Why economics is a dismal science

The Geneva-based Latsis Foundation sponsored a symposium with Nobel prizewinner Joseph Stiglitz in September 2012 about finding a new paradigm for economics. The conference offered warning messages for planners and politicians.

By Peter Hulm

For a non-mathematician, modern economy theory can read like a collection of the latest buzzwords from chaos and catastrophe theory* that you don’t quite understand, followed by terrifying conclusions, if you can puzzle out what it is trying to say.

For example, Imre Kondor of Germany’s Parmenides Foundation told a select group of economists gathered in Zurich on 11 September 2012 that in human societies, with “several basins of attraction”, studying “the random walk of the system” indicates that “the dynamics of the system will be reminiscent of the punctuated equilibrium type evolution of biosystems”.

Struggling with my weak memories of the butterfly effect from disaster movies (a butterfly flapping its wings in the Amazon can lead to a hurricane over the Atlantic), I could just understand his argument that “evolution in such a landscape will depend on [the] initial condition”.

But his main point was that the landscape in which the evolution takes place “will be extremely sensitive to details of the concrete distribution of the interactions, as well as to small shifts in the values of the noise or the external field”.

So the butterfly effect is not the whole story: “Small changes in the boundary conditions may influence [...] agents even deep inside.”

The risks to our economic and banking systems are clear, says Kondor. “Any impact on even a single agent will spread, in an unforeseeable manner, to the whole system via the strong random correlations” (i.e. the effects are unpredictable). Ouch!

Stiglitz & Co

Kondor’s paper was presented to a conference sponsored by the Geneva-based Latsis Foundation about “economics on the move”, in answer to a provocative question: “Can economics as a scientific discipline [...] extricate itself from its current conceptual crises” and benefit from advances particularly in the natural sciences.

Nobel Prizewinner Joseph E. Stiglitz, who has devoted his time lately to castigating ignorant economic thinking by politicians, spoke on Thursday (13 September) on the need for a new paradigm and takes part in a panel discussion on the lessons to be learned from systemic risk.

To a non-economist, conference papers often read like an in-joke: “The Topology of the e-Mid Interbank Market during the Sub-Prime Crisis”, “Cascading Failures in Bi-Partite Graphs”, “A Flow Network Analysis of Direct Balance-Sheet Contagion in Financial Networks”. And so on...

The consumer is king - LOL

Some economists, however, just cannot help talking intelligibly. Paul Ormerod of Volterra Partners, UK, presented a paper on Tuesday 11 September about “Network Effects on Decisions Among Many Similar Choices”.  

His disturbing conclusion: hierarchical networks (of consumers, with some known as experts, for example) predict that one product would emerge as a clear winner “even without any inherent superiority”, “culminating in a winner-take-all distribution for the superstar network”. 

So much for if you build it, they will come.

His models suggest that if one product is only marginally better than its competitors, consumers often cannot pick up on the difference, and the network influence will predominate (we buy Microsoft or Apple products).

 “Companies in my experience do understand complex systems more than governments,” Ormerod noted. But this does not mean that businesses are safe from network domination. Until the product gets into the market and consumers have expressed their preferences, no matter how much pretrial testing has been done, there is still a probability that it will fail, because consumers have not yet decided whether they like it.

“You may have a preference for Mexican restaurants, but until you go into a restaurant and taste the food you do not know whether you like it.”

So much for the informed consumer.

Now for the bad news, again

So what is the rest of the bad news? Giovanni Dosi from Pisa in Italy looked at a key question for economic recovery: what is the effect on jobs and wages if investment is based on past profits or when it is tied to expectations about future demand from consumers.

One common argument is that if workers show flexibility about their wage demands the economy will be less volatile. This holds “only when investment is profit-led,” he reported. “Where investment is driven by demand expectations, wage-flexibility has no effect on either growth and unemployment,” Dosi concluded. “In turn, this result casts doubts on the ability of wage-flexibility policies to stabilize the economy.”

In other words, don’t expect wage cutting to get the economy moving again. That might be cheering news for workers. But it comes along with the finding that investment won’t do any good unless the company already has the cash behind it to invest in recovery.

Competitivity and wealth

Or how about this calculation from Boris Pobodnik of Croatia’s Zagreb School of Economics and Management? He measured the competitivity results from the World Economic Forum (the Swiss came top this year) against gross domestic product per head (i.e. wealth) over the past 10 years to discover what the changes are of a country being able to pull itself out of poverty through competitiveness. Could Bulgaria catch up to Germany’s current standard in 10 years? he asked. He calculated the odds at 0.003 per cent (three chances in 100,000).

The only European country punching above its competitivity rating in terms or wealth was France. Norway was below, because it had oil. “If you have oil you don’t need to have a competitive economy, “ he observed. All the Asian countries with large Chinese populations scored above the line, with Greece down at the bottom -- a key determinant of their attractiveness to investors.

The Latsis Symposium might have attracted a self-selecting group of discontents, but they were able to bring plenty of examples of the failings of mainstream economics in the 21st century’s second decade.

Matthias Lengnick from Germany’s University of Kiel stated bluntly: “The simple process of money creation that is present in every macroeconomics textbook goes hand in hand with financial stability.” In order words, our financial masters are learning everything wrong about how money works “It allows bankruptcy cascades that produce the threat of systematic and deep crisis.”

No U.S. middle class

With econophycisists (physics specialists) moving to the economics field, old ideas must be tossed out of the window, said Viktor Yakovenko, from the University of Maryland. Joseph McCauley (guess his discipline) predicted over five years ago: “Econophysics will displace economics in both the universities and boardrooms simply because what is taught in economics classes doesn’t work.”

Such as? Well, “there is no such thing as the middle class,” declared Yakovenko with no apologies to Mitt Romney or Barack Obama. There are the rich (3% in 1997) and the rest of us  (earning less than $120,000 some 25 years ago), otherwise known as the poor. The fate of these two classes is also governed by different formula, known as “thermal” and “superthermal” conditions in astro- and plasma physics.

We thermal equilibrium types, i.e. the poor (and it doesn’t matter whether you were earning nothing or $200,000 in 2001), have existed for 30 years in an extremely stable situation with regard to income distribution. For the superthermals, the millionaires in annual income, the variation has been highly dynamic.

What that meant is that the faction of upper fraction income as part of the total in the system climbed from 4% in 1983 to 20% in 2001. But it also tends to swell during stock market booms and shrink during busts.

But overall income inequality in the States has “increased significantly as a result of the tremendous growth of the income of the upper class”. And in 1986 (the stock market crash), 2000 ( the dot-com bubble burst) and 2008 (the latest collapse), inequalities increased just before the mini-catastrophes.

It’s the demographics, stupid

And what was the cause of these collapses? Not misjudgements by traders, criminal banks and improvident borrowers, Yakovenko speculated. The answer was simple demographics.

In the mid-1980s baby boomers (those born after 1950) started saving for their retirement on reaching 35. Stock markets boomed. In the 1990s they reached 40 and salted away an even larger portion of their earnings, but there weren’t enough successful firms to invest in.

Shares and dividends stagnated, leading to a number of crashes as people pulled their money out of such poorly returning investments.

It was all in a 1993 book by Harry S. Dent, who predicted: “The Next Great Depression will be from 1998 to 2023.” 

Don’t say you weren’t warned.

In economics, the answer to the question “Do you want the good news or bad news first?” seems to be:”Sorry, there is no good news.”

I did get an answer to one question I had about economists: what do they talk about outside the lecture hall? I sat close to a bunch (or should it be a pride?) at meal time, and they were talking about their dreams.

I could swear that one said he had been dreaming in Latin, another said he couldn’t stop dreaming in black and white, and the third said he dreamed of a formula which he couldn’t work out, even when he woke up. Is that weird or what?

* Chaos theory, simplified, says single events can lead to different and sometimes unpredictable results (which reminds me of Albert Einstein's definition of madness: when you keep doing the same thing and expect different results). Catastrophe theory says that at some hard-to-predict point, everything goes to hell, no matter how carefully you plan it to avoid disaster.