The ballet dancer stands on her toes, in an elegant display of (wo)manhood, but it is not her natural state of existence, nor can she maintain herself in her position for long. Similarly, the Theory of General Equilibrium is elegant in construction but impracticable in reality. The need to balance economic variables was not born in economics, it is an import from the sometimes artificial (& idealistic) world of mathematics.
Declaimer: This article was originally in October 2017, and some of the data points may be outdated
Take water. If movement (of a river, say) is defined as dynamic while stagnancy is defined by statism, then a river is in dynamic equilibrium, while the sea is in static equilibrium. The Water Cycle would be in a dynamic equilibrium. But water does not change when you start to observe it, so it does observe physical/ mathematical rules that are true under all normal conditions.
But why would you expect human beings to behave similarly? Water does not have an ‘internal motivation’, which changes its behavior based upon an internal stimulus. So its behavior has only one dimension, its reaction to an external stimulus. Any theory that seeks to explain the behavior of water will only have to take into account the kinds of stimuli it is subjected to. All of these are mathematically amenable, and the subject forms part of Physics.
Human beings are internally motivated, so while they do react to external stimulus (some of which is the subject of Economics), they are driven by their Psychology. This adds a layer of ‘roughness’ to human behavior, that makes it impossible to measure it in discrete numbers. It needs fuzzy processing, more logic than mathematics.
Take Dynamic Stochastic General Equilibrium (DSGE), a theory that uses stochastic variables (whose values are independent of each other, but mostly ‘anchored’ to each other) to propose an ‘expected value’, that is ‘in equilibrium’. Rather like a house of cards that is ‘generally in equilibrium’, but can collapse any time, and don’t you look at me when it does. It is ok if you tell the buyer of a house the fine print, that this is prone to flatten you every 6 months, so you really should be sleeping outside in tents.
The point is, that these caveats are neither articulated nor provided for (with ‘fragility supports’, a Nassim Taleb/ Hyman Minsky idea). The underlying bed of Psychology on which it rests is not acknowledged, which creates problems. The ambition to be a ‘science’, which reduces uncertainty and prescribes ‘solutions’ for the user, puts it into the domain of pseudo-sciences.
Doesn’t Astrology seek to do the same? But when you see the astrologer call out his parrot, you know from common sense that he, the practitioner, does not know more than his parrot, hence caveat emptor. After all, we all do enough pop astrology to know that we hate our brother because he is this confusing Gemini, so we take the astrologer’s forecasts with a spoonful of salt. Still, imagine tying up our Repo Rate to the astrological configurations of Modiji’s birth charts, or what astrologers say about the BJP prospects in 2019.
But back to the House of Cards metaphor. Can you imagine buying a house that can’t survive the tail-wagging of a nearby dog? The implicit belief in the robustness of an economic model must be educated by a deep knowledge of the underlying Psychology. But both individual Psychology (a.k.a. Neurology) and Social Psychology are unstable subjects, with ideas germinating and dying because of the inability to be applicable universally.
A good example is the story of the idea of Ego Depletion (in Psychology). Do people have a limited amount of willpower? Will power is powered by ‘ego depletion’, which drives various character-building processes like the control of self-gratification. Freud described ego as the aspect of our personality that makes decisions about how to interact with the real world. This incomplete idea was then built upon by Bau Meister.
Various studies showed ‘ego depletion’ capability, (a.k.a. Self Control) as needing mental energy & motivation (System2 energy), even showing a fall in glucose levels, when we use willpower. What is often misunderstood as laziness, is just exhaustion. In a Bau Meister study, students who eschewed chocolate cookies, and ate radish instead, were too exhausted to last out on a puzzle, giving up in 8 mins, as compared to a Control Group that didn’t have to exercise this willpower (19 mins), or students who weren’t part of the study (21 mins). This study was later discredited on the ground that it could not be universally replicated, so the concept of ego-depletion is now withdrawn from Psychology.
But the idea that ‘ego depletion’ is infinite and can be built up with practice (like any body muscle) remains part of the literature on personal transformation. It drives learnability (which needs low ego states) and hence can be built up as a skill rather than an attitude and easily observed in small children, who can’t keep their hands off the candy in a store. Early diabetics know that this elasticity creates future plasticity, i.e., an exhausting resolve to keep off chocolates can take you to a point where you lose your taste for sugar.
We have unique levels of egotism and different capabilities to understand/ manage our egos, but the idea that it can be changed to the point of plasticity is a big one. Controlling/ depleting your ego remains an important life skill and the building block of your personality. So should Ego Depletion remain an idea in Psychology or not? For self-management, I would think yes, but as a standard to be prescribed for hiring in large companies, maybe no.
Wherever you are on this debate, the point is that Psychology, a social science, has the humility to put out its caveats, and you, the user decide where to stand on a debate. But that makes Psychology not very important to driving public policy, even though its usefulness cannot be questioned.
The problem with Economics is that there are no similar stories of the destruction of ideas. Nobody has called back the Nobel Prize given to Modigliani-Miller for Dividend ‘Irrelevance’, or the Black & Scholes model for having an elegant Bell Curve in its Probability Density Function. Right now, since 2013, the Phillips Curve has been violated by the fact that unemployment and interest rates are not inversely correlated, but the Fed continues to explicitly use it to determine policy. That it might effectively trigger the next recession, even as the Fed tries to prevent it, is similar to using your hand to cover the House of Cards, only to tip it over.
The Fed’s current pursuit of inflation targeting is flawed because inflation has not reacted to falling unemployment, even in the short run. That may be because the last recession created a structural downshift in Labour Utilisation, with the Baby Boomers going out. Some of the drops in unemployment came from people going out of the labor force, only to be replaced by new higher-skilled millennials, who took up their jobs. As the slack gets taken up, it does not result in an uptick in bargaining power because of psychological factors. Millennials are too indebted and too scared to negotiate.
Whatever it is, the debate depends on where you are. The point is that the Phillips Curve ‘prescribes’ a focus on inflation, the moment unemployment goes down. Being a single-equation mathematical model, it must be either used or rejected outright, there is no grey area or space for debate that it allows. And since it has set the Fed’s agenda for long, nobody dares to say that this time, things might be different. Who will bell the cat?
Psychology again. In markets, we are used to saying that things are never different, for good reason. But when the underlying macroeconomic model is based on artificial money funding artificial economic activity, then perhaps it is time to ask.