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Is Economics a Science?

October 30, 2011

Economics claims to be a social science. Is it, and if not could it be? If not do economists have any valid claim to advise decision makers?

The current macroeconomic orthodoxy is based on elaborate theorising based on on highly dubious assumptions, the chief of which is that everyone has access to perfect information. This would not matter if this theory produced correct predictions, but it has comprehensively failed. It is enough to ponder the Queen’s question, why did nobody predict the 2008 crash? In fact someone had predicted that something like it was inevitable, but he was not listened to. Orthodox theory does not predict surges in asset prices. It assumes that they reach equilibrium, whereas as Werner [Werner 2005] argues that commercial banks ration credit and determine its allocation. Strategies that seem optimal for individual banks include excessive credit extension for speculation in existing assets such as real estate or stocks(shares). This leads to rising asset prices in an ineleastic market, and a self reinforcing circle. This is unsustainable, and once this is realised a vicious cycle of decline sets in. In the wake of the 2008 crisis this is widely understood, though orthodox economics still does not explain it. Werner however had shown that orthodox theory failed to predict the behaviour of the Japanese economy in the 1980s and 1990s and came up with his credit creation theory.

How has orthodox theory so comprehensively failed? The original classical economics was also based largely on theory, but it did not explain continuing underemployment during the great depression. The British economist J M Keynes explained this, but at the expense of introducing an empirically determined parameter – the multiplier. Subsequent econometric models included a number of empirical relationships. These seemed to work fine until the 1970s when many things change, e.g.: The floating of the dollar and thus the end of the era of fixed exchange rates agreed at Bretton Woods in 1944. (This was precipitated by the US current account deficit, arising from the Vietnam war [Hutton 1999?]), and the gradual relaxation of exchange controls and credit controls leading to globalisation.

Confidence in such models rapidly evaporated. The Lucas critique, named for Robert Lucas’ work on macroeconomic policymaking, argues that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. Instead to a reworked and more rigorous version of classical economics – neoclassical economics, came into vogue. There have been many developments since, but most appear to have been based on reliance on elaborate theory insufficiently tested against what happens in the real world.

Richard Werner developed his credit creation model [Werner 2005] without using any macroeconomic data series, but when he tested it on such data his relationships were convincingly verified.

In his book  1934 ‘The Logic of Scientific Discovery’, the philosopher Karl Popper suggested a methodology of science based on the idea of falsifiability. No scientific theory can be proven to be true, but a false theory can be proved false by example. A theory which continues to survive all the difficult tests to which it is subjected deserves to be trusted as provisional truth.

This is to be contrasted with pure inductivism, whereby patterns in data are identified and are presumed to persist into the future and in new circumstances. Werner calls himself an inductivist, but I believe he follows Popper’s prescription. Seems pretty much commonsense to me. Why don’t other economists follow his example, and that of physicists and cosmologists?

On November 2nd 2011 70 students walked out of the Economics 10 class at Harvard. Their letter of explanation can be read at http://hpronline.org/campus/an-open-letter-to-greg-mankiw/.

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