Remember that all models are wrong; the practical question is how wrong do they have to be to not be useful

George Coopers’ view on the current state of the science of economics in his book “Money, Blood and Revolution”.

About fifty years ago, historian and philosopher of science Thomas Kuhn published his most influential book The Structure of Scientific Revolution. With this publication, Kuhn opened the world’s eyes to a new, innovative way of looking at science and the way it develops over time. He argued that scientific knowledge does not improve by means of a steady, linear process but rather through a set of well-defined stages, all of which are incompatible with each other. To each of these stages belongs a different “paradigm”. In Kuhn’s view, paradigms constitute a widely accepted set of theories affecting the way scientists operate and come to solutions within a certain field. Just like a pair of tinted glasses, they provide scientist with a peculiar and unique way to look at the world, which will never be equal to that of someone wearing a different pair of glasses. Thus, for example, when Copernicus first questioned the idea that Earth lies at the center of the solar system, a real Scientific Revolution began. This revolution eventually lead to that highly dreaded paradigm shift known as heliocentrism.

A science in crisis

In the light of recent events, some argue that economics may well be the next candidate for a paradigm shift. Could failure to come up with an effective, well-defined recipe against the financial crisis be a symptom that economics is itself nothing less than a science in a crisis? In his latest book Money, Blood and Revolution George Cooper tries to find the answer, highlighting how the existence of many scattered, conflicting views has thrown economics in a state of chaos.While mainstream economics is still based upon the Neoclassical school, conventional economic policy is fuelled by the idea that the economy is well manageable through monetary channels, making Monetarism “overwhelmingly dominant”. Meanwhile, in the light of questionable outcomes reached by austerity-policies, an enthusiasm for Keynesian stimulus seems to be picking up once again.

Unrealistic foundations

Only within one chapter of Coopers’ book, nine leading schools of economic thought are cited and explained, signaling the fact that “all is not well in the field of economics”. To make things worse, many of their core ideas rely on features that do not fully belong to the real world. One example is given by the Neoclassical school, perhaps the one that most needs to be put under scrutiny, given its prime role in the academic world. Feeding on Adam Smith”s ideas, this school is built on the foundations provided by three basic assumptions:

  1. People have rational preferences.
  2. Individuals maximize utility and profit.
  3. People act independently on the basis of full and relevant information.

These axioms may be otherwise summarized as individualism, maximisation and equilibrium, the last one being the consequence of the first two. Yet, it wouldn’t be too much of a gamble to state that reality appears to be working differently. What needs to be challenged is not only the idea of equilibrium. The Austrians already did so with their Business Cycle Theory, postulating an economy that oscillates around its equilibrium state without ever reaching it. This time Cooper goes one step further by challenging the very idea of maximisation. Individuals, he argues, do not act as rational optimisers but rather as competitors. They do not seek to reach the best outcome in absolute terms, but rather try to outperform their peers and closest competitors, leading to what may be best defined as a “Darwinian economy”. This is why, for instance, we would greet a raise in salary with great enthusiasm, but only until we find out that our new salary is still lower than our colleague’s, who does exactly the same job. Within this framework, the axiom of individualism falls, given that competition is a collective phenomenon.

Bloody money

If economics is entering a state of crisis, its constituting paradigm ought to be redefined. This leads to Coopers’ final insight, an attempt to re-write economics inspired by William Harveys’ work on the circulation of blood. Although it might seem, to say the least, a little unrelated at first, Cooper compares the flow of money within the economy to the human body’s circulatory system. Money flowing from the bottom to the top of the social pyramid is compared to freshly-oxygenated blood leaving the lungs to reach all other organs. This upward push is made possible by capitalism. At the same time, progressive taxation, made possible by the existence of democracy, acts to push wealth back down. This partnership between capitalism and democracy is responsible for modern economic growth. Given quantitative easing (QE) measures influence asset-holders that are often located at the top of the pyramid, they are not nearly as effective as putting money at the bottom, to trigger spending and provide growth. It appears obvious, in the light of this theory, that fiscal (Keynesian) stimulus becomes the strategy of choice.

Stop thinking we’re thinking

Similar ideas can be found, in a less romanticized fashion, in a 2009 article by distinguished economist Paul Krugman, published under the title How did Economists get it so wrong? “When it comes to the all-too-human problem of recessions and depressions”, Krugman argues,  “economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly”, suggesting that the mathematical beauty of fully rational markets should not be mistaken for reality. Just like Cooper, after a rather detailed appraisal of the current status of economics, Krugman reaches the final conclusion “that Keynesian economics remains the best framework we have for making sense of recessions and depressions”.

Whether existing academics will listen to these new ideas is doubtful, and re-writing economics is a quest that calls for more than a 200-page book. After all, Keynesian stimulus is not exactly a novelty. Yet, if time is ripe for a paradigm shift, a new way of looking at the too often irrational human behavior may well be a starting point.