“Premises economics and economic models?Ever since its eighteenth-century

“Premises assumed without evidence, or in spite of it; andconclusions drawn from them so logically, that they mustbe necessarily erroneous” – Thomas Love Peacock, crochet castleOf what use are economics and economic models?Ever since its eighteenth-century inception, the science of economics has been methodologically controversial. Even during the first half of the nineteenth century, when economics enjoyed great prestige, there were skeptics like Peacock. For economics is a peculiar science. Many of its premises are unbacked statements which at first sight hold true, such as “Individuals can rank alternatives” or “Individuals choose what they most prefer.” Other premises are simplifications such as “Commodities are infinitely divisible,” or “Individuals have perfect information.” However, modern behavioral scientists question and at times utterly reject these assertions. For example, Nobel laureate Herbert Simon proposed the theory of bounded rationality, which says that people are not always able to obtain all the information they would need to make the best possible decision. Further, economist Richard Thaler’s idea of mental accounting shows how people behave irrationally by placing greater value on some dollars than others, even though all dollars have the same value. They might drive to another store to save $10 on a $20 purchase, but they would not drive to another store to save $10 on a $1,000 purchase. On the back of such platitudes and simplifications, such “premises assumed without evidence, or in spite of it,” economists have erected a mathematically sophisticated theoretical edifice, whose conclusions, although certainly not “necessarily erroneous,” are nevertheless often off the mark. The various and often contradictory theories thus, bewilderingly for some, coexist simply because they stem from opposing ideas about the human state of nature. The most striking of this deals with the opposition between Keynes and Hayek in the 20th Century. On the back of the Great Depression the 2 economists argued on how best to deal with the resulting crises. Hayek advocating against government expenditure while Keynes advocated for an aggressive intervention by the government. Neither theory can be known as “correct” simply because they stem from different assumptions about the role of government and whether humans are inherently selfish. Hayek believed that “easy money” from the government will not convince companies to not repeat the same mistakes and cause a structural fault that may result in future recessions as well. However Keynes believed that the government had to intervene in order to help society and help the society “grow out of a recession”.So, economics in itself does not have a set answer or theory that is universally acceptable. This then leads us to question if indeed economics can be relied upon to provide any useful answers that policy can be enacted upon, like mathematics, physics or biology. For example, after the economic successes of the generation following World War II, economic growth stalled in the 1970s, and many came to doubt that anybody knew how to restore prosperity without rekindling inflation. So, if economics cannot give actionable intel or “settled science” then it does not have all the answers, few theoretical sciences do. But is economics useful? But what question is one posing when one asks, “Is economics useful?” are we inquiring about the goals of economics, about the methods it employs, the replicability of its results, about the conceptual structure of economic theory, or about whether economics can be reduced to physics? If economics is a science, is it the same kind of science as are the natural sciences? Or is it more of a social science, like sociology or psychology, not really scientific but called a science to appease its practitioners? Economics then,can be argued as being useful as an argument, an argument for and an argument against. The argument that one can be both right and wrong at the same time. Economics is an argument to support a value. Be it “freer the market, freer the people” or “we are all dead in the long run”, economics or rather the philosophies and theories that provide the assumptions of economics can support your stand. Economics and economic policy making is however necessary as it allows a government or household to make decisions based on their priorities. A government or household then has to play the balancing game, too much austerity and you get the great depression under Herbert Hoover, too little and your get Greece in all its modern day “glory”. So is this argument useful? An argument based on economic theory is useful as economic theory builds on observations of human tendencies and thus allows us to model what may be often considered the salient aspects or variables in human behaviour in order to make decisions on how to allocate resources and achieve policy outcomes. The idea of equitable outcomes, equal opportunities and efficiency being generally the socio-economic outcomes that governments strive for it is important to identify a clear economic ideology to base public policy on due to the limited amount of resources available. It is often unfeasible or impractical to perform experiments in order to determine the best way to distribute our resources. Moreover such a “best” way may not exist due to the values, assumptions and social contracts that undergird our society. For example a libertarian in the mould Milton Friedman may believe that government regulation is inherently bad whereas a Keynesian may believe it to be necessary to create growth. Thus, there is a need to construct models drawing relationships between a few manipulatable variables, which would allow society to make decisions more efficiently. Economic models attempt to do this by constructing theories based on human behaviour to model relationships. These theories are based on past data from which observable trends are isolated and theories developed on the back of it. In creating such theories, economists isolate from the infinite number of factors that influence an economic phenomenon the few key variables that are most important. They can then construct models based on these theories, which can be used to forecast policy outcomes and make decisions.  However, being based on past regression cycles economics may be able to predict or fail to predict certain events. Historically speaking, the first recorded speculative bubble of the Tulip “Fever” in the Netherlands was unexpected and thus could not be predicted by economists of the age considering the lack of precedent in terms of an economy wide downturn or recession. However even in the modern age of the 21st century with all the mathematical modeling and economic theories, economists failed to predict the 2008 financial crisis with the exception of a few economists who realised the vast structural deficiencies in the system. The idea that people would eventually not pay their housing bill is not rational and there seems to be no historical precedent for it. This meant that the vast majority of households and governments failed to predict this and were unprepared for what is now known as the”Great Recession”.  The fraud of major rating agencies can neither be “accounted for” in economic models nor predicted based on past data. This limits the ability of such economic models and economics to predict and be able to help prevent economic crises. The ultimately human aspect that undergirds economics and the application of it thereof means that economic theories and policies supposedly backed by such theories have the capability to awry. To explore the Great Recession further, macroeconomists, especially within central banks, were too fixated on taming inflation and too cavalier about asset bubbles. Financial economists, meanwhile, formalised theories of the efficiency of markets, fuelling the notion that markets would regulate themselves and financial innovation was always beneficial. Wall Street’s most esoteric instruments, the CDOs and MBSs mentioned with much disdain now, were built on these ideas. So there are key problems that are involved with making decisions based on economics. However it would be wrong to assume that these faults of being blindsided to be symptomatic of the whole subject. Because economists were hardly naive believers in market efficiency. Financial academics have spent much of the past 30 years poking holes in the “efficient market hypothesis”. A newly prominent field, behavioural economics, concentrates on the consequences of irrational actions. So there were caveats aplenty. But as insights from academia arrived in the rough and tumble of Wall Street, such delicacies were put aside and absurd assumptions were added. No economic theory suggests you should value mortgage derivatives on the basis that house prices would always rise. Finance professors are not to blame for this, but they might have shouted more loudly that their insights were being misused. Instead many cheered the party along (often from within banks). Put that together with the complacency of the macroeconomists and there were too few voices shouting stop. The charge that most economists failed to see the crisis coming also has merit. To be sure, some warned of trouble. The likes of Robert Shiller of Yale, Nouriel Roubini of New York University and the team at the Bank for International Settlements are now famous for their prescience. But most were blindsided. That was partly to do with professional silos, which limited both the tools available and the imaginations of the practitioners. Few financial economists thought much about illiquidity or counterparty risk, for instance, because their standard models ignore it leading to troubling prognostications if this were to be repeated again; and few worried about the effect on the overall economy of the markets for all asset classes seizing up simultaneously, since few believed that was possible. Macroeconomists also had a blindspot: their standard models assumed that capital markets work perfectly. Their framework reflected an uneasy truce between the intellectual heirs of Keynes, who accept that economies can fall short of their potential, and purists who hold that supply must always equal demand. The models that epitomise this synthesis—the sort used in many central banks—incorporate imperfections in labour markets (“sticky” wages, for instance, which allow unemployment to rise), but make no room for such blemishes in finance. By assuming that capital markets worked perfectly, macroeconomists were largely able to ignore the economy’s financial plumbing. But models that ignored finance had little chance of spotting a calamity that stemmed from it. What about trying to fix it? Here the financial crisis has blown apart the fragile consensus between purists and Keynesians that monetary policy was the best way to smooth the business cycle. In many countries short-term interest rates are near zero and in a banking crisis monetary policy works less well. With their compromise tool useless, both sides have retreated to their roots, ignoring the other camp’s ideas. Keynesians, have become uncritical supporters of fiscal stimulus. Purists are vocal opponents. To outsiders, this cacophony underlines the profession’s uselessness. Thus the ideas and various arguments in the field of economics are uncertain like shifting sands and yet these very ideas and theories should be continually used not because they are perfect but because in the distant potential they have the potential to be and despite all their faults there is no alternative simply because the only way to improve it is to feed it more data by using it and thus improve it.


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