In order to make any sense of the current European economics, let’s address the relevant issues of economic methodology.
First of all, almost all of the economic theories that we use are based on the notion of ‘welfare economics’. When the economists build models of events the analysis nearly always reduces to establishing a benefit that accrues to various parties that, if in luck, is value-judged in monetary terms.
Take this approach to its logical limit (as did Larry Summers, the US ex-Secretary of the Treasury) and the economic theory will hold that all industries fraught with polluting the environment should, as a matter of economic efficiency, be placed within poor countries on the basis of the fact that the resultant human deaths are less detrimental to the economic output than those of the citizens in rich countries. Mr. Summers ran the argument mockingly during the seminar dedicated to the setting out of the policy document for the World Bank in 1991. Notably, this is exactly what is done routinely in practice.
The problem with mainstream welfare economics (that for the most part is neo-classical) is that it does not account, or does a terrible job of accounting, for the essentials of life: environmental health, ability to seek and find justice, road congestion, quality of public schools, social fabric, public safety, etc. The ‘invisible hand’ should but has emphatically not been an efficient guide for the above. If you need any convincing, go to China or India or Russia or any other country deemed to be economically successful and see if you want to live there. Then make a hop over to Japan that, according to most economic metrics, is in the state of a two decade-long economic paralysis. Run your own ‘touch and feel’ comparison.
Marxist or Keynsian economics fares even worse in my view. ‘Common good’ theories idealize the governments’ ability to execute and thus far have a meaningful conceptual flaw, so I would generalize this deficiency of economics, the deficiency of its ability to account for crucial elements in life, as applicable to the entirety of its field of study.
For those of my readers who dislike the dry language of analysis, here is a quick example to relate to. Imagine yourself waking up on a beautiful summer morning thinking: “I wonder what Germany’s month-on-month growth number is, ‘cos if it’s up it will certainly make my day. Why should I care whether my family is healthy and whether my children are in good schools, or whether the road that I will be taking to work today is safe and uncongested… Who cares about all that if, God willing, Germany’s growth numbers are up.” Sounds absurd – but this is exactly what most modern economic analysis and the ensuing financial journalistic blabber does!
Next, how do we choose economic theories? Unlike in physics or other natural sciences where theories predict the results of experiments (experiments are then set up, the results either prove or falsify the hypotheses – or is it hypothesi) economic theories are chosen on the basis of their persuasion power. They are chosen on the basis of their ability to illuminate our understanding of the state of affairs. In this sense, economics is not a science in a rigorous sense of the word, but is more akin to a debate club, an exercise in rhetoric. Deirdre McCloskey, a Harvard economist, goes a step further, running parallels between economic theories and poetry, between artistic expression and scientific proofs.
Science it is not. Not only economic theories often do not have falsifiable propositions, not only the tests are hardly ever undertaken in the relevant time frame (the domains of economic laws, unlike in physics, are limited in both time and geography), often the practitoners of economics fail to agree on what constitutes a bone fide scientific issue: should we correlate monetary policy and inflation? or unemployment or inflation? – and which metric is a better predictor of ‘blah’ etc…
And what about the finance theories that are the derivatives of economic theories? The view that is difficult to resist is that they stack up even worse. My 20 years of practicing in this field have convinced me beyond all doubt that no finance professional has been able consistently to predict much of anything.
A metric to bear in mind: the R-squared correlation between stock prices predicted by broker research and the actual stock prices is between -3 and +3 per cent depending on the sample taken, i.e. the forecast precision averages out to a mathematical zero. We are talking about the top educated economists and finance research fellows trying to predict simple things – the price for the proxies of corporate value (stocks) using a number of well-known simple arithmetic exercises such as Discounted Cash Flow Model and other such like – and universally ending up with naught in predictive power. Take a stack of investment research and run a little Excel spreadsheet for yourself if you find this statement hard to believe (I wrote a whole paper on the topic at business school).
Further, economic questions are nearly always colored by ideology. Karl Marx was a big propagator of the idea, in fact, I think he introduced the world to ideology coloring. For him, all fields of inquiry (in his view, mathematics and logic included), the choice of problems and approaches to them is socially conditioned. Social science practitioners rarely refute this bold claim. Conversely, I agree with Marx precisely because economics is not a science. Call it what you may – a field of inquiry, a welfare paradigm but it is not a science in a technical sense. I would advocate that even if the distinction is sometimes blurred, mathematics-based sciences are meaningfully less affected by what political party runs Washington at the moment. In economics, however, there are no objective scientific truths.
To say that our best economic theories are based on rhetoric and persuasion rather than on what is real ontologically would be the same as saying that if someone had a religious leaning, then the explanation for thunder in terms of God’s anger would be most illuminating, whereas the perception that the Sun revolves around the Earth should not have ever warranted any doubt or further proof for its obvious phenomenology. And this is exactly what most economic debates appear to me to be like.
Debate clubs are not to be taken lightly. As McCloskey aptly put it, all of our politics is speeches or speeches about speeches – yet politics meaningfully affects our lives.
…to be continued
July 10, 2012 Moscow-New York flight
I would have to agree with pretty much all you are saying here. I find your take to be first rate, and an excellent analysis. I’ll make only two stipulations, as it being purely my “conjecture” on the subject, and certainly quite open for more debate. First, Economic Theory (in my view) is something I would categorize as “art” and not at all a “science” (therefore I believe on that point we are in agreement). We are still back-dated to the original Adam Smith “free trade” system of economic theory, with various tweaks (such as you mentioned Keynesian or Marxist adjustments). I tend to say that the Keynesian model isn’t being used properly (in current measures), because we have incorporated certain Friedman “supply-side” growth models to which have put onerous “debt” in exchange for more “growth”, in expanding our global wealth specifically. I think Keynes only intended to provide “patches” to the issues of expansion or the aftermath of war torn societies, because of the need during the times in which he lived. I think the modern interpretation of Keynes is not one of: “In case of emergency, break glass”; which is solely my interpretation of what he was getting at…but rather, (and forgive my comparison metaphor) a leaky roof with a ton of patches on it, instead of replacing the whole darn roof in one fell swoop. Obviously in any paradigm there will be “winners” and “losers”, and in the modern world we are somewhat foregoing “security” for “expanded wealth”. It’s a tradeoff that could turn out great (if we make certain adjustments and easements for expansion as we continue to grow), or to excrement if we continue to spend beyond our means as revenues dry up and we face an enormous bubble of an aging society in need of safety net programs like social security and medicare. Aldous Huxley really makes a fine point about the rate of physical “Human” growth (which is currently adding 80 million new humans to the planet each and every year; and only losing about 55 million in return). In light of the fact that we are adding 25 million aggregate bodies to the planet each year (give or take a few million), the need for expansion based systems is unfortunately going to be with us for a while, as a result. Somewhere in this “mish-mash” I have put forth there is a solution to the problems caused by globalization and human expansion, as of yet that successful paradigm has yet to reveal itself. I also think the divisiveness of American politics has created such bad blood that the political will to find bi-partisan solutions (using the same metaphor, “to replace the entire roof”) is going to be nearly impossible, unless a more logic-based paradigm is created that tips its hat to “wealthy” individuals while simultaneously concerned with the welfare of the “poor” and “middle class”. I would certainly like to hear more of your discussion on this topic, as I think you have your finger on the pulse.