory (MMT), and complexity economics offer better insights into financial instability, public spending, and economic cycles.
Q3: How can Australia reform its economic policies?
A: Regulating speculative lending, investing in public banking, and adopting MMT principles can ensure economic stability and reduce inequality.
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Debunking or Unlearning Economics? Chatting with Steve Keen and Friends (YouTube)
Debunking economics (pdf – safe to download)
The research committee of Modern Money Lab
This article was originally published on Social Justice Australia
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"For decades, neoclassical economics has shaped policies that serve corporate interests while neglecting financial stability and social well-being."
Whatever a system does -- that is its purpose.
We have a Reserve Bank that operates on the same principle.
And the Reserve Bank is so determined to serve corporate interests that they even have their own definition of unemployment.
“The RBA uses a technical and more narrow definition (than the government) : it says full employment is the level of unemployment that's consistent with stable wage or price inflation.”
Just think about the implications of that for a few moments.
It really is staggering.