[OPE] The Financial Times and the mysteries of the dismal science

In an editorial, "At your own risk" (July 27 2009), the Financial Times
reflects on the predictive and explanatory power of economics:

(...) Queen Elizabeth stumped her hosts at the London School of Economics by
asking why no one had seen the financial crisis coming. (...) Some of
Britain's leading economic experts have now sent the Queen a reply. They
point out that some did foresee the crisis, prominent economists included.
What failed was the "collective imagination of many bright people". More can
be said. The economics profession's obliviousness to imminent collapse has
led it to search whatever soul it may have to learn where it went astray. A
prime suspect is a theory too optimistic about the
rationality of people's choices and the possibility of capturing them in
mathematics. The truth may be simpler and more depressing: that no economic
theory can
perform the feats its users have come to expect of it. Economics is unlikely
ever to be very good at predicting the future. (...) But its irresponsible
use does not mean economics is useless. It is rather good at explaining the
past and guessing unintended consequences of well-meaning policies -
invaluable tools for cleaning up financial markets. So we do need economists
in public debate, but ones not blinded by mathematical sophistication or
paradoxes beyond the lay public's grasp.
http://www.ft.com/cms/s/0/530b042c-7adf-11de-8c34-00144feabdc0.html?nclick_check=1

This is of course fairly shallow thinking. Modern economics is essentially a
description of techniques for money-making, and an inquiry about how market
actors are most likely to trade under assumed conditions. The success of a
technique depends on its application; in this sense there is no technique
that guarantees success, and economics can hardly be blamed if the
techniques fail. The problem is rather with the theoretical assumptions -
the eclectic concoction of foundational assumptions which guide the
economist in fathoming market behaviour.

If the central theoretical assumption of your economic science is that
markets will spontaneously tend towards creating economic equilibrium, you
are not wellplaced to understand the 23 slumps in the world market breaking
out successively in 1825, 1836, 1847, 1866, 1873, 1882, 1891, 1900, 1907,
1913, 1921, 1929, 1937, 1949, 1953, 1957, 1960, 1970, 1974, 1981, 1990, 2001
and 2007. The best you can say, is that there were exogenous obstacles
interfering with market functioning, but this creates the problem that
economics cannot explain economic disturbances because the causes themselves
cannot be economic - they must be sought in psychological factors, political
policies and social or cultural circumstances external to market trade. This
cripples economic science right from the start, because every time it tries
to explain market action it must refer to a non-market environment external
to its explanatory apparatus.

No doubt human choices - the power of human agency - plays an important and
even decisive role in shaping economic history. But common sense tells us
that it is ludicrous to think that human choices and decisions about
economic matters are made simply according to a rational financial calculus
by individuals only. Important decisions are often made by groups, states
and organisations, not individuals. They involve non-financial
considerations as well. Those choices are moreover not made in a void, but
in a specific historical context which enables some realistic options, rules
out others, and makes some decisions more likely than others. Obviously we
will understand nothing about what motivates individual choices unless we
include the total context in which they occur.

All this was acknowledged in classical political economy, because its
foundational inquiry was not primarily about how markets would balance out
as a result of a myriad of individual choices, but about "who benefits",
i.e. about the gainers and losers of economic activity. This meant a focus
on human interests, material interests, and this is also precisely how Adam
Smith justified his concept of the "hidden hand": pursuing self-interest in
the main best served the general interest, even although those interest
could conflict. Political economy originated in a "moral science" about
resource allocation which developed into a "political arithmetick" concerned
with tax burdens on the community, and from there into a general inquiry
into the workings of commercial society. This made political economy a
social science from the beginning, concerned not simply with the trading
decisions of individuals, but with how the individuals were related in
society, with social relations. The power of Adam Smith's classic treatise
was not at all that it provided a technically correct explanation of market
functioning, but rather that he provided shrewd insight into the human and
social processes involved in economic life. All this has been lost from
modern economics, which just dolls up its mathematical equations with a few
banal analogies about human nature.

The consequence of all this is that economics has no profound or systematic
way of theoretically reconciling the individual and the social, the micro
level and the macro level, human agency and social structure. It lacks, in
other words, any systematic understanding of social causation. Once we admit
the existence of structurally conflicting and competing interests (which are
not just economic interests), and drop the crippling assumptions of modern
economics, a lot of the myseries disappear. For instance, it becomes clear
that economic authorities of all kinds have a vested interest in not
sounding the alarm for an impending crisis, because doing so would cause an
immediate negative response from the markets. That would cost a lot of
money, and thus, one remains silent about the impending crisis until nobody
can deny it is happening.

Jurriaan

Interests
Micro-macro

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Received on Tue Jul 28 09:03:16 2009