Economics As a Science

<> Paper to the Skeptics Society – 26 September, 2009

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<>Keywords: History of Ideas, Methodology & Philosophy;

<> <> <>Today I want to reflect on the extent to which economics is a science and the extent to which it is not. In doing this I come from the approach of someone who was trained a scientist, who continues to think of himself as one, and who is heavily influenced by the philosophy of Karl Popper. I suppose that makes me a sceptic.

<> <> <>The point about a sceptic is that they are continually testing the theories they hold against the facts, and trying to improve them. As such, they are what Thomas Kuhn called revolutionaries, challenging and replacing the conventional wisdom. I take it that the Skeptics Society consists of fellow iconoclasts. Today I am going to address some of these false gods directly. Perhaps you hold some dear. Please understand I am just applying the standards of scientific scepticism to them as you expect to be applied elsewhere.

<> <> <>Popper points out that even though you know your theories will be replaced by better ones, hold on to the best you have until a better one comes along. Towards the end of this presentation I will talk of some examples where scientific economics has held – even still holds – theories knowing their weaknesses, and where we may make progress in the not too distant future – one hopes.

<> <> <>Popper said the most important Platonic dialogue is The Apology in which Socrates reflects on the Delphic Oracle’s utterance that he is the wisest of men. He concludes that he is only wise because he knows how ignorant he is. As another of my heroes, Isaac Newton described himself, he was ‘only a child playing on the beach, while vast oceans of truth lie undiscovered before me.’

<> <> <>Newton also said ‘If I have seen further than others, it is by standing upon the shoulders of giants.’ That is one of my themes today. Science is the accumulation of wisdom. We would do well to recall and understand the giants of our science before we claim some particular insight. Some of the greatest minds of the last two hundred years were economists – some were scientists.

<> <> <>I want to begin however, talking a bit about the contrast between the subtlety of economics and the crudity of its critics. A couple of examples will illustrate my point.

<> <> <>I am frequently told that economists believe that per capita Gross Domestic Product is the measure of welfare of a nation. That is a strange claim since every economist knows that the more relevant measure is Net National Income because GDP includes depreciation and it measures the income of a region not of the people who belong to the region. They differ because of, among other things, some of the profits of the region go to investors outside it.

<> <> <>Such things are overlooked by the critics, but even more extraordinarily, they only rehash what economists have always known. I do mean ‘always’. The creator of the statistical base out of which GDP comes was Simon Kuznets who wrote in his original report in 1934 ‘the welfare of a nation can scarcely be inferred from a measurement of national income’. But you wont find him quoted in the standard critiques of GDP, nor John Kenneth Galbraith who wrote an elegant chapter decrying its use as a measure of welfare in his Affluent Society some fifty years ago.

<> <> <>I am not denying that some people use GDP as the measure of welfare, or that GDP is an economists’ measure. My point is that properly trained economists use it for other purposes – the purposes for which it was designed. Politicians, journalists and business people like to talk about GDP as if it is a measure of welfare and bolster their ignorant use by claims that economists agree with them, even when they dont.

<> <> <>You might say, why in the last 75 years have economists not constructed a better measure of welfare? The short answer is that we have tried, and we have not been able to develop a satisfactory one.

<> <> <>Today there is another attempt going on by a committee led by Joseph Stiglitz and Amartya Sen, two other giants of the profession – I shall name only giants today. Their preliminary report was released about a week or so ago. What I found interesting is that they have concluded there is no single measure of economic welfare, and are looking for a number of indicators.

<> <> <>Which rather undermines all the critics who have their own single measure which they claim is better than GDP. There is no unique single measure of a nation’s welfare. Had there been economists would have developed it – around 74 years ago. One must never assume that the best economists are as stupid as their critics.

<> <> <>Now I am going to use the concept of GDP later today. I will use the measure as an indicator of market activity, which is what economists designed it for. Couple of caveats – I shall be referring to annual market activity, and when I make comparisons through time I shall be referring to volume GDP, that is production adjusted for the change in prices. Sorry to be tedious – but I am an economist and have to understand such things. Incidentally, GDP was originally derived for tracking unemployment. Today we know that it is not a very good short run indicator for this purpose, that economic activity and unemployment track differently. So even if the activity contraction has ended we may expect rising unemployment for a while yet.

<> <> <>My second illustration is that I am often told, by those who have not studied economics, that economics depends upon unlimited economic growth. That cannot be true since many giants of the economics profession – Thomas Malthus, David Ricardo, Karl Marx, John Maynard Keynes and Joseph Schumpeter, for instance – were stagnationists who expected economic growth to come to an end; Keynes wrote of the ‘euthanasia of the rentier’. What he meant, and others thought too, was that as capital was accumulated, the return on capital would fall, until there would be no incentive to invest, and economic growth would stop. This is a consequence of the laws of thermodynamics. As Paul Samuelson has pointed out, economics is grounded in those laws – without them there would be no trade-offs, a fundamental notion of economics.

<> <> <>The difficulty with this stagnationist approach was that per capita incomes in the rich world quadrupled in the 180 years between Ricardo and Schumpeter. You can set up auxiliary hypotheses to explain the inconsistency but in the 1950s, as the data became available, it became evident that a theory of economic growth dominated by pure capital accumulation was inconsistent with the facts.

<> <> <>We now know, following a famous 1956 paper by Bob Solow, that what he called ‘technical change’ adds to economic growth. By technical change he meant ‘a shorthand expression for any kind of shift in the production function. Thus slowdowns, speedups, improvements in the education of the labour force, and all sorts of things will appear as “technical change”.’

<> <> <>The story of how the scientific community has misinterpreted this economic research for its own political purposes belongs to another occasion. The point to be made here is that it is simply not true that economics says that economic growth is necessary. When there is no more technical change, the growth may stop but there will still be a role for economics.

<> <> <>Were the critics a little sharper, a little more subtle, they could instead argue that the current economic system is dependent upon economic growth. The technical mechanism is that the true profit rate is close to the growth rate; so no growth, no profits. When growth exhausts itself the nature of the economic system would change. If you want to pursue the implications of that you might read – well, er – Malthus, Ricardo, Marx, Keynes and Schumpeter.

<> <> <>So there are two kinds of economics. One is what competent economists do, and the other is articulated by the politicians, journalists and business people who have misunderstood professional economics, often for self-serving ends. This self-serving is the key reason why this misrepresentation dominates the public discourse. Why bother to get it right if ignorance supports one’s ends? It is the scientist who pursues getting it right as an end in itself.

<> <> <>I was taken by a history of Lysenko whose pseudo-science, which confused phenotype with genotype, was imposed for political ends to the detriment of Soviet Agriculture. What struck me was that a large proportion – perhaps 95 percent – of the Soviet biological profession simply accepted the faulty paradigm. Of the remainder, about half got on with doing proper science and the other half ended up in Siberian concentration camps – or worse. But that so many Soviet biologists got it desperately wrong does not prove that biology is not a science.

<> <> <>I’d like to think that there would be a higher proportion of the economics profession who could see the fallacies in an imposed economics paradigm, and certainly fewer of us end up in concentration camps. One day there will be a very interesting analysis of how so many economists were misled into thinking the macroeconomics which has led to the current crisis had so much validity. But not all did, and economics can claim that it is being corrected by the facts.

<> <> <>Notice that I am distinguishing between what economics is and what economists – and others such as business people, journalists and politicians – think. If you use a definition that economics is what economists do, then deciding whether economics is a science becomes a question of whether economists are scientists, an empirical question.

<> <> <>Probably all the giants of economics were scientists in the sense that they practised a scientific method which Popper would recognise. When we look at shorter members of the profession – even those who were followers of the giants – we observe another way of pursuing economics.

<> <>To make the division clear, I shall contrast sceptics with the believers. Sceptics are the scientists who are continually testing the hypotheses they hold against alternative hypotheses. For them knowledge is tentative but it also progresses as it replaces existing hypotheses with better ones – typically as a result of an encounter with facts.

<> <> <>On the other side there are the believers, who hold a known truth which is invulnerable to challenge. Facts do not challenge their truths, or cause them to be replaced with a better ones. Rather the task is to explain the facts within the framework of belief; if necessary they will ignore inconvenient facts.

<> <> <>Let me give some examples. Suppose the belief is in the literal veracity of the bible. The biblical account of the development of the world is inconsistent with the theory of evolution. Therefore the theory of evolution is wrong and the challenge becomes to explain why it is wrong thereby keeping the integrity of the literal veracity of the bible.

<> <> <>Or consider the right wing economic philosophy which rejects taxes and other forms of economic intervention. Economics has a well established and rigorous theory that if pollution generates costs to others, then an effective way of improving economic welfare is to use taxes and such like. Global warming appears to be a straight forward example of pollution generating costs to others. So the extreme right challenges the premise that global warming is caused by human actions. Thus they see no need to impose taxes and other economic interventions to deal with this problem. That seems to be the position of the New Zealand Act Party.

<> <> <>A third example is the belief in the policies which we call Rogernomics, and which are more widely known as ‘neo-conservative economics’. They were applied in New Zealand between 1985 and 1993, and so the Rogernomics believers conclude they worked because their theory says so. As it happens the economic growth rate for New Zealand did not speed up under Rogernomics. Indeed per capita GDP stagnated from 1985 to 1993, so it was the same in 1995 as it been eight years earlier. It was in that period that we got badly behind Australia.

<> <> <>I should like to tell you how Rogernomes explain this stagnation since they said their theory promised economic growth. I’d really like to know, since I have a theory which explains why the stagnation happened and I would like to test it against alternative theories. Unfortunately the Rogernomes simply ignore the fact of stagnation. I know of no case of any of them mentioning it, let alone gives any account of why it happened contrary to their theory and promises.

<> <> <>You will detect here the frustration of a scientist. I get better theories by comparing mine with others using the facts that test them. But how can I do that if they ignore the facts?

<> <> <>There is also a policy issue here. It is hard not to conclude that Rogernomics and its Ruthanasia successor failed. There is currently a committee to consider how we might speed up economic growth and catch up with Australia in GDP per capita terms. At least three of its five members were Rogernomes. It will be interesting to see to what extent they address the failure of the policies they advocated in the 1980s and 1990s.

<> <> <>Another group you need to be wary of is those who are paid by their employers to represent their business interest. While they they do a good job, sometimes they reflect the firm’s or sector’s interests.

<> <> <>More fundamentally, as Galbraith pointed out, we are the slaves of the conventional wisdom which is a mix of what Keynes called the thinkings of ‘defunct economists’, our aspirations which are not always based on reality, and the theories which support the hegemony of the dominant interest groups of a society.

<> <> <>While I was meditating on such things – indeed while I was writing this paper – journalists announced the ‘recession was officially over’ because GDP increased 0.1 percent between the March 09 and the June 09 quarter.

<> <> <>What gave the journalists the authority to claim that the recession was officially over? There is no official definition of a recession in New Zealand; there is not even a standard one. The journalists probably did not have the foggiest idea of what economists mean by a ‘recession’, other than they knew it was a bad thing.

<> <> <> <>The number which led to these pronouncements was a minuscule plus 0.1 percent of GDP, but equally it could have been presented as minus 0.2 percent of GDP per capita, Moreover, there is a margin of error for any figure the Government Statistician reports, and the quarter by quarter GDP change is subject to a large one. They are also subject to revision – five of the eight quarters of the last two years were revised with the new announcement. Or had you realised that the average growth rate in the last decades boom was about 0.9 percent a quarter,. So the June quarter outcome was not only that output per head was falling, but since economic capacity is continuing to grow, the underutilised capacity in the economy was growing too? Bad news for the unemployed and putative unemployed.

<> <> <>You can infer that I am a little irritated by the way the media handled the story. Nobody likes a recession, but the subtlety of the economist’s analysis is lost in the crudity of the journalists’ anxiety that the recession – whatever they mean by it – is over. We sceptics cannot be sure of course, but do not be surprised if this week’s hoopla seems silly in a year’s time. As the Minister of Finance said ‘Tough times are still ahead’. Probably. My assessment is that there are very tough times still ahead of us.

<> <> <>Mechanical measures and definitions do not properly reflect the evolution of the economy. If someone said that a eutrophied lake was saved because the oxygen level was no longer diminishing, a limnologist would think them as uninformed (at the kindest). This is equivalent to the announcement the recession is over, Economies are just as complex as ecologies.

<> <> <>(The commentary on the following day was more informed, including my talking to Katherine Ryan on Radio New Zealand’s Nine to Noon program at a level – I hope – intelligible to the public but which most economists would appreciate. If I dont they soon tell me.)

<> <> <>My irritation arises, not only because of the poor quality of so much of the commentary, but because it sets the tone for the public. I am likely to be deluged in the next few weeks by sentiments of ‘hooray the recession is over and things are getting better’, followed up a little later by ‘you economists misled us, things have not improved that much’.

<> <> <>We did not mislead you. You chose to listen to people who were commenting beyond their competence. That’s not the economists’ fault. Nor is it our fault if the public relies on the same people to initiate them into the mysteries of GDP and economic growth. If one listens to dwarves the stories are going to be a bit short of genuine content.

<> <> <>So we face a confusing stories. Much of economics may be scientific but many economists are not, and in any case most of the public learn their economics from those who could not possibly be considered professional economists.

<> <> <>As one last attempt to convince you that economics is a science – and like all sciences complex and subtle – let me look at three areas where economics is progressing. Note how in each case the evolution is due to a dialogue between theory and fact, and how like all scientists I make no apology if the current theory is to be replaced by a better one, albeit one which stands on the shoulder of the old one.

<> <> <>I promised to finish off with some examples of well held economic theories which are under pressure at the moment. I’ll give three. In the nature of things, some of the people I am going to mention are not quite the giants I have been mentioning, but I need to give you some pointers. They are all pretty tall.

<> <> <>Economic Behaviour

<> <> <>First there is the theory of individual economic behaviour. For a long time economists have held, in an increasingly rigorous form, the notion of rational economic man – homo economicus. He – he is always male – takes all that is known into consideration .and pursues his own self-interest by maximising his utility which reflects only his welfare and does not vary through time. A little introspection suggests that we dont actually do this; the theory held on for the simple scientific reason that there was not a better one to replace it. When we use it for policy purposes, many of us make ad hoc adjustments to bring homo economicus closer to actual behaviour.

<> <> <>Recently some economists have been looking at the psychological literature to obtain insights into human behaviour. Among my heroes are Richard Thaler, Matthew Rabin and Daniel Kahneman the psychologist who received the so-called Nobel prize in economics in 2002 (the Prize awarded by the Bank of Sweden in honour of Alfred Nobel).

<> <> <>While economics has not yet got a rigorous theory, it is certainly making progress. I tell you this example to illustrate that economics evolves. I admit there is a lot of resistance to behavioural economics. It includes those who are comfortable with the old paradigm and dont want to learn anything new. (Keynes remarked we rarely learn anything fundamental after the age of 30.) It also includes those with a political agenda who think that behavioural economics justifies the state over-ruling individual preferences (it doesnt). So, Lysenko like, their politics overrules science. Meanwhile you will find increasing application of the theory; the Kiwi saver scheme was influenced by Thalerian principles, although hardly anyone mentioned it.

<> <> <>Happiness and Material Consumption

<> <> <>My second example illustrates that economics, like other sciences, can have an anomaly which has yet to be resolved. Two hundred years ago, Jeremy Bentham said the more you consumed the happier you were. That has been a central assumption in economics ever since. But is it true?

<> <>We have only had the data to test the proposition in recent years. The most important involves asking whether people are happy and comparing their responses with their incomes, after controlling for other variables. There is some research which indicates that the subjective responses are consistent with objective data, but of course the area is treacherous.

<> <> <>When we pull together the available evidence we find that a rise in average material consumption in poorer societies seems to be associated with rising average happiness. However that does not seem to apply to affluent societies. The best example from the longest data series is that levels of consumption have doubled in the United States over the last 60 years, but there has been no rise in average happiness there.

<> <> <>Even so, while rising average incomes do not increase happiness over time, those with higher incomes at any point in time are happier than those with lower incomes. But not that much happier. Some work Ryan You and I have done (you’ll have to go to the original paper to get the details) shows that the happiness score goes up from 8.1 to 8.3 when annual income rises from $20,000 to $120,000 – by 0.2 points on the 0 to 10 scale. In contrast happiness falls by 0.5 points if an employed person becomes unemployed, which suggests that a job is far more important for happiness than the income it generates. Even more dramatically, the happiness of a married woman who becomes separated falls 0.6 points on average and the man who moves from married to separated falls 1.2 points.

<> <> <>So income is not as important in determining happiness as a range of other – not economic – things. Insofar as income is important, it seems to be because it demonstrates one is higher up the pecking order, rather than the additional material consumption it generates. What this all means is unclear. Its an anomaly. Probably the best source if you are interested in the subject is Richard Layard’s book Happiness although I dont agree with everything he says. (I’m a sceptic.)

<> <>The Global Financial Crisis

<> <> <>My third example is a major row going on in economics which has been precipitated by the Global Financial Crisis. The disagreement has long been there but new facts and new events have exposed it. It would take me a whole of the afternoon to explain the dispute, but I have to be brief.

<> <>Following the Great Depression of the 1930s, Keynes wrote his General Theory of Employment, Interest and Money. (no mention of GDP, you’ll notice) which became the basis for what we know as the Keynesian paradigm of how the macro-economy works. By the 1960s it was challenged by monetarism (the expression was not invented until 1968) which evolved to a point where it is said the founders such as Milton Friedman would no longer recognise it. This alternative paradigm (there is quite a lot of the Keynesian apparatus in monetarism) became dominant for policy purposes at the US Federal Reserve and in the popular press and business community, but not in the academy which divided between – in the jargon – ‘saltwater economists’ who were Keynesians (generally) working in American universities on the east and west coasts and ‘fresh water’ ones who were anti-Keynesians usually working in inland American universities.

<> <> <>In the academy this was all good competitive fun, with lashings of rhetoric – and some (I’m afraid) personal abuse. In the policy domain there was an uneasy truce. The arrival of the Global Financial Crisis has now turned the truce into open public war. Think of the disagreement whether light was a wave or a particle – but shift it to the twenty-first century with its greater and instantaneous public communication and of a more immediate policy concern.

<> <> <>I’ve tried to put the argument fairly, but I dont want to seem to be sitting on the fence. Briefly my position is I am with the Keynesians, although I have doubts about American Keynesianism which is too influenced by the peculiarities of the US government arrangements. Moreover I dont think the Americans have thought enough about the particularities of their economy whose currency is also the international means of exchange. I warned you that economics can be complex and subtle.

<> <> <>You may be surprised that I should be Keynesian given that Keynes published his book almost three-quarters of a century ago, about the same time as Bohr’s complementarity, Heisenberg’s uncertainty, and Pauli’s exclusion principles and Schrodinger’s equation They all remain in the foundations of quantum mechanics but the subject has evolved. So has economics.

<> <> <>An even better example might be that this year we celebrate the 150th anniversary of Darwin’s On the Origin of Species. The book still speaks to us, even if the theory has had to be enriched by a host of subsequent research. Keynes’ General Theory has a similar status.

<> <> <>So let me finish this brief discussion with the cryptic remark that I reckon that progress will not just happen with the Global Financial Crisis testing the two paradigms. There will have to be a new theoretical innovation based upon some previously unavailable empirical data. I speculate that it will be the incorporation of balance sheets into Keynesianism. Keynes knew about them, but there was not enough material to incorporate them into his account – except crudely.

<> <>However there is a bigger lesson here. Paradigmatic battles are not resolved as easily in the social sciences as they are in the natural sciences – although none of them has lasted as long as the one about the nature of light. It is worth recalling Plank’s law: “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.”

<> <> <>That may be true in physics. It is even more so in the social sciences.

<> <> <>Conclusion

<> <> <>What I have tried to do today is answer the question of whether economics is a science. My conclusion is that there is a strongly scientific element in much of economics and many economists are scientists. Regrettably though, many of those who use economics do not do so in a scientific way, which is why it is right to be sceptical about what you are told are economic truths. But that does not mean that none exist.

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