Economists are supposed to monitor and analyze the economy, warn us if risks are getting out of hand, and advise us on how to make things run more effectively — right?
Well, even though that's what most people expect from economists, it's not at all how they see their role, warns CFA and behavioral economist Daniel Nevins.
Economists, he cautions, are modelers. They pursue academic lines of thought in order to make their models more perfect. They live in a universe of equations and presumptions about equilibrium states and other chimerical mathematical perfections that don't exist in real life.
In short, they are the wrong people to advise us, Nevins claims, as they have no clue how the imperfect world we live in actually works.
In his book Economics For Independent Thinkers, he argues that we need a new, more accurate and useful way of studying the economy:
However far you go back, you can find economists who had a more realistic approach to how humans actually behave, than the way that mainstreamers assume they behave in the models that the Fed uses to pick winners and losers.
You mentioned credit cycles, business environment, and behavioral economics. What I've done is to say, “Okay. We know that the modeling approach, the systems of equations approach doesn't work. But instead of starting completely from scratch, what can we find in the economics literature that is maybe more realistic?”
And the interesting thing is that if you look at the work that was done, the state of the profession before the 1930s, before Keynesianism took hold, you can find a lot of work that was quite sensible.
I think where that points is towards this notion that when we think about economic volatility, there are really three things that we need to bring together:
One is the behavioral side. And we have to be realistic about the way that people really process information, the way that they truly make decisions.
The second has to do with the way businesses operate and all the challenges that businesses face to gain and retain profitability. That's something that economists were intently focused on before Keynesianism and then it became kind of sidelined afterwards because all of these models assumed that businesses didn't have any challenges.
If you pick apart the standard models that the Fed uses that are taught in PhD programs, they assume that business are always profitable, they always sell all of their output instantaneously, and they know exactly what their customers want, and businesses don't struggle. So, that's another thing we need to correct that you can find a lot of useful research if you know where to look (before Keynesianism and at the nontraditional schools that have continued in the older approaches).
And then the third thing is the credit side where mainstream economics is just so off-target, especially in their models that exclude any role for banks. Effectively, mainstream economists have made assumptions about the way money works and the way banks work that just flat do not match how they actually work in real life. That's something that's hugely critical to understanding economic volatility and understanding financial crises. But even regular business cycles have a lot to do with the ebbs and flows of bank lending. And banks just aren't included in standard macroeconomic models(…)
Until you understand that the economic profession is really not doing anything like what I would say they should be doing—studying these things that go wrong, the recessions and depressions and crises—you might not realize that we shouldn't really be relying on mainstream economists to tell us how policies should be crafted, to tell us what risks might be out there. We need a different approach.
Click the play button below to listen to Chris' interview with Daniel Nevins (46m:19s).
TRANSCRIPT
Chris Martenson: Welcome, everyone, to this Peak Prosperity podcast. I am your host Chris Martenson, and it is February 20, 2018. Now, as you're probably aware, one of the great flaws of classical economics is that it assumes that people are rational. Humans are not rational. We're rationalizers. Big difference.
The other thing conventional economics gets wrong is, well, pretty much everything. It insists that giant, complex open systems, like a dynamic and growing economy, can be expressed in closed-form equations that literally were last improved in the 1700s before the second law of thermodynamics was even expressed and understood.
To talk with us today about mainstream economics, why it's important to you, where it gets it wrong, and how it can be improved, is Daniel Nevins. He's a CFA. He's invested professionally for 30 years, including more than a decade at both J.P. Morgan and SEI Investments. And he's perhaps best known for his behavioral economics research which was included in the curriculum for the Chartered Financial Analyst Program and earned him recognition as one of the founders of goals-based investing.
He has an economics degree from the Wharton School of Business and a degree from the University of Pennsylvania's Engineering School. Daniel, welcome to the program.
Daniel Nevins: Thank you, Chris. I really appreciate the invite. You guys do great work, and I'm glad to be a part of a podcast.
Chris Martenson: Oh, thank you. So, Daniel, when we say we're going to be talking about economics, some people are tempted maybe to not even listen to this. Why is it important, today particularly, for the average person—heck, everybody—to understand economics and, more importantly maybe, the ways and methods of mainstream economics and where it's taking them?
Daniel Nevins: That's a great start, Chris. And it really leads into where I started my book because you think about the way that mainstream economists approach the economy. You think about the kind of things that can happen in the economy that affect people, the bad things that happen, recessions, depressions, various types of crises, financial crises, fiscal crises. You would think that the economics profession would define themselves as a group of people that study those types of events. But if you then listen to actually how they define what they do, it's actually very different than that.
There's an economist some people may be familiar with up at Harvard named Dani Rodrik. He's a trade economist. He wrote a book two years ago, I believe, called Economic Rules. It was intended to be a guideline for how economists could conduct their work and how they define themselves. And if you pick up that book and read through it, you'll see all the way through it, he defines the role of an economist as being, to manage a collection of models.
That's what he says economics is, and that's really what the profession says economics is. And it's not just a collection of models; it's a collection of what we could call equilibrium models. Mathematical models, all of these models start with a system of equations, a system of mathematical equations and the presumption that you can describe the economy as a system that's always converging towards this notion of a perfect equilibrium, something where the economy is always at full employment and everything is hunky-dory.
But, in fact, we know that the economy is far from perfect. And until you understand that the economic profession is really not doing anything like what I would say they should be doing—studying these things that go wrong, the recessions and depressions and crises—you might not realize that we shouldn't really be relying on mainstream economists to tell us how policies should be crafted, to tell us what risks might be out there. We need a different approach. That's really the premise behind the book that I've written, is that there is a better way to think about the economy that doesn't begin with, “My job as an economist is to sketch out systems of mathematical equations and solve them.” There is a way of thinking about the economy that actually looks at the real things that can happen, the real things that can go wrong, and the risks that we should be watching.
Chris Martenson: Now, there's a couple ways I want to approach this because this is important. I mean, this is why I think the average person needs to understand this, is that the economists are really making very, very large decisions about where things are going to go. And in some cases—my view, Daniel—they're kind of binary; either they get it right or they get it wrong. If they get it wrong, it could be spectacularly wrong, such as with the giant quantitative easing programs which are as much a monetary experiment as a sociological experiment, being conducted by people who are running these crazy closed-form economic models.
And a book that really caught me was called The Origin of Wealth by Eric Beinhocker. And in there, he's talking about economics. He's talking about how at a Santa Fe Institute meeting where they had physicists, all Nobel Prize winners or heavy-duty prize winners from all the big, heavy industries out there—physics, chemistry, economics, all that. All the hard scientists were shocked to discover that the economists were still running these closed-form equations, like you said, that seek to describe the world as if it has an equilibrium point.
“If we just do a couple—tweak a couple things, you know what's going to happen? Well, we're going to hit this thing called an equilibrium point.” But no such thing actually exists. Yet the way you start your book, chapter one, is with a quote that says, “There's no one left in economics to argue that the emperor has no clothes.” And then still quoting, “Economist David Colander, writing about his surveys of economics graduate students, in response to a question about what would put them on the fast track, only 33 percent of graduate students sited having a thorough knowledge of the economy. Whereas, 82 percent cited excellence in mathematics.”
Now, how is it that economic students today, Daniel, believe that excellence in mathematics is literally by far the most important tool for achieving the fast track?
Daniel Nevins: Well, I think of the economics profession as really a giant special interest group.
Chris Martenson: Yeah.
Daniel Nevins: Generally, special interest groups are typically good for themselves, and they tend to do things that aren't necessarily good for the greater whole, the greater population. So, I think—just thinking about human nature, humans are self-interested beings. It's not surprising, I don't think, that the macro profession evolved the way that it did.
Essentially, the macro profession—And I gave a talk a couple months ago that I began with an excerpt from a biography of John Maynard Keynes. And most people credit John Maynard Keynes with having founded the discipline of macroeconomics with his book, The General Theory, published in 1936. And his predominant—his most prestigious biographer, who's written about ten books on Keynes, said that when Keynes sat down to write his book, what he was really trying to do was to push a political agenda that he had already been pushing for about six, seven, eight years at that time, which was to get the British government to spend more money.
He was a big proponent of deficit spending. The British economy was not in good shape at that time. And his biographer pretty much laid it out that Keynes' editorials and his efforts at lobbying politicians hadn't been successful, so he developed this notion that, “Okay. I need to develop a new theory. And that theory will convince the whole economics profession that we should join this effort to take over the reins of the British economy.” And if you have a goal that ambitious, I think mathematics was the obvious tool with which to make that happen.
