Does The Teaching of Economics Take The Markets into Account?

A post I wrote for the Inomics Blog and was published yesterday. 

I'm working on writing up my thesis at the moment, will continue posting more on the Icelandic pension system after I've finished that or when I find time to!

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“I write to you from a disgraced profession” were the words of James K. Galbraith, the son of one of the most successful bestsellers of books on economic and financial matters. “Economic theory… failed miserably to understand the forces behind the financial crisis.”

For those of us who know or have studied mainstream economics theory, this sounds pretty much correct: despite the thousands of pages of economic theory we studied in our undergraduate programs, we had essentially no idea what the heck was going on when the crash belatedly arrived. What baffles most is that senior economists – including those who were teaching the undergrads – did not seem to have much of an idea either. Respect for economists collapsed parallel to world economic activity and one startling but clear observation dawned upon many: the market did not fit the description made of it in the textbooks!

That, to say the least, must be a problem. Mainstream economic theory assumes this and that to reach its conclusions about whatever the subject at hand might be. Included in those assumptions are quite a few quirks about the market(s) that seem to defy reality. Those assumptions are that the markets are “efficient”, where the e-word does not seem to mean the same thing as in everyday life, and that there are no cheaters, which the Ponzis and Maddoffs of the world and the “Lie-bor” scandal have taught us, again, is not the case. Also, everybody is “rational” or at least “rational up to (fixed) boundaries” but, again, rational in economics does not mean the same thing as in everyday life. Isn’t that a problem on its own that one has to keep different definitions of words in mind depending on whether one is on the subject of economics or speaking to one’s spouse?

The truth is that mainstream economics, especially the higher degree of it, is as good as useless when it comes to the market place. I will soon finish my PhD degree in economics and some potential non-academic employers that I’ve met ask me immediately how much market experience I have. I’ve got some and it calms them down but I did not understand vividly until recently why they were so focused on asking me the market-experience question right after they heard that I was earning a PhD in economics.

The reason is that many PhD students in economics are doing the type of economics that could never be applied to the markets! The stuff they are doing is mathematically proving the existence (not the size!) of some obscure factor in an even obscurer model of an economy that has not, does not and will not ever exist. Some employers have told me that they have had to “de-educate” newly graduated PhD students in economics for them to be valuable employees. Their mind had simply been trained in thinking about economics of a non-existent economy and not the one they were living in. Is it any wonder that most PhD students in economics are not immediately grabbed by the financial market – unless they know how to program in Matlab, R, C++ and SQL – and instead linger on in academia, sometimes just to find a job that pays the bills?

Teaching economics: what is it good for?
Economics teaching has to change! Economics as it is taught today is not producing highly skilled labour that can be a valuable input in the manic-and-panic markets that exist in the real world but not in the textbooks. Keynes was in fact quite close to being absolutely right: “the master-economist must possess a rare combination of gifts… He must be mathematician, historian, statesman, philosopher…”

Today, the trained economist is mainly a mathematician but the other four traits are forgotten or secondary at best. Worse than that, the trained economists is not a mathematician in the mathematics of real-life markets, full of chaos, uncertainty and feedback loops, but of orderly markets and rational behaving firms and individuals that never cheat and are never subject to influencing each other.

The trained economist is therefore trained in the mathematics of something that does not exist. He holds none of the traits that Keynes thought were necessary for the master-economist. If this is not changed respect for economics and economists will continue to dwindle and the potentials for wide affluence that the not-yet-science could deliver will never be delivered.