The Follies of Mainstream Economics: Puzzles and Myths

By Imad A. Moosa

In the January 1994 meeting of the American Economic Association, Michael Mussa, a former Chief Economist of the International Monetary Fund, was telling a joke about economists. The joke went like this: “There are two things wrong with the country. We have turned over the healthcare system to doctors and we have turned over the legal system to lawyers. The good thing is that we haven’t turned over the economy to economists”.

This is not true, however. The economy (and the livelihoods of ordinary people) is run by economists, directly or indirectly. Economists are used by politicians and corporate interests to provide intellectual justification for whatever they want to do. The global financial crisis was brewing under the watch of two economists, Alan Greenspan and Larry Summers. Economists provide the rationale for deregulation and privatisation for the benefit of the oligarchy. Economists lead developing countries to economic ruins by enticing or forcing them to accept the principles of the Washington Consensus: liberalise, privatise and deregulate.

Yet, economists come up with the most bizarre, and sometimes plainly silly, ideas and promote them as food for thought, if not breakthroughs in human knowledge. Economists (at least those following the mainstream neoclassical school of thought) are notorious for thinking that economics is more like physical science than social science. As a result, economics has been mathematised beyond recognition while potentially useful insights from other social sciences have been brushed aside. The economy is supposed to follow “laws”, and behaviour can allegedly be modelled so that accurate predictions can be derived. This is delusion and a triumph of wishful thinking over reason.

Economists talk about puzzles that are not really puzzles and promote myths to justify policies and actions that may otherwise be resisted. Let us start with puzzles, which arise for three reasons. The first is that an empirical finding that is very specific to the sample, definitions and testing techniques becomes a law of physics, in which case any deviation from this law is a puzzle. The second reason is that a puzzle is a deviation from the predictions of a theoretical model that is based on incredibly unrealistic assumptions. The third reason is that a puzzle is a puzzle because of a procedural error has been made.

Once a puzzle has been “baked”, it gives the “baker” prestige and glory, perhaps even the Nobel Prize in economics (which is not really Nobel Prize, and should be abolished rather than awarded for nonsense). Puzzles persist, as I am yet to see a proposition that a puzzle has been resolved once and for all. The great mathematician, Grigori Perelman, has managed to solve a hundred year old puzzle in topology, the Poincaré conjecture. This great achievement was acknowledged by mathematicians all around the world, but any economist who dares suggest that the Meese-Rogoff puzzle is not really a puzzle runs the risk of being demonised and smeared.

Let us look at some of the puzzles promoted by economists who like to look “sciency”. The exchange rate determination puzzle is a puzzle because the empirical models relating the exchange rate to a set of macroeconomic factors are hopeless in terms of explanatory and predictive power. This is a puzzle only because economists think that foreign exchange market participants observe macroeconomic factors and react in a uniform way to changes in these factors, which cannot be further away from the truth.  

The capital structure puzzle is a puzzle because no one knows how companies determine the choice between debt and equity financing. Well, four or five theories exist to explain capital structure, any of which can be confirmed or falsified. Then who cares—why is this a big issue?

The presidential puzzle is a puzzle because some economists playing with numbers found that stock returns are higher under Democratic than Republican presidents. The 1929 crash supposedly occurred only because Herbert Hoover, a Republican, was in charge. The fact of the matter is that the opposite can be proved by playing around with the same numbers. What is important, however, is that the difference between the two major parties with respect to pro-business attitude is rather subtle. Chris Hedges thinks that the two parties are effectively one party, the “corporate party”.

The equity premium puzzle is a puzzle because return on equity is higher than return on bonds. Well, this is called risk-return trade-off! It is a puzzle only because a theoretical model with an incredible set of assumptions predicts that the equity premium is lower than it should be in reality. The idiosyncratic volatility puzzle is a puzzle only because some economists playing with numbers found negative correlation between risk and subsequent return. It is still a puzzle, even though a large number of economists have shown the opposite. Once a puzzle has been established, it remains a puzzle until hell freezes over.

Some puzzles are puzzles because economists theorise in their ivory towers without observing reality. The forward premium puzzle is a puzzle because the forward exchange rate cannot be used to forecast the spot rate accurately. Well, this is not a puzzle because the forward rate has nothing to do with forecasting: it is calculated (by bankers) from a simple formula by adjusting the spot rate for the interest rate differential. A banker will always quote the rate calculated this way—otherwise, the banker will be on the wrong side of profitable arbitrage and cannot hedge the underlying position. A good economist by today’s standard would write a mathematical model to represent the relation between the spot and forward rates (the more complex, the better) instead of simply asking a banker about how the forward rate is determined.

A silly puzzle is that people consume less when they retire, because a theoretical model says that this is not supposed to happen as consumers are “rational optimisers” who endeavour to smooth life-time consumption. While unnecessarily sophisticated explanations have been put forward for this puzzle, some simple explanations can be suggested. For the majority of people, retirement income is lower than the income earned while working, which leads to a drop in consumption during retirement. People retire when they get old, and old people consume less food, less beverages, less travel and less clothing. They consume less food because their digestive systems are not as good as they used to be. They consume fewer beverages because their livers are not as powerful as they were once. They spend less on travel, either because they have been everywhere or because they do not want to die or get injured while they are away—and surely they cannot put up with long queues in airports and long flights. They spend less on clothing because they no longer have to wear suits and ties to go to work.

Myths are portrayed by some economists as undisputed facts of life for ulterior motives. To start with, myths are used to support self-glorifying rhetoric: the myth that econometric forecasting is reliable because econometrics (which is a con art) is a science, the myth that cointegartion can be used as a test for spurious correlation, the myth that meaningful inference for policy-making can be derived from multiple regression, and the myth of causality testing, which is ludicrous.

Some myths are spread to support ideology. Examples are the myth of the superiority of the free market system, the myth that the private sector is more efficient than the public sector, and the myth that privatisation is conducive to economic growth. These myths are used to justify a reverse-Robin Hood transfer of wealth from the poor to the rich in the name of efficiency. Presumably, this would be beneficial to the poor because of the trickle-down effect, which in itself a big myth. The myth of too big to fail is used to justify the confiscation by failed banks of taxpayers’ money (bail-out) or depositors’ money (bail-in), so that the CEOs of those banks can still receive their bonuses and golden parachutes. The myth, that economic growth can be propelled by low and negative interest rates, is used to justify the disastrous policy of ultra-low and negative interest rates for the benefit of banks and corporate interests. The myth, that under fractional reserve banking system the central bank controls the money supply, is used to allow banks to profit by creating money out of thin air. The myth that imports are bad for economic growth, which is inconsistent with the basic principles of macroeconomics, has been used by the Trump administration to wage a trade war that no one can win.

Last, but not least, some puzzles are based on myths. In a publication of the World Bank entitled Puzzles of Economic Growth, eight puzzles are suggested under the theme (myth) that a large public sector and regulation retard economic growth. The most “entertaining” of the eight myths are about Venezuela and Haiti. One puzzle is why the economy of Venezuela is in a bad shape, when it has billions of oil barrels. The answer is very simple: a country that is subject to brutal sanctions and the target of attempts at regime change cannot have a healthy economy. The second is why the Dominican Republic has been visited by tourists many more times than Haiti, despite being situated on the same island. This is like asking why more people visit Switzerland than Albania, even though they share the same continent (the same goes for Egypt and Somalia). More people visit the Dominican Republic because it has better roads and regular power supply (among other things).

The economy is a serious business. It should not be left to economists who believe that some silly ideas are puzzling puzzles or those who promote myths to enable politicians to pursue policies that harm the majority of people.

Controversies in Economics and Finance
Puzzles and Myths
Imad A. Moosa, Royal Melbourne Institute of Technology (RMIT), Australia

Read chapter 1 on Elgaronline.

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