It is not new news that standard economic theory provides a very poor foundation for predicting the path of the economy in the real world. I do not believe the Fed’s economic outlook has EVER included a recession in its forecasts, although they happen with depressing regularity.
Milton Friedman’s classic 1983 essay “The Methodology of Positive Economics” set as the standard for an economic model’s success its ability to make predictions, and urged that one ignore whether the assumptions embedded in it were true or not. This is a sensible idea, and one that generally held sway, at least up until recently.
The complete inability of theory or models to predict the financial crisis has led to much rethinking about economic theory and methodology. George Soros, long critical of standard theory, established the Institute for New Economic Thinking to tackle both the theory and practice of economics. Compared to other sciences, economics is primitive. Consider that Daniel Kahneman, a psychologist by training who never took an economics course, was awarded the 2002 Nobel Prize in economics. It would be unthinkable for a non physicist to win the Nobel in physics.
A recent meeting at the Santa Fe Institute was devoted to complexity economics, a broad term that is meant to encompass the type of approach necessary if economics is to advance to the levels of other more established sciences.
The keynote speaker the first evening was Ken Arrow, the youngest person to win the Noble in economics at 51, and still going strong at 92. Ken gave a synoptic view of current economic theory, much of which he invented, but was unsparing in his criticisms of its shortcomings and candid about how much we do not know and how much work is yet to be done.
All of this is, of course, of vital interest to those of us in the investment world who are trying to navigate in a domestic and global economy about which too little is known and even less can be predicted.
It is generally acknowledged that economics is rife for a paradigm shift. The idea of a paradigm shift was introduced by Thomas S. Kuhn in his 1962 book The Structure of Scientific Revolutions. He argued that rather than progressing in a linear way, science advances when one way of looking at or understanding the world is supplanted by a completely new way, which overthrows and replaces the old paradigm.
The current paradigm in economics is one that embeds the notion that the economy is fundamentally an equilibrium system; one that is at, or close to, equilibrium, where supply and demand are in balance. The hydraulic metaphor is often employed to describe the state of the economy. That is, one hears about the economy cooling, or overheating, or there being pressure on labor markets or prices. Money “flows” in one direction or another. It is assumed in almost all models that economic phenomena follow a normal, or Gaussian distribution.
The simplifying assumptions of modern economic theory make it mathematically tractable and allow for the construction of elegant and complex models, some of which are perhaps useful. But enabling us to predict economic phenomena is not their strong suit.
Modern financial theory rests almost exclusively on this foundation, and its weaknesses are the weaknesses of the current economic paradigm.
In my opinion, if economics and finance are to make substantial progress, a new paradigm will be necessary, one that employs far more realistic assumptions than does standard theory, one that rejects normal distributions for the more accurate power law distributions we actually see, one that incorporates the insights of social psychology and behavioral finance, and finally, one that may not be a theory at all, but rather a loose family of domain dependent models or even heuristics that enable us to navigate our environment more successfully.
I hope to flesh this out a bit more in future posts.
Read the series:
Part I: Time Travel in the Minsky Moment
Part III: "We Have Involved Ourselves in a Colossal Muddle..."
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