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Sunday, June 28, 2020

The Purpose and Failure of Economics

Uncertainty is one of the most essential concepts in economic analysis. It is distinctly different from risk in the following sense: 

whenever the future is imperfectly predictable,
  • The instances where we can estimate the probability of the possible outcomes, knowing that those outcomes are the only possible ones, are instances of risk;
  • The instances where we cannot estimate the probability of outcomes, nor with any reasonable level of confidence confine the set of possible outcomes in a closed system, are instances of uncertainty.
Modern economists are quick to dismiss this distinction, the reason being that the discipline of economics has narrowed down acceptable research methodology to those that can always generate rigorous answers to the questions asked. Those who operate outside of this mainstream are confined to the fledgling realm of political economy. 

Interestingly, this marginalized intellectual community has seen a renaissance in recent years. It started earlier, but the Great Recession of 2008-2010 gave it an unexpected, albeit welcome boost. More and more students - and even some practitioners - of economics were disturbed by the utter, universal failure of the economics profession to predict, and prescribe remedies for, the economic crisis. Formal models, the status of which originates in the New Classical Macroeconomics revolution of the 1980s, failed to explain the events that led up to and caused the recession.

I have previously noted that a survey of major macroeconomic forecasts from 2007 were on average 261 percent wrong about the budget deficit in 2009. It is worth noting that if Congress wanted to influence the economy in 2009, they would have had to make their fiscal-policy decisions in 2008, based in part on the forecasts from 2007. With the stunning level of error in many of those forecasts, it is not surprising that questions are being asked about what use we really have of economists and their profession.

It is no secret that economics has declined and deteriorated into an almost liturgical affinity for correlative statistics and eclectic mathematical exercises. What is less known is that this methodological paradigm inherently deprives economists of the ability to analyze most real-world economic problems. The discrepancy between what economics can do and what we need from economics is even more colorful in economic policy: most decisions on taxation, government spending, monetary expansion or contraction, even regulations, are made on the doorstep of a future that is at least to some degree uncertain.

By exegetically limiting his methodological scope to econometrics, the modern economist distances his science - a social science - from society and its most pertinent problems. It is, namely, the ultimate purpose of economic thought to provide solutions to problems that get in the way of prosperity. It is, simply, the duty of the social scientist in general, and the economist in particular, to contribute to the advancement of human society. Since uncertainty is an integrated part of human existence, the economist's refusal to apply, let alone learn methodology that recognizes uncertainty, demotes his work and his science from intellectual relevance to an inconsequential relic.

For the record, there are rare exceptions where econometrics make a difference. Those exceptions are microeconomic in nature and focus their perspective on individual markets and industries. Financial economics is perhaps the only field where a high level of technical sophistication is necessary; that said, the financial industry is also the one that has the most to lose, at least short term, from inability to understand uncertainty.

With the economist's inability to understand uncertainty, his scholarly purpose collapses into a question mark. Our purpose with scientific thought is not to simply document its existence and its functions. It is to seek ways to better the human condition. Everything human is imperfect; everything human can be improved. An explanation of human behavior that does not inspire a purpose of betterment eventually becomes nothing more than a random walk through reality.

The economist carries a particularly heavy responsibility on his shoulders. No social scientist is better suited to find improvements in our socio-economic organization than the economist. His specialization is conventionally defined as the conditions under which humans satisfy their needs by means of scarce resources. Therein alone is the value the economist adds to the betterment of the human condition.

There is, however, another dimension to the economist’s responsibility, one that has been ignored to the point of forgotten in the modern practice of economics. Modern-day economists have taken the relationship between human needs and scarce resources to the extreme, reducing it essentially to a chess game, soluble with a set of recursively soluble equations.

Human life is not confined in that way. It is open-ended and much more qualitative than quantitative. Originally, economists took this into account: before abbreviating the definition of their discipline they also saw their endeavor as the study of satisfaction of human needs by means of scarce resources, but they also recognized that the process under which those resources are produced and distributed takes place subject to uncertainty.

Our society cannot be reduced to a chess game with finite solutions. As a system of human interaction grows more complex, the outcomes of that interaction become increasingly uncertain. We humans respond to this by creating institutions - understood broadly - that help us manage uncertainty. We can master risk, but we can only manage uncertainty. Our ability to do so varies over time, but for the politician whose fiscal policy influences a third, sometimes half, of the economy, it is of critical importance to understand the role that these institutions can - and cannot - play.

It is here, in the intersection between private, organic management of uncertainty and its statist, synthetic equivalent, that the economist faces his biggest challenge. Since the socio-economic system wherein government operates, is open-ended and organic in nature, the economist cannot study it and dispense policy advice based on a methodology that assumes that the system is closed in nature. 

It is time for the economics profession to return to methodological pre-school and re-learn the distinction between orthodox and heterodox economic theory.

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