Tuesday, October 27, 2009

Adbusters - Can Economists Improve the Human Condition?

Uh . . . . maybe? Indirectly? Well, OK, not likely. Someday?

Seriously, this is an interesting article from Adbusters.

Can Economists Improve the Human Condition?

“Do you need math to study economics at university?” is a question I often get asked. Here is a cautionary tale for anyone who still has illusions about the relationship between the two disciplines. A friend of mine teaches economics at Cambridge, England. Recently she had a first year student who was very good indeed at math. So much so that he complained there wasn’t enough of it in his course. For his second year, he was sent on an exchange to the other Cambridge: the Massachusetts Institute of Technology. Emails of an increasingly desperate nature began to whiz back to my friend across the Atlantic. The final one said simply: “Help! Please let me back home. There isn’t any economics in this course. It’s all math.”

Things are not quite so bad in most places, but math is becoming increasingly pervasive in economics. Just for the record, at the right time among consenting adults, I too use math. There are both good and bad reasons for employing it in the service of economics. So far mainly the bad ones have prevailed.

It wouldn’t matter much if policy makers didn’t take economics so seriously. Hardly anyone bothers about some of the lunacies in literary theory, for example. But economics matters and, at the frontiers of the discipline, a subtle but profound shift is taking place. Economics is starting to become more realistic, more rooted in institutions, in history, in the real world and, as a result, more useful.

That is, in fact, how economics started off in the first place. Only then it wasn’t called “economics” but “political economy,” symbolizing the fact that economies do not exist independently of political systems and institutions.

Economics is starting to become more realistic, more rooted in institutions, in history, in the real world and, as a result, more useful

Adam Smith single-handedly founded the discipline of economics over 200 years ago, and his influence is profound even today. Yet his seminal book The Wealth of Nations contains no equations at all. Instead Smith uses carefully constructed arguments supported by a wealth of historical evidence. English stockbroker David Ricardo, author of On the Principles of Political Economy and Taxation (1817), is less well known – but the standard economic theory of trade is still based on his work. More than a century later, two figures from opposite ends of the political spectrum made wide-reaching contributions to economics. John Maynard Keynes was trained as a mathematician at Cambridge, switching later to economics. Friedrich Hayek, the intellectual inspiration for Thatcherism, had deep insights in psychology as well as in economics. Ricardo, Keynes, Hayek and a host of other key figures in economics studiously avoided math. Instead they used thoughtful arguments backed up by evidence.

So how has math come to be so pervasive in economics, when so much was achieved without it? The worst reason is that the use of math makes economists feel like they are proper scientists. They suffer from deep “physics envy.” Physicists have to use math. (Try doing quantum physics in words.) And they are real scientists, who really have explained how lots of things really do work. So if we use math, that makes us real scientists, doesn’t it? Well, the logical error in this last sentence is pretty obvious. But it doesn’t stop the inner glow of satisfaction that most economists feel when they cover the page in mathematical symbols.

So how has math come to be so pervasive in economics, when so much was achieved without it?

There is a more serious and more damaging reason why math, or at least a particular kind of math, is used in economics. This is inextricably linked with the concept of “economic man.” Economics is essentially a theory about how individuals behave. And the standard theory not only assumes that individuals are self-interested, but that they behave like some sort of supercomputer – always gathering every bit of information relevant to a decision. These individuals then make the best possible decision out of all available options. Not just a good decision, but the very best. Or, as economists like to say, optimal.

There is a whole branch of math devoted to optimal solutions: differential calculus. It is the ideal tool for a theory stating that individuals behave in a way optimal for them, given their tastes and preferences. So, for example, if you eat junk food and weigh 300 pounds as a result, or if you drink heavily and destroy your liver, or if you smoke and get cancer, hey, that’s your choice. You must have been making what you believed to be the best possible lifestyle choice for you, and calculus can prove it!

This is still the basis for a lot of the economics taught in university. Yet, paradoxically, it has been precisely the use of math within economics that has undermined this view of the world. It’s also a reason why the subject is moving on dramatically.

Math can be very useful in economics provided that we think of it simply as one tool among many. It is a tool that can assist us in logical thinking. It’s like another language – it can help us find our way around.

Math can be very useful in economics provided that we think of it simply as one tool among many.

Math has helped economists understand the implications of the economic man theory of behavior. After more than a century of research, economists determined that the theory is a marvelous intellectual construct, but a completely empty box. It has no testable implications. When economists say “demand curves slope downwards” or “people are paid what they are worth,” they have no theoretical basis for making these assertions. We cannot logically deduce from the theory of economic man behavior that either of these statements, both widely used by economists, are true.

Pioneers like the 2001 Nobel laureates George Akerlof and Joseph Stiglitz moved the subject on in the 1970s. They realized something else was needed, so they abandoned the idea that people have perfect information when they make decisions. They developed the concept of “bounded rationality”: the idea that though we may try to make the best decision, we may not succeed due to a lack of vital information. So in a world of bound rationality, people who binge on junk food or smoke heavily are not necessarily seen as making the best possible decision for themselves. The work of Akerlof and Stiglitz was a huge step forward in making economics more realistic.

Daniel Kahneman and Vernon Smith, the 2002 Nobel winners, made even bigger strides with their work. They actually went out into the world and conducted experiments to see how people really do behave. Observing and deducing just like real scientists! And they found that most of the time people don’t behave like the economic man at all. In his Nobel lecture, Kahneman stated: “The central characteristic of agents [people] is not that they reason poorly, but that they often act intuitively. And the behavior of these agents is not guided by what they are able to compute, but by what they happen to see at a given moment.”

In other words, the whole concept of a rational, calculating economic man is being abandoned completely. The economic man theory postulates that people have all the relevant information to make the best possible decision. In this new approach people have – at best – imperfect information … they stumble along, trying to make reasonable decisions, sometimes succeeding but often failing.

“An economist who is only an economist cannot be a good economist.”

The rules of behavior people use depend on the specific time and place. When the Soviet Union fell, for example, the policies forced on Soviet markets – based upon economic man – were disastrous. They led to theft and asset stripping on a stupendous scale and a massive fall in living standards. The policies failed to account for the fact that Russia and the other nations of the Soviet Union had little or no experience of how markets worked. Above all, they failed to take into account that in the West there are very few pure “free markets” – institutions, law, custom and practice all mediate the workings of markets. An outdated view of the world forced these tired policies on the Russians.

The new approaches that have developed to replace the economic man, perhaps surprisingly, make economics much harder. Instead of just manipulating some equations, we have to think hard about what the relevant rules of behavior are in any particular context. And we have to restore the importance of institutions and history. In short, we have to restore the idea of political economy in a totally modern guise. Hayek is mistrusted by many, but there is a profound truth in his remark: “An economist who is only an economist cannot be a good economist.”

All this makes economics more humble. Instead of claiming a completely general theory of behavior – applying to all people at all times in all places – economics is now much less grandiose. But ultimately, these changes will serve to make the discipline more realistic … and potentially more powerful as a force for helping to understand and improve the human condition.

Paul Ormerod studied economics at Cambridge University and did a postgraduate degree at Oxford. He is the author of The Death of Economics, Butterfly Economics and Why Most Things Fail. Download some chapters from his website, www.paulormerod.com.

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