Post-Real Economics

“Too large a proportion of recent ‘mathematical’ economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols.” – John Maynard Keynes

“Simplicity does not precede complexity, but follows it.” – Alan Perlis

“Stop trying to change reality by attempting to eliminate complexity.”– David Whyte

One of the most important concepts that my economic, philosophical, and political mentors have drilled into my head is this simple statement: Ideas have consequences. As a corollary to that, bad ideas have bad consequences. Mauldin’s corollary is that bad ideas can often overwhelm good ideas when applied by government bureaucrats, and that long after the market has rejected bad ideas, they may live on in academia and government bureaucracies.

Let me offer a somewhat controversial statement: Economics in general is populated at its core by a lot of bad ideas. And these bad ideas have come to be accepted as the correct interpretation of how the economy functions and thus have become the basis for economic policy.

Thus it should come as no surprise that, like so many other hidebound institutions these days, the economics profession is experiencing a crisis of confidence. Theories advanced by some of its supposedly most talented members have proven time and again to be wrong when applied to the real world. But rather than rejecting their theories, most of the economic establishment continues to tinker around the edges.

This is not the first time that such a crisis has occurred in economics. We have seen economists espouse mercantilism, Malthusianism (a particularly pernicious branch of economics), Marxism and communism, socialism and its twin brother fascism, Austrian economics, capitalism, the gold standard and its cousin bimetallism, monetarism, protectionism, and a whole list of corollary theories like rational expectations, the efficient market hypothesis, and dynamic stochastic general equilibrium. Add to these the growing popularity of New Monetary Theory and variations on it. This list is by no means exhaustive, but just reading it is somewhat exhausting. Some of these theoretical bulwarks have already been dismantled, but others still clutter the halls of academia and policymaking.

I have been quite scathing in my treatment of economists who rely on models that are consistently wrong. I’ve been critical of Keynesianism and the worlds of rational expectations and the efficient market hypothesis, but I have not actually offered an alternative view other than to generally espouse a more Hayekian approach, with more than a casual nod to Adam Smith and the French economist Bastiat, along with the rest of the classicists. But this eclectic mixture is not really an economic basis for policy-setting in the future. My lack of specificity can pretty much be explained by my ongoing search for a better approach.

This week’s letter is going to be an examination of academic economics today and why it fails to explain reality, and I’ll point readers in a direction that can offer a more fruitful explanation of how the economy really works. I readily accept that I will be drummed out of most economists’ Lamb’s Book of Life for espousing too many heresies of the first order. I should hasten to say that much economic research is quite useful and does help to explain how the world works. It is just certain specific branches of economics that have been problematic, but these are the branches that have most influenced government and Federal Reserve policy.

Economics Has a Problem

Economics in general has a problem. It wants to be seen as a true science, on the level of physics or biology or chemistry, rather than one of the soft sciences like sociology or history. At various times, economics has been called “political economy” or “philosophical economy.” Political economy was, in the words of Adam Smith, “an inquiry into the nature and causes of the wealth of nations,” and in particular “a branch of the science of a statesman or legislator [with the twofold objectives of providing] a plentiful revenue or subsistence for the people… and to supply the state or Commonwealth with a revenue sufficient for the publick services.”

That is still a pretty good definition of what economics should be. What many in the profession have attempted to do, however, is to make economics a branch of mathematics.

True science has rules you can’t break. The law of gravity makes for very specific physical behavior that can be mathematically modeled. Economists want us to believe that their own theories and models of reality are similarly reliable. Utilize them faithfully and they will lead us to economic bliss: a state of Equilibrium where all factors exist in Blessed Balance. And the really wonderful thing about this notion is that if the system you are describing is said to be in balance, you have some chance of describing it mathematically. And that allows your philosophical economic science, which can discuss only possibilities about how the world works (as the lowly sociologists and psychologists do), to be elevated above the mere social sciences.

By the way, this is not a slam aimed at the so-called “soft sciences.” There is an enormous amount of solid research that is being done to help us understand the intricacies of the human mind and society. That it is not mathematical makes it no less useful. And that is pretty much my view of economics. Economics is an enormously useful tool for those of us who are trying to understand business and investments and government policy. But to paraphrase Dirty Harry, “An economist has to know his limitations.”

The Idea of Economic Equilibrium is Nonsense

The whole concept of an economy’s being in equilibrium is simply academic nonsense. Equilibrium is a chimera that exists only inside assumption-ridden equations. The real world is a complex, dynamic, out-of-balance mess that doesn’t fit inside anyone’s box. Those theories and equations only work when you assume away the real world. So is it any wonder that the models don’t give us results that look like the real world?

Economists and Madmen

One of my favorite Keynes quotes (and there are lots of them) is:

Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

The problem in economics is that not only economists but politicians and people in general take economic models and the academics who create them seriously. After all, the people offering these dictums are the best and brightest among us. They give each other degrees and go to conferences where they confirm their brilliance. Sadly, they are often what Nassim Taleb describes as “intellectuals yet idiots.” Seriously, how do you argue with a PhD economist, especially when he has a Nobel prize to back up his pronouncements? He looks down on you as a naïve child who doesn’t have the understanding of a mature adult.

How can the very people who claim to understand how the economy works be so bad at predicting and managing it? The quick answer is that the real economy is far more complicated than they’re willing to admit. I can imagine this is hard medicine to swallow when you have spent years trying to simulate an almost infinitely complex system with computer models that are necessarily limited as to inputs, variables, and algorithmic sophistication. But if your model tells you very little about reality, what good is it?

Fortunately, some economists recognize these limitations and are looking for better ways to understand the economy. Unfortunately, that group is vastly outnumbered by old-school economists in government, central banks, international institutions, corporations, and universities. They are everywhere, and they have the ear of those who make important decisions that affect all of us.

The Fatal Assumption

As much as I like to quote John Maynard Keynes (he does have the best quotes in economics), I find his basic thesis to be the fundamental flaw in current macroeconomic thinking. Quoting from Wikipedia,

In the 1930s, Keynes spearheaded a revolution in economic thinking, challenging the ideas of neoclassical economics that held that free markets would, in the short-to-medium term, automatically provide full employment, as long as workers were flexible in their wage demands. He instead argued that aggregate demand determined the overall level of economic activity and that inadequate aggregate demand could lead to prolonged periods of high unemployment. According to Keynesian economics, state intervention was necessary to moderate “boom and bust” cycles of economic activity. Keynes advocated the use of fiscal and monetary policies to mitigate the adverse effects of economic recessions and depressions.