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Economics: poor science, strong faith
On this site one can find a host of implicit and explicit criticisms of economic science and its practitioners. Using the Question and Answer form this page explores in more detail the shortcomings of economics as a science. It should be noted that the critique is leveled primarily at the currently predominant neo-classical economics - also indicated as orthodox or traditional economics. There are, fortunately, many economists who also strongly criticize their neo-classical colleagues. Moreover, many economic sub-disciplines have levels of scientific rigor, theorizing and practical application that far surpasses those of orthodox economics. Unfortunately, though, the practitioners of these sub-disciplines are as a rule much less influential than their orthodox colleagues – especially the monetary economists. Nevertheless the biggest hope for improving economic science lies with these less orthodox, more critical economists.
Question: So what are the faults in orthodox economic thinking?
Answer: Orthodox economic theory is based on a series of premises that even economists themselves admit are far removed from reality. Yet they are standard in almost all economic theorizing. The prime example is the concept of economic man (homo economicus): the view of man as a perfectly rational being, all of whose decisions are aimed at maximizing economic benefits. Obviously, human behavior is much more complex than that, driven as it is by a wide array of factors: psychological, social, and biological forces, rational as well as emotional. Only recently – i.e, over the past few years - have a few established economists started working on these non-economic factors. Apparently, in economics only now the insight takes hold that for most non-economists is little more than common sense: that human decision-making and behavior reflects more than the maximization of economic benefits.Then there is the concept of perfect competition in a perfectly functioning market. In most economic theory the point of departure is a market in which an infinite number of players compete on an equal basis, resulting in an optimal balance between supply and demand. Even economists admit that such markets do not exist in real life. In real markets there is always inequality: some players know more than others, have more assets than others, or can work together with other players to influence pricing. Yet in spite of this obvious phenomenon much economic theory is based on the premise that competition in markets is absolutely free and fair. Worse, this theory more often than not forms the basis of economic policy. One example is the privatization of public services - justified by the contention that the private sector, because it is subjected to market forces, can supply the services involved more efficiently and therefore, better and cheaper. In practice, of course, most privatized public services have faced no or hardly any competition - and have therefore not been exposed to market forces. The predictable result has been that many of these newly privatized services have abused their monopolistic position for the benefit of their management and shareholders. Where this has not happened the tempering force has been government control rather than market forces.
Another misbegotten concept central to economic theory is that of the closed market: a market where goods, services or money circulate internally, but do no flow in or out. Obviously, in this age of globalization, there are no such markets – or if there are, they are of no significance in the grand scheme of things. A parallel premise is that of the transparent market, where all players have complete knowledge of the supply and demand of goods, services and money – a knowledge that enables them to lower or raise prices depending on relative scarcity. Today’s markets, in which goods, money and to a lesser extent services flow freely across borders, are of course so large and complex that market players do not come close to knowing all factors that influence demand, supply and price setting. Thus globalization invalidates the concept of the closed market as well as that of market transparency.
A final, more general fault in economics, and possibly the most harmful one, is the premise that there are economic laws that function over and above the (sum of) individual actions of people. This error stems from the desire of economics to be recognized as "hard", "natural" science. Just as, for example, physicists, economists therefore search for universal laws that determine economic reality and can be expressed in mathematical equations. In this same train of thought they consider their theories to be universally and eternally valid. However, economics is not a natural science but a social one. The economy is the result of the sum of individual decisions taken by millions of human beings. There is no reason to assume that there are universal laws that determine those decisions, or the sum of those decisions – i.e., macro-economic processes. The search of economists for economic "laws" that are universally valid is, therefore, comparable to the search for the Holy Grail. The assumption that such laws exist is, therefore, pure faith, and should have no place in what purports to be a science.
Question: How do the faults in economic science relate to the concept of money creation?
Answer: Throwing out these basic assumptions of traditional economics has important consequences for the concept of money creation. Most notably, the combination of lack of insight in markets and of open markets means that no economic actor sets prices on the basis of the amount of money circulating in the economy. That means that the basic notion of traditional monetary economics, i.e., that an increase in the money supply (unmatched by an equivalent increase in products and services) will inevitably lead to inflation is invalidated. Likewise, the fact that markets are not closed and money, goods and services freely flow across borders means that an increase or decrease in the money supply does not automatically translate into inflation or deflation.
In short: the whole concept that the money supply directly influences prices because relatively speaking, an increase makes goods and services scarcer, leading to price increases (inflation), and a decrease makes goods and services more abundant, leading to a decrease in prices (deflation), is nonsense. Unfortunately, however, the implication of this faulty concept, i.e., that there is a need to keep tight reigns on he money supply - even in a situation, as today, when the shortage of money is obvious - remains as strong as ever.
Question: Are there, apart from faulty premises, other shortcomings in economic science?
Answer: Yes there are. Another major weakness of economics is its methodology, notably, the tendency to draw far-reaching conclusions on the basis of scanty evidence from a very limited number of cases. A comparison with medical science is illuminating. Medical doctors base conclusions on the effects of certain types of behavior on human health, such as smoking on heart failure, on research among thousands, sometimes tens of thousands of subjects: human beings. Any doctor drawing conclusions on the basis of, say, a few dozen, let alone two or three subjects, would be the laughing stock of their profession. Yet (macro)economists do not hesitate to draw the most far-reaching conclusions on the comparison of a few, sometimes only two countries. For example, international financial organizations such as the World Bank or OECD regularly announce that their studies show that countries having a free trade regime have more economic growth then countries that do not. The problem with this statement is that there many other factors that influence economic growth, and that taking just one – the trade regime – as "the" explanation is an inadmissible simplification of reality. Comparing two groups of twenty "research units", that is, countries, is no basis whatsoever for drawing conclusions. Again, note that in medical science, a comparison of thousands of research units – persons – is considered necessary to minimize the chance that causal factors other than the one investigated will influence the research results. For example, in the above example of the relationship between smoking and heart failure, the factor diet, i.e., intake of greasy foods, would be such a factor. By taking a large number of research units, divided in smokers and non-smokers, the influence of this (and other) causal factor(s) can be neutralized, as it may be assumed that in such large groups differences in diet are evened out. No such methodological finesse for economists, though – as said, in some cases they even go as far as to draw conclusions on the basis of comparisons between two countries – even though . And that whereas countries differ much more from each other then human individuals - which means much larger numbers would be needed to eliminate the influence of other than the investigated factors. These studies, therefore, have little to do with science. And indeed, they are usually undertaken not, as would be the case in a scientific study, to discover scientific truths. They are carried out to propagate economic dogma, i.e., the blessings of free trade.
A final weakness of economics to be discussed here is its tendency to deify economic theories that were conceived decades or even centuries ago - in conditions that were very different from today. This, of course, is a consequence of the desire to explain economic reality in terms of universal, eternal laws. In addition, it is exemplary of the fact that in some respects economics is more a religion then a science: whereas (good) science, especially social science, adapts to changing realities, religious institutions tend to stick to their dogma’s and beliefs for better or for worse. A good example of this tendency is the infatuation of economists with the theory of free trade, initially developed by a brilliant man named Ricardo in the early eighteenth century. In that period countries, and economies, were much less diverse than they are today, productive capacity was smaller, and technology levels were much more uniform. In that context it made sense, as Ricardo did, to argue that free trade stimulated all countries to produce what they were best equipped to produce, creating a kind of international division of labor. With low technology levels and limited production capacity, countries could not produce everything. According to Ricardo’s theory of comparative advantages they therefore specialized on those internationally traded goods they could produce best, and left the production of goods in which they were less efficient to other countries. Thus, each country could find its niche in the international market, as a result of which free trade benefits all.
On the basis of Ricardo’s theory economists sing the praise of free trade up to this day. However, things have changed since Ricardo’s time. Thanks to technological development productivity and hence, productive capacity has increased enormously. As argued elsewhere on this site, in comparison demand has fallen behind. Consequently a limited number of countries, making use of modern technology, is able to meet the demand for practically all goods that are traded internationally. That means that for many, especially poor countries there no or insufficient comparative advantages, making it impossible for them to partake in international trade with some measure of success. Had Ricardo been alive today one may assume he would have recognized this, and would have adapted his theory. Not so economists, who continue to support their continuous calls for liberalizing trade by referring to a theory that, however brilliantly conceived, was developed several hundred years ago in circumstances very different from today’s.
Question: What should be done to make economics better science?
Answer: Rather then searching for economic truths in the form of universal, natural laws economic science should focus on explaining and if possible, predicting human behavior. A point that needs particular strengthening is distinguishing between correlation, cause and effect. In this economics has much to learn from psychology and sociology, especially in the field of methodology. First year sociology students are drilled in logically sound approaches to analyze cause and effect. For example, if a relationship is found between phenomena A and B, they should investigate if changes in phenomenon A are caused by phenomenon B, or alternatively, if changes in phenomenon B are caused by phenomenon A. Also, a third possibility is taken into account, namely that changes in A and B are caused by a third factor, C. A good example, used in first year social science methodology courses in The Netherlands, is the conclusion to be drawn from the concurrent decline, observed in the second half of the 20th century, of the number of births (phenomenon A) and the number of storks (phenomenon B) in the country. According to the theory of babies being brought by storks, the declining birth rate (A) would be caused by the declining number of storks (B). The more critical analyst might consider that even though there is a clear relationship (or correlation) between phenomena A and B, it is not necessarily a causal one. It would therefore be useful to look for one or more other causal factors: C, D and E. Unfortunately, such methodological basics receive little attention in the teaching of economics. The result is that established as well as new theories are insufficiently tested against empirical evidence using rigorous logic. That is, there is no attempt, as there should be in serious science, at falsification, i.e., a conscientious effort to prove a theory wrong. Instead, facts and figures are sought out that support the theory and, in the worst case, evidence to the contrary is ignored. The overall outcome of these shortcomings in economic methodology is the continued uncritical acceptance of dogma’s that have come to be accepted as universal truths.
Question: But aren’t economists at least right on the importance of the "invisible hand of the market"? On the fact that, given time and freedom from intervening factors, equilibrium in markets will restore itself? And hence, in arguing that intervention in markets should be avoided?
Answer: With regard to the tendency of markets to move towards equilibrium, yes, economists are right. With regard to not intervening in markets, no. The problem is that before equilibrium restores itself an awful lot of damage can be done – damage that must and can be avoided. The cause of such damage is that, especially at the level of national economies, there is a tendency for both negative and positive processes to feed upon and reinforce themselves. If this goes unchecked it leads to extremes in both a positive and a negative sense. Here we return to the self-fulfilling prophecies that so strongly influence economic processes (and explain the few cases in which economists predict correctly). For example, when economic prospects look good people will spend more easily and business, expecting increasing demand, will invest in expansion. That will create growth, which will make the economic outlook even more positive. Stocks will rise, and with it investment capacity. Companies will obtain higher profits, consumers will happily borrow and spend. Governments will increase spending as rising wages, stocks and profits add to revenues.
If the economy goes the other way, downward, the opposite occurs. Consumers will buy less and borrow less, and companies will limit investment. With less tax money coming in government revenues diminish whereas costs of unemployment benefits rise. Job losses and downward pressure on wages reduce demand, causing more job losses, bankruptcies, declining stock values, and further cutbacks in investments.
The upward spiral stops automatically - when at some point, economic decision-makers start to realize that stock and real estate prices have gone up to disproportionate levels. A minor event can trigger a panic, people start selling stock, real estate prices decline. Again a self-reinforcing process is started: more people start selling, prices decline further, and so on. Businesses start cutting costs and reducing investments, the first layoffs occur, people foresee a less bright economic future and cut back on spending and borrowing. Banks tighten the supply of credit and speculative bubbles deflate, destroying billions of dollars. Thus money is destroyed, withheld or withdrawn from the real economy at the moment it is most sorely needed. Hopes are for the economy to make a soft landing, but if the decline is rapid chances are greater the economy ends up in a downward spiral.
Unfortunately, in a downward spiral there is not, as in the case of an upward spiral, a sudden u-turn. The economy may hit rock bottom when the economy has contracted by tens of percentage points – as happened in the Great Depression in the 1930s and more recently, in the 1990s, in Eastern Europe and parts of Eastern Asia. A recovery may then occur, but is by no means certain. In many cases, for a recovery to really pick up and become self-reinforcing external inputs or events are needed. After the crashes of the 1990s the recovery of Eastern Europe and Eastern Asia (excluding Japan, which since the crash of 1987 has not seen a real recovery) has depended largely on foreign investment. The situation in Russia started to pick up only after rising oil prices led to a significant inflow of hard currency. The Great Depression of the 1930s was overcome through massive public investment in the fighting of World War II – investment that was financed through loans at a time when government debt was still relatively low. Even the recovery in the US in the 1980s, in the anti-government Reagan era, was pushed by a massive investment in armaments.
In conclusion: in case of a major slump equilibrium will restore itself, but that may well be at a level where, through lack of money, society’s productive capacity remains hugely under-utilized. In other words, in a downturn the private sector, faced with a lack of investment capital and little incentive to invest due to stagnant demand, is likely to be unable to reverse the downward spiral into an upward one. A major intervention on the part of governments is therefore required. Today, with the global economy in the doldrums and high levels of indebtedness, as well as the dire need for a major investment in sustainable development, such an intervention is urgently needed. However, with government revenues falling and social security costs rising governments lack the money to do so. With already high indebtedness, graying populations and hence, prospects for sharp rises in social security and health care costs in the future, more government borrowing also is no option. The only way out, then, is money creation for sustainable development.
Question: If economics is such poor science, how come its tenets and practitioners are so rarely questioned?
Answer: That’s a good question. Considering the shoddy science they practice it is amazing that economist are held in such high regard – and that their predictions and recommendations are taken so seriously. To some extent non-economists are likely to be dazzled by the arrogance and status of economists, and by their high-flying academic discourse and sophisticated mathematical modeling. Because this has to be said for economists: in spite of the shortcomings of their science many are brilliant academics, able to convert ideas, concepts and relationships between variables in the most elegant and sophisticated mathematical models. Unfortunately, the weakness lies in the most basic concepts and assumptions – and with weak foundations the theory built on those foundations, however brilliantly conceived and executed, is also weak. Indeed, an adequate analogy of economics would be that of a beautiful edifice built upon inadequate foundations - and therefore, non-functional. However, foundations, of buildings as well as sciences, are mostly hidden from sight, making their soundness difficult to judge. That soundness is therefore rarely questioned – certainly not by laymen. Hence, faced with the academic brilliance and status of economics non-economists, including scientists from other disciplines, politicians, journalists and other opinion leaders, do not even think of challenging the tenets and decrees of orthodox economics – just as non-physicists would not consider challenging the basic tenets of physics.
There is, however, an important difference between economics and physics. Contrary to the object of physics that of economics is an everyday topic, in people’s conversations as well as the mass media. And when the topic comes up, the mantra’s of economics are parroted instead of critically questioned. Economics has, to a large some extent, become religion, with economists as the high priests. The basic tenets of the economic faith have been repeated over and over, so much so that they have come to be unconditionally accepted as universal truths by both priests and lay persons. The latter is true especially for the taboo on money creation for public investment and the existence of universal economic laws – though less so for free trade, the blessings of which are hotly debated by a vociferous minority. As in an ordinary religion faith is all, no room is left for common sense, and heretics challenging the faith are chastised or even excommunicated. Worse, as in a religion, the priestly caste is more interested in converting the unfaithful than in the systematic study of reality and the thorough empirical testing of hypotheses - to prove that their beliefs are, according to the scientific principle of falsification, not wrong.
Question: So what are the consequences of these shortcomings of economics?
Answer: Most important is that, as already mentioned, economic theory has been turned into dogma. Dogmas are universally and eternally valid, and therefore, are not questioned. That has made economics a stagnant enterprise unable to adjust to changing realities. This is all the more serious since, due to the importance given to economic development in general and money in particular, it has led to economists behaving themselves as a clerical caste. As in real religions, debate only takes place on details of the faith – the faith as a whole, its basic tenets, are no object of discussion. Moreover, the debate only takes place among the anointed, not with outsiders: laymen are ignored. Rather than engaging them in open discussion laymen – including politicians, journalists, and other opinion leaders – are being showered constantly with the mantra’s of the Real Faith: Free trade is good for all! Money creation will cause inflation! Reducing taxes promotes growth! The private sector is more efficient and therefore better than the public sector! And so on.
As a religion economics has been extraordinary successful. Both inside the priesthood, i.e., the academic community, and outside it there are few that dare question the established beliefs. That is logical since, as in any religion, retribution is harsh: the heretics are, in the best of cases, ignored or ridiculed and, if the dangers to established interests are considered more serious, excluded from the academic debate and banished to the fringes of the academy. Messages of dissent are suppressed by keeping them out of the established ways of communication, i.e., academic journals and the mainstream press.
On certain topics, such as free trade, there are more voices of dissent, especially outside the academic community. But these are outside the mainstream, and have little or no influence on policy making. Most notable, however, remains the fact that the command "thou shan’t create money for public investment" is universally accepted – apparently even by the most lunatic fringes of the alternative community (though this may partly be due to lack of interest in the issue, as the whole concept of money is condoned). To put this dogma up for discussion people will have to start trusting their own capacity for reasoning and judgement - and not, as happens now, leave the issue to the priests while stating "I wouldn’t know, I’m not an economist". To paraphrase: the issue of money creation is too important to be left to economists.
Question: So what to do?
Answer: What is needed is: A new economics
For more on economics click on: The darker side of economics
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