By Maria Dahl, Junior Consultant at the Organisation for Economic Co-operation and Development (OECD), Paris
Statistical models are inefficient and out of touch. Economic doctrine needs shaking up.
Milton Friedman argued “economics has become increasingly an arcane branch of mathematics rather than dealing with real economic problems”.
My romance with Mr. Economics began in Spring 2009. Thanks to his continuous attempts to explain real world challenges, such as poverty and unemployment, it is still going strong. I consider his mathematical and conceptual frameworks valuable tools for understanding problems such as inequality. But his abstract tendencies have grown more dominant of late. I suspect he is cheating on me with Ms. Mathematics. Many economists have felt the same heartache: Friedman, Krugman, Keynes, Marx, Stiglitz; the list goes on. Regrettably, Ms. Mathematics cannot explain our economy like Mr. Economics can. Mr. Economics was born as a social science. Classical economists such as Adam Smith were philosophers, not mathematicians.
This affair is ruinous. Mr. Economics and Ms. Mathematics’ models are based on unrealistic assumptions: that the behaviour of economic agents remains consistent within the model’s structure and human decisions are based on rational expectations. By extension, economic agents must fully understand their economic environment. But this leaves no room for imperfect knowledge, asymmetric information, and adaptive expectations, all common human characteristics proven by psychologists and behavioural economists, like Lo et al. The adoption of statistical analysis leads Mr. Economics to assume the economy shows a normal distribution. That assumption has been discredited by four crises that have broken out in the past 20 years, in 1987, 1994, 1998, and 2008. These crises were much larger than any possible tail event that statistical models with a normal distribution could have predicted, says Kaletsky. Mr. Economics does not even admit crises exist, say Verdo, and Hendry and Mizon.
Increased dependence on numerical values to describe the economy, such as GDP, means Mr. Economics risks omitting important factors. What about social wellbeing, inequality of opportunity, and environmental degradation? Kuznets asked such questions in 1941, and Easterlin later. Ms. Mathematics emphasizes the use of measurable risk, neglecting the economy’s immeasurable uncertainty. Hodgson fears emphasis on risk ignores the observations of late economists like Keynes, who highlighted economic uncertainty.
You may wonder why Mr. Economics’ affair with Ms. Mathematics matters for economic policy. How economists think about the economy directly affects the way policies are formulated. Reinhart and Rogoff’s 2010 report played a large role in support of austerity policies across the Western world. It was proven wrong a week ago, by Professors Ash, Pollin, and Herndon at the University of Massachusetts, due to miscalculations and unconventional statistical techniques. That adds weight to my concern about this affair. Then there is GDP, the weak social welfare indicator. This points governments in the wrong direction when creating policies. Increasing crime and car accidents increases GDP for example, critiqued Fleurbaey in 2009. Mr. Economics should look at quality, not just quantity. Discussions about the state often relate to its size. This misses the point, says Phillippe Aghion. A more poignant question is how government can effectively deal with societal problems. He thinks a ‘smart state’ is more relevant. A ‘smart’ state realises when it should cut back and when it must intervene. It implements well-targeted policies so that expenditure is used more efficiently. It supports a better market economy, by tackling three major sustainability challenges: environment, debt, and equality, say Aghion and Cagé.
Mathematical methodology prevents economists and policymakers from asking the right questions. We should feel outraged at the current state of economics. In the conclusion to his book, Indignez-Vous (Time for Outrage), Stephane Hessel says: “to create is to resist, to resist is to create”. We must resist, to allow the creation of a better methodology that reflects the interconnected and complex society we live in. We should not accept measurements simply showing deviation from models. We can address Mr. Economics’s deviant ways, by using living economic models rather than zombie economics, argues Quiggin. In spite of his affair, I still love Mr. Economics and believe we can change things for the better.
Aghion, P. and J. Cagé (2012), “Rethinking Growth and the State” in Canuto, O., Leipziger, D. M. (eds.), Ascent after Decline: Regrowing Global Economies after the Great Recession, World Bank
Ash, M., R. Pollin and T. Herndon (2013), “Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff”, Working Paper Series, No. 322, Political Economy Research Insitute, Amherst
Easterlin, R.A., (1974), Does economic growth improve the human lot? Some empirical evidence, P.A. David, M.W. Reder (Eds.), Nations and households in economic growth: Essays in honour of Moses Abramowitz, Academic Press, New York
Fleurbaey, M. (2009), “Beyond GDP: The Quest for a Measure of Social Welfare”, Journal of Economic Literature, Vol. 47, No. 4, pp. 1029-1075
Hendry, D. F, G. E. Mizon (2011), “What Needs Rethinking in Macroeconomics?”, Global Policy, Vol. 2, No. 2, pp. 176–183
Hessel, S. (2010), Indignez-Vous, Hachette Book Group, New York
Hodgson, G. (2011), “Reforming Economics after the Financial Crisis”. Global Policy, Vol. 2, No. 2, pp. 190–195
Kaletsky, A. (2009), “Goodbye, homo economicus”, Real-world economics review (50, September)
Kuznets, S. (1941), National income and its composition 1919-1938, National Bureau of Economic Research, New York
Lo, A., D. V. Repin, B. N. Steenbarger. 2005. “Fear and Greed in Financial Markets: A Clinical Study of Day-Traders”, American Economic Review, 95 edition
Quiggin, J. (2010), Zombie Economics, Princeton University Press, Princeton
Reinhart, Carmen M., and Kenneth S. Rogoff. 2010. “Growth in a Time of Debt.” American Economic Review, 100(2): 573-78
Verdo, Y. (2013), “L’économie est-elle une science exacte?”, Les Echos, Paris, April 8th 2013