The Assumptions Economists Make

Finance experts must ditch unrealistic conjecture and embrace eclecticism, finds Michelle Baddeley

April 19, 2012

Economics is a vast, complex subject, and in The Assumptions Economists Make, Jonathan Schlefer attempts the challenging task of bringing together the wide range of ideas on which modern economics rests. His background is in political science, and he was editor-in-chief of the Massachusetts Institute of Technology's Technology Review - a magazine that regularly covers cutting-edge economics. So Schlefer has been well placed to develop not only his own knowledge of economic analysis but also a more objective perspective on economics and its essential debates than might be found among economists themselves.

Economics can be a very tribal subject, particularly among the foot soldiers who have careers to forge and employers to impress. An economist from one tribe will rarely communicate respect for economists in another tribe. While the giants and Nobel prizewinners can afford more magnanimity and open-mindedness, most economists will not often admit that their ideas are driven by ideology. Yet by selecting one set of assumptions over another, economic models can be constructed, with a spurious quantitative plausibility, to support a range of positions. Unrealistic assumptions are sometimes defended via recourse to Milton Friedman's positivist defence - in other words, unrealistic assumptions can be justified if they are constructed into models with predictive power. The problem is that economic models often lack predictive power. And assumptions can be used in creative ways: white can be black and black can be white - if you have the right set of assumptions.

Reliance on unrealistic assumptions has created a crisis in economics in the sense that no single tribe seems able convincingly to capture the economic and financial realities with which we have to live. Hence the flurry of letters from economists to newspapers in the wake of financial crisis: large numbers of well-regarded economists from polar extremes expressing their opinions as if these were the objective truth; acting as if their one tribe had the holy grail and all other economists were just misguided, stupid and/or venal.

Some of this is untangled in Schlefer's assessment of economics. The book is a largely chronological analysis, and although he aims to connect the old debates with modern events, this is achieved patchily. Nonetheless, the early chapters on the classical and early neoclassical economists, including Adam Smith, David Ricardo, Karl Marx and William Stanley Jevons, explore some of the key ideas and important misconceptions.

These chapters are genuinely informative and interesting. There are also some crucial points about instability in general equilibrium theory. General equilibrium theory presents a stark, stylised mathematical account of trading between utility-maximising consumers and profit-maximising firms. Modern mainstream macroeconomic theories blend general equilibrium theory with assumptions about dynamic consumers and firms, affected by stochastic shocks to construct dynamic stochastic general equilibrium (DSGE) models - and these are the models that finance ministers and central bankers use to guide their real-world policymaking. The important point from Schlefer is that the DSGE approach is based on a dangerous misconception that equilibrium in general equilibrium models is generally stable.

Schlefer also discusses other intellectual struggles within economics, although the relatively straightforward tone disappears in the middle of the book, after explorations of Jevons' utility theory. The subsequent discussions of imperfect competition, theories of production, the long run and the short run are perhaps too complex for the general reader. Esoteric discussions of producer theory highlight some important but forgotten debates - including the Cambridge capital controversies about the meaning and measurement of capital. Nonetheless, much of the middle is indigestible even for an economist who has studied these things, let alone for the lay reader. Yet alongside obscure debates are explanations of simple constructs, such as a price index and how to calculate inflation, which raises the question: who is the target reader of this book?

Aside from economics' more arcane debates, some important practical themes are explored, including the problem of uncertainty and the reliance (until recently) on conceptions of quantifiable uncertainty. Schlefer neatly identifies three faces of uncertainty as part of the explanation for financial instability: uncertainty encourages savings by anxious householders, precautionary hoarding of cash by banks and dampened entrepreneurial investment by fearful firms. He captures well the apparently small differences in assumptions that generate large gaps in policy implications: for example, the reversal of cause and effect in neoclassical versus Keynesian models of savings and investment. In the modern unstable and recessionary world, identifying whether it is savings that generate investment or investment that generates savings is an important question.

There are plenty of other useful insights about policy design, reflecting the fact that Schlefer believes that good policymaking requires conciliation. For example, Thomas Sargent (one of last year's Nobel prizewinners) has developed a model that allows the US Federal Reserve Bank to hold three conflicting theories, their reliance on one versus the others fluctuating as the economy fluctuates, but with no one theory ever completely abandoned. This hybrid approach works better than other models in capturing inflation-unemployment trade-offs in the real world.

Schlefer's criticisms of economics are often damning: "Many people are wrong about economics much of the time." He's not completely impartial and reserves his harshest words for mainstream neoclassical analysis, at least in its "bastard" forms. On the assumption seen in some business-cycle models that workers choose to work harder when productivity is high, he observes: "This idea is nuts." Schlefer notes: "The crudest forms of neoclassical theory tend to sally forth when economists don't understand what's happening." He comments that economists have "too many models and too many stories, and don't explain enough". More judiciously, he observes that if a model challenges your convictions, then you need to change either the model or your convictions; the problem with most economists is that they do neither. He favours structuralist approaches because these blend the logic and internal consistency of neoclassical ideas with the external consistency and predictive power of Keynesianism. Structuralism brings together social conventions/contexts, political institutions and expectations in a robust analytical approach. It also draws on ideas from the natural sciences. The importance of environment is illustrated using ecological predator-prey models in which populations of predators (wildcats) and prey (hares) fluctuate as food supplies and/or predation ebb and flow. Interactions between predators and prey generate oscillations and overshooting - mirroring similar patterns in the economy. For example, models based on predator-prey dynamics can capture cyclical economic/financial fluctuations and can also capture overshooting in the real economy after financial bust.

Schlefer's book is more comprehensive in its coverage than might seem possible for a relatively short book aimed (presumably) at the layperson. Inevitably, there are some important omissions: Adam Smith's The Theory of Moral Sentiments is sidelined in favour of The Wealth of Nations. Important economic thinkers past and present - including Irving Fisher, Joseph Schumpeter, Friedrich Hayek, Daniel Kahneman and Amos Tversky - are not mentioned. Some key topics relevant to Schlefer's themes are largely ignored, including lags, unemployment hysteresis, asymmetric information, temporal discounting, risk preferences and behavioural economics. Overall, however, this book is an impressive and informative analysis of the economics literature - and it presents some useful insights about how a more eclectic, catholic approach might allow economics to progress more convincingly into the future.

The Author

Jonathan Schlefer has been a research associate at Harvard Business School on the business, government and the international economy programme for nearly five years.

He completed his undergraduate studies in ancient Greek literature and mathematics at Harvard University in 1972 and subsequently spent a number of years working as a journalist. It was while he was editor-in-chief of the Massachusetts Institute of Technology's Technology Review that he became interested in economics, he recalls: "As a journalist, I could read an article here or there, but really had no sense of the broader intellectual landscape. So, through whatever folly, I entered the PhD programme in political science at MIT."

While conducting research for his thesis, Schlefer twice spent a full year in Mexico City at the Institute of Economic Research at the National Autonomous University of Mexico. He confesses: "I used to watch Mexican telenovelas, giving the excuse that they were good for my Spanish. I have fortunately recovered from that addiction."

Schlefer enjoys reading all sorts of books, from ancient and modern poetry to volumes on quantum physics for non-physicists, and he is an avid white-water kayaker.

The Assumptions Economists Make

By Jonathan Schlefer

Belknap Press/Harvard University Press, 384pp, £21.95

ISBN 9780674052260

Published 29 March 2012

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