Why the “dismal profession” is still more creed than science

Image credit: AstroU Montreal

Economics is nominally the study of how economies function. As economies consist of large numbers of quasi-independent actors providing and consuming a wide range of inputs and outputs, it’s clearly infeasible even with today’s powerful computers to attempt to capture and model every single element and interaction within a modern economy. Economists therefore, just like chemists and physicists and biologists, create simplified models in order to elaborate fundamental principles and see what kinds of alterations result in what kinds of effects.

Economists tend to be quite attached to their complex mathematical models, much as doctors used to be attached to leeches (in both methodological and literal senses of the phrase) and small children are attached to their favorite soft toys. Complicated equations provide a comforting impression of scientific precision, the attainment of which is important throughout the so-called “social” sciences which generally lack proper empirical foundations. Sometimes these models can be very helpful, providing insight into phenomenon that are so large they are invisible to us working at the ordinary human scale.

But like all models, if one or more fundamental assumptions are wrong then the entire model is invalidated. Any policy proposals resulting from such compromised models will at best be spurious and at worst be deeply harmful.

As all attempts at centrally-planned economies have amply demonstrated, a market economy is always dramatically superior to rule-by-bureaucrat. Adam Smith in his seminal work The Wealth Of Nations was among the first to realize that money acts as a signal between consumer and producer and thus without any conscious human intervention over time results in a near-optimal mix of inputs and outputs. Smith further realized, although sadly this crucial aspect is perpetually forgotten by nearly everyone, that markets alone are insufficient to ensure that money will remain free to act as a signaling mechanism. He understood that human nature will ultimately result in oligarchies being established as producers form cartels by means of which artificially to raise prices and thus gouge consumers.

Thus a key role for government is to ensure adequate regulation of markets so as to work against the tendency towards consolidation of producers into comfortable cartels.

The USA is the world’s leading example of what happens when the rich and powerful simply buy government and thereby ensure legislation is permanently in their favor. The railroad barons of the late 19th century paid US politicians to pass laws that forced farmers to sell their produce to the railroad companies, which then transported the produce to cities and sold it for enormous markups. Today US politicians are still perpetually eager to exchange the well-being of ordinary citizens in return for juicy campaign contributions. A recent study by Princeton academics showed that between 1990 and 2010, 86% of all legislation favored by the Republican Party enabled the ultra-rich and major corporations to increase their wealth and power at the expense of everyone else.

This tendency operates at State level as well. For example, it is illegal for residents in Florida to attempt to use solar panels to generate electricity because Florida law mandates purchase of electricity from the State utility. In Oregon it is illegal to gather rainwater off one’s own roof because the law mandates that all water must be obtained from the State utility. There are literally tens of thousands of US laws at both Federal and State level that are all designed to enrich the few at the expense of the many. Thus the USA can rightly be regarded as an example of total failure of the system of representative democracy, unless of course one redefines the term to mean “representative principally of the interests of the rich and powerful.”

And yet most economists defend overall US policy because they assume perfect markets and rational actors as per their delightful Excel models.

But models are worthless unless they can accommodate real-world facts. The baleful history of economics strongly demonstrates a general failure to take important details into account. Peter Keen, an Australian economist, has spent his entire career as an outsider because he’s been willing to point out the many errors inherent in standard economic models and thus the blunders of standard economic advice. Not surprisingly, he’s not invited to many parties and he’s never been offered a comfortable sinecure at the IMF or the World Bank.

We must however resist the temptation to throw out the proverbial baby with the bathwater. While deeply flawed, economics nevertheless does contain some important truths. As we noted above, one of the major successes of classical economic theory is the explanation of why markets are superior to command-and-control systems. It’s worth exploring why this is invariably the case.

Let’s imagine we have a society of ten thousand people. They are distributed across a geographic area where some locations are nicer than others (better weather, nicer views, easier commute to work, etc.). As a result of the simple fact that more people will want to live in the nicer places than will want to remain in the less desirable locations, the price of accommodation will rise in the nicer places do to relatively static supply but quite elastic demand. As a result, the cost of living in the nice places will be higher than the cost of living in the less desirable locations.

Now let’s imagine we have two electricians, Mary and Bob. Mary lives in one of the nice locations and her rent is $2,000 per month; in addition she spends $1,000 per month on food and utilities, so her total monthly expenses before discretionary expenditures is $3,000. Bob lives in one of the less desirable places and his rent is $1,000 and he spends $1,000 per month on food and utilities, so his total monthly expenses before discretionary expenditures is $2,000. If the government or some other authority believes it ought to enforce comparable wages across the entire nation, it’s obvious that either Mary will end up with too little income to meet her needs or Bob will end up with more than he requires to meet his needs. Either way, social unfairness will result simply because of disparities between locations. Conversely in a market economy, Mary will charge more for her services than Bob will charge for his, in order to compensate for their different relative costs of living.

In a command economy, however, money cannot function as a signaling mechanism. Let’s see what happens to Mary and Bob under such circumstances. Let’s assume some authority has established $2,500 as the national standard income for electricians. After struggling to pay her bills for several months, Mary decides to move to a cheaper location. Bob meanwhile is very happy because he now has more than he requires to meet his monthly expenditures. But when Mary shows up, there are now two electricians in the same town and only enough work to support one person. Meanwhile in Mary’s old location there are now insufficient electricians to meet demand for their services.

The information that should have been transmitted by money has been blocked, and a cascade of unwanted consequences inevitably follows. The government is unable to operate at a sufficiently micro-level to compensate for all the thousands of unwanted consequences resulting from the decision to impose a national wage for electricians and so the economy increasingly becomes distorted and dysfunctional.

This happened in the real world in both the Soviet Union and in Mao’s China, and continues to happen in places like Venezuela and Cuba. It also happens in countries where governments set national wage levels for employees in the public sector. The result is always to create unnecessary hardship for individuals because there is no information flowing between producer and consumer that would bring outputs and consumption into balance.

(As a side-note, markets have little to do with capitalism because markets have existed for thousands of years while capitalism only emerged with the Industrial Revolution because machinery made it possible to apply money to increase factor productivity by means of automation. Capitalism requires markets but markets don’t require capitalism.)

From such a simple example as given above we can see that markets are an essential mechanism of social fairness. Money and markets give individuals some choice over their employment and expenditures whereas a command economy removes such choice and replaces it with State-determined patterns of income and consumption.

But markets are, just like the human beings who create them, woefully imperfect. Unfortunately, classical economics fails entirely to incorporate the reality of such imperfections. Most economists are still taught that people can be modeled as “economically rational actors” seeking always to optimize their local condition. We know from ample evidence however that this is in fact never the case. People have instinctual prejudices, people are very often utterly ignorant of the most important information that ought to influence their decisions, we apply far too high a discount factor to future events, and we’re overly influenced by what we believe our neighbors are doing. Organizations both public and private are full of incentives both intentional and accidental that distort decision-making and result in sub-optimal outcomes.

In short, we are for the most part incompetent economic actors and not at all the rational beings assumed by nearly all economic models.

Furthermore, there are circumstances in which markets can’t work at all, and when governments misguidedly attempt to introduce “market forces” the results are always dire. That’s why so many of the supposed “economic reforms” that began in the 1980s in the USA and UK were ultimately so harmful and resulted in huge additional costs being imposed on hapless consumers.

Let’s take a look at a situation where a market cannot operate and see what happens when complacent economists and dull-witted politicians conspire to impose a quasi-market in order to gain efficiencies.

Most countries have a railway system. To create railways one must acquire land, lay track, and thereafter run locomotive services upon that track. Due to the phenomenal expense of creating a railway system, and due to the fact that land has a great many uses that make it very valuable, it is implausible to imagine a situation in which there are multiple separate railway services all running parallel to each other across the nation.

But without such multiple services all running in parallel, there can be no competition. And without competition there is no mechanism to balance supply against demand through means of finding by empirical means the price at which the majority of people will wish to use the service and thereby driving efficiencies across the supply chain in order to reach this price while still enabling a profit to be made by the suppliers. Instead, whoever owns the track will have the ability to price-gouge.

Railways are a natural example of a situation in which market forces cannot apply. Other examples include the supply of utilities (water, sewage, electricity and gas) and the provision of infrastructure (roads, bridges, tunnels).

It’s not surprising therefore that the British experiment in wholesale privatization of the railways and utilities resulted in atrocious outcomes. British people now pay far more for these things as a percentage of income than before, and the quality of service delivered is often far worse. Many economists, however, continue to argue that such privatizations must nevertheless be considered “successful.”

Which just goes to show how skeptical we ought to be of pronouncements made by economists.

At the same time we must note that some privatizations were successful. The key difference is that successful privatizations occurred in sectors of the economy where true competition was possible. Thus automobile manufacture, the provision of air transportation, and the provision of telecommunications services all became more efficient and prices fell while service quality either remained constant or improved. But economists have for the most part failed to recognize the crucial factors that make the difference between success and failure. Thus their models remain fundamentally flawed and their recommendations often harmful.

Today many classical economists claim that hoarding and price-gouging of items like face masks is a sign that “markets are working as they should.” The naïve argument is that when hoarders and scalpers buy up hundreds of thousands of face masks and then seek to sell them at massively inflated prices, this will send a signal to producers and they in turn will produce more masks in order to meet demand and thus eventually bring prices back down again.

It’s not difficult to see the problems inherent in this argument. First of all, the money signal isn’t being passed on to the producers of face masks; it’s being absorbed by those who have bulk-purchased in order to price-gouge those in urgent need of these supplies. Secondly, the time lag between demand and any ramp-up of production is too long to accept in a situation where the masks are required immediately, not a year hence.

The naïve economic argument is therefore no different from saying that ships shouldn’t carry lifeboats because ultimately the loss of a ship will result in the production of more ships that will also be somewhat more seaworthy. It’s lovely advice in theory but disastrous for the real human beings involved because it fails utterly to account for the time-lag between sending of signal and adjustment of action. Unless we arbitrarily set the value of all human life at zero, the hidden cost (loss of lives) vastly exceeds the notional benefit of strict adherence to “market forces.”

Economists are not unlike cosmologists who decide to reject all empirical data in favor of clinging to the Ptolemaic model of the universe because of its elegance and simplicity.

Real science, however, adjusts theory when the predictions of the theory fail to match observation. Newtonian mechanics failed to explain deviations in the orbit of Mercury and so forced the development of Einstein’s General Theory of Relativity which perfectly predicts Mercury’s actual orbit (and a great deal more besides). Economics meanwhile is still mostly trapped in the days of alchemy and doctors reading from Galen instead of looking at the evidence before their own eyes.

One day, economics will become a reliable science. Until then we ought to be wary of assuming that economic models always provide satisfactory predictive power and therefore that economic policy should be based on what economists believe. Far better for us to learn from real-world data and adjust theory until it more adequately accounts for what we really see happening in the world.

Only after economics has transitioned from being a creed to being a true science will the advice of economists be somewhat less perilous to adopt.

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