Adam Smith Did Not Make Predictions

The Daily Reckoning HERE: carries an post, “Bubble Deniers”, by Bill Bonner, co-author of three New York Times best-selling books, Financial Reckoning Day, Empire of Debt, and Mobs, Messiahs and Markets:

“Long gone are the days when economists thought deeply about how life actually works. Adam Smith, Adam Ferguson, Anne-Robert Turgot - the great “moral philosophers” - all died hundreds of years ago. Since then, the trade has gone bad. They’re all numbers guys now. An economist, of the modern variety, is a statistician…an extrapolator…and a mountebank.* If numbers go up two months in a row, he predicts they will go up another one. He rarely stops to ask whether his numbers really make any sense. Instead, he merely adds them up and rolls them out. Thus - at the bubbly top in 2006 - he was he able to describe the likelihood of default on a certain derivative instrument as a “Six Sigma event” without laughing. A Six Sigma event happens once every 2,500,000 days. Then again, when the Bubble of 2002-2007 popped, they happened once a week.

The blogs are full of chatter on the subject. What good is the economics profession, asks Paul Samuelson, if it cannot foresee the biggest single economic event in at least a quarter-century?”

Comment
I agree with the broad sentiments of Bill Bonner with a few caveats.

There are an enormous number of economists working today and it is more than likely that some of them did warn about the pending bubbles before ‘sub-prime’ entered financial discourse. Popular books of the pending stock market crash, like a stopped clock are likely to be right at sometime.

Paul Samuelson, characteristically, hits the nail on the head: why did the economics profession fail to “foresee the biggest single economic event in at least a quarter-century?”

Partly, the answer is that large as it is, economists are not members of a unified science. Many economists focus solely upon in-doors experiments, with real people, or imaginary experiments with equations.

Some do not look out of their windows at all and in fact have been carefully groomed not to do so; most do not look over-the-fence at what closely aligned disciplines are doing or have done (think of sociology, psychology, anthropology and, above all, history), and they suffer promotion-withholding disdain from colleagues if they do so, and are disregarded by the sniffy-nosed severity of those who form tenure committees that pass over anyone showing evidence of a lack of disciplinary-defined gravitas.

For those who master the black arts of econometrics, only as good as the data they sometimes painfully collect, or the harder tests of stratospherically higher mathematics and their fateful misunderstandings of the real world, despite their mastery of their imaginary worlds without humans in them, the result is largely the same - neither the colourful future they arrogantly believe they see (with pay-cheques to match) nor the black-and-white past they virtually invent are connected to the real world.

Prediction in modern economics is the Holy Grail (more like the Devil’s Jest). Adam Smith avoided making predictions; he observed, as was the rightful duty of a moral philosopher, and reported to all who would read his books. He stuck to the humble arts of an influencer; he was not a man hawking a career-winning system.

He held on to humble hopes that legislators and those who influenced them would think about his observations and, slowly and gradually, they might adopt measures to change some of their and their predecessors’ behaviours a step at a time.

His sense of history (surely the great laboratory of human experience), based on a remarkable understanding of the whole range of human behaviours across and at all levels of society throughout history and the present, lowered his expectations as to what was tolerable by ‘so weak and imperfect a creature as man’, contrasted with what was possible if the world perfectly conformed to utopian imaginations, where the people in it behaved impeccably as ‘rational maximisers’ in the manner the out-of-touch theorists believed they would (give-or-take a few heroic, not to say fool-hardy, assumptions). Ironically, Smith is described today as such a philosoper in the image of today's 'rational maximisers!

Readers perplexed by the crisis should consult ‘The Recession: causes and cures’ (2009) by David Simpson, a classical economist. It is available from the Adam Smith Institute: www.adamsmith.org

Neoclassical theories Do Not Explain How Modern Economies Function

‘Crisis papers: editorials and other articles’ posts (16 Dec) on Democratic Underground.com (HERE):

“Theory vs reality: why market absolutism fails”

“The Perfect Market"

”Neo-classical economists, and their political acolytes, are convinced that “free markets,” completely undisturbed by government interference, yield optimum social and economic results. For example:

“In the free market, the individual would have to produce a good that the other person desired in order to receive a good in return. Adam Smith's "invisible hand" of the market guides all participants in society to promote the best wishes of everyone else by pursuing his own wants and desires.” (Jacob Halbrooks)

To sum up: “Economic man” and “perfect markets” are abstract constructs which, due to their clarity and simplicity, allow theoretical economists to devise complex mathematical models. However, they have no counterparts in the real world, which compromises the application of these concepts in public policy.”

Comment
Overall, most of the criticism of neoclassical economics contents in the article I have written myself in Lost Legacy. However, there are caveats that I would make in case this is taken as my agreeing that criticism of neoclassical economic theory amounts also to criticism of markets in the real world. It most certainly does not; neoclassical economics is not the same as real world markets.

Markets are real; modern economics is a theory, and theory in social sciences should be judged by how it reflects the real world. The theory that the earth was ‘fixed’ and ‘unmoving’ at the centre of the solar system was ‘elegant’, increasingly complex (72 separate vortices to make things ‘fit’ badly), and also utterly wrong. Observations eventually corrected the foundational error. But the constituent elements making up the solar system were predictable and hardly changing, unlike the constituent elements making up an economy.

With markets, observations of how they ‘worked’ led to theories about them closely related to what was observed, and a ‘foundational’ theory about them, as in Adam Smith’s 'Wealth Of Nations’, appeared before mathematical theories about markets from the 1870s were applied, refined, and given a ‘life’ of their own in the 20th century.

Scores of the brightest economists from mid-20th century onwards detached from observing how markets were evolving from those that Adam Smith had written about and how they were changing. The theorists wrote increasingly complex models of how their models worked, not how markets worked. In time, the scores became thousands and they trained tens of thousands of students about the ‘beauties’ of the models of markets. Precious few of whom observed what was going on around them (they ceased to look outside their windows).

Long detached from the real world inhabited by real humans, economists refined their assumptions about 'Homo economicus', ‘rational behaviour’, ‘perfect markets’, ‘growth theory’ and ‘general equilibrium’, until they came to believe that their ‘as if’ models were true factually as well as ‘proven’ mathematically. Those who had the attention of legislators and those who influenced them, turned their abstractions into policy absolutes and have few claims to ‘making a positive difference’ in how the world performed – and in developing countries their performance record is not good.

That ‘perfect free markets’ as an abstraction had never applied as a reality, (Smith, for example, never used the words ‘laissez-faire’) was ignored; they became a principle assumption of policy, even though the active presence of ‘big government’ falsified assumptions about ‘perfectly free markets’. Worse, the manifest competitive failings of corporate giants, which needed attention on grounds of competitive justice, were vocally protected on the authority of prominent economists on grounds that any corrective intervention was an ‘abuse’ of ‘free markets’!

Even policies that were perfectly compatible with Adam Smith’s advice on how to deal with legislative abuses by some ‘merchants and manufacturers’ were resisted, aided and abetted by lobbyists of legislators and those who influenced them from interest groups funded by the same abusers. These real and powerful active forces in ‘free’ markets' do not appear in the equations of general equilibrium.

Worse, the theorists of modern economics, from the very top of the profession right through to the keenest, brightest, and most convincing of graduates of the top schools, truly believed (yes, with almost religious conviction) the metaphysical assertion of Jacob Halbrooks, as quoted above, namely, that ‘Adam Smith's "invisible hand" of the market guides all participants in society to promote the best wishes of everyone else by pursuing his own wants and desires’.

And they believe this nonsense despite the contrary evidence of exactly what Adam Smith said in Wealth of Nations (WN IV.ii.9: p456); they neither “look outside their windows”, nor read the books that they misquote from.

So, in the abstract world of neoclassical markets, they introduced into them a mystical, abstract, and wholly imaginary force that is their sole claim to the relevance of their abstractions for the real world, namely that “an invisible hand”, disembodied, ubiquitous and multi-talented, ‘leads’ each and every player to do exactly what they are required to do by a mysterious force (some actually credit it to God!) that guides their every transaction, of which there must be trillions taking place each working hour, irrespective of the outcomes, into a utopian perfect harmony. Not only is this wishful thinking; it is contrary to ordinary facts.

It’s nonsense, but unlike the harmless fun of the myth of Santa Clause visiting each child with presents once a year, the myth of an invisible hand is pernicious when economists, who should know better, come to believe that it exists as the guiding principle of markets.

I have sometimes felt, when addressing my peers with the gist of my paper on the invisible hand myth (downloadable from the Lost Legacy home page), that I am spoiling their party by pointing out that, like Santa Clause, it is a myth.

First of all, Adam Smith did not relate his use of the metaphor of ‘an invisible hand’ to market transactions; this was an invention of neoclassical theorists, aided by propagandists (some paid, others out of their misguided, convictions) for the activities of large corporations, which corner markets and act non-competitively, and in some cases destructively.

Added to the waste and destructiveness of big government, the combined effect of monopolistic corporations and bad government is an indictment of the economics profession’s inability to realize their shortcomings as the subject is presently constituted. Economists who understand how markets work in the presence of big government would have something worthwhile to contribute, but economists, who onlyunderstand how their models work in the abstract, fall far short of what is needed to guide policy makers.