Economics is not a hard science, and mathematical models won’t explain why people behave as they do. A much broader perspective is needed.
The Guardian recently asked nine economists whether we’re heading for another global financial crash and they gave many different answers. Yet still we turn to economists as if they were physicists, armed with scientific predictions about the behaviour of the body economic. We consumers of economics, and economists themselves, need to be more realistic about what economics can do. More modesty on both the supply and the demand side of economics will produce better results.
Following the great crash that began nearly a decade ago, there has been some soul-searching about what economics got wrong. Probably the self-criticism should have been more far-reaching, both in academia and banking, but it’s there if you look for it. In particular, the economic thinkers loosely clustered around George Soros’s Institute for New Economic Thinking (Inet) have produced a telling account of what went wrong.
Adair Turner, who saw top-level decision-making as head of Britain’s Financial Services Authority and now chairs Inet, gives a measured, cogent version of the critique in his book Between Debt and the Devil. Yes, leading academic economists did challenge the mathematical models of market perfection and, yes, financial markets may have followed oversimplistic versions of those models. Nonetheless, Turner argues, “the dominant strain of academic economics and of policy-making orthodoxy” failed to see the crisis coming, and actually contributed to it.
The key flaws were the efficient market hypothesis and the rational expectations hypothesis: economists too often assumed that market actors not only behave rationally but do so according to the same mental models deployed by economists. (Soros himself has spent a half century trying to expose this fallacy.) Modern big-picture economics (macroeconomics) also “largely ignored the operations of the financial system and in particular the role of banks”.
Market fundamentalism understood itself as the diametric opposite of the communist command economy, but in fact made the same cardinal mistake: to believe that a rational model could encompass, predict and optimise the dynamic complexity of collective human behaviour. As Roman Frydman and Michael Goldberg write: “Like a socialist planner, the economist thus believes that he can accomplish great feats, because he supposes that he has finally uncovered the fully determined mechanism which drives market outcomes.”
Large parts of academic economics fell prey to what has been called physics envy, by analogy with the Freudian notion of penis envy. Like some other areas of social science, it aspired to the status, certainty and predictability of physics. I have long thought that this hubris was fed by the fact that economics, alone among the social sciences, has a Nobel prize. Strictly speaking, it is only the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, endowed by the Swedish central bank and first awarded in 1969, not one of the original Nobel prizes. But everyone calls it the Nobel prize. Moreover, politicians and decision-makers listen to economists in ways that they don’t, for example, listen to political scientists of the rational choice school that dominates many American university departments. This may partly be because a politician who practised rational choice politics would soon be kicked out of office, whereas the public has had to pick up the bill for those who practised rational choice economics.
This does not mean we should not pay attention to economists, nor that economics is unworthy of a Nobel prize. It just means it’s not a hard science like physics. Done properly, it takes account of culture, history, geography, institutions, individual and group psychology. John Stuart Mill said: “A man is not likely to be a good economist if he is nothing else,” and John Maynard Keynes observed that an economist should be “mathematician, historian, statesman and philosopher in some degree”.
In another remarkable formulation, Keynes wrote: “Economics is essentially a moral science.” Indeed, one could argue that the Nobel prize for economics belongs somewhere midway between those for physics, literature and peace. Economics is, at best, a multidimensional, evidence-based craft, alert to all the influences on human behaviour, at once ambitious in scope and modest in its claims for what we can ever predict in human affairs.
What should follow from this revised, new-old understanding of the character and place of economics? I don’t know enough about university economics courses to say whether they need to adapt, but I was struck by a manifesto published a couple of years ago by economics students at Manchester University. This advocated an approach “that begins with economic phenomena and then gives students a toolkit to evaluate how well different perspectives can explain it”, rather than mathematical models based on unrealistic assumptions. (A colleague of mine claims to have heard a fierce argument between two economists in the common room of Nuffield College, Oxford, which culminated in one exclaiming to the other: “All right, assume immortality!”)
If economics is like other disciplines, it probably changes more slowly than it should, because of the strong inertial effect of older faculty personally invested in a certain way of doing the subject. Then there’s the conduct of major players, be they ministers, central bankers or business leaders. I recently read a splendidly robust lecture by the veteran investor Charlie Munger, Warren Buffett’s partner in Berkshire Hathaway, delivered in 2003, well before the crash. “Berkshire’s whole record has been achieved without paying one ounce of attention to the efficient market theory in its hard form,” he said, adding that the results of that efficient market doctrine in corporate finance “became even sillier than they were in the economics”.
Munger’s sage advice was to restore economics’ proper multidisciplinary character, not overweighting what can be counted against the unquantifiable, nor yielding to the craving for false precision, nor privileging theoretical macroeconomics over the real-life microeconomics that helped guide Berkshire’s long-term investment decisions.
We ordinary punters should learn the same lesson. We should ask of our economists, as of our doctors, only what they can deliver. There is a scientific component to medicine, larger than that in economics, but medical studies themselves indicate how much our health depends on other factors, especially psychological ones, and how much is still unknown. Economists are like doctors, only less so.