Sunday, December 20, 2009

The Problem With Economics?

Last Sunday, I posted on Paul Salmuelson's legacy in economics, paying a tribute to a giant in economics. But not every economist shares these views.

On Friday, Paul Krugman referred to Michael Hudson's critical assessment of Samuelson in a recent blog entry, Why economics is the way it is:

A number of people are linking to this reprinted critique of the work of the late Paul Samuelson. I could point out that the critique thoroughly misunderstands what Samuelson was saying about international trade, factor prices, and all that. But there is, I think, an interesting point to be made if we start from this complaint:

Can it be “scientific” to promulgate theories that do not describe economic reality as it unfolds in its historical context, and which lead to economic imbalance when applied?

Actually, there was a time when many people thought that institutional economics, which was very much focused on historical context, the complexity of human behavior, and all that, would be the wave of the future. So why didn’t that happen? Why did the model-builders, led by Samuelson, take over instead?

The answer, in a word, was the Great Depression.

Faced with the Depression, institutional economics turned out to have very little to offer, except to say that it was a complex phenomenon with deep historical roots, and surely there was no easy answer. Meanwhile, model-oriented economists turned quickly to Keynes — who was very much a builder of little models. And what they said was, “This is a failure of effective demand. You can cure it by pushing this button.” The fiscal expansion of World War II, although not intended as a Keynesian policy, proved them right.

So Samuelson-type economics didn’t win because of its power to cloud men’s minds. It won because in the greatest economic crisis in history, it had something useful to say.

In the decades that followed, economists themselves forgot this history; today’s equation-mongers, for the most part, have no idea how much they owe to the Keynesian revolution. But in terms of shaping economics, it was the Depression that did it.

Michael responded to Krugman's post with this reply which I share with you:

Krugman criticized my criticism of Samuelson {1}, referring readers to the UMKC reprint of my Counterpunch article. So I wrote this in response.

I have recently republished my lecture notes on the history of theories of Trade, Development and Foreign Debt {2}. In this book I provide the basis for refuting Samuelson's factor-price equalization theorem, IMF-World Bank austerity programs, and the purchasing-parity theory of exchange rates.

These ideas were lapses back from earlier analysis, whose pedigree I trace. In view of their regressive character, I think that the question that needs to be asked is how the discipline was untracked and trivialized from its classical flowering? How did it become marginalized, taking for granted the social structures and dynamics that should be the substance and focal point of its analysis? As John Williams quipped already in 1929 about the practical usefulness of international trade theory, I have often felt like the man who stammered and finally learned to say "Peter Piper picked a peck of pickled peppers", but found it hard to work into conversation {3}.

But now that such prattling has become the essence of conversation among economists, the important question is how universities, students and the rest of the world have come to accept it and even award prizes in it!

To answer this question, my book describes the "intellectual engineering" that has turned the economics discipline into a public relations exercise for the rentier classes criticized by the classical economists: landlords, bankers and monopolists. It was largely to counter criticisms of their unearned income and wealth, after all, that the post-classical reaction aimed to limit the conceptual "toolbox" of economists to become so unrealistic, narrow-minded and self-serving to the status quo. It has
ended up as an intellectual ploy to distract attention away from the financial and property dynamics that are polarizing our world between debtors and creditors, property owners and renters, while steering politics from democracy to oligarchy.

Bad economic content starts with bad methodology. Ever since John Stuart Mill in the 1840s, economics has been described as a deductive discipline of axiomatic assumptions. Nobel Prizewinners from Paul Samuelson to Bill Vickery have described the criterion for economic excellence to be the consistency of its assumptions, not their realism {4}. Typical of this approach is Nobel Prize winner Paul Samuelson's conclusion in his famous 1939 article on "The Gains from International Trade":
In pointing out the consequences of a set of abstract assumptions, one need not be committed unduly as to the relation between reality and these assumptions. {5}
This attitude did not deter him from drawing policy conclusions affecting the material world in which real people live. These conclusions are diametrically opposed to the empirically successful protectionism by which Britain, the United States and Germany rose to industrial supremacy.

Typical of this now widespread attitude is the textbook Microeconomics by William Vickery, winner of the 1997 Nobel Economics Prize:
Economic theory proper, indeed, is nothing more than a system of logical relations between certain sets of assumptions and the conclusions derived from them ...

The validity of a theory proper does not depend on the correspondence or lack of it between the assumptions of the theory or its conclusions and observations in the real world. A theory as an internally consistent system is valid if the conclusions follow logically from its premises, and the fact that neither the premises nor the conclusions correspond to reality may show that the theory is not very useful, but does not invalidate it. In any pure theory, all propositions are essentially tautological, in the sense that the results are implicit in the assumptions made. {6}
Such disdain for empirical verification is not found in the physical sciences. Its popularity in the social sciences is sponsored by vested interests. There is always self-interest behind methodological madness.

That is because success requires heavy subsidies from special interests who benefit from an erroneous, misleading or deceptive economic logic. Why promote unrealistic abstractions, after all, if not to distract attention from reforms aimed at creating rules that oblige people actually to earn their income rather than simply extracting it from the rest of the economy?

Michael Hudson


Links and Notes:

{1} http://krugman.blogs.nytimes.com/2009/12/18/why-economics-is-the-way-it-is/

{2} http://www.amazon.com/exec/obidos/ASIN/3980846695/counterpunchmaga

{3} John H Williams, Postwar Monetary Plans and Other Essays, third edition (New York: 1947), from page 134.

{4} I have surveyed the methodology in "The Use and Abuse of Mathematical Economics", Journal of Economic Studies 27 (2000):292-315. I earlier criticized its application to international economic theorizing in Trade, Development and Foreign Debt (1992; new edition, 2009), especially chapter 11.

{5} Paul Samuelson "The Gains from International Trade", Canadian Journal of Economics and Political Science, Volume 5 (1939), page 205.

{6} William Vickery, Microeconomics (New York: 1964), page 5.

Michael's criticism is one that will strike a methodological note with many economists who feel that the discipline has moved too far into the realm of irrelevancy as economists look to formulate sound theorems based on "mathematical rigor" instead of theories based on basic social observations of human nature.

I believe that behavioral finance was a response to addressing many gaps that we readily observe in economic theory. Having completed a Master's in Economics at McGill University, I passed those mathematical courses, but I was always attracted to questions of economic methodology. My courses in philosophy taught me to question everything, including economic theorems.

Economics is an evolving field. As Isaiah Berlin would say, there is inherent beauty in diversity. Let there be mathematical modeling but let there also be more open debates on what is really going on in the economy.

My practical experience in the investment world taught me to be weary of quantitative models that claim to measure all risks. This is pure nonsense. Just a few years ago, everyone was claiming we "tamed risk once and for all", and then "BOOM!", 2008 humbled the sharpest minds on Wall Street.

The economists who were tracking the bigger macro trends - including the net issuance of CDOs and other securitized products and the trillions flowing to hedge funds and private equity funds - knew that the global financial system was heading for a hell of a collision.

Now, where is my copy of When Genius Failed? I just love that book.

***UPDATE***

Those of you who want to read more on this subject, should read this testimony from David Colander which was submitted to Congress in early September: The Failure of Economists to Account for Complexity. This is an excellent summary, well worth reading.

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