September 30, 2016

Mainstream Economics Has Failed, Part 2

From the 1950s to the 1980s economics was transformed methodologically. The ambition among leading economists was to elevate their academic discipline to something that resembled physics in methodological rigor. The transformation included the creation of the Swedish central bank's Nobel Memorial Prize in Economics in 1968.

Disdainfully referring to good old political economy as "chit chat" and "opinionizing", the modern breed of economists built their entire professional existence around the formidability of econometrics. Regressions, it was said, could tell truth from falsehood and establish a system of laws in economics that would have the same reliability as the system of laws in physics. 

Quantitative analysis is never wrong in social sciences - on the contrary, it is necessary to establish a bridge from theory to reality and, not to forget, in the other direction as well. But the difference between quantitative analysis in physics and in economics is that physics does not deal with matter that has a will of its own. The laws of classical mechanics, which stood model for the methodological transformation of economics, always apply - as opposed to laws of economics which apply only when individuals are motivated to act in accordance with them. 

Econometrics has effectively served as the empirical arm of the mechanization of economics. But in order to do so, econometricians have had to define a "scope of rigor" (my term) for what results they can accept in their models. If the result is non-rigorous they cannot stand by it - and sadly often pretend as though it does not exist.

Here is where the mechanization of economics becomes a real problem. In order to make sure that the economic system works as smoothly and as generally as the laws of classical mechanics, economists have to disregard essential characteristics of human behavior. One of those is the tendency of humans to stop pursuing profit as entrepreneurs or investors, and spending more, in the face of an uncertain future. 

Unlike non-organic matter, humans create outlooks on the future and make at least part of their plans as economic agents based on how confident they feel about the future. Lack of confidence - or the presence of uncertainty - suspends the "laws" of economics and puts the entire system of equilibrium in jeopardy. 

This, again, creates economic "solutions" that modern-day economists have a very hard time dealing with. If they forecast a sharp downturn in the economy, and the suggested result is "non-rigorous", then the average modern economist will not stand by his forecast. Instead of sounding the alarm, saying "we are facing a future that is so bad I cannot even accurately predict it" he gives priority to his "mechanized" analysis over empirical results. 

Underneath the mechanization efforts, economists have placed an organizing principle for the economy that, again, is borrowed from physics. While modern physicists will resist the notion that their object of study is filled with harmony and balance, the classical laws of mechanics rest on that premise. That is what economists have used as a foundation for their long-term equilibrium system. In its simplest form, this premise dictates that the economy always reverts back to long-term equilibrium after recessions.

As an unintended consequence, economists have thereby excluded the possibility of depressions, or even long periods of stagnation at below-capacity economic activity. This is not a deliberate choice, but - again - an unfortunate result of their choice to try to elevate a social science, with its inseparable ties to human nature, to the methodological levels of physics (where human nature is irrelevant). 

Nevertheless, the exclusion of scenarios that fall outside of long-term equilibrium models has the unfortunate consequence of seriously weakening the credentials of economics in explaining, and finding solutions to, persistent economic crises. This is why economists, when confronted with the crisis of subpar economic performance in the Western world today, often fall back on old-school conventions within the traditional realms of fiscal and monetary policy

As a first step toward restoring the credentials of economics as a relevant, go-to social science, it is time for economists to dare step outside of their mechanized comfort zone. There are theoretical traditions in economics that can provide some guidance as to how to do this. 

What are those traditions, and what can they do for us?

Stay tuned. 

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