The then Federal Reserve Bank of New York’s Chairman William McChesney Martin’s love for economists was well-known in the banking circuit during the 1950s. He once told a visitor, “We have fifty econometricians working for us at the Fed, and they are all located in the basement of this building, and there is a reason why they are there.” He continued, “They are in the building because they ask good questions. They are in the basement because they don’t know their own limitations, and they have a far greater sense of confidence in their analyses than I have found to be warranted.”
Lots of things have changed since the 1950s. During the last six decades, economists have moved out from the basement to hold top positions within the Fed, even as Chairmen. Economists have started making policy decisions for central banks, fixing taxation rules, designing frameworks to fix development trajectories of a country, monitoring environmental issues, and fixing volatility in the financial markets. They are also engaged nowadays in building models that can predict future national income, output, inflation, economic conditions, price of a stock, the yield of a bond, population growth etc.
Since the onset of COVID-19, such forecasting models are mushrooming in order to predict the spread of the virus and the impact of the pandemic on the global economy.
It has been observed that forecasting models (be it statistical/mathematical/based on economics or epidemiology) have time and again failed in predicting crises and proposing a holistic solution to come out of the crises. For example, just a few months before the onset of the COVID-19 pandemic, the World Bank (WB) and the International Monetary Fund (IMF) were very optimistic about the global economic growth, and projected a better global economic growth rate in 2020.
It appears that their economic models did not have any clue about the pandemic that was about to hit hard. Perhaps, this unpredictability of predictive models is true for any forecasting model (like Neil Ferguson’s epidemiological model on the spread of COVID-19 in the United Kingdom). However, among all, the discipline of economics (mainstream) has the dubious distinction of proving to be consistently inadequate in providing accurate projections and holistic steps to come out of economic crisis or emergencies.
The mainstream neoclassical economics has even assumed that all major economic problems are already being solved and predicted that economic crisis is a matter of the past. In 2003, Nobel Laureate in Economics Robert Lucas, in his presidential address to the American Economic Association, claimed that economic crises like the Great Depression of the 1930s are a matter of the past.
He added that macroeconomics and “…its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades.” Within five years of this tall claim, the world had witnessed one of the worst economic crises in recent times, the global financial crisis (GFC). Within less than 20 years, the whole world is at the brink of a severe global recession in the history of mankind because of the spread of a virus.
Similarly, Mohammad Yunus, the poster boy of micro-credit worldwide, had expressed high hopes in abolishing world poverty through the expansion of micro-credit and visualised “sending poverty in a museum” in the early 2000s. Latest research has raised serious doubts on his claims and it is not very certain as of now whether micro-credit has any positive, empowering and sustainable impact on the lives of people from low-income groups. After almost 20 years, poverty is not in the museum but still visible, out on the street!
Be it the Great Depression of the 1930s, the oil crisis, the East Asian crisis or the recent financial crisis of 2008, time and again, economic models and propositions have unfailingly disappointed. This is highly astonishing, more because the discipline of economics has observed ‘immigration’ of a large pool of professional forecasters, statisticians, management graduates, data scientists, technical experts and engineers over the last couple of decades. No other social science/art subject has witnessed such an influx of diverse professionals and experts from other technical backgrounds.
There is no debate that any discipline generally gets enriched as ideas from other disciplines pour in. The subject of economics must have got richer by receiving interdisciplinary views, opinions, methods and sophisticated techniques. Furthermore, economics is one of the rarest disciplines of art that extensively uses high-end, sophisticated software including Python, Matlab, SAS, R, E-views etc. for its daily academic activities.
This brings us to the pertinent question as to whether there are some fundamental problems with the discipline of economics and economic modelling. We feel the problem rests in the core assumptions of any model. Models are based on assumptions; the more realistic the assumptions, the better predictability a model has. Unfortunately, mainstream neoclassical economic models are built on assumptions that are far from reality.
The discipline has been broadly divided into two streams — microeconomics and macroeconomics. The mainstream economics or the neoclassical microeconomics builds on the sole aim of finding utility — maximising behaviour of consumption, production and investment. It assumes that individuals are rational and the most rational thing an individual (be it a consumer, investor, saver, seller or the government) would do is to try to reap maximum benefits out of their economic actions. If at the micro-level, individuals are behaving exactly mentioned above, then, at the macro-leve,l the market system would achieve an equilibrium (and optimum) level by equating supply and demand in each and every market.
However, as ‘Doughnut’ economist Kate Raworth describes, if we were to picture a rational human being from the textbooks of economics, he would definitely be looked like a selfish person, standing alone, with money in hand (but desires for more!) and a head full of calculations. Further, the subject also assumes that this rational human being knows how the macroeconomy works and can predict the future course of the economy and other related indicators! How come a common man can predict the future of an economy, when the best intellectual minds and trained economists fail to do so? Don’t you think this is utterly ridiculous?
On the contrary, rather than being self-centred, human beings are observed to be social, kind and interdependent individuals, who tend to help others, cooperate with fellow citizens and like to share things with others. Human beings love to help others, as this spread of COVID-19 has displayed. Even small countries are helping big ones, medical professionals are assisting the infected by risking their own lives, and communities are providing free rations, food, medicines and money to the others who do not have.
In a pandemic situation, a typical ‘rational’ human being would just sit back inside their house and only take care of their needs. But a majority of people are doing otherwise. And this sense and act of solidarity and thinking about others helps us as a society to grow and counter crisis like this one in an effective manner.
So, when economists assume that men are self-centred rational beings, it may be convenient in building an economic model. But the model built on such naïve assumptions does not take us any close to the reality. Economic modelling and the dominant section of the subject is full of such bizarre and unrealistic assumptions.
As experiences from COVID-19 crises have been teaching us, we are as vulnerable as thy neighbour. The better my neighbours are doing, the better my neighbouring states are equipped with to tackle any crisis, the lesser would be my vulnerability. The individual-centric approach is not a ‘rational’ approach to live better.
Similarly, the general equilibrium model — the ‘daddy’ of all mainstream contemporary economic models — assumes that adding individuals’ demand curves would provide a similar downward sloping demand curve for the macroeconomy. When a similar upward sloping aggregate supply curve intersects the above-mentioned demand curve, an equilibrium price and output could be derived for the economy as a whole.
It further assumes that any divergence from the equilibrium level (due to crisis or shocks) is self-adjusting as the economic system will automatically go back to the equilibrium level, eventually. It, therefore, completely ignores and denies that there exists any shock or crisis that may have the ability to distort the economy permanently.
An economy is full of agents with different behaviours, needs, capabilities and abilities. The individual demand curves, therefore, would be completely different from each other. Thus, simply adding their demand curves is highly unlikely to produce a demand curve for the economy as a whole.
Experiences from the past and historical incidents teach us those economic crises are inevitable. No crisis is self-adjusting, and it requires active participation of the existing individual resources with boost from the state and public agencies to pull out the economy of crisis-like situations.
Last but not the least, all the economic models are based on the assumption of ceteris paribus (all other things remaining the same). It implies the variable ‘X’ will impact variable ‘Y’, provided everything else in the economy remaining the same. However, in reality, everything else keeps on changing making the assumption utterly nonsensical.
Apart from the assumptions, mainstream economics extensively uses a blend of statistics and mathematics, called econometrics, to test the hypotheses and forecast future trends. Those who use and practise econometrics believe that the presentation of theory through charts, graphs and diagrams does not necessarily amount to an econometric analysis. It was Ragnar Frisch, the first Nobel Laureate in Economics, who established and popularised econometrics as a separate discipline.
With the increasing availability of high-frequency data on households and firms, and the accessibility of sophisticated computing facilities, econometrics shifted its focus to micro-level data but application on the macroeconomy. With the development of new estimation and testing methods, experts from this discipline focused to financial modelling, volatility forecasting, panel regressions etc.
The usefulness of econometrics has been widely celebrated by the mainstream economists on the ground of
1) wide applicability and acceptability of econometrics;
2) ability to handle complex problems and complicated data sets;
3) the ability of econometrics to bring scientific rigour into the discipline of economics; and
4) the success of econometrics in rightly predicting the future of an economy quite precisely.
Use of econometrics has been considered the key element to get published in one of the topmost global journals. The more complicated and sophisticated the economic model is, the further praises and applauds an economics research paper receives in an international conference! Even, an increasing number of econometricians have received the Nobel Prize in Economics for their contribution in building econometric models (as of now at least five).
The fallout of this obsession with econometrics has been the over-inclusion of mathematical and statistical material, replacement and negligence of other relevant sub-disciplines (like the history of economic thoughts, labour economics, economic sociology, the economics of inequality, economic history and geography, agricultural economics, political economy, gender economics etc.) from the curriculum of economics.
The over-usage of complex mathematical models has made the whole application of econometrics lesser and lesser useful, and rather ,too complicated to be related to the real world. A problem, which can be well-represented by simple charts and graphs and arguments, has given way to abstract mathematics and unrealistic assumptions. Even if common economic sense indicates to reject a gibberish result, economists seem to not reject it because of its ‘statistical’ significance. Rather, they would start working to find explanations which can defend the nonsensical results.
Economics doesn’t only falter at predicting future outcomes, but its models are also inadequate to provide proper policy prescriptions and directions to remove economic stumbling blocks. Even after being so resourceful, the discipline has not been able to solve some of the basic problems of mankind — poverty, hunger, unemployment, income inequality — or provide clear guidance to pull the common people out of misery due to any crisis or pandemic. T
here are some small successes around the periphery, but the core problems remain the same. Even, it appears, the celebrated development models of international institutions and aid agencies — which flow of funds, aids, ideas and blueprints from the developed Global North to the poor Global South — would be enough to ‘catch up’ on the latter while the former tend to fail miserably.
On the contrary, there has been a rise in inequality rather than narrowing the gaps inter and intra-countries. Furthermore, time and again crises and pandemic like COVID-19 arrives, thereby pushing the poor countries of the Global South into more vulnerability and misery.
This is because, with assumptions, the subject is rigid and obsessed with its policies and solutions. For example, at present, the topic of discussion for almost all public meetings, government statements, reports of international institutions and economic seminars is the growing concern over the falling rate of global economic growth due to the spread of COVID-19.
Economics is obsessed with the growth rate of income and output. Economists believe that a higher growth rate of total income or gross domestic product (GDP) of a country indicates higher income per head. A bigger cake implies a higher share for everyone. However, it has been proved time and again that higher economic growth doesn’t necessarily imply higher prosperity, happiness, increasing distribution of resources, or lesser inequality. A high tide not always lifts all the boats!
Similarly, neoclassical economics is obsessed with private business and capitalists, and believe in the power of free market. Since the book written by Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, mainstream economics has assumed that the involvement of the state is a ‘sin’, and thus, it is argued that the lesser the involvement of the state, the more the role of the private sector, the better and effective would be the economic policies.
This has been the economic logic for most of the influential international agencies including the WB, IMF and Asian Development Bank among others. On the basis of these policy prescriptions, most of the economies, predominantly belonging to the Global South, have witnessed a gigantic withdrawal of the state from essential sectors like health, education, banking, physical infrastructure etc. Economics has killed the welfare state.
The COVID-19 crisis has made us realise how important the role of a welfare state is. Any crisis would be handled better and effectively if the role of the state is bigger, better, and for the welfare of all. The handling of COVID-19 crisis by Kerala, one of the states in India, has evolved as an ideal model worldwide. Kerala has been able to contain the spread of the virus due to its well-managed and efficient public health infrastructure, among others. The COVID-19 pandemic has just made us reinvent the welfare state.
This pandemic has created a serious global economic crisis and a better, equitable and efficient distribution of the available resources is to be ensured even at the cost of economic growth. Thus, in order to handle the aftermath of the COVID-19 pandemic, the economists must have to think beyond mere growth rate of GDP.
Be it the Great Depression, GFC, Asian Crisis, COVID-19 or any other crisis-like situation, the common thread that connects all of them is that they didn’t suddenly break out, but displayed several signs beforehand. The economic models, howsoever mathematical and sophisticated, failed to catch the early warnings, because of the faults in their models.
Economist Hyman Minsky is one of the few to argue that any financial and economic system, as contrary to the claims of the mainstream economists, generally tends to be unstable and dynamic. Achieving equilibrium and to remain at that level is a myth.
The 2008 financial and banking crisis proved Minsky right to a great extent, and confirmed that financial markets and macroeconomy are inherently unstable. A small but growing section of the discipline, mainly hailing from Marxist, Institutionalism and post-Keynesian schools of thought, have started questioning mainstream economics and its unrealistic assumptions and theories. They are generally referred to as the Heterodox Economists.
It has been increasingly recognised that economics, being a subject of society and the people within, is full of multifarious possibilities and combinations. So, one must be very careful before making any assumption about the behaviour of people and their actions. Human behaviour is constantly changing and evolving; putting restrictions on them by certain assumptions may work theoretically, but never practised.
If we are ready to accept the complexity of the economy, then it is not very difficult to make economics better and beneficial for people, the larger good. Further, being a subject closer to people and society, it would be far better if mainstream economics let ideas from sociology, history, philosophy, geography, political science and anthropology to flow in. This will definitely add value to the subject and will certainly bring realistic perspectives that are closer to the ground. Perhaps, predicting would be easier then, or who knows, not needed at all!
Appelbaum, Binyamin. 2019. The Economists’ Hour. UK: Picador.
Keen, Steve. 2017. Can we avoid another Financial Crisis? UK: Polity Books.
Moosa, Imad A. 2017. Econometrics as a Con Art: Exposing the Limitations and Abuses of Econometrics. UK/USA: Edward Elgar.
Raworth, Kate. 2017. Doughnut Economics. UK: Penguin Random House.
About the authors: The article has been jointly authored by Kaustav K. Sarkar and Rukmini Thapa. Kaustav is a Research Scholar at TISS, Mumbai and Thapa is an independent researcher based in India.