Why economics fails as a science?

Another super article on State of Economics in The Economist (HT: thebrowser.com).

It begins with failure to forecast growth post-Lehman crisis. Quicker recovery was expected. But it never came:

BACK in October 2008, just after the investment bank Lehman Brothers collapsed, the International Monetary Fund unveiled its forecasts for growth in 2009. The IMF is the global lender to national governments; its economic pronouncements are highly respected. So what did it predict? The US would grow 0.1% in 2009, countries in the euro zone 0.2% and the world as a whole 2.6%. The actual outturns were declines of 3.5%, 4.2% and 2.6% respectively.

This lamentable short-sightedness was not unique. Economists have regularly failed to predict recessions and were completely caught out by the recent financial crisis, as the Queen famously noticed.

Failure has been there for a long time:

The shortfalls of the profession are old news. All the way back in 1994, Paul Ormerod wrote a book called The Death of Economics, lamenting the failure to forecast the Japanese recession or the collapse of the Exchange Rate Mechanism, from which Britain was turfed out in 1992. “The ability of orthodox economics to understand the workings of the economy at the overall level is manifestly weak (some would say it was entirely non-existent)” Ormerod wrote.

To be fair to economists, there are two reasons why their forecasts are often likely to be wrong. The first is that humans are not inanimate objects; we change our behaviour and we watch the news. If every economist forecast a recession for 2013 and the predictions were widely publicised, businesses would cancel their investment programmes and consumers would start saving, not spending, for fear of losing their jobs. The recession would occur now, not next year.

Second, the economy is a complex mechanism with many working parts. Economists cannot run real-time experiments in the same way as scientists; operating one version of the economy with high interest rates and another with low rates, as a pharmacologist can offer one patient a new drug and another a placebo. There is no way of isolating the various factors that affect growth.

Comparison to Physics rather Physics envy:

Modern economists are often accused of “physics envy”, filling their papers with complex equations to make them look like “real” science. But in one important sense, the subjects are similar; they can be divided into two. There is sub-atomic physics which deals with the tiny particles that make up matter, and then there is classical mechanics, which deals with the effect on bodies of forces like gravity.  Marrying the two has not always been easy. Similarly, there is micro-economics which deals with how individuals and companies behave; and macroeconomics, which deals with the overall economy.

There are various ways of dividing modern economic thought, but one divide is the way they marry the micro and the macro. The Chicago/neoclassical school tends to build up from the micro level, looking at the way that rational individuals will respond to incentives. The Keynesian school sees that the aggregated response of rational individuals might have perverse outcomes, as in the paradox of thrift, so calls on the government to take action in response. The two sides have also accumulated political baggage with the Chicago school reluctant to see that governments can do nay good and the Keynesians reluctant to acknowledge that there may be a limit to the effectiveness of government intervention. 

The shift in economic though from Keynes to Free market and back to Keynes is interestingly told:

The history of economics can be viewed rather like the regular sequence in the Peanuts cartoon strip, whereby Lucy snatches the football away every time that Charlie Brown tries to kick it. Just when economists have reached a consensus, events in the real world proved them wrong. Classical economists assumed that, left to itself, an economy would find its way back to balance; in a downturn, wages would fall and workers would price themselves back into jobs. Then came the Great Depression and the subject was changed irrevocably by John Maynard Keynes.

..After 1945, the Keynesian school assumed that with careful tweaking of government policies, the economy could be managed successfully. If there was unemployment, then the government could put its foot on the accelerator; if there was inflation, then it as time to touch the brakes. Then came the 1970s, when both inflation and unemployment were high, and economic thinking changed again.

The Keynesian consensus was overturned in the 1970s by Milton Friedman, who asserted that the apparent trade-off between joblessness and inflation was an illusion. Workers responded to Keynesian policies by demanding higher wages, so the net result was higher inflation with no reduction in unemployment. Instead, governments should focus on by controlling the money supply, which would prevent inflation from rising. But the Chicago school’s attack on Keynesianism was much broader than the monetarist label which became attached to it; indeed, it turned out that the nature of money was very hard to define and monetary targets were largely abandoned within a decade or so of their adoption.

Since 1970s it has been period of  “ations”:

The time was right for these theories to gain adherents. The 1970s was a period of crisis; of strikes, power cuts and higher oil prices. The political tide turned; in California, a referendum, Proposition 13, heralded a revolt against high property taxes. In Britain, Mrs Thatcher came to power followed shortly after by Ronald Regan in America. It was the age of the “ations” – deregulation, liberalisation, privatisation and crucially the Great Moderation, a period of steady growth, falling inflation and lower unemployment that marked the 1990s and early 2000s.  

🙂

So is there any thing we know in economics:

The best we can say about economics is that we know what not to do; we have plenty of modern examples from African kleptocrats to totalitarian North Korea. A functioning modern economy needs respect for property rights; a government that is able to collect taxes and offer a social safety net; banks that allow the payment system to function; markets that allow businesses to raise capital and so on. Once those essentials are in place, whether the right top tax rate is 40% or 50%, the right interest rate is 1% or 5% is largely a matter of trial and error, and of political acceptability.  

Much is made of the difference between Britain’s “Anglo-Saxon” model and of France’sdirigiste approach, between the British government’s austerity drive, and France’s pro-growth approach. But for all the rhetoric, Britain’s GDP per head in 2011 was $36,090, according to the IMF, while France’s was $35,156, almost identical. Britain plans to balance its budget by 2017, and so does France.

Despite the small differences in outcome, economists will continue to debate the merits of the competing systems as vigorously as Reformation clerics debated the difference between transubstantiation and consubstantiation. Mr Schlefer’s book, which is deeper and richer than this (already long) blog note can elucidate, is a very valuable addition to the debate.  

Superb read…

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