On Saturday, within the context of discussing who the Fed’s next Chair might be, The New York Times asked What Is Economics Good For? Interestingly, if unsurprisingly, the Times asserted that “the task of the Fed’s next leader will be more a matter of craft and wisdom than of science.” That’s largely because of a less than stellar track record on the part of economists (and by extension, investment managers): “The trouble with economics is that it lacks the most important of science’s characteristics — a record of improvement in predictive range and accuracy.” As I have noted before, economists have exhibited an “all-too-frequent willingness to elevate a favored ideology ahead of the actual facts.” Indeed, for many economists it seems a point of pride. That they simultaneously tend toward an unwarranted triumphalism too (macroeconomics “has succeeded: Its central problem of depression prevention has been solved”) is both tragedy and delightful irony rolled into one astonishing package.
Per Rama Cont, whose background is in physics, a “hard” science: “When I first became interested in economics, I was surprised by the deductive, rather than inductive, approach of many economists.” In science, practitioners are supposed to observe empirical data and then build a hypothesis to explain their observations. However, “many economic studies typically start with a theory and eventually attempt to fit the data to their model.”
Many (including analysts as disparate as Cullen Roche and Ben Schreckinger) go so far as to equate economics with religion. Cullen, like Cont, would (wisely) have us start with stylized facts – as broadly understood and accepted – and work our models and theories from there. That’s how science is supposed to work. But for economists, it’s often a process honored only in the breach.
In its broadest context, science is a careful, systematic and logical search for knowledge, obtained by examination of the best available evidence and always subject to correction and improvement upon the discovery of better or additional evidence. That is the essence of the scientific method, which is the process by which we, collectively and over time, endeavor to construct an accurate (that is, reliable, consistent and non-arbitrary) representation of the world. Otherwise (per James Randi), we’re doing magic, and magic doesn’t work. Even so, most of us, most of the time, beset as we are with cognitive and behavioral biases, prefer magic and even pretend that the magic works.
Aristotle, brilliant and important as he was, posited, for example, that heavy objects fall faster than lighter objects and that males and females have different numbers of teeth, based upon some careful – though flawed – reasoning. But he never bothered to check. Checking and then re-checking your ideas or work offers evidence that may tend to confirm or disprove them. By collecting “a long-term data set,” per field biologist George Schaller, “you find out what actually happens.” Testing can also be reproduced by any skeptic, which means that you needn’t simply trust the proponent of any idea. You don’t need to take anyone’s word for things — you can check it out for yourself.
Recent examples of people refusing to check out what is readily demonstrated include global climate change denial (largely denialists on the right) and anti-vaccination or anti-GMO hysteria (largely conspiracy theorists on the left). Economists are hardly alone.
To a layperson, a scientific theory is often deemed to be mere speculation. But to scientists, a theory is an explanation for something that’s backed by very good evidence and which can be used to make a variety of accurate predictions. Examples include the theory of gravity. But “proof positive” isn’t part of the scientific lexicon. Science advances via inductive falsification, which allows for only tentative conclusions, no matter how well grounded they are.
Deductive reasoning is demonstrably complete. The premises of an argument constructed according to the rules of logic always imply the argument’s conclusion. Not so for induction. There is no comprehensive theory of sound induction, no set of agreed upon rules that license good or sound inductive inference, nor is there a serious prospect of such a theory.
But the tentative nature of the scientific enterprise in no way compromises its power. The advances of science are of a truly mind-boggling scope and influence. The scientific method is the most powerful knowledge tool the world has known. It is how we can find out how the world works.
Even so, the scientific progress of the social sciences (such as economics) has not kept up with what has been accomplished in the hard sciences (like physics). In the social sciences, pretty much everything is up for grabs. The complexity is extreme. Confirmation bias abounds. Ideology is rampant. The difficulty is so acute that some wonder if any sort of foundation is discoverable.
Economics remains lost in an imaginary and mythical world where people are rational and the markets are efficient. That’s their story and they’re sticking to it with religious conviction if not fervor. The investment world isn’t a lot better, even though it is supposed to be “marked to market” every single day. As William James famously noted, many people think they are thinking when they are merely rearranging their prejudices. That so many people will be forced to pay for that ideological failure — when market fragility inevitably rears its ugly again — is unfortunate in the extreme. If only they were more like Joe Friday — starting with just the facts and building from there. Doing so might provide us a more scientific economics and better investing too. Is it too much to ask to focus simply on what works?
Edited to add: I should have remembered and noted this typically excellent article by Barry Ritholtz, which seems to be an inspiration for the NYT piece. I should also have noted the fine book by Robert Hagstrom, Investing: The Last Liberal Art.