Full Of Holes :The Problems With The Old Economics



“Too large a proportion of recent ‘mathematical’ economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols.”
Declaimer: This article was originally in August 2017, and some of the data points may be outdated

The world once believed that the Earth was flat, some 400 years after Newton discovered gravity. It was logically possible to deduce that if there is gravity, and there is water on Earth, then it could only be spherical. Yet, we believe only what we can see, so it took Galileo’s telescope to look at other planets in the Solar System before people came round to the view that it was possible that the Earth was round.

The point is, that bad ideas have often taken over our collective understanding, and have stayed there despite evidence to the contrary. Such ideas are all over the place. Religion and sociology, oppress women to control their sexual availability. In politics and in nationalism, they send millions to their deaths to feed someone’s ego. In the sciences, they provide tools that fool you into believing that you have a parachute, so that you jump from the airplane, only to discover that you only have an umbrella.

Economics is one such ‘science’. In fact, the very claim to be a science is itself a bad idea. A science sits on an underlying bed of axioms and ‘facts’, that don’t change when they are observed. By this criteria, Economics is not even a science. Its application is not constant, changing according to the conditions and the economic player. Yet, by aspiring to mathematical precision, it claims to be a science with universal applications. This is both misleading and dishonest.

I quote this very beautiful line from John Mauldin: “We have seen economists espouse mercantilism, Malthusianism, Marxism and communism, socialism and its twin brother fascism, Austrian economics, capitalism, the gold standard and its cousin bimetallism, monetarism, protectionism, and a whole list of corollary theories like rational expectations, the efficient market hypothesis, and dynamic stochastic general equilibrium. Add to these the growing popularity of New Monetary Theory and variations on it. This list is by no means exhaustive, but just reading it is somewhat exhausting. Some of these theoretical bulwarks have already been dismantled, but others still clutter the halls of academia and policymaking.”

Hayek’s laissez-faire and Adam Smith’s ‘invisible hand’ come close to acknowledging the uncertainty of human behavior, but Kahnemann put it best when he postulated that like psychology, Economics should be more of a set of checklists that drive human behavior, a set of ‘models’ that try to anticipate the results of such behavioral processes. It is in its claim to be able to forecast, that is reflected in the arrogance of Economics and economists.

A bad tool in the hands of a fool is doubly dangerous. We see it daily on the roads of Delhi, but have we thought of the damage done to our lives by, say, a government economist whose flawed tools are setting the rules by which you and I live? His crime is that he does not know his limitations. He is there because of Economics, and the credibility of his calling derives from the credibility of the claims of the subject.

Think of the politician’s problem statement. The mandate of the government is to govern, i.e., manage its subjects. To do that, it must understand and drive their behavior, so as to maximize their collective welfare/ happiness. It must turn to the specialist, the person who claims to know. And his knowledge must be perfect, like the taxi driver who promises to take you from one place to another. You will have no respect for the taxi driver who is not sure whether his ride is taking you to Saket or CP.

So the economist selfishly misleads. He claims to know what he is doing, offloading the uncertainty in his skills (and understanding) onto the user. The academic establishment teaches the Economics it can teach, i.e., left-brain ‘facts’ and mathematical models that are communicable, even if they are flawed. Like a Driving School that pretends that clutch-brake-accelerator is enough to learn driving, omitting to tell you that your accident track record will actually depend on how you handle the Jat who tries to overtake you on his bike.

The mathematical models will assume away reality, so as to make their models ‘realistic’, i.e., to obey the standards of elegance demanded by mathematics. The Rationality Assumption is a very big one, they even gave a Nobel Prize for the Dividend Irrelevance Theory, which ignored human nature. Today’s idea of Free Cash Flow (FCF)-based valuation of companies flies in the face of this classical theory.

The General Theory of Equilibrium is simply academic nonsense. The idea is a chimera that doesn’t exist in the real world. Can you imagine that various bad ideas, from Trump’s Mercantilism, and China’s Totalitarianism to North Korea’s whatchmacallit, could co-exist in a stable equilibrium that stands on its own, held together by some ‘invisible hand’? Were it not for border guards, could East and West Germany have co-existed, with their different models of Economics, one specialising in producing Olympic champions, while the other produces everything else?!

One of the big implications of this fount of bad ideas is to point out just who uses them. A knife in the hands of a sensible person can be used to cut vegetables, but in the hands of a brat, can kill someone. We have seen what the idea of Socialism has done to Bengal, here in our own backyard. The oversimplification of Marxist thought led to a very different practice, from the idealistic precept that it espoused. While this is true of any religious/ political thought, what is not appreciated by academic economists is how their obtuse, theoretical papers end up in the real world.

In the corporate world, we have had a flawed understanding of the Cost of Capital and the spectacular failures of the Black & Scholes ‘bell curve’ assumption. It is amazing how Business Strategy is run by groups of people (a Board of Directors, for example) without understanding the laws of GroupThink, and how people change their personalities when subjected to group dynamics. I have seen Boards shrug off Risk Management strategies as ‘speculation’, using the word without even bothering to define it.

In Central Banking, how can the very people who claim to understand the economy be so bad at predicting and managing it? While a small community of academics are recognizing this (many of them call themselves Behavioural Economists, in order to distinguish themselves from the older, mofussil set), they are vastly outnumbered by the old school, who dominate industry and government.

To the extent that Business Strategy is run by economists and econometricians, the whole Strategy function incorporates is focused on issues that are ‘inside the ship’, rather than ‘studying the sea’. So in all group decision-making, environmental volatility is ignored, especially that coming from the major commodity markets (equity, debt, currency, assets, and commodity). Static assumptions are taken to project the current reality forward, simply because it is mathematically elegant. When it turns out to have no truck with reality, this is blamed on the external environment, as if it was nobody’s job to anticipate that. The idea that volatility is uncertain, and hence cannot be managed, is one of the worst ideas in Corporate Strategy, but there is nobody to even pretend to understand it, let alone manage it.

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