Friday, November 03, 2006

More on the dismal science

I have drawn some inevitable flak for my criticisms of economic theory in the Financial Times. That’s no more than I expected. Here’s the article; the comments and my responses follow.

Baroque fantasies of a peculiar science

Published in the Financial Times, October 29 2006

It is easy to mock economic theory. Any fool can see that the world of neoclassical economics, which dominates the academic field today, is a gross caricature in which every trader or company acts in the same self-interested way – rational, cool, omniscient. The theory has not foreseen a single stock market crash and has evidently failed to make the world any fairer or more pleasant.

The usual defence is that you have to start somewhere. But mainstream economists no longer consider their core theory to be a “start”. The tenets are so firmly embedded that economists who think it is time to move beyond them are cold-shouldered. It is a rigid dogma. To challenge these ideas is to invite blank stares of incomprehension – you might as well be telling a physicist that gravity does not exist.

That is disturbing because these things matter. Neoclassical idiocies persuaded many economists that market forces would create a robust post-Soviet economy in Russia (corrupt gangster economies do not exist in neoclassical theory). Neoclassical ideas favouring unfettered market forces may determine whether Britain adopts the euro, how we run our schools, hospitals and welfare system. If mainstream economic theory is fundamentally flawed, we are no better than doctors diagnosing with astrology.

Neoclassical economics asserts two things. First, in a free market, competition establishes a price equilibrium that is perfectly efficient: demand equals supply and no resources are squandered. Second, in equilibrium no one can be made better off without making someone else worse off.

The conclusions are a snug fit with rightwing convictions. So it is tempting to infer that the dominance of neoclassical theory has political origins. But while it has justified many rightwing policies, the truth goes deeper. Economics arose in the 18th century in a climate of Newtonian mechanistic science, with its belief in forces in balance. And the foundations of neoclassical theory were laid when scientists were exploring the notion of thermodynamic equilibrium. Economics borrowed wrong ideas from physics, and is now reluctant to give them up.

This error does not make neoclassical economic theory simple. Far from it. It is one of the most mathematically complicated subjects among the “sciences”, as difficult as quantum physics. That is part of the problem: it is such an elaborate contrivance that there is too much at stake to abandon it.

It is almost impossible to talk about economics today without endorsing its myths. Take the business cycle: there is no business cycle in any meaningful sense. In every other scientific discipline, a cycle is something that repeats periodically. Yet there is no absolute evidence for periodicity in economic fluctuations. Prices sometimes rise and sometimes fall. That is not a cycle; it is noise. Yet talk of cycles has led economists to hallucinate all kinds of fictitious oscillations in economic markets. Meanwhile, the Nobel-winning neoclassical theory of the so-called business cycle “explains” it by blaming events outside the market. This salvages the precious idea of equilibrium, and thus of market efficiency. Analysts talk of market “corrections”, as though there is some ideal state that it is trying to attain. But in reality the market is intrinsically prone to leap and lurch.

One can go through economic theory systematically demolishing all the cherished principles that students learn: the Phillips curve relating unemployment and inflation, the efficient market hypothesis, even the classic X-shaped intersections of supply and demand curves. Paul Ormerod, author of The Death of Economics, argues that one of the most limiting assumptions of neoclassical theory is that agent behaviour is fixed: people in markets pursue a single goal regardless of what others do. The only way one person can influence another’s choices is via the indirect effect of trading on prices. Yet it is abundantly clear that herding – irrational, copycat buying and selling – provokes market fluctuations.

There are ways of dealing with the variety and irrationality of real agents in economic theory. But not in mainstream economics journals, because the models defy neoclassical assumptions.

There is no other “science” in such a peculiar state. A demonstrably false conceptual core is sustained by inertia alone. This core, “the Citadel”, remains impregnable while its adherents fashion an increasingly baroque fantasy. As Alan Kirman, a progressive economist, said: “No amount of attention to the walls will prevent the Citadel from being empty.”

So there you have it. Now the critics, published in the 1 November FT and online:

Letter 1: Did this sceptic ever take a course in the one science that calls itself dismal?

Sir, Philip Ball ("Baroque fantasies of a most peculiar science", October 30) quarrels with what he calls neoclassical economics. Perhaps his scarce argument may be better allocated against a competing end: might he notice that physics attempts to describe, explain and predict the action of matter in space, motion and time?

Economic theory establishes a baseline description of human behaviour, while always positing that when humans act, considerable complexity results. Perhaps Mr Ball never took a second course in the only science that, for its challenges, calls itself dismal.

Chris Robling,
Chicago, IL 60602, US

Do you understand this? I don’t. Yes, that’s what physics does. And your point is?
‘Economic theory establishes a baseline’: well yes, except that it doesn’t, because it manifestly doesn’t describe the way people act even to first order. But the real criticism is that neoclassical economics isn’t consistent even on its own terms – if you swallow its assumptions, the conclusions don’t follow. Steve Keen’s book
Debunking Economics shows why.

“A second course”? Is this some kind of American euphemism? Sorry, too strange.

By the way, I suspect most people use the phrase ‘the dismal science’ without knowing what Carlyle was implying (or even that it was Carlyle who implied it). Look it up – it’s interesting. He considered economics dismal not because it was shoddy, but because it dealt with unpalatable truths about human nature. The article in which he used the phrase was, after all, about “the nigger question”.

Letter 2: A critic paints another unrecognisable portrait of economics

Sir, Philip Ball says it is easy to mock economic theory ("Baroque fantasies of a most peculiar science", October 30). It is even easier to mock a caricature of economics, which is what he does, resorting to the tired cliché that we economists think we are doing mechanical physics. Once true, perhaps, but certainly not recently.

Like so many critics of economics, he paints an unrecognisable portrait of the subject. Economists do indeed use models that assume perfect competition and identical agents with unchanging behaviour, but only when it is useful to do so. At other times, we make other assumptions, including those used in the kind of models Mr Ball wrote about in his interesting book Critical Mass.

Economics is distinctive in using the concept of equilibrium - a state in which no individual consumer or business has an incentive to change behaviour - as a powerful analytical tool. It is so useful that evolutionary biologists, for example, use it all the time too.

I do of course have criticisms of my own subject. In particular, the typical undergraduate syllabus lags far behind all the remarkable developments of the past decade or two, such as information economics and behavioural economics. But the baroque citadel is Mr Ball's own fantasy; we economists moved out of it long ago, as a proper look at the mainstream journals (or a list of the Nobel winners) will show.

Diane Coyle,
Enlightenment Economics,
London W13 8PE, UK

Paul Ormerod tells me I would actually get on well with Diane. I think he’s right; I’ll probably get on with anyone who plugs my book. But I think I mostly agree with Diane anyway, except that I do wonder whether ‘we economists’ refers to a more select bunch than she appreciates. It is precisely those economist I mentioned in Critical Mass who are typically marginalized by the mainstream. I used ‘neoclassical’ so much in my article that I was worried by the repetition, precisely to make it clear that that is what I was criticizing, not the interesting ideas that get put forward outside of it. I understand that agent-based modelers have become so fed up with being excluded because their models violate neoclassical dogma that they have been forced to start their own journal.
The ‘citadel’ is not my term, nor my fantasy – it is the expression used by Alan Kirman, one of the pioneers of economic agent-based approaches. Ask Paul Ormerod. Ask Paul Krugman, for that matter. If they all feel this way, surely there’s a reason?

Letter 3: More risk finance fiascos on the way

Sir, I want to congratulate Philip Ball for his insightful and long-overdue comment about the domination of the economic profession by frustrated mathematicians and physics lecturers (October 30). He is incorrect in one regard, however, when he comments that "there is no other 'science' in such a peculiar state".

In fact, the worlds of finance and risk management have embraced the same nonsensical application of quantitative methods that he describes so well operating in the world of economics. This "derivative" view of credit risk and other important issues of global capital finance has badly damaged the ability of investors to perceive risk and gives managers an unreasonable view of the risks that they do accept. Witness the latest fiasco involving the hedge fund formerly called Amaranth. And there will be more examples very shortly.

Christopher Whalen,
Managing Director,
Institutional Risk Analytics,
Hawthorne, CA 90250, US

Well, precisely. I talk briefly about derivatives and risk management in Critical Mass, simply to say that you’re not going to do very well forecasting risk if you insist on thinking that market noise is Gaussian.

Letter 4: Economists are busy dealing with the impact of 'real agents' in the economy

Sir, Contrary to what Philip Ball believes, many economists are already busy "dealing with the variety and irrationality of real agents" ("Baroque fantasies of a most peculiar science", October 30). These economists include several Nobel prize-winners: Herbert A. Simon, Daniel Kahneman, Vernon L. Smith and Thomas C. Schelling. In fact, the Nobel prize this year was awarded to Edmund Phelps for challenging the Phillips curve trade-offs by "taking into account problems of information in the economy".

Mocking economic theory is easy but doing so by perpetuating "rigid dogma" about economics and economists is pure hearsay. A survey of recent literature in mainstream economic journals or textbooks should enlighten this misconceived view.

Chee Kian Leong,
639798 Singapore

OK, so it’s basically the same point as Diane Coyle’s. But the question of the Nobels is curious. (Needless to say, Simon and Schelling loom large in Critical Mass.) I’ve talked with others about the strange fact that economics Nobels often (though by no means always) go to contributions that lie outside the mainstream, and thus outside of neoclassical dogma. (One could add Stiglitz and Sen to the list, for example.) This speaks of impeccable taste (or nearly so) on the part of the Nobel committee. But it is puzzling – nothing like it happens in the other ‘sciences’.

The bottom line is: do you believe in neoclassical general equilibrium theory, with its efficient market hypothesis, its exogenous shocks, its aggregate price curves and all the rest? If not, do you think it is right that this is what students learn and come to believe about the way the economy works? And that papers which question the theory’s fundamental principles should be excluded from much of the literature?


Robert Vienneau said...

I think you mean to refer to "exogeneous" shocks in that last paragraph. I guess its a question of the sociology of economics how tight an equation one might want to make between neoclassical economics, mainstream economics, and orthodox economics. Is game theory, or perhaps only some trends in game theory, worthy of attack too?

Philip Ball said...

Thanks for spotting that typo Robert - now corrected.
For comments on game theory, see Paul Ormerod's article in the FT, mentioned in the post above. As Paul says, game theory is still generally concerned with rational agents, so somewhat problematic in this context.
And yes, decoupling the terms neoclassical, mainstream and orthodox is a tricky business. Paul is good on this too.