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Sunday, October 29, 2006

Neoclassical Theory under Fire from the Sciences

This is Philip Ball, "consultant editor of Nature and the author of Critical Mass," with a criticism of neoclassical theory:

Baroque fantasies of a most peculiar science, by Philip Ball, Commentary, Financial Times (free): It is easy to mock economic theory. Any fool can see that the world of neoclassical economics, which dominates the academic field today, is a gross caricature in which every trader or company acts in the same self-interested way – rational, cool, omniscient. The theory has not foreseen a single stock market crash and has evidently failed to make the world any fairer or more pleasant.

The usual defence is that you have to start somewhere. But mainstream economists no longer consider their core theory to be a “start”. The tenets are so firmly embedded that ... it is ... rigid dogma. To challenge these ideas is to invite blank stares of incomprehension – you might as well be telling a physicist that gravity does not exist.

That is disturbing because these things matter. Neoclassical idiocies persuaded many economists that market forces would create a robust post-Soviet economy in Russia (corrupt gangster economies do not exist in neoclassical theory). Neoclassical ideas ... may determine ... how we run our schools, hospitals and welfare system. If mainstream economic theory is fundamentally flawed, we are no better than doctors diagnosing with astrology.

Neoclassical economics asserts two things. First, in a free market, competition establishes a price equilibrium that is perfectly efficient: demand equals supply and no resources are squandered. Second, in equilibrium no one can be made better off without making someone else worse off.

The conclusions are a snug fit with rightwing convictions. So it is tempting to infer that the dominance of neoclassical theory has political origins. But ... the truth goes deeper. Economics arose in the 18th century in a climate of Newtonian mechanistic science, with its belief in forces in balance. And the foundations of neoclassical theory were laid when scientists were exploring the notion of thermodynamic equilibrium. Economics borrowed wrong ideas from physics, and is now reluctant to give them up.

This error does not make neoclassical economic theory simple. Far from it. It is one of the most mathematically complicated subjects among the “sciences”, as difficult as quantum physics. That is part of the problem: it is such an elaborate contrivance that there is too much at stake to abandon it.

It is almost impossible to talk about economics today without endorsing its myths. Take the business cycle: there is no business cycle in any meaningful sense. In every other scientific discipline, a cycle is something that repeats periodically. Yet there is no absolute evidence for periodicity in economic fluctuations. Prices sometimes rise and sometimes fall. That is not a cycle; it is noise. Yet talk of cycles has led economists to hallucinate all kinds of fictitious oscillations in economic markets. Meanwhile, the Nobel-winning neoclassical theory of the so-called business cycle “explains” it by blaming events outside the market. This salvages the precious idea of equilibrium, and thus of market efficiency. Analysts talk of market “corrections”, as though there is some ideal state that it is trying to attain. But in reality the market is intrinsically prone to leap and lurch.

One can go through economic theory systematically demolishing all the cherished principles that students learn... [I]t is abundantly clear that herding – irrational, copycat buying and selling – provokes market fluctuations.

There are ways of dealing with the variety and irrationality of real agents in economic theory. But not in mainstream economics journals, because the models defy neoclassical assumptions.

There is no other “science” in such a peculiar state. A demonstrably false conceptual core is sustained by inertia alone. This core, “the Citadel”, remains impregnable while its adherents fashion an increasingly baroque fantasy. As Alan Kirman, a progressive economist, said: “No amount of attention to the walls will prevent the Citadel from being empty.”

The author seems to believe he has a better theory of aggregate fluctuations:

[I]t is abundantly clear that herding – irrational, copycat buying and selling – provokes market fluctuations.

That's fine, but when he says "The theory has not foreseen a single stock market crash" as his argument against neoclassical theory, he should first realize macroeconomists don't focus on predicting the stock market, and then he ought to put his theory to the same test. Can he predict stock market crashes? If he can predict the stock market's random walk behavior, will he then go on to show he can provide improved forecasts of the things macroeconomists care about? More generally, can physicists predict earthquakes, etc.? If I ask, why is there gravity, will physicists be able to tell me? Should I accept string theory as evidence of their success and superiority? The existing paradigm in physics doesn't work and the new one, string theory, doesn't produce testable implications and may be little more than mathematically sophisticated philosophic musings - is that where we want to head?

I don't mind the criticism, it's good for us and there are truths in what is said. But I always resent the arrogance of scientists from other fields thinking they can mosey on over to economics for a few minutes, diagnose our ills, and solve all our problems. I'd suggest they solve the problems in their own discipline first, or show a bit more humility when giving advice to others, especially when, as above, they are clearly unaware of vast swaths of literature such as the published work on corruption. And along those lines, and for the record, we're well aware of and have models for the list of things he mentions in his "abundantly clear" theory of market fluctuations. If he actually tried to build these models rather than simply casting aspersions at the existing paradigm, he'd find it isn't as clear as he thinks.

Update: I'd characterize this as a typical response to this post - Thoma was off the mark, but interesting discussion!:

Economics vs physics chez Thoma, by Felix Salmon: Mark Thoma's readers are certainly busy on weekends! A post of his on the general subject of physics vs economics went up on Sunday, and already it's got 52 comments and counting.

The impetus for the blog entry is a piece by Philip Ball in the FT, wherein a hard scientist attacks the soft scientists in the economic realm for their dogmatism and lack of falsifiability.

Thoma initially takes a slightly dubious tack in response, complaining that physicists can't predict earthquakes (they never claimed that they could) and that "the existing paradigm in physics doesn't work" (it does). But things rapidly get more subtle and interesting in the comments: a prime example of the blog format really enriching the debate.

Let me join in and also trumpet the quality of the comments I get here, and say thanks while I'm at it.

    Posted by on Sunday, October 29, 2006 at 02:57 PM in Economics, Science | Permalink  TrackBack (3)  Comments (132)

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