What’s wrong with economics?

This is the title of a speech by DeLisle Worrell, Governor of the Central Bank of Barbados. Another speech/paper which looks at problems with economics. Interestingly, it comes from a central banker of a very small developing economy. So, it has some other insights.

He is dismayed over recent developments in economics:

Back in the sixties, when I began my career in economics, we were all too aware of the limitations of the discipline: it was static where the world was dynamic, it assumed competitive markets where few existed, it assumed rationality when we knew full well that economic agents were not rational (at least not by the definition economists use), the choice of first principles was always arbitrary and culture bound, economics had no way of dealing with changing tastes and technology, and much else besides. Econometrics was equally plagued with intractable problems: economic observations are never randomly drawn and seldom independent, the number of excluded variables is always unmanageably large, the degrees of freedom unacceptably small, the stability of significance tests seldom unequivocably established, the errors in measurement too large to yield meaningful results (when we could estimate their magnitude at all, that is), the proxies we always have to use instead of the theoretical variables unacceptably distant from the variables they are meant to represent.

So we understood that we could not rely entirely – or even mainly – on theory and tests to say anything useful about the real world.

Over the past 4 decades I have become increasingly dismayed as I have observed the economics profession being taken over by a generation of economists who have lost sight of the limitations of what they can know, with the help of the tools and techniques available to us. We write as though anything that we can set down in a theoretically “correct” specification of an equation has to be true, even when the evidence to the contrary is right before our eyes, and obvious to everybody who is not an economist. When our empirical tests fail to yield expected results we do not take our theory back to the drawing board, but we fudge some explanation that we think might be plausible.

Hmmm… He points following problems:

  • The exchange rate is not a price of anything
  • Prices have not been set by markets since the end of the agrarian economy
  • Economics uses the laws of physics as they were known in the nineteenth century
  • Learning to observe the world as it really is
  • Replacing the GDP with the HDI
  • Discarding unscientific practices
  • Replacing slavish reverence for maths with methodological eclecticism

All points are worth noting about, but the first two are like amazing. In first he says exchange rate is not a price but just a conversion factor!

Economists cannot understand how the exchange rate of small resource poor countries like Barbados, Cayman, the Bahamas and the OECS can remain unchanged in terms of their numeraire (the US dollar) indefinitely, because they deceive themselves into thinking that the exchange rate is a price. Economists believe that prices are arrived at by demand and supply in a market, and since the demand and supply will change over time, then the price has to change as well, otherwise the market will not clear. So they have to invent some artifice to  explain long term exchange rate pegs, especially in countries like the OECS that have no exchange controls.

But in fact the mistake is to believe that the exchange rate is the price of foreign exchange. You can’t eat, drink, smoke or wear foreign exchange; foreign exchange is not a commodity. Rather, the exchange rate is what it says on the tin, a statement about the relation between one measure of value and another. The value of the shirt I bought at Havana Nines in Miami airport for US$50 is twice that amount in BDS$, because the exchange rate of the US$:BDS$ is 1:2. In exactly the same way that a 10 mile walk is equivalent to a walk of 16  kilometers, because the “exchange rate” of miles to kilometers is 1.6:1. It makes as much sense to keep changing the exchange rates between currencies as it would to keep changing the value of a mile in terms of a kilometer. The only outcome of flexible exchange rates is increased uncertainty, with no benefit whatsoever.

This is obvious to ordinary people, but to modern economists it is preposterous. No matter that it is confirmed by observation the world over. Not just in the Caribbean, but in regions scattered across the globe, there is a tendency for currencies to cluster around large attractors in their neighbourhood; in Europe it is the euro, in the Americas the dollar, in Southern Africa the rand, in the Indian Sub-continent the rupee. It is the notion of flexible exchange rates that is ridiculous, not the acceptance of the superiority of pegged exchange arrangements. We should remember that the notion that flexible exchange rates are an acceptable way to manage the international economy has risen to ascendency only in the last 3 decades or so, a period I believe will be seen by history as a dark age of economics.

Phew! I have not read that anywhere! Dark age of economics is being said by quite a few econs.

What about the second point? HE says when Adam Smith wrote about economics prices were indeed set in markets. You had farmers who would go to markets and prices would be determined. Worst is this was written as industrial age was beginning and has remained a standard since then. Prices are not determined in markets anymore!

In the agrarian economy the worker tends his farm during the week, and goes to market on market day; in the industrial economy the hotel worker travels from home to workplace every day, and he or she may go supermarket shopping any day. In the agrarian economy the farmer takes his produce to market on market day, in the industrial economy he sells it on contract to the supermarket. In the agrarian economy goods and services are exchanged in the market on market day; in the industrial economy shops and businesses are open every day. In the agrarian economy each market is clearly defined in time and space; in the  industrial economy there is no spatial restriction – commodities are exchanged right across the world – and there is no single defined period over which all transactions must be completed. Buyers and sellers make contracts for whatever period is mutually agreeable.

I have come to believe that economists have built a discipline for a world which has largely vanished, and that is why we have nothing sensible to say about the challenges that face the world economy today. Economics does not give you a straight answer about the price of oil or any other commodity, about the exchange rate of the euro to the dollar, about the impact of deficit reduction in EU countries, about the effects of interest rate changes by the Federal Reserve, about the motivation for stock market fluctuations, or about any other economic question of interest. It is true that there is a dominant position in the economics profession on each of these issues, but that dominant view has proved badly wrong, and persistently so.

I now believe that we need a new paradigm in economics, one that is appropriate to how individuals and societies conduct economic exchanges in an industrial society.

Phew again. Read the rest of the speech for more details.

I am not sure how economists would react to this speech. Most would just mock it off. But it does deserve a thought or two. He does make some great points.

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2 Responses to “What’s wrong with economics?”

  1. Raghu rajan asks why did economists not spot the crisis? « Mostly Economics Says:

    […] Bank of Barbados says he is searching for Practical Economics. He made waves earlier with his superb speeches questioning economics relevance in today’s […]

  2. Challenges facing Caribbean economists « Mostly Economics Says:

    […] has been posing tough qs on economics and economists since the crisis (see  these superb speeches What’s wrong with economics? and What’s wrong with economics – […]

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