economics

Macro-shamonomics : The Flaws Of Macro-Economics

Sanjeev

Sanjeev

There was a time when ‘doctors’ used to bleed patients with mental health problems (on the diagnosis that ‘the devil has got ‘em’). That used to count as medical ‘science’ at some point in human history. One day, historians will look back at economics and put the same inverted commas around the description.

Declaimer: This article was originally in March 2018, and some of the data points may be outdated

Few professions have disappointed as many people, and as spectacularly, as Economics, in recent history. The legal profession, perhaps, and politics, that old suspect, but then, nobody claimed grandly to be the answer to the world’s problems, the way that Economics has. From being the moral compass of the world to being the prescription of Public Policy, even governance, to the current fad of deciding the models of human happiness, Economics has evolved in fits and starts, always interesting, always ambitious, but always wanting.

The Great Recession has laid bare many of these claims. Mathematical models, which claimed to lay out precise boundary conditions, have failed miserably in a large number of areas: in credit rating models, CDS pricing, and option pricing (Black Swan effect), this list is incomplete, there is not an area of economic endeavor that has not suffered the effects of dis-preparedness by economic players, who believed in Classical Economics. Keynesians have been using older models to argue that keeping interest rates low and creating new money will revive aggregate demand, in turn reviving the economy. To the point when rates were taken negative on 40% of the world’s bonds, destroying the savings impulse. The distortions so created have yet to play out on their after-effects when the current process of deleveraging could uncover fingers of instability, which nobody has even imagined, let alone seen.

Hayek has said long ago that markets and (individual) entrepreneurial action are the best drivers of economic growth and revival. In today’s world, most such initiatives are innovative/ technological breakthroughs, which can be sudden disruptors of existing industries or creators of new ones.

Macro-economists have been running a Faustian conspiracy, to protect the reputation of their models rather than question their efficacy. Just like the Great Depression was born out of serious policy errors in Fiscal and monetary policy, the aftermath of the Great Recession may have seen grievous errors from the usage of outdated models, in a world where technological innovation (even more than entrepreneurial initiative) is the driver of economic growth.

This has been seen in other academic areas where there are large data gaps and huge uncertainty in the cause-effect relationships between driving and independent variables. In String Theory, for example, there are these ‘fads’ that build up among physicists, and the observed facts no longer seem to matter. Simply because no set of facts fills up completely the un-knowable gaps, leaving enough space for your favorite theory (espoused by a celebrity theorist). A phenomenon is also seen in a much lower discipline, Politics.

Such ‘purges’ are nearly political developments, like Mao’s Great Leap Forward or the rise of Nazi-ism. Any thought process contrary to the establishmentarian philosophy is crushed. And the establishment is dominated by some celebrity economist, who has a vested interest in the survival of his espoused viewpoint. In the case of macroeconomics, the mathematical elegance of the model had to be maintained at all costs, even if it meant assuming away reality. Paul Krugman has been cheerleading the QE operation in the US, regularly pointing out that all the money printing has not (yet) resulted in the onset of inflation. Rather like blowing a balloon and then celebrating the fact that it has not yet burst, and that indicates that it will never burst…! The effects of the gigantic bubble in bonds have still to play out yet, but I mention this as an example of how the consensus can be hijacked by a celebrity economist, who drives public policy in a particular direction, with no possibility of any mid-course evaluation.

But Physics will remain a science, principally because observations don’t change in different experiments with similar conditions. In particular, the observed (i.e., the inanimate object) does not change because it is being observed. On the other hand, macro-economics is trying to model individual human behavior and study its agglomerates. Given that human beings have individual minds, their behavior can be vastly more complex and unpredictable than the behavior of atomic particles. So the normative Dynamic Stochastic General Equilibrium (DSGE) models of macroeconomics do not work, except patchily. And there is no way to tell when they will work, or not. Particularly the NOT.

This creates a peculiar problem for the user of macroeconomic models. He must consider himself educated in macro-economics and hence must think he ‘knows’ what is going to happen. But if macro-economics itself does not know, then how can the user tell when he does not know? So he THINKS he knows, and then does things in that belief. If he was doubtful, he would not jump off the top floor. In that, macroeconomics turns out to be a pernicious sham and very dangerous miseducation that does not even post a disclaimer to the user, to jump at his own risk.

It is particularly pernicious when used in public policy because politicians will quote economists to justify and push through a flawed policy. A case of the blind leading the blind, but in Pied Piper fashion.

This new sub-branch called Complexity Theory (which mimics the role of Chaos Theory in Physics) seems to have started right. One, it has the humility to not be prescriptive about its conclusions. Everything is studied as a range of possibilities, it uses Uncertainty Mathematics (Probability Theory, Benoit Mandelbrot, Fibonacci Spirals, Monte Carlo models, etc) rather than the discrete numbers that you know as Mathematics.

Compare it to the Keynesian Dynamic Stochastic General Equilibrium (DSGE) of the classicists. Taleb put it very well with his Bed of Procrustes metaphor. If the visitor was too tall, Procrustes would cut the guest’s legs till they fit the bed. Humans try to fit observed data within the boundaries of what they know; just like the observed horizon at the sea beach got us to the conclusion that the earth was flat. DSGE uses traditional mathematics to compute models of variables that are both random and independent (or at least have a wide enough range of possibilities, to count as random). Like stock prices, for example. Then how do you submit such data to the rigorous boundaries of discrete numbers?

Complexity Theory goes in a different direction. It tries to marry Information Theory with the definition of complex systems. At the same time, Information Theory seeks to define a signal and separate it from the noise, a complex system is defined as millions of independent units moving in regular patterns (the human body, the celestial bodies in the universe, stock prices, tectonic movements in the earth’s crust, even the machinations of a woman’s mind with its multi-optimization of unstable, complex priorities). The key is to define a pattern and predict its regularity.

The trouble is in calling all this a ‘science’. Education, yes, maybe. Art, definitely yes. But an all-things-to-all-people science that everyone can and should know……that should come with a lot of disclaimers.

Governments often tend to distort the signals with their action, increasing complexity. The UPA Govt ran high deficits and saw high inflation with high taxes. The result was that some 30% of the middle class was engaged in ‘businesses’ or professions that were directly or indirectly engaged in the evasion of taxes, or otherwise, (through a series of stratagems) stealing from the government. What started as errant behaviour, has hardened into culture, with generations of Indians doing the same thing the same way. The distorted signals sent out by Government action, changed the definition of entrepreneurship…..evading taxes and power broking/ lobbying became central skills without which the making of goods or services was not enough to bring in a profit.

Think of the Jodhpuri CA. For 2 generations, they have migrated to the hostels of Burra Bazar in Kolkata, and formed the backbone of the ‘entry market’ (a.k.a. the money laundering trade), which links Kolkata to Jaipur, Surat, Baroda, Rajkot, and Mumbai. Today, they are told that what they have been doing is not a Business/ Profession, but theft. Do you expect them to understand? And now, how do they change behavior overnight?

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