February 15, 2017

Make Economics Great Again

Economics is one of the most important academic disciplines. It produces knowledge about one of the fundamental components of a civilized society: 

1. the satisfaction of human needs,

2. by means of production and distribution of scarce resources, 

3. subject to fundamental uncertainty. 

Economists hold in their hands - whether they like it or not - the key to prosperity for all mankind. It is their (our) moral duty to explain to our policy makers, and to the general public, the difference between policies that elevate a society out of misery, and policies that hurl it back down again. 

It would be wrong to say that economists have ever excelled at what their profession has set out to do. However, there have been times throughout our history when economists have actually been relevant and changed the course of history. Giants of our discipline such as John Maynard Keynes and Milton Friedman have had influence at the systemic level, changing the very design of fiscal and monetary policy, as well as government institutions.

Robert Mundell's work was very influential in building the European Union and its central bank. Gunnar Myrdal and John Kenneth Galbraith strongly influenced the design of the modern welfare state. 

There are many other, men and women whose contributions deserve respect, regardless of whether we think the outcome was good or not. What matters is that economists use their discipline to change society for the better, as they understand "better". 

Unfortunately, in the past half century, or even less than that, the very nature of economics has changed. The discipline - if I may speak of it as a collective of practitioners - is no longer trying to grasp the fundamental, systemic problems of our time. The modern economist is fragmented, narrowly focused and in many instances systemically illiterate. 

I cannot blame individual economists for this. The problem lies in how economists are trained, what goes into a graduate program - and what is expected to come out of it. There are exceptions, no doubt, but the overwhelming trend since at least the late 1980s has been to concentrate graduate programs on mathematics and econometrics. The kind of old-style theory training, along with thorough methodological studies, that went into the work of early-20th century economics education, is gone. 

What ability does a student have to answer questions about the slowdown of growth across the Western world, when he can go through undergraduate and graduate training without ever putting the IS-LM model to work? How does a newly trained economist explain the reasons why the Quantitative Easing-style monetary stimulus is entirely ineffective against the slow-to-no growth rates in Europe? Can any practitioner of the dismal science clarify why fiscal austerity has not elevated Greece out of its long, agonizing depression?

To be fair, many economists have addressed these problems. It is not for lack of interest in these issues that economists fail to contribute to a better world. The problem lies with how economists are trained and what is considered "appropriate" methodology in the profession in general. The three pillars of mainstream economic methodology - econometrics, optimization and equilibrium - confine the pathways of thinking among practitioners of the dismal science. Each of these three work against the better practice of economics, and are deserving of blog articles of their own.

As a result of a narrow-minded methodology, economists often have a limited and rigid world view. The world has to possess certain properties, and behave in certain ways, in order to be the square peg that fits a square hole. If the world is a round peg, the economist either shies away from analyzing it - escaping into microeconomic sophistry - or performs his work and is surprised when the world refuses to comply. (This latter case has many examples which I will return to later.)

With this in mind, it was hardly surprising to read the Wall Street Journal's article "Economists Grapple with Public Disdain" from January 9, 2017 (the online version was published on January 8.) Reports the Journal:

The nation's leading economists are suffering an identity crisis as many of the insttitutions they helped build and causes they adanced have come in for piublic schorn and rejection at the ballot box. ... Many economists have been champtions of free trade and globalization, ideas under assault among rising populst movements in advanced economies around the world. The rise of [President] Donal Trump, with fierce rhetoric against elites, in particular, left many at [the annual AEA] conference questioning their place in the world. 

This identity crisis is formulated succinctly by University of Chicago economist Steve Davis, who is quoted as saying "I used to think facts and analysis will ultimately carry the day but now I'm not quite sure."

This statement is refreshing, as it is part of an effort to fundamentally rethink the role of economics in the real world. However, that rethinking process should not include questioning the "facts and analysis" part. Here, Davis is taking a step in the wrong direction. The question is not whether facts and analysis will prevail as the arbiter of truth; the question is how you pursue those facts, what analysis you perform.

As an example, consider the austerity policies that have been tormenting the Greek economy for a good long six years now. Initially, the recommendation from reputable institutions, filled to the brim with economists (the European Central Bank, the International Monetary Fund) of high standing in the profession, was that: a) austerity was a good idea, and b) one round of austerity should do it. Yet here we are, seven years after the first austerity proposals were brought forward, and the Greek economy is nowhere closer to recovering from its budget-and-growth crisis than it was when I published my book Industrial Poverty in 2014. There, I expressed serious criticism of austerity as practiced in Europe, predicting that it would only sink the continent further into the macroeconomic wasteland of stagnation and despair.

Today, early 2017, the reputable economists at those big institutions have been proven wrong more times than they would ever admit – and I have been proven right. I do not mention this to brag, but to make my case in response to the comment by Steven Davis: it is not analysis per se that is wrong, but what kind of analysis you perform.

I do not use econometrics. I do not use equilibrium theory. I use erstwhile tools developed by economists whose main contributions are now older than half a century.

The decline of economics began when its practitioners decided to try to turn into a discipline of quasi-natural science stature. Econometrics, the roots of which emerged already in the 1920s, is not a bad contribution – in fact, it has many merits and is definitely useful within its confined proper space. A similar argument can be made for, and against, optimization. But the pursuit of a physics-style credibility in economics led economists to be seduced by the perceived rigor of correlative studies and artful mathematics. They forgot the strict limiations of those methods.

In order to measure the effects of austerity on an economy, using mainstream economics methodology, economists must assume that the economy is fundamentally a mechanical system. Variables that increase at a given resistance will also decrease at that resistance. Yet that is not at all how the economy works in real life. Specifically, on Greek austerity, it is not the case that the economy will contract and expand at the same pace, with the same “eagerness”. Yet you have to assume both of them in order to find a smooth, rigorous solution in a traditional macroeconomic model.

There are quantitative methods that loosen these restrictions. However, judging from the advice that economists of reputable standing have been dispensing to the Greek government – and to other government bodies involved – those methods have not been employed in this case.

Contrary to the confinement to mechanics, or proxy-mechanics, required by mainstream economics methodology, the real world behaves in such a way that:

a)    Consumers, investors and entrepreneurs respond more rapidly to bad news than to good news (with one important exception);

b)   Consumers, investors and entrepreneurs can be overwhelmed with uncertainty and therefore change their behavior entirely from what is “normal”; and

c)    When overcome with fundamental uncertainty, economic agents can be unwilling to respond to good news below a certain magnitude.

In order to understand, analyze and estimate the reactions of an economy given these three points, a macroeconomist must learn and master the relations between five concepts: consumption, investment, saving, liquidity and uncertainty. Once he can master these five concepts, and how they are related to each other, he has a platform to build good, common-sense, reality-based macroeconomic analysis on. To be able to do that, though, the modern economist in training – primarily the graduate student – must be given room to study those concepts, their origins and their evolution. That would be time taken away from the cul-de-sac methodology that, over the past 30-35 years or so, has gradually removed economics from the real world.

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