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Why economists disagree

August 20, 2003

In his recent column, T C A Srinivasa-Raghavan has been very critical of economists.

In his disdain for them he outdoes Keynes who had hoped that "economists could get themselves thought of as humble competent people on a level with dentists." (Keynes collected works IX, page 332).

Instead of showing that degree of humility, economists according to TCA, are always disagreeing about policies without understanding them in the proper context.

For example, economists argue that the Reserve Bank of India is accumulating too much foreign exchange when they had pointed out earlier that the government was mishandling exchange rates so badly that the country would run out of foreign exchange.

Economists seek to find an optimal level of reserves but fail to recognise that such optimality does not exist..

That economists are frequently contrarians goes without saying; but it is arguable that the state of economics has not been carefully considered by TCA.

Innovation and progress in most sciences goes through at least three stages. First observations lead to some general conclusions that are in an early phase attributed to divine intervention.

Thus when Newton saw regularity in the motion of heavenly bodies, he concluded that such an orderly phenomenon was clear evidence of divine existence and that is reflected in man's understanding of the laws of nature.

At a later stage sciences develop laws by specifying premises and deducing the outcome. Arguments based on these presuppositions are dismissed or asserted by predicting outcomes.

When outcomes turn out as predicted, it strengthens the general law and when it fails, it casts doubts on theory.

For example, after the theory of relativity however unsure we may be of the universality of the law of gravity, we do not expect a brick to fly upwards.

That, as Kant, said is in the nature of laws that they are believed by us to have a predictable application.

The third stage of development is what is known as logical positivism, that is logical empiricism or scientific empiricism. In this state of development there is scepticism in the universality of the predicted law until it is adequately tested by scientific method.

That is the stage where dental theory is considered useful not only when it enables dentists to mend teeth regularly but when the entire causal chain is clear to us.

This state of development seldom emerges without considerable analysis of data and refutes hypotheses that do not emerge from data. There is a degree of the methodology of metaphysics.

Economics has also evolved along these different stages. When Adam Smith used the notion of the invisible hand he was almost hinting at divine intervention but since divinity could not be claimed as rational, hypotheses in economics depended upon the presuppositions of the theory.

These were developed with great consistency and rigour from the outset.

In social sciences it is not easy to gather data with simple observations because human beings do not react as exactly as planets do, but at least the metaphysics of economics could be evolved by developing rigorous and logical analysis however shaky the veracity of the presuppositions are to facts.

It is because economics is primarily in a metaphysical state that it is unpredictable. Economists increasingly justify their arguments with careful analysis of the data; but unlike other sciences, economics did not develop from first-hand observations and data collection as other sciences did.

Unlike early scientists like Tyco Brach or Galileo who made predictions from their own observations. Indeed very few economists except perhaps Ricardo or Keynes even participated in the markets that they hypothesised about.

Inevitably they predict outcomes from well developed theories. Based as they are on consistent premises, economists predict how markets should react not how they will react.

TCA condemns economists for their disagreements; but it is in the nature of the subject that it is not always possible to distinguish between how rational people should react as how they do react. That would require an ideal economist.

There is perhaps no ideal economist; but an exceptionally good one, who TCA would have admired, John Flemming of Oxford University, died two weeks ago at the young age of 61 after a painful illness.

He always struck me as precisely the best man at providing the balance between what should happen and what does happen.

As this is a fitting time to pay him tribute for his enormous ability and clarity I hope I shall be permitted to describe him in the context of what makes an ideal economist.

He was academically outstanding and was reckoned with Martin Feldstein as one of the two brightest economists to emerge from Nuffield College.

I give two [economic] examples of his immense teaching ability. The first time was when he explained to me a simple technique for avoiding confusion with discounted cash flows where it is important to know both present values and internal rates of return.

He said one should calculate net present values at different interest rates and then draw a simple two dimensional curve where the Y-axis had present values and the X-axis the rate of interest.

A well behaved equation would result in a downward sloping curve and the internal rate of return would be the point at which the curve would intersect the X-axis.

On another occasion I was puzzled by the Keynesian problem that when interest rates fall to low levels, a liquidity trap emerges. At the time I could not figure out why nominal interest rates cannot also turn negative.

After all, if banks charge you a rate for borrowing money from them they can also pay you money with adequate security for relieving them from the cost of idle money.

This would provide a stimulus for the economy so in return the government could compensate them with a subsidy. I had asked this question when the Japanese could not find a way of encouraging investment even when interest rates were negligible.

John replied instantly that negative rates would provide no incentive to investment because the borrower could withdraw money at a negative interest rate and immediately deposit it back in the banking system as security at a zero rate of interest without undertaking any activity.

Now both these examples may be better illustrations of my stupidity than John's intelligence, but let me assure the reader that I had previously asked the question[s] of many renowned economists none of whom responded as swiftly or concisely as John did.

He moved easily between the academic professions and great institutions like the Bank of England and the European Bank for Reconstruction and Development where his outstanding abilities were well recognised.

He never gave up his Oxford base and came back to the University to be Master of Wadham College, which had the best class results in its history at the end of John's last term.

I have brought John into this article not just because I wanted to pay him some tribute but because for some of us at least he was as ideal an economist as we shall ever come to know.

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