Saturday, August 14, 2010

Why you cannot and MUST NOT trust Mainstream Economists

   Readers of this blog know that I hold  most mainstream economists in contempt. Not a day goes by when you hear or read comments like "(such and such bit of economic data) was Greater(or lesser) than economists estimates." Even Milton Friedman, a mainstream economist in his own right said that economic theories should be judged by their track record in predicting events "rather than by the realism of their assumptions." Measured by Friedman's yardstick, the utility of their predictions has been minimal for decades. Few if any mainstream economists saw the last two bubbles in technology and housing including virtually all of the Federal Reserve economists, those in the Presidents cabinet and in Treasury as well as in economic think tanks. Their clumsy and self serving measures to "fix" the situation they missed has by some measures, made the situation worse and I and many more informed and intelligent observers have pointed out. Why has this been so? What is it about their predictions and measures has rendered their value to society so utterly useless? Even with Cray computers and complex econometric models and formulas, these economists advising our politicians and corporations have blown it. I have struggled to try to discern what factors have led these folks to be so consistently wrong and one of my first clues was some remarks by Niall Ferguson at the Aspen Ideas Conference this summer which I again provide a link to:
Niall all but accused them of faulty assumptions and models. So his remarks put me on the trail of the history of modern economics and a study of their traditional assumptions and their cherished laws and models. Adam Smith in his  18th  century Wealth of Nations was of course the seminal work on economics but it was the economic thought of the mid 19th century  authors who laid down the basis for what we call classical economics which has been modified and expanded by  a host of economists. But one striking fact virtually leaped off the page in my research. To understand how their economic theories came about, you have to know something about Mid 19th century physics. The physicists of the time were struggling to explain  using Newtonian precepts the new discoveries made in heat, and light and electricity , matter and energy and the mysterious forces governing the behavior of these magical discoveries. Physicists like Faraday and Helmnholtz were struggling to form a unified explanation of the relationships between matter and energy, a struggle that continued into the twentieth century with Planck, Bohr, Einstein and a host of others but in the mid 19th century, the field was new and the concepts raw and only partially formed. Into this maelstrom of fascinating ideas stumbled our classical economic forefathers who wondered if the same mysterious forces of energy  holding matter together in equilibrium might  also be a unifying energy force governing the equally mysterious forces governing wealth relationships among peoples. The absurdity of such a  quaint notion given  what we know about physics today seems comical, but at the time prominent economic  thinkers such as William Stanley Jevons in England(pictured above), Vilfredo Pareto in Italy, and Leon Walras in France and others felt that such a unifying link united two different fields might exist, might even certainly exist. These budding economists developed the notion that something they called Utility, which they defined roughly as economic satisfaction and well being, pervaded economic intercourse in much the same way that the nebulous physical force of energy pervaded all space. Perhaps energy and utility were not just analogues. Perhaps they were virtually one and the same, just existing in different fields?!! Religion and philosophy was added to the mix as these thinkers started looking for more analogous relations in Physics with economic concepts of labor, capital,money, resources and so forth. These nascent economists recognized that mathematics was a powerful underpinning to Physics and it was just a short step to then realize that for economics to become a science, that mathematics would have to be added to the mix. Physicists at the time debated the concept of equilibrium of forces that hold matter and energy in balance and so this concept of equilibrium had to be part of economic "science." They developed the notion that markets were closed systems and non market resources outside of a market system were "externalities"to such a market system. Inputs like money and resources, outputs such as goods and services flowed in a closed  circular system along with consumption and distribution.  If there were general laws governing physics, would there not be general laws governing economics? Eric Beinhocker in a book published in 2006  entitled:

Origin of Wealth: Evolution, Complexity, and the Radical Remaking of Economics

points out the influence of the new and controversial theory of evolution upon the evolving theories in economics. In fact ideas of evolution and natural selection posited by people such as Malthus may have influenced Charles Darwin and the idea of economics being an evolving system continues well into the 20th century. Thorstein Veblen and Alfred Marshal, Joseph Schumpter and Freidrich Hayek all explored the relationship between economics and evolutionary theory. But Mainstream economic thinkers were more comfortable with the idea that the economy was alike a rubber ball rolling around inside of a bowl, eventually coming to rest in equilibrium at the bottom of the bowl and there the economy would rest until some new externality acted upon the ball sending it to a new equilibrium. The idea that economics might be a complex system always evolving never really took hold in traditional classical economics but at long last, some of these newer notions of how the economy really functions are starting to appear and be discussed by folks like Fergusson and Beinhocker at Harvard. In a forthcoming post I will attempt to explain some of these new attempts to elucidate how economics really works and whether these new ways of thinking might help economics improve its dismal track record assessing risk and predicting future economic events.

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