A great divide holds back the relevance of economists

By Mark Thoma
July 26, 2011

By Mark Thoma
The opinions expressed are his own.

Reuters invited leading economists to reply to Mark Thoma’s Op-Ed on the “great divide” in economics and will be publishing the responses. Here are responses from Ashwin ParameswaranJames HamiltonDean Baker, Lawrence Summers, and a recap of Paul Krugman’s.

How much confidence would you have in the medical profession if the teaching faculty in medical schools had very little experience actually treating patients, and very little connection to – even a lack of respect for – the practitioners in the field? Would your confidence be improved if medical research had little to do with the questions that are important to the doctors trying to serve patients?

Unfortunately, that’s a pretty good description of how economics has been practiced. The questions academic economists are trying to answer have little connection to the problems faced by business economists trying to help their firms make good, profitable decisions (and vice-versa). And though academics pay some attention to government policy, particularly Federal Reserve policy, addressing the problems faced by government economists trying to help policymakers make the best possible choices is not the main focus of this research.

This division between academic, government, and business economists is driven by the fact that economic theory and econometrics can be used for two different things. One is learning about how the world works. These “how and why” questions are the focus of academic research. For example, academic economists try to understand why demand curves slope downward, how business-cycle fluctuations in GDP come about, and how prices are determined in market economies.

The other use of theoretical and empirical economic models is forecasting, for example predicting where the economy is headed so that businesses can react accordingly, and predicting what might happen if various government policy proposals are implemented. These are the “what if” questions that economists in government and business are most interested in. What will happen to tax revenue if business taxes are cut? What will happen to the demand for my product if the Fed raises interest rates? What is the most likely course that the economy will take?

Again, a comparison with the medical field is useful. Science can help us to learn about how the body works, and that certainly aids our efforts to battle disease. This is an important area of research, and we wouldn’t want to cut it short. But knowing how the body works isn’t enough, we also need the ability to diagnose current illnesses and to predict when someone is going to get sick. In addition, we need to have treatments available to fix the problems that we’ve identified. Periodic checkups, for example, allow us to predict who might get coronary disease, and then take action to avoid much bigger problems down the road.

Academic economists have emphasized the “how it works” part of economics; in econometrics, for example,  the focus is on hypothesis testing to determine which model of the economy is best, rather than on forecasting the future of the economy. Academic economists do evaluate policy proposals theoretically and empirically, and they do provide forecasts of the economy. But forecasting in particular is not the main focus of their efforts, , and they’ve all but ignored – even looked down their noses upon – forecasters and practitioners in the government and business communities. They are often viewed as data grubbers who use old-fashioned models and techniques, and are thus unworthy of attention from high-minded academics.

However, a few practitioners saw the housing bubble coming. Shouldn’t academic economists try to learn from them? What did they see that the academics missed? In addition, if the practitioners in the field are unaware of or do not have the technical ability to use the best approaches to the problems they face – criticism from academic economists over how business economists used value-at-risk models prior to the recession comes to mind – whose fault is that? Shouldn’t academics try to help the practitioners get over this hurdle instead of turning their backs on the problem, and then looking down at them when they don’t use or misapply cutting edge techniques?

The failure of academic economists to predict the crisis shows just how costly such insularity and arrogance can be. The patient (the economy) didn’t need to have a heart attack (financial meltdown), because even though the signs were there, the academic community had little interest in learning how to read them, let alone in developing early warning and intervention strategies for bubbles and other problems. The Fed does some of this, of course, and the financial crisis has motivated some academic interest in developing early warning systems that would have helped us to identify and do something about stock, housing, and other bubbles before they inflated to dangerous levels.

The medical profession would do much worse without connections between the practitioners in the field and the how-it-works types in the labs. The questions researchers ask, for example, are shaped by the needs of the practitioners trying to prevent and cure illness. What types of tests can doctors do in their offices and labs to quickly and reliably indicate the current health of a patient and to forecast future health problems? In economics, if reliable tests for bubbles had been available to business economists, that could have saved the economy from considerable losses.

Economics has lost the connection between the practitioners and the academics. This may have something to do with the desire among economists to become more of a science – a heavy focus on theory and math is the result. But no matter the cause, if we want to do all that we can to avoid big economic problems, and if we want to use the feedback from those testing economic ideas on real world applications as a way of better understanding how the economy works, then we must reestablish these ties.

PHOTO: A stethoscope rests on a container of hand sanitizer inside of the doctor’s office of One Medical Group in New York March 17, 2010. REUTERS/Lucas Jackson


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More worrying than the division between the academic and practical economists is the parts where they agree : Most Economic ‘Theory’ is just plain nonsense : for example the much touted MV=PT that is used to explain the “Velocity of Circulation of Money’ – well there is no ‘circulation of money’ to have any velocity : Butchers do not use their retail takings to buy consumer goods from bakers – they use it to pay off debts back along the supply chain… to the farmer and the landlord… and ultimately the bank – the money is destroyed when the loans are repaid. The likes of MV=PT which is actually a tautology pretending to be an equation does not prove that there is a “circulation of money” that has a “velocity” it is just a ratio that they defined V=PT/M that means nothing much at all in reality.
You can create it yourself from 1=1 : multiply both sides by MPT to get MPT=MPT then divide both sides by M to get MPT/M = MPT/M.
On the left, bracket it so it looks like : M(PT/M) and on the right cancel the M’s on the top and bottom to get : M(PT/M) = PT. Now define PT/M to be = V and give it a grandiose sounding name like the “Velocity of Circulation” and replace the (PT/M) with your new defined V to get MV=PT. All theses terms can be anything at all : M can be the amount of money M0 or M3 or M5 or the amount of Martians in the White House, similarly the other terms can also mean anything at all P can be the amount of peas on your plate ! The trick is, as you’ve defined one of the terms in the “equation” ‘V’ using the other terms in the equation : P,T & M the ‘equation’ will always be true – it’s a definitional tautology – it’s little more than a kids “add it to the first number you thought of” number trick. At base, the split is not between one type of economist and another it’s between Economists – who don’t know how to do equations and Mathematicians who do and between economists who don’t know how to do Double Entry Booking and Accountants who do.
The latest batch of economists appeal to Ricardo to justify Free Trade – Well Ricardo’s idea was essentially “let’s specialise” otherwise known as “let’s put all our eggs in one basket and de-skill in various industries”. To an extent, it might be allowed that it has something to commend it to some extent, but now with the WTO allowing “Freedom of Movement of Capital” as well as goods and services this allows the Chinese do Uni-Trade – they sell goods to us and use the money to buy – not our goods in return (al la Mr Ricardo) but to buy our companies, land, bonds, shares and turn us into Tenants of our new Chinese Landlords in our own Country – there is no theory of International Trade that says this Uni-Trade is a good idea – it’s a one way ticket to the end of western Civilisation.

Posted by de_chandos | Report as abusive

@de_chandos- that’s very clever what you did with the equation but it is slight of hand. All equations must have both sides equal.

You claim V=PT/M (the Wikipedia definition uses different letters) doesn’t make sense. But it does because one can fit numerical values into the equation. Whether the numerical values that are inserted are valid or the results obtained are valid is your point.

How about W=V/A, the power formula, or E=MCsquared? ( sorry I can’t type exponents). It isn’t possible to actually demonstrate the speed of light times the speed of light. It is derivative of A=VT, the acceleration equation.

If what you are saying is that money is not a physical quantity and therefore can’t be measured, than what is it about it can be measured? It is certainly real enough in book keeping ledgers. So it must be in the bookkeeping where the money supply expands or contracts or even vaporizes during market crashes? The fact that wealth can vaporize on the stock market is due to the fact that stock traded at one time for a specific value is sometimes assumed to be the value of all the un-traded stock and people act accordingly, and also due to the fact that stock bought for one price may rise or fall by the time it is sold. That may be the BS of the market place because the valuations may have nothing to do with sensible reasons. Fear and greed is the engine. If all the stock traded at once it would have a low value. But that’s the way it’s done and I suppose there’s no point in arguing about it. Here you have a point – is that M or PT?

Transactions obviously have speed or investment houses wouldn’t be building high-speed computers to trade in milliseconds. Isn’t that a good demonstration of V?

And individuals and countries measure their wealth relative to each other all the time. It doesn’t seem too difficult to determine when a country is rich versus one that is poor. Isn’t that a good demonstration of PT? It is obvious that a wallet with thousands of dollars has more money than one with a few dollars as long as they are in the same currency. But the relative value of currencies doesn’t seem very reliable and may be as explosive as splitting atoms.

But in many ways, money is no more real than the probable location of an electron or nuclear particles, yet that hasn’t stopped physicists from writing about them or devising formulas to try to define their behavior. And they get results from their equations.

For the rest of your comment, how does the flow of manufacturing to low wage countries (and that is something of a mirage too if you live in the low wage country – all things being relative) qualify as uni-trade?

Japan and the OPEC countries could have been labeled uni-traders a few decades ago. The difference between China and Japan and OPEC was that they were converting some of their dollar surpluses into real estate and other assets in this country. China buys debt.

You charge there is something wrong with the Chinese alone and that it will bring about the death of “Western civilization”. The Chinese have become just as westernized in the exchange of whatever it is everybody is exchanging. I’m sure they have the same question.

If were going to consider pointed questions: what makes “western” civilization western? Someone warned, “Never the twain shall meet”. Too late – what happened because they did and so far it isn’t terminal and even it could be, how is anybody going to decide and write the death certificate? Why would anybody believe the coroner?

Posted by paintcan | Report as abusive

Sorry I made a mistake – W=VA. Watts equals Volts times Amps. I’m not an electrician and can’t remember formulas unless they bite me. But that’s a handy one to know for daily use. Another one that is handy is Hp=W/750 (Horsepower equals Watts/750).

All equations could be reduced to 1=1. Some are 0=0 And you didn’t debunk the equation you just caricatured it. You left out the prospects that some transactions can result in substantial profits. It can sit in a saving account and eventually be lent out (or cover prior loans?) or be immediately reinvested in high-speed trades. Where’s money circulating faster?

Posted by paintcan | Report as abusive