Neoclassical economics and the failure of predictions

 

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In my book “Science and the Economic Crisis”  I dedicate a chapter to discuss the roots of neoclassical economics and the comparison of its predictions against reality. In summary my thesis is the following :

1. Predictions in science are used to test theories, that is, the hypotheses and the assumptions underlying these theories;
2. There has been a failure in the prediction of all recessions that occurred from 1989 to 2012 (see here and  here). But the most spectacular failure occurred for the 2008 crisis (which was instead predicted by some economists belonging to different schools than the neoclassical).
3. Models used to make predictions are based on the neoclassical theory;
4. Neoclassical economics rests therefore on hypotheses and assumptions that are not consistent with reality and for this reason it is a pseudo-science;
5. Indeed neoclassical economics has given support to the idea that free markets should naturally finds an equilibrium state and by deregulating and liberalizing the markets would increase the efficiency of the economic system. On the contrary, by doing so one has created the conditions for the unstable regime that gave rise to the crisis.

  1. The disastrous predictive power of the neoclassical economists is a fact attested by any study on the subject (see here here and here): for example, the last reference we read a clear framing of the problem

The failure of economists to predict the Great Recession of 2008–09 has rightly come under attack. The areas receiving most criticism have been economic forecasting and macroeconomic modeling. Distinguished economists – among them Nobel Prize winner Paul Krugman – have blamed developments in macroeconomic modeling over the last 30 years and particularly the use of dynamic stochastic general equilibrium (DSGE) models for this failure.

  • Diapositiva39For many neoclassical economists the goal of the theory is not to make predictions, and indeed many thinks that the theory predicts that no one can make predictions in agreement therefore with the ideas of the Nobel Prize for Economics Robert Lucas:

One thing we are not going to have, now or ever, is a set of models that forecasts sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September. This is nothing new. It has been known for more than 40 years and is one of the main implications of Eugene Famas efficient-market hypothesis, which states that the price of a financial asset reflects all relevant, generally available information. If an economist had a formula that could reliably forecast crises a week in advance, say, then that formula would become part of generally available information and prices would fall a week earlier.

On the one hand this thesis presupposes the existence of an equilibrium in the economy: only in a stable equilibrium condition (small) perturbations becomes negligible and can ne rapidly absorbed into the economic system. On the other hand, why do economists continue to make predictions and give economic policy suggestions if the neoclassical theory would only give a description, a posteriori, of what happens? However, it is not at all like that. The models based on the assumptions of neoclassical economics are commonly used for making macro-economic forecasts of all major world institutions (IMF, ECB, World Bank, OECD, national governments, etc.) and neoclassical economists continue to give  suggestions on economic policy. For instance, the austerity policies are indeed based on this theory.
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The point is that predictions are wrong because the models on which they are based are wrong. In particular, the problem is the hypothesis of equilibrium is as trivial as unrealistic. Very briefly I support the thesis that in the book is that:

During the last half-century, neo-classical economic theory has provided the theoretical basis for the idea that, in order to increase market efficiency, governments should privatize their industries and deregulate the markets themselves. This result would be proven by sophisticated economic theories, which, through logical-deductive procedures, characterized by a formal mathematical rigor, would provide a series of mathematical theorems to support these conclusions. However, considering the assumptions underlying those mathematical theorems used in this economics, there is a remarkable difference between the conditions in which they can be applied and reality; here, realism, unlike rigor, takes a back seat.

  1. One of the hypotheses about the failure of the predictions is that if someone would have had a model to predict the crisis he would have become multi-millionaire and therefore would have had no interest to make people aware of his model and predictions. This fact has happened: an example is described in great movie “The Big Short
    The_Big_Short_teaser_poster
    (inspired by real events and characters) where different stock traders had understood the regime of great instability of the markets in the near of the financial crisis and have been able to derive economic benefit from it. But, in fact,  they were the exceptions because the dominant belief of academic economists and therefore of the public opinion and of the majority of stock traders was that expressed by the Nobel laureate in economics Robert Lucas:

I am skeptical about the argument that the subprime mortgage problem will contaminate the whole mortgage market, that housing construction will come to a halt, and that the economy will slip into a recession. Every step in this chain is questionable and none has been quantified. If we have learned anything from the past 20 years it is that there is a lot of stability built into the real economy..

In my book I consider many other examples, among which:

The Governor of the Central Bank of Australia Glenn Stevens has captured the reaction of neoclassical economists to the recent financial global crisis as follows <<I do not know anyone who predicted this course of events What we have seen is truly a tailoutcome the kind of outcome that the routine forecasting process never predicts.>> Not one neoclassical economic model had, in fact, anticipated the great crisis: in 2007 these were all in line with the OECD s observation that <<the current economic situation is in many ways better than what we have experienced in years>>.

Contrary to what  Robert Lucas writes in my opinion the facts show very clearly hat there is no stability in the economy and that the myth of equilibrium and of self-regulation of markets has  precisely created the the unstable regime which gave rise to the crisis we are now living for more than a decade. Theoretical economists should not think about developing a “formula” to make money in the financial markets but rather they should interpret the macroscopic structural developments in the economy. The comparison that I use in the book is the one with seismologists who cannot predict when and where an earthquake occurs, but they can identify earthquake zones. Obviously seismic zones change in geological eras while the instability of an economic system in a decade or so. However, unlike the seismology, economists have a lot of data – the problem being to know how to read them. The failure of neoclassical economics lies in assuming that the markets tend to equilibrium and that is why there is a lot of stability in the real economy. Or, quoting again Robert Lucas

My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades

Instead, my thesis is that the concept of equilibrium is understood in the context of neoclassical economics in a completely trivial form and that 

while in physics mathematics was used to obtain precise explanations and successful predictions, one cannot draw the same conclusion about the use of mathematics in neoclassical economics in the last half century. This analysis reinforces the conclusion about the pseudo-scientifi c nature of neoclassical economics we reached previously given the systematic failure of the predictions of neoclassical economists

  1. In a simple and effective way, Feynman explained the concept of a scientific theory s falsifiability during a memorable lecture, in which he explained how does scientific research work

Let me explain how we look for new laws. In general we look for new laws through the following process: first we guess it. Then we calculate the consequences of this guess, to see what this law would imply if it were right. Then, we compare the computation results to nature, to experimental experience to see if it works. If the theoretical results do not agree with experiment, the guess is wrong. In this simple statement is the key of science.

A good criterion is the following: a theory is scientific if, and only if, it is experimentally confirmable that is, if the theory is able to acquire a degree of empirical support by comparing its predictions with experiments. To be confirmable, a theory must be expressed in a logical and deductive manner, such as to obtain from a universal statement, in a rigidly linked way, one or more particular consequences that are empirically verifiable.

  1. In the eighties the Santa Fe school  was organized by Phil Anderson (Nobel Prize for Physics, considered the father of the field of complex systems), Ken Arrow (Nobel laureate in economics) and David Pines (physicists). This is an evidence that thas already taken place a long discussion between economists and physicists anderson-arrow-pines(see Anderson, Arrow e Pines   The economy as an evolving complex system” 1991). Indeed, the discussion took place, leaving puzzled physicists and not leading to anything regarding the neoclassical economic theory as it still relies on those amazing assumptions as rational agents and self-regulation of markets. In this regard it is interesting to report the reaction of the same Phil Anderson in the discussion with economists when he heard for the first time the theory of rational expectations in the famous meeting of 1987 in Santa Fé

 You guys really believe that?

The interested reader can deepen the thought of modern theoretical physicists thirty years later the school of Santa Fe (already, the clock is ticking!) In “One Hundred Years of Solitude” where I explain why neoclassical economics has lost contact with the rest of the natural sciences not only thirty years ago but a hundred years ago. To read the views of other physicists, that I discuss in the book, one can start for example from the 2008 Nature editorial of the French theoretical physicist, an expert in the study of financial markets, in his  entitled “Economics needs a scientific revolution”  published in the aftermath of the failure of Lehman Brothers,

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Compared to physics, it seems fair to say that the quantitative success of the economic sciences is disappointing. Rockets fly to the moon, energy is extracted from minute changes of atomic mass without major havoc, global positioning satellites help millions of people to find their way home. What is the flagship achievement of economics, apart from its recurrent inability to predict and avert crises, including the current worldwide credit crunch? Why is this so? […] To me, the crucial difference between physical sciences and economics or financial mathematics is rather the relative role of concepts, equations and empirical data. Classical economics is built on very strong assumptions that quickly become axioms: the rationality of economic agents, the invisible hand and market efficiency, etc.

or in the book by Mark Buchanan (2014)  “Forecast: What Physics, Meteorology, and the Natural Sciences Can Teach Us About Economics”  

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Like many other physicists I care to financial and economic theories to be about twenty years, when many of us began to move from their traditional research area and to apply the speculative mode of physics to others. In approaching the study of economic theory I was expecting to face a corpus of speculative theory and mathematics developed with the same dedication to intellectual honesty as that seen by studying physics, aeronautical engineering, neuroscience and social psychology. The truth is unpleasantly different. If we study the economic theorems that claim to explain how markets function and analyze the conditions in which these theorems have been supported, and the consequences which have resulted in the actual markets, there is an exorbitant discrepancy between the statements of the specialists and the reality . This statement does not apply to all economists, of course, but too many of them. It is as if, beginning to explore the details of Einstein’s theory of relativity turns out that in fact, in spite of the reputation that has to be one of the deepest and best tested, in use despite that physicists will do at every opportunity , there is no reason to give her credit. The confidence of physics and science would be irreparably undermined, and with good reason. It is so with the economic, at least one applied to markets

Even  Benoit Mandelbrot  wrote a book on economics and on the fluctuations of the financial markets:

Conventional financial theory assumes that variation of prices can be modeled by random processes that, in effect, follow the simplest “mild” pattern, as if each uptick or downtick were determined by the toss of a coin. What fractals show, and this book describes, is that by that standard, real prices “misbehave” very badly. A more accurate, multifractal model of wild price variation paves the way for a new, more reliable type of financial theory.

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