Flawed theories can cost billions

Economics has come under increasing criticism in recent years, from both inside and outside the discipline. John Sutton, a mainstream economist, has written a thoughtful and intelligent book reflecting upon the state of the subject.

Sutton starts from the premise that the world is a complicated and messy place. To many, this will be self-evident, but some of the problems that economics has encountered stem from a failure to recognise the fact. The book, based on three lectures given at the University of Leuven in 1996, attempts to answer a single, deep question. To what extent can conventional economic analysis succeed in representing the world by means of simple mathematical models?

He gives some good examples of where economics is really useful. One concerns taxi cabs in San Diego, where Sutton spent some time in the 1980s. The authorities abolished restrictions on the number of licensed cabs, which then doubled, but prices remained fixed. As economics predicts, the effect was to reduce the number of daily fares each driver obtained, leading to very long working hours. Remembering the textbook model of supply and demand, the city fathers then abolished price control. However, far from equilibrating the market, this made matters worse.

Sutton points out that a key assumption of the core model of economics was not warranted in this case. Consumers did not have access to full information on rival firms' prices; more particularly, the locals did but the tourists and visitors did not. A 1977 model developed by Joe Stiglitz distinguishes between "informed" and "uninformed" consumers, and predicts the development of a dual market, one with high prices and the other with low. This is exactly what happened in San Diego. Sutton charts the various policy vicissitudes, until 1991 when controls were brought back. Modern economic theory did well in understanding the various outcomes of the different institutional arrangements.

But Sutton is also refreshingly frank about the limitations and failures of economics. Indeed, he points out that the ability of conventional economics to produce general results in his own speciality of industrial organisation, or the structure of markets, is seriously limited. He is also sceptical, with good reason, of the ability of time-series econometrics to resolve theoretical disputes within economics.

A limitation of the book is that it does not really confront a fundamental problem for orthodox theory, namely the assumption that individuals and firms can be treated as "rational maximisers", an admission that Sutton himself makes freely. The difficulties that this causes are illustrated in an example that Sutton claims as a great success of economics, but which subsequent events have discredited. This relates to the pricing of financial assets in general and, specifically, to the theory of option pricing. Robert Merton and Myron Scholes received the Nobel prize in 1997 for work that appeared to establish an exact theoretical formula for the pricing of share options, and that sparked the creation of today's multi-billion-pound derivatives markets.

Sutton does point out certain empirical problems for this model, but claims that "the true model is known to a degree of precision adequate for the purpose in hand". Alternative theories, in which physicists have been particularly active, abandon the assumption of rationality, and allow individuals to alter their behaviour patterns according to the influence of others. Such models predict that there will be many more very large changes in share prices than the orthodox model implies. The test between the rival approaches took place in 1998. Merton and Scholes were partners in Long Term Capital Management, a massive hedge fund built around their theory. The huge changes in prices which took place caused the complete collapse of the fund, with a loss of $4 billion (£2.8 billion). The stability of the whole of Wall Street was threatened, and was rescued only by the intervention of Alan Greenspan and the Federal Reserve.

This book will appeal to economists, and it can be recommended highly to everyone in the profession from postgraduate student onwards. It is written in a clear style but the lecture format on which it is based inevitably leads to a terseness of presentation. This may make it harder for non-economists to grasp, but anyone who is interested in how a serious conventional economist views his discipline will benefit from it.

For all the strengths of economics, Sutton does conclude that "the problems identified by early critics of the standard paradigm are indeed deep and serious, and should not be brushed aside". Whether his open-minded call for a more relaxed and eclectic view of research methods will be answered looks dubious, certainly within the UK academic establishment where the fervour of belief in the success of economics appears to have intensified rather than diminished.

Paul Ormerod is a director, Volterra Consulting.