HOW TO THINK ABOUT ECONOMICS, PART II

Last week I wrote about an intriguing new book—The Puzzle of Modern Economics—that grapples with the question of whether economics is fatally flawed or only partially blemished, in which case it’s better than the alternative of throwing up your hands and screaming. Yesterday I stumbled across another recent addition to the genre of reassessing the dismal science that’s no less thought provoking: Economyths: Ten Ways Economics Gets It Wrong.


My first reaction: There are only 10 missteps in economics? We could, of course, turn the subject around and focus on the 10 (or more?) things that economics gets right, like the deep understanding of why free markets and capitalism is generally preferable for promoting economic growth vs. the various state-centered alternatives. But the really big picture isn’t under scrutiny in Economyths, written by mathematician David Orrell, an author who’s tackled similar subjects before, including The Future of Everything: The Science of Prediction. His latest book gets into the nooks and crannies of economics and attempts to point out where theory and real-world application separate.
Orrell zeroes in on the basic problem under scrutiny when he writes: “Economics gains its credibility from its association with hard sciences like physics and mathematics.” But as many observers have pointed out in recent years, the fusion of the dismal science and hard science only goes so far, and at times the assumption that there is such a linkage is dangerous. But this is an old idea, as Orrell himself points out by quoting Issac Newton’s perennially relevant counsel from 1721: “I can calculate the motions of heavenly bodies, but not the madness of people.”
Have we learned anything in the subsequent centuries? Orrell offers some elegantly written arguments for staying cautious on answering “yes.” The central challenge, he opines, is breaking free of the legacy that binds us to the historical record in economics. “It turns out that many of the ideas that form the basis of modern economics have roots that stretch back to the beginning of recorded time,” he writes. “That’s one reason why they are proving so hard to dislodge.”
As one relatively recent example, he examines a staple in economics: the supply and demand curve. “If economics has an equivalent of Newton’s law of gravity, it is the law of supply and demand,” he reminds. And for good reason, considering that as a practical description of pricing, the supply and demand curve illustrates how markets reach equilibrium—the point at which supply and demand are balanced. If supply or demand changes, or both, so too will prices. As Orrell explains,

In one sense, the law of supply and demand captures an obvious truth – if something is in demand, then it will usually attract a higher price (unless it’s something like digital music, which is easily copied and distributed for free). The problem arises when you decide to go Newtonian, express the principle in mathematical terms, and use it to prove optimality or make predictions.

But while the law of supply and demand does a pretty good job of describing prices for general purposes, it’s not perfect and so it can be misleading at times in terms of predicting prices, at least in the short term. In other words, don’t confuse economics with physics, Orrell warns. The reason is that people are a key part of economic analysis, a distinction that doesn’t harass astrophysicists or aerospace engineers. The classic rules of supply and demand break down at times because of the man on the street. Why? People and their seemingly odd preferences. Orrell explains that this distinction is particularly relevant for analyzing certain assets that are sought for their investment value.
The Economist recently made a similar observation:

Financial markets do not operate in the same way as those for other goods and services. When the price of a television set or software package goes up, demand for it generally falls. When the price of a financial asset rises, demand generally increases.

Why the difference? The reason is surely that goods and services are bought with a specific use in mind. Our desire for them may be driven by fashion or a desire to enhance our status. But those potential qualities are inherent in the goods themselves—the sports car, the designer sunglasses, the fitted kitchen. Such goods may be means to an end but the nature of the means is still important.

Overall, such differences between physics and economics “helps explain why large economic models, which are based on the same laws, fail to make accurate predictions,” Orrell advises. In fact, this is old news. Economists have been telling us for a long time that stuff happens and so the standard theories of what should happen are susceptible to, well, temporary insanity, heightened risk aversion, chaos, or whatever you’d like to call it.
Even the so-called classical economists recognized that markets aren’t perfect and sometimes succumb to the disequilibrium du jour. J.S. Mill’s Principles of Political Economy from 1848, for instance, noted that moments of “commercial crisis” arise at times. “At such times there is really an excess of all commodities above the money demand: in other words, there is an under-supply of money,” Mill wrote.
Of course, Keynes emphasized the fluctuations in aggregate demand in The General Theory of Employment, Interest and Money as the critical variable in crises.
In any case, Orrell reminds that economics cannot be reduced to one fundamental law. There are multiple schools of thought in economics and not one is entirely right…or wrong. The evidence for thinking so is that predictions fail. They fail enough of the time to keep the crowd guessing. “One reason is that the economy is made up of people, rather than inanimate objects.”
Those damn people! If it wasn’t for all the wetware, maybe economics would resemble physics.