Sunday 26 March 2017


Good economists are almost always right about almost everything

So much everyday government policymaking is dominated by economic reasoning, such as the price controls imposed upon utilities

crystal ball tarot cards
Orthodox economics tells us that it is impossible to predict significant financial crises in advance  Photo: Alamy

Good economists are usually about as right as it’s possible to be. There, I said it.

That shouldn’t be controversial. After all, that’s why economists get paid so much and why societies managed according to economic principles such as sound money, secure property rights and effective competition are much more prosperous than others.

It’s why so much everyday government policymaking is dominated by economic reasoning, from the price controls imposed upon utilities, such as water and electricity (even called “economic regulation”), to the rules on how economic reasoning has to be used in devising regulation and setting taxes (so-called “impact assessments”).

It’s why the tools of economic reasoning, such as game theory, have come to dominate so many other disciplines, from evolutionary biology through moral philosophy to political science and military strategy, most famously including nuclear weapons policy — there is even a branch of physics called “quantum game theory”.

It’s why your television screens are full of economists every day, explaining not just news events, but almost everything, from which football managers are the most skilled to why singer Katherine Jenkins is so successful.

Yet, despite the ubiquity and spectacular triumph of economic reasoning in our culture, many readers will think my claim laughable. Economists right? We are used to reading articles and books debunking orthodox economics. What about the black swans? What about the irrationality? What about the Queen’s bewilderment that economists didn’t foresee the financial crisis? Didn’t even Lord Turner, chairman of the Financial Services Authority, declare that orthodox economics had produced a “50-year-long giant intellectual mistake”?

Some such challenges are easily deflected. Orthodox economics tells us that it is impossible to predict significant financial crises in advance – or else everyone would predict them and trade off that and so they wouldn’t happen. There’s little point in criticising economists for being unable to predict shocks they say are impossible to predict.

But challenges to rationality are trickier. Many economics writers respond along the lines of “Ah . . . but you see there is lots of academic economics work based upon irrationality or neural networks or disequilibrium reasoning” or whatever. That’s not my answer. There is, of course, a rather modest amount of work done on heterodox economics of that sort, but most of it isn’t going anywhere and mainly it’s not needed, because orthodox tools are so powerful and fruitful.

Modern orthodox economics is a rich and broad field of endeavour that it is impossible to encapsulate in a pithy sentence or paragraph. But here’s my best go. Some textbooks will tell you economics is the study of incentives. I unpack that as follows: economics is the discipline that tells you why behaviour makes sense.

If my left arm goes up, a physicist might tell you about the atoms and molecules and forces that took it there. A biologist might tell you about the electrical impulses in the nerves in my arm and the hormones and energy transport in the blood. A certain sort of old-fashioned psychotherapist might tell you about how raising my left arm resolved the struggle between my super-ego and my ID. But economics is the discipline that seeks to explain why I raised my left arm in terms of why that made sense to me, given my objectives and beliefs.

That is why what is called “rationality” is so important in economics. Much popular discussion fails to grasp the point of rationality in economic theory. It is often thought that economists assume people are rational, rather as scientists once upon a time assumed there was no friction — a sort of simplifying assumption from which we will one day move on and that can be shown not to apply in many practical cases.

So much is written purporting to show that people are not always rational. Former Federal Reserve chairman Alan Greenspan famously said in 1996 that stock markets were exhibiting “irrational exuberance”.

Lord Turner wrote two reports creating important government policies based on his claim that people are often irrational — his pension review of 2005 and his report on the financial crisis in 2009. Indeed, in his famous Turner Review of the financial crisis as chairman of the FSA he claimed to be able to demonstrate the failure of almost the entirety of finance theory as it had developed since the 1950s, albeit without feeling the need to name-check the great men who had produced that theory or consider how they might have defended their ideas.

But rationality is not an assumption of orthodox economic theory in that sense. Instead, it is what is called an “axiom”. No behaviour can prove that people aren’t, in fact, rational, because for an orthodox economist the only kind of explanation of any behaviour that counts as an economic explanation is an explanation that makes sense of that behaviour — that shows why the behaviour is rational.

Irrationality and other heterodoxy is usually little better than an all-encompassing conspiracy theory, explaining everything and thus nothing — for while many behaviours may not be rational, there is no behaviour that is not irrational. In the process, heterodoxy misses all that is fruitful and important. To see why, let us take a famous example.

In the 19th century economics faced a mystery. In the Irish potato famine of the 1840s and during the Paris Commune of the 1870s, when the prices of staple food (in the one case potatoes, in the other bread) went up, demand went up also. Pondering this mystery, economists eventually reasoned as follows.

When prices rise there are two kinds of effect. There is the effect that the price of this good is now higher than of others, so people will tend to switch away from the now more expensive product. But there is also the fact that when products are more expensive, people’s incomes go less far — they are made poorer. Poorer people may spend more of their income on essentials, such as food, and less on other things, raising demand for staple foods. When folk don’t have much money to begin with, a rise in the price of bread or potatoes will have a large effect on their incomes.

In extreme cases such “income effects” may be even larger than the other switching-between-products effect, explaining the mystery of demand rising with rising prices. This insight is the basis of modern consumer theory.

Suppose instead we had answered: “Obviously, if people were rational, then when prices went up they’d buy less. But they aren’t always rational, as demonstrated by the examples of bread and potatoes.” Then we would have missed the key insight.

Contrary to most popular commentary, the main financial economics models have worked extremely well during the financial crisis, and remain in place. But even supposing they hadn’t, that wouldn’t have proved we should abandon the attempt to make sense of events; to abandon the attempt to offer an orthodox economics account. For very often it is when we are forced to grapple with a mystery, with behaviour that does not at first seem to make sense, that we produce the greatest insights.

The insights orthodox economics will eventually produce in reaction to the financial crisis will advance our social and economic life and prosperity even further than economics has done already. For good economists, given time and sound theory, are almost always right about almost everything.


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