The Great Economics debate.

Economist Constantin Gurdgiev v Village Editor, Michael Smith.

Constantin Gurdgiev writes:

The Global Financial Crisis and the Great Recession are actively reshaping how we analyse social phenomena, and how that analysis should shape public-policy choices. In many ways, changes in our attitudes to social inquiry have been positive.

For example, more critical re-appraisal of rational-expectations-based models in macroeconomics and finance have enriched the traditional policy analysts’ toolkits and advanced our understanding of choices made by various economic agents and governments.

A shift in econometric tools away from those based on restrictive assumptions concerning underlying probability distributions towards new methods based on more direct integration of the actual data properties is also underway. The result is improved analytical abilities and potentially more streamlined translation of data insights into policy.

Public debate about how we teach economics in schools and universities and how economic parameters can  promote social and cultural values, as evidenced by the ongoing debate at the OECD and other institutions about introducing measures of quality of life and social well-being into economic policy toolkits are yet more examples of the longer-term positive change.

Without such changes to reflect the extraordinary circumstances the entire discipline of social science would have risked sliding into complacency and statism.

However, in many areas, changes in our approaches to social studies – not just economics – have been superficial at best, and occasionally regressive. 

Before the crisis environmental sciences largely existed in the world of mathematical modelling, with core forecasts of emissions paths and their effects on the environment ignoring behavioural inputs.

These technocratic models influenced both public opinion and policies. In a way, perhaps ironically, environmental policy was further removed from the realities of human and social behaviour than, say, finance or macro economics.

The emitter of CO2 was not treated as a human being requiring supplies of energy, goods and services in ways that were a function of real characteristics like age, gender, family and income. environmental policy analysts are focused on purely aggregate targets at the expense of realism and social and economic awareness.

Over recent years, the thrust of environmental policies has drifted away from local considerations of the impact of pollution on quality of life and economic environment considerations. As a result, environmental policies and programmes, such as wind energy development or waste-incineration, are becoming more orthogonal, less a function of the particular interests of real people.

Rhetoric surrounding these environment considerations is also becoming more detached. For example, Ireland’s attempt to make a play at European wind energy markets, represented by massive wind farms and miles of pylons, is now pitting our imagined (or mathematically-derived) exports potential, fuelled by nothing more than massive subsidies and consumer rip-off pricing for electricity, against all those soft interests in preserving the countryside’s natural amenities, cultural heritage and other economically and socially meaningful resources.

Behaviour-rich analysis is more mainstream in finance than in environmentalism. The result is distortion of public responses to environmental movements.

In most basic terms, there are three core problems with the current state of social sciences and policy-formation mechanisms. None of these problems is new to the post-crisis world or unique to economics. In fact, in many cases economics  is years ahead of other social sciences in dealing with these shortfalls.

They are: insufficient modelling tools, poor data, and politically-captive analytics and decision-making.

The first problem is the lack of rigorous modelling tools capable of handling behavioural anomalies. Put differently, we know that people often make non-rational choices and we occasionally know how to represent these choices using mathematical models. But we are far from being able to incorporate these choices into macro-level models of aggregate behaviour.

For example, we know that individually people often frame their choices with undue emphasis on past experiences, even when such framing can lead to undesirable or suboptimal outcomes. Yet we have few means of reflecting this reality in economic models, although we are getting better at capturing it empirically. There are also some problems at the nexus of mathematics and complex economics.

The problem of insufficient tools is often compounded by the problem of over-reliance on technocratic analysis. Put simply, we live in a world dominated by policies targeting aggregate performance metrics (such as global emissions levels or nationwide GDP growth rates).

This implies that we often aim to create policies that are expected to deliver specific and homogeneous outcomes across a number of vastly heterogeneous geographies – physical, cultural, political, social and economic systems, nations and societies.

The only feasible approach to such policymaking is via technocratic reliance on ‘hard’ targets and prescriptive policy designs. The core pitfall of this approach, catastrophic to risk management, is that when a harmonised policy fails, it fails across all heterogeneous locations and environments.

This is what happened, indeed is happening, with the euro area. The more credence we give to technical models-driven solutions being right all of the time in all of the locations, the higher is the probability that a policy failure will be systemic, rather than localised.

The only alternative to this fallacy of reliance on technical analysis and hard target-based modelling is to permit local innovation and differentiation. This traditional approach is not in vogue in a world where global institutions and aspirations dominate the local and where pseudo-scientific fetishism for technical knowledge dominates social science and policy-making.

Beyond the technocratic fallacy of over-reliance on mathematical models and the shortage of some key tools, looms an even larger problem.

Consider the most recent example of a systemic fail –  to predict the current financial crisis.

Instead of tools shortfalls, this failure derives from the problem of analysis and policy capture by political and economic interest groups that firstly determine the agenda for policy analysis and research, then define the parameters and scope of such research and, finally, set bounds for measuring, monitoring and actioning the data, including as policy.

With the onset of the crisis, economists working outside regulatory offices, ministries and central banks gained access to more financial data than ever before. Still, even with data in the public domain, analytical resources come at a cost premium, as anyone attempting to compete with, say the Department of Finance, finds out very quickly.

In the time it takes an independent analyst to compile and analyse data, the Department of Finance can deploy dozens of staff to flood the media with reports and papers. The asymmetry of resources drives the asymmetry of power in analysis and this fuels the asymmetry in policymakers’ perception of the lessons from the data.

For example, lone voices of dissent or single pieces of contrarian analysis are pushed aside by the sheer magnitude of consensus, even though the magnitude may be little more than one agency compounding the insights of another.

We might be able to produce better insights into the workings and risks of the banking sector today than before the crisis, but this does not mean that the actions of regulators and their Governments are going to be any better informed or better tailored.

Even when independent analysis and scrutiny are available, regulatory and policy responses largely ignore empirical insights. In a recent study, I and a co-author looked at asset prices across a number of advanced economies before and after the crisis.

Using a very simple econometric model, we showed that data before 2006 were providing clear and loud signals as to the emergence of a number of crisis-level risks. However, to derive this result we had to calibrate the model using a parameter that was set at ten times the levels assumed to be likely by the banking regulators.

Our public servants simply were not required to do this analysis so regulators around the world sleepwalked the entire financial system into the latest crisis and found themselves utterly unprepared for the fallout.

This is not unique to our study conclusions. Back in 2005 to 2006, inside the Irish civil service there were several senior voices raising concerns over the direction of our economy. These were echoed by a number of research papers and analysts warnings coming from the ranks of independent and academic economists.

They were ignored not because they lacked an empirical basis, but because the policymakers were captive to consensus view aligned with their own political objectives.

Nobel prize winners Robert Shiller (2013) and Edmund Phelps (2006), and other economists such as Nouriel Roubini, Roman Frydman and Michael D Goldberg repeatedly warned about systemic problems in the US property and financial markets generally back in 2004-2007. The NYU Stern School of Business research centre did the same for the banking sector.

Last, but not least, in academic economics, research into non-rational, non-representative agent models has been on-going since the start of the 1990s, largely unbeknown to the general public and politicians. In fact, since the mid-1990s, the majority of the Nobel Memorial Prize awards in economics have gone to researchers who pushed aside the bounds of rational expectations and/or representative agent frameworks.

Still, the problem of policy capture by the often poorly informed adherents of specific schools of thought are hardly unique to economics. Let’s take two examples of policies that have captured public imagination and policymakers’ attention, while sporting only tenuous empirical foundations. 

One is wind and wave energy. Although it appears that there is a near-consensus in academic and policy circles that these two sources of energy offer preferred alternatives to traditional fuels, in reality, such consensus can and should be questioned. The latent energy stored in water and wind is huge. However, wind-energy harvesting is also subject to externalities.

A key one is the transfer of the cost of pollution abatement from the commons relating to energy production and use, to the commons relating to land and amenity. This externality was already mentioned above. Credit for pointing this out must go to economists not environmental scientists. Another one is the transfer of the cost of energy-related pollution to consumers.

In the real world, different consumers obtain energy through different channels. Some channels offer energy-users a subsidy over the other. Some channels come with a choice that a consumer can make to substitute between different service providers based on environmental and economic costs considerations, other channels do not.

Again, credit for pointing this out goes to economists; environmentalists are all too often simply opt to ignore these realities in pursuit of aggregate emissions targets over and above the consideration of their feasibility or their effectiveness in the face of social, cultural, political and economic realities.

For example, state-owned public transport is commonly priced differently from privately-owned public transport and both are priced distinctly from private transport.

Unless use of energy is uniformly priced across all modes of transport and unless all modes of transport are perfectly substitutable, some consumers of public transport will receive subsidies at the expense of others and the majority will be subsidised relative to private transport users.

Thus, a suburban family is likely to pay a higher price for pollution per mile travelled than an urban one. The fact that in many cases a suburban family might have been forced (by planning, zoning, pricing and other systems operating in a heavily distorted markets) to make a choice of living outside the areas with dense cover by transport alternatives does not enter into the determination of pollution-linked taxes and prices.

Any decent economist can be expected to understand this much. Yet the simplified worldview that public transport subsidies and private transport taxes are always good persists among our policymakers and within environmental lobby.

Another example of policy that is empirically shoddy, yet politically heavily supported is electrification of transport. Recent research shows that in the US, even if electrical vehicles (EVs) made up over 40 percent of passenger vehicles, there would be little or no reduction in the emission of key air pollutants.

Now consider the case of Ireland, where the ESB has been running a multi-billion-euro investment programme aimed at developing EV networks since the early days of the financial crisis.

In other words, just as the value of private-sector investment shot through the roof, the Irish semi-state sector, encouraged by policymakers and subsidised by high prices for consumers, launched into a major investment programme based on questionable benefits to the economy and society at large.

The Government of the day even announced back in April 2010, with the country rapidly hurtling toward an IMF-led bailout) a €5,000 grant to EV buyers. That Ireland’s electricity supply currently comes primarily from environmentally damaging sources does not phase the environmental policy advocates.

The debates about the current state of economics and social sciences in general are a welcome departure from the pre-crisis status quo, where such discussions primarily took place in the marbled halls of academia and beyond the scrutiny of public attention.

However, it is worth remembering that the core problems faced by social-policy analysts today are the age-old ones of insufficient modelling tools, poor data, and politically captive analytics and decision-making. We might be able – with time and effort – to fix the first one.

Fixing the other two will require a paradigm shift in the way we collect and publish data, and in the way our political and public service elites approach policy formation. In other words, two thirds of the problems for economics and the social sciences are political, not scientific. •

Michael SmithEconomist-cover writes:

Constantin draws attention to some voguish critiques of economics and says they are critiques of social science. He addresses: insufficient modelling tools, poor data, and politically-captive analytics and decision-making.

I would not detract in any way from the analysis he provides of these above, though I might call one last time to mind the economists shouting for the property market in 2006, because their salaries depended on it. But he is too kind to economics if he limits criticism to these. Economics imposes theories based on various assumptions of perfection but tries to apply them in a variously imperfect world.

Economics doesn’t just underrate the prevalence of rational (perfect) views, it also makes too many assumptions on the basis of a perfect economy, in circumstances, for example, of perfect competition and does not focus on explaining actual economies but instead on describing an economic “utopia”, which of course is different from most people’s idea of a ‘real’ utopia (but that’s a different criticism). Economics as it is practised aims to demonstrate social optimality in a model world, not to explain the real world as observed empirically.

This led most of the economics profession, cheerled by the  market-fetishist Economist magazine to assume that creation of all the clever financial products that characterised the Lehman’s and subprime problems for example were backgrounded in a market where all material variables were known to the participants.

Of course they did not allow that bankers were being incentivised to create products that would reap a quick return even if they were long-term unstable. They didn’t know that sub-prime was possible. But they should have.

More generally, for example Robert Lucas criticises the use of overly simplistic econometric models of the macroeconomy to predict the implications of economic policy, arguing that the structural relationships observed in historical models break down if decision-makers adjust their preferences to reflect policy changes. Policy drawn from large-scale macroeconometric models is often distorted since economic actors change their expectations of the future and adjust their behaviour accordingly.

Economics also tends to make the assumption time and space are of no consequence: for example that trading a good has no effect on the good or the parties – as if the goods were abstract numbers without real correlatives; or that the appeal of trickledown economics can be assessed as if were not delayed. And it assumes that conduct is prompt and rational.

Schumpeter said that this is “in all cases a fiction. But it proves to be sufficiently near to reality, if things have had time to hammer logic into men. Where this has happened, and within the limits in which it has happened, one may rest content with this fiction and build theories upon it”. But empirical evidence suggests that “anomalous” behaviour can survive for a long time in real markets such as in market “bubbles” and market “herding”.

So adding these flaws to the  ones Constantin acknowledges, economics makes presumptions about models, data, time, individual behaviour, collective behaviour and human integrity that don’t stand up.

But these are mere quibbles, the guts of the critique of economics is that  very premises of economics are every bit as dubious as its proponents are cocky.

1. For a start the method of economics is heavily inductive.  It proceeds on the basis that humans will continue to behave as they have behaved. But classical economics also assumes that behaviour is a certain historic version of self-interest.  In the age of climate change, an age when the richest 85 individuals provocatively own half the planet’s wealth we are actually going to need to change our view of what self-interest is so radically that the body of classical economics and its theories on demand, supply, taxation, competition, debt, interest rates, inflation and the rest will become useless as a predictor of future behaviour. 

Ingrained inequality and environmental collapse are historic catalysts for revolutionary change. We need look no further than Communist Russia to see how little relevance classical economics holds under anti-capitalist, anti-profit paradigms including Marxism.

Admittedly the inductive method of all social science, not just economics, is fragile in the age of climate change.

2. A further weakness in economics is that the value-neutral efficacy and efficiency it champions are not goals where the end they facilitate is a bad one.

3. Unlike social, environmental and cultural goals economics is not a goal in itself. But you wouldn’t know that from economists. 

Indeed for the anthropocentric it can easily be argued that environmentalism focuses on the environment and culture on works of art and  heritage and that they too are therefore instrumental to human beings for whom the social dimension alone offers an appropriate non-instrumental, end-not-means focus.

Sadly, in our economocentric world, economics is the king of social sciences, the king of policy imperatives. It elevates both a societal end and a means beyond what is appropriate and then uses its macho disciples to shunt aside all other ends and means as secondary, weak and sort of girly. Economics has itself become a corruption at least as insidious as the deadening self-interested forces Constantin Gurdgiev, for example, sees on the Left.

4. Economics has taken the place of legitimate ends. The UN considers politics should address economic, social, environmental and cultural imperatives. In a world where religion is no longer the imperative the tacit aim of policy is happiness, or as social scientists call it, wellbeing or quality of life which is the aggregation of these four imperatives. 

If probed, people in wealthy democracies ask policy-makers above all to improve wellbeing and quality of life rather than the economy. This reflects the logical preference for quality over quantity and for ends (like happiness) rather than means (like opportunity through wealth/money/GDP) in mature human experience.   

5. Though most academic definitions of economics say it measures material wellbeing, practitioners rarely focus on this – they focus on wealth, money, gross domestic product (GDP); and even academics allow GDP as the primary indicator of wellbeing, since happiness certainly and quality of life perhaps, is difficult to measure. A big mistake: it has long been recognised that economic measures are poor indicators of the wellbeing or quality of life of individuals and the population and of sustainability of an economy and society.  

As Robert F Kennedy declared “GDP measures everything … except that which makes our lives worthwhile”.

At least outside Bhutan economics’ invariable focus on GDP focuses as its end on a means (product)!  Remember that GDP registers an oil slick and its clean up as an increase in wealth as it entails economic  activity. 

Economics disgraced itself by for so long using a surrogate indicator as the primary indicator, and allowing the surrogate to become a goal in itself. This cannot be excused lightly as “policy capture” for it is endemic, it is what gets most economists up in the morning.

6. Even if economics made its ambivalent focus efficiency, capitalism is far more wayward. A discipline that elevates capital to its goal is unlikely to promote humans. The means became the end. It is the lunatics in charge of the asylum. And it has brought  us to a pass where inequality has become a gospel, where in just one generation we may have doomed humanity after 200,000 years to extinctive runaway climate change, where we have squandered scarce resources to the point of depletion, where owning things became a good in itself and where the imperative of pandering to the market brought us to a culture of Big Brother and the News of the World. A dead end.

7. But perhaps the biggest offence of economics is  that a social science  whose sole purpose should be instrumental fails even to provide for an externality-free efficacy, for a pure market.

If it did it would address the  fact that individuals suffer from unfair structural imbalances caused by the accidents of birth and childhood education, over which  they have no control.  The market should, in justice, compensate for these inequalities – level the playing field – but in practice it exacerbates them by allowing itself to be insidiously used to argue that the rich need to be paid more and taxed less in order to “incentivise” them. Economics has become an agent of unfairness.

And if it provided for an externality-free efficacy, for a pure market, it would properly price scarce resources including climate-change-inducing greenhouse gases. Instead eminent economists including Constantin Gurdgiev and Colm McCarthy regard with mild indulgence the characteristic failures of economics, as it is practised.

They treat failures to factor in the scarcity of resources (like water, peat, building materials) and the limitations – because of climate change – of the amount of carbon we can inject into  the  atmosphere, as minor, understandable peccadilloes that require a tweak, rather than in-built systems failure of a discipline whose time is past. Posterity will not forgive the current generation of economists their indulgence of profligacy with this fragile earth.

8. Economists too have failed  to appreciate the possibilities that can be achieved by incentivising good human behaviour, not the bad or greedy – through price signals. They have failed to promote taxing bad things (like pollution, obesity) and focused instead on taxing good  things (labour primarily). 

9. Beyond this the ascendancy afforded economists because of their usefulness in promoting the wealth of those who hold power, has led to a voguish disparagement of regulation and of simple prohibition of bad behaviour. More of both would have averted “shouldna been possible” economic and environmental armageddons which have destroyed so much human and natural capital. 

10. It is particularly gratifying that it can easily be argued that environmentalism providing, as it does, for sustainability – the handing down to the next generation of the same legacy of human resources that we inherited, is a superior discipline which subsumes the only useful tenets of economics, in requiring the efficient use of resources not just by this generation but so that future generations have the same options.

As well as being long-term economics, environmentalist, like culture, also has the advantage of transcendence, magnificence, beauty and being not just a means to an end, but an end in itself. Economics is tawdry by comparison.

So, what should we do if we could free ourselves of economics and its glaring deficiencies?

Quality of Life should  supersede GDP as the determining gauge of societal success, though of course wealth and income are components of it. 

We must treat it as seriously as GDP. We should begin by measuring it with the acuity that we apply to measuring GDP. We would collect all the data that go into measuring GDP but for a wider range of elements – economic but also social, environmental and cultural. We measure unemployment and income.

We measure school-leaving age, prison populations, crime rates, community facilities and health. We measure air and water quality, carbon consumption, how long people commute and if they are close to green space.

We measure theatre attendance and book sales. We ask people if they think their quality of life is improving. We measure a hundred criteria to see if society and the environment and not just the economy is improving. Then to see if we’re richer than say France we compare these not GDP and we compare our trajectory with theirs.  Ultimately we expect to get (say) five percent annual improvements in quality of life to show the country is improving.

So, how could we programme quality of life into policy? A good way is through shifting taxes away from good things like labour onto bad things like development that does not serve national quality of life (or sustainability which is another word for long-term quality of life).

We’ve heard about a carbon tax which focuses on carbon, we’ve seen how environmental taxes like that on plastic bags work. We’re beginning to look at taxes on junk food. But there’s a logic that would take us in the direction of disincentivising practices that are inimical to quality of life.

It’s now time to look beyond carbon and environmental taxes to a quality of life or sustainability tax. Otherwise government’s role in furthering the happiness of its citizens will remain haphazard.