What’s Wrong with Economics
Address to the BES AGM
June 30, 2010
Back in the sixties, when I began my career in economics, we were all too aware of the limitations of the discipline: it was static where the world was dynamic, it assumed competitive markets where few existed, it assumed rationality when we
knew full well that economic agents were not rational (at least not by the definition economists use), the choice of first principles was always arbitrary and culture bound, economics had no way of dealing with changing tastes and technology, and much else besides. Econometrics was equally plagued with intractable problems: economic observations are never randomly drawn and
seldom independent, the number of excluded variables is always unmanageably large, the degrees of freedom unacceptably small, the stability of significance tests seldom unequivocably established, the errors in measurement too large to
yield meaningful results (when we could estimate their magnitude at all, that is), the proxies we always have to use instead of the theoretical variables unacceptably distant from the variables they are meant to represent.
So we understood that we could not rely entirely – or even mainly – on theory and tests to say anything useful about the real world. I love numbers, and it is obvious that to gain any insight about how an economy works you need to start
with a theory, so theory and tests are part of the armoury I would expect to use. However, the writers who attracted me to economics – Arthur Lewis was a prime example – understood that theory was more than a set of equations and some
algebraic manipulation, and that empirical economics was not about “proving” a theory, but rather about using data to enrich one’s intuition about how the economy works. Also, they understood that most of what explains economic processes and interactions cannot be captured by the algebra and calculus that economists have at their disposal.
Over the past 4 decades I have become increasingly dismayed as I have observed the economics profession being taken over by a generation of economists who have lost sight of the limitations of what they can know, with the help of the tools
and techniques available to us. We write as though anything that we can set down in a theoretically “correct” specification of an equation has to be true, even when the evidence to the contrary is right before our eyes, and obvious to everybody who is not an economist. When our empirical tests fail to yield expected results we do not take our theory back to the drawing board, but we fudge some explanation that we think might be plausible.
These are not trivial matters. They lead economists to incorrect interpretations of economic motivations, transactions and processes, and, as a result, to policy recommendations that can be guaranteed to fail. I offer two examples.
The exchange rate is not a price of anything
Economists cannot understand how the exchange rate of small resource poor countries like Barbados, Cayman, the Bahamas and the OECS can remain unchanged in terms of their numeraire (the US dollar) indefinitely, because they deceive themselves into thinking that the exchange rate is a price. Economists believe that prices are arrived at by demand and supply in a market, and since the demand and supply will change over time, then the price has to change as well, otherwise the market will not clear. So they have to invent some artifice to explain long term exchange rate pegs, especially in countries like the OECS that have no exchange controls.
But in fact the mistake is to believe that the exchange rate is the price of foreign exchange. You can’t eat, drink, smoke or wear foreign exchange; foreign exchange is not a commodity. Rather, the exchange rate is what it says on the tin, a statement about the relation between one measure of value and another. The value of the shirt I bought at Havana Nines in Miami airport for US$50 is twice that amount in BDS$, because the exchange rate of the US$:BDS$ is 1:2. In exactly the same way that a 10 mile walk is equivalent to a walk of 16 kilometers, because the “exchange rate” of miles to kilometers is 1.6:1. It makes as much sense to keep changing the exchange rates between currencies as it would to keep changing the value of a mile in terms of a kilometer. The only outcome of flexible exchange rates is increased uncertainty, with no benefit whatsoever.
This is obvious to ordinary people, but to modern economists it is preposterous. No matter that it is confirmed by observation the world over. Not just in the Caribbean, but in regions scattered across the globe, there is a tendency for currencies to cluster around large attractors in their neighbourhood; in Europe it is the euro, in the Americas the dollar, in Southern Africa the rand, in the Indian Sub-continent the rupee. It is the notion of flexible exchange rates that is ridiculous, not the acceptance of the superiority of pegged exchange arrangements. We should remember that the notion that flexible exchange rates are an acceptable way to manage the international economy has risen to ascendency only in the last 3 decades or so, a period I believe will be seen by history as a dark age of economics.
Prices have not been set by markets since the end of the agrarian economy
A second example of economists’ misrepresentation of the world is the notion that prices are determined by an equilibrium of supply and demand in a market. This notion is so fundamental to economics that it is accepted without question, and not only by economists. A visitor from Mars would find this quite strange, because when he looked around him, he would be hard pressed to find anything resembling a market in which buyers and sellers negotiate the price of things bought and sold. In real life retail prices are always predetermined by the seller, and wholesale, producer and other prices are determined by contract.
This was not always the case. Economic history is not my specialty, but my understanding is that in the agrarian economy economic transactions typically took place via markets. The farmer would till his fields and raise his livestock five days a week, and on the sixth day he would load his produce on some form of transportation and take it to the nearest market town, where he would trade it with artisans, fishermen and other farmers who had products that he needed and that his household did not produce. In many African societies, I am told, the marketing is done by women. The seventh day was often the day of rest and
recuperation, at least in the Western societies from whom we draw our traditions. In this economy, sellers will adjust their prices over the course of the market day to ensure that they dispose of the entire supply that they have brought to market.
This was the world in which the early economists like Adam Smith grew up, and these were the arrangements which they reflected in their models of the economy. It was a quite literal description of the behaviour they experienced every day. The overwhelming proportion of the populations lived in villages in the countryside, their daily activity for most of the week was production and consumption. Trading, that is, economic exchange, took place only on a single day, in a discrete space, for a specified time. It made sense to think of economics as the business of trading in markets.
Unfortunately, the timing was all wrong. Economics was born at the sunset of the agrarian age, and at the birth of an industrial age in which the nature of economic transactions was completely transformed. The founding fathers of our discipline
invented theories for a world which was about to vanish from history. In the industrial society, a category to which Barbados and most of the Caribbean rightly belong, the overwhelming proportion of the population lives in conurbations, where people live, work, produce, consume and conduct economic exchange in the same space, and contemporaneously. In the agrarian economy the worker tends his farm during the week, and goes to market on market day; in the industrial economy the hotel worker travels from home to workplace every day,
Click here to view video of What's Wrong with Economics" presentation by Dr. DeLisle Worrell to the Barbados Economic Society (BES) AGM on June 30, 2010