Recently, at the House of Sweden, there was a feisty exchange among the newest Nobel laureates. First, one of the economics winners, Robert Shiller, questioned the validity of the efficient markets hypothesis, the prize-wining idea of co-laureate Gene Fama. This prompted chemistry winner, Martin Karplus, to say “What understanding of the stock market do you really have?” He reckoned economics can’t explain the market and questioned if “the dismal science” is even a science.
That conversation demonstrates the understandable frustration people have with the economics profession. That frustration deepened with the financial crisis, which few predicted, and the anemic recovery that followed it, where economic policies failed to revive growth. It leads many to ask: “What use are economists and their theories?”
It’s important to understand that economics isn’t fortune-telling. If you judge a single economic model by its ability to predict the future, inevitably it will fail you. Economics merely aims to determine the best use of scarce resources. That requires some understanding of how different factors in the economy interact. For example, if you have limited means to boost the economy and increase government spending, what happens to income?
To answer that question, economists design models that describe how the economy functions. These models are abstractions of the real world, which is complicated and contains an uncountable number of factors. It’s similar to drawing a map: to construct a tractable map, you must make choices about what to include. If you included every tree, hill, and country road the map would be too confusing to be useful. The purpose is to understand how different, relevant factors relate to each other. That serves an important role, but it makes no guarantees. You might take a highway featured in a road atlas and a truck could slam into you on that road. But that doesn’t negate the validity of the map. Driving on a highway poses some risk and, as financial economics cautions, so do markets.
What is included or left out in an economic model is where things get contentious, but economic models are still valuable. Many maps exist of New York State that don’t resemble each other, but all are useful. For a hike in the Hudson Valley you’d use a trail map that contains every path and hill. But if you were driving from New York City to Albany, a trail map wouldn’t get you too far — you’d use a road map. Or if you wanted to understand the size and location of New York relative to Ohio, you’d look at a coarser map of the states. Each map is accurate in the right context, but often useless for other purposes.