The failure of economics

George Soros made his BIG pile ($billion) shorting the British Pound on 16 September 1992 thereby driving it from the European Exchange Rate Mechanism.  It is estimated the speculators eventually cost the British taxpayers over 27 billion Pounds.  So now he occasionally makes an attempt to prove he isn't really a thieving soulless bastard by funding some lefty human rights organization.  On other occasions, he will try to prove he isn't being held captive by the same ideas that have recently caused so much financial chaos.

Having a BIG pile tends to absolve someone of many sins so Soros is still thought of as a financial expert.  And once in awhile, he actually gets something right.  This time, he is writing about the foolishness of economists trying to portray their business as a hard science like physics.  I could hardly agree more.  Over the years, I have done my best to ridicule the notion that economics is more of a hard science that the other social "sciences" like sociology or cultural anthropology.  Let me explain why.

Scholarly investigation involves two phases—digging up the facts and communicating them to others.  Economics tends to appear more "scientific" right out of the gate because many of its facts tend to be numbers already.  So you have hard data to use—like housing starts and factory utilization.  As most of us were taught in junior high, math is the language of science so manipulating these numbers using complex formulas makes economics LOOK scientific.  But appearances are indeed deceiving because it takes more than a lot of numbers to prove a point—something most economists wish the rest of us would ignore.

Here's the big problem.  Any communication involves getting an idea from one brain to another.  For example, writing encounters difficult problems because to make communication happen, the writer must choose his words carefully and formulate his sentences and paragraphs well.  Then, the reader must have a vocabulary at roughly the same level as the writer and be skilled at extracting meaning from print.  As we all know, this process often fails and even when it does work, its uses are limited.  It is impossible to construct a building from a written description so architects use drawings.  Musical notation was invented to communicate the ideas of sound.

When used correctly, math communicates ideas in ways that are extremely powerful because math works!  But like writing and musical notation, math has its limitations too.  For example, when describing a regular shape like a sphere, a mathematical formula is so powerful, you can take it to a machine shop and construct a sphere to extremely precise tolerances.  However, using math to describe an irregular shape like a car fender is much more difficult.  In fact, when using computers to instruct machine tools to make such an irregular shape, you wind up using the brute force of specifying thousands of Cartesian coordinates.  The folks who make animations have discovered it is almost impossible to mathematically describe the motion path of a running human so the preferred method is to affix data points to a real human and record them.

The point here is that if mathematical formulas cannot describe something as simple as irregular shapes or motions, what makes the economists believe that their mathematical models can describe something as complex as human behavior?  The truth is, their complex-looking models cannot predict much complexity and so they tend be be vast over-simplifications of reality.  These models might be more interesting than the formula for a sphere—but not by much.  And it is utterly amazing what economists leave out of them.

My favorite example is aesthetics.  That appearance is economically important is beyond rational debate.  Beautiful whores make much more money than ugly ones, seashore properties sell for much higher prices than properties next to a landfill, Apple computers sell for a significant premium simply because they are created by industrial designers with a lot of talent, etc.  From eyeglasses to sports cars and a lot in between, looks make a significant economic difference.  Yet TRY to reduce this economic fact to a mathematical formula.  It simply cannot be done.  The best an economist can do is tell you to check out the data generated by the market.  Well duh!  By the time something has been evaluated by the markets, virtually all the work necessary to create a product has been done.  The best an economist can tell us is that aesthetics is merely an add-on that commands a premium over what something would fetch according to his "law" of supply and demand.  So by leaving out aesthetics and how beautiful things are generated, the economist describes only about 15% of economic reality—the boring 15% at that.

We have reduced the economics profession to a bunch of math nerds who somehow believe that by using ever more complex formulas, they can describe reality.  It doesn't work like that.  Yet we still follow these charlatans over the cliff because they have convinced us their complex math makes them as scientific as physicists.  Maybe they should try musical notation (just kidding!!!)

Anyway, Soros gets it on some level that modern economic theory has failed and gives some pretty sound reasons for his analysis.  However, if you read his whole speech it winds up concluding that the Euro is dead unless Germany spends its wealth to save it.  So the man proves that even starting with some good insights, he comes to a bogus conclusion simply because he cannot escape the trap of his thinking as a currency speculator.

Ah yes, Institutional Analysis—my nominee for the official language of economics.

The Full Text Of George Soros' Famous Speech

Festival of Economics
June 2, 2012
Trento, Italy

Ever since the Crash of 2008 there has been a widespread recognition, both among economists and the general public, that economic theory has failed. But there is no consensus on the causes and the extent of that failure.

I believe that the failure is more profound than generally recognized. It goes back to the foundations of economic theory. Economics tried to model itself on Newtonian physics. It sought to establish universally and timelessly valid laws governing reality. But economics is a social science and there is a fundamental difference between the natural and social sciences. Social phenomena have thinking participants who base their decisions on imperfect knowledge. That is what economic theory has tried to ignore.

Scientific method needs an independent criterion, by which the truth or validity of its theories can be judged. Natural phenomena constitute such a criterion; social phenomena do not. That is because natural phenomena consist of facts that unfold independently of any statements that relate to them. The facts then serve as objective evidence by which the validity of scientific theories can be judged. That has enabled natural science to produce amazing results.

Social events, by contrast, have thinking participants who have a will of their own. They are not detached observers but engaged decision makers whose decisions greatly influence the course of events. Therefore the events do not constitute an independent criterion by which participants can decide whether their views are valid. In the absence of an independent criterion people have to base their decisions not on knowledge but on an inherently biased and to greater or lesser extent distorted interpretation of reality. Their lack of perfect knowledge or fallibility introduces an element of indeterminacy into the course of events that is absent when the events relate to the behavior of inanimate objects. The resulting uncertainty hinders the social sciences in producing laws similar to Newton’s physics.

Economics, which became the most influential of the social sciences, sought to remove this handicap by taking an axiomatic approach similar to Euclid’s geometry. But Euclid’s axioms closely resembled reality while the theory of rational expectations and the efficient market hypothesis became far removed from it. Up to a point the axiomatic approach worked. For instance, the theory of perfect competition postulated perfect knowledge. But the postulate worked only as long as it was applied to the exchange of physical goods. When it came to production, as distinct from exchange, or to the use of money and credit, the postulate became untenable because the participants’ decisions involved the future and the future cannot be known until it has actually occurred.

I am not well qualified to criticize the theory of rational expectations and the efficient market hypothesis because as a market participant I considered them so unrealistic that I never bothered to study them. That is an indictment in itself but I shall leave a detailed critique of these theories to others.

Instead, I should like to put before you a radically different approach to financial markets. It was inspired by Karl Popper who taught me that people’s interpretation of reality never quite corresponds to reality itself. This led me to study the relationship between the two. I found a two-way connection between the participants’ thinking and the situations in which they participate. On the one hand people seek to understand the situation; that is the cognitive function. On the other, they seek to make an impact on the situation; I call that the causative or manipulative function. The two functions connect the thinking agents and the situations in which they participate in opposite directions. In the cognitive function the situation is supposed to determine the participants’ views; in the causative function the participants’ views are supposed to determine the outcome. When both functions are at work at the same time they interfere with each other. The two functions form a circular relationship or feedback loop. I call that feedback loop reflexivity. In a reflexive situation the participants’ views cannot correspond to reality because reality is not something independently given; it is contingent on the participants’ views and decisions. The decisions, in turn, cannot be based on knowledge alone; they must contain some bias or guess work about the future because the future is contingent on the participants’ decisions. more