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March 24, 2009

Question Economics, as it's often practiced, is really a kind of "cargo cult science."

That term was originally advanced by physicist Richard Feynman. Here's how he defined it, after describing a number of examples of the achievements of the practitioners of modern pseudosciences, such as reflexology and UFOlogy, and also the "soft sciences" represented by the fields of education and criminal rehabilitation:

... In the South Seas there is a cargo cult of people. During the war they saw airplanes with lots of good materials, and they want the same thing to happen now. So they've arranged to make things like runways, to put fires along the sides of the runways, to make a wooden hut for a man to sit in, with two wooden pieces on his head to headphones and bars of bamboo sticking out like antennas -- he's the controller -- and they wait for the airplanes to land. They're doing everything right. The form is perfect. It looks exactly the way it looked before. But it doesn't work. No airplanes land. So I call these things cargo cult science, because they follow all the apparent precepts and forms of scientific investigation, but they're missing something essential, because the planes don't land.

So how does that insight apply to the field of economics? Better still, how does that apply in the current state of the world today?

Doug Reich explains:

... rather than understanding and initiating the fundamental cause of some effect the cargo cult imitates the form of the causal process in the hope that it will bring them the actual effect. In this case, the islanders created an imitation airport in the hopes that it would result in actual goods being brought by airplanes. In the same way, Keynesian economists can be thought of as cargo cult economists.

Everywhere we hear the Keynesian doctrine that in order to restore economic prosperity, we must encourage spending. If only people would spend we would be OK. The Fed is lowering interest rates to zero in order to encourage lending. Obama is proposing to spend hundreds of billions of dollars to "restore" economic growth. Naturally, the money for these programs will be created out of thin air by the Federal Reserve when it purchases Treasury securities with fake money.

In a simple barter economy, you would not think to offer nothing for a good that you desire. You would offer something that you own or have created. In reality, nothing changes when you introduce a medium of exchange (money) in order to simplify transactions. In order to actually spend money, you must produce something and offer it as a value for a value. In other words, spending or "demand" is a consequence of production. Your demand is your supply which is in essence Say's Law.

Notice that the cargo cult economists try and imitate the form of a valid economic transaction by advocating the creation and expansion of paper money. When the government prints paper money and offers the paper dollars for goods and services, it appears that someone has produced wealth and is exchanging it for an equal value. After all, in the past, when the paper was backed by real wealth (gold), it was observed that there was a lot of paper money around. So, just as the cargo cults fabricated control towers and runways in the hope that it would bring real goods, the cargo cult economists believe that by creating paper money with fancy ink and stamping a large number on it, wealth will result. But just as the "planes don't land" for the islanders, creating paper money does not create goods.

What we observe among "cargo cult economists" is an absolute devotion to economic theory in absence of real empirical evidence that might support the theory, or worse, evidence that directly contradicts what would be predicted to happen by applying the theories. We see, for instance, Nobel-prize winning economist Paul Krugman pushing for massive amounts of fiscal stimulus and qualitative (or quantitative) easing of monetary policy by the Fed, despite all evidence to the contrary of either policy ever being genuinely effective.

But why is that? Why would such a prominent economist apparently disregard the actual outcomes observed from applying the economic theories he advocates? Why would he also go so far as to suggest that the inevitable failures from applying such demonstrated flawed or inadequate theories are either the inevitable result of not doing even more of what the theory demands or because the people responsible for executing the policy were incompetent to do so.

Physicist Jean-Phillippe Bouchaud tackles that question in his essay Economics Needs a Scientific Revolution, which appeared in edited form in the October 2008 edition of Nature, and from which we stole the title of our post (emphasis ours):

Classical economics is built on very strong assumptions that quickly become axioms: the rationality of economic agents, the invisible hand and market efficiency, etc. An economist once told me, to my bewilderment: These concepts are so strong that they supersede any empirical observation. As Robert Nelson argued in his book, Economics as Religion, the marketplace has been deified.

It would seem the theory itself can never be wrong and can never be discarded. And that's the kind of thinking that can turn even a Nobel-prize winning economist into the leading witch doctor for the popular field of cargo cult economics, where unquestioning devotion to dogma outweighs observed reality. Bouchaud constrasts the hard science of physics with the soft science of economics (again, emphasis ours):

Physicists, on the other hand, have learned to be suspicious of axioms and models. If empirical observation is incompatible with the model, the model must be trashed or amended, even if it is conceptually beautiful or mathematically convenient. So many accepted ideas have been proven wrong In the history of physics that physicists have grown to be critical and queasy about their own models. Unfortunately, such healthy scientific revolutions have not yet taken hold in economics, where ideas have solidified into dogmas that obsess academics as well as decision-makers high up in government agencies and financial institutions. These dogmas are perpetuated through the education system: teaching reality, with all its subtleties and exceptions, is much harder than teaching a beautiful, consistent formula. Students do not question theorems they can use without thinking.

Bouchaud continues on to offer his prescription for strengthening the economics profession, but we'll conclude with his assessment of the outcome of applying economic models that rely upon assumptions not supported by real-world empirical observations:

Reliance on models based on incorrect axioms has clear and large effects. The Black-Scholes model was invented in 1973 to price options assuming that price changes have a Gaussian distribution, i.e. the probability of extreme events is deemed negligible. Twenty years ago, unwarranted use of the model to hedge the downfall risk on stock markets spiralled into the October 1987 crash: -23% drop in a single day, dwarfing the recent hiccups of the markets. Ironically, it is the very use of the crash-free Black-Scholes model that destabilized the market! This time around, the problem lay in part in the development of structured financial products that packaged sub-prime risk into seemingly respectable high-yield investments. The models used to price them were fundamentally flawed: they underestimated the probability of that multiple borrowers would default on their loans simultaneously. In other words, these models again neglected the very possibility of a global crisis, even as they contributed to triggering one. The financial engineers who developed these models did not even realize that they helped the credit mongers of the financial industry to smuggle their products worldwide –they were not trained to decipher what their assumptions really meant.

Real science begins with observations, then moves onto developing models that describe observed reality, which are then tested and tried by experiment under normal and extreme conditions. In our view, that's the direction economics needs to go if it's ever to develop into a true "hard" science.


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