Number Crunchers

By John T. Harding


It's time to bring economics back to the real world.

Econometricians got lost in their maze of numbers, fixated on "proving" through mathematical models their assumptions about how the world works.

Numbers are useful and valuable, if they are based on real-world observations, and econometrics has a place in formulating theories and dealing with real-world problems. But to a large extent, the number crunchers hijacked the field of economics a long time ago, and got so involved in dealing with the abstract that they lost touch with the real world.

Similar mistakes are made in other fields, and the history of such practices goes back to the Euclidean Age. Deductive logic sets up a premise -- often arbitrary -- which is assumed to be true. Then the practitioner develops further statements derived from that first premise, building a system that, assuming the opening premise is true, will also be shown to be true for the real world. The practitioner then looks to the real world to gather examples that match the theoretically proven model.

The problem, however, is that while the model -- called a syllogism -- may follow all the rules of deductive logic, if the beginning premise is faulty, then the entire system is flawed. Computer programmers call it the GIGO syndrome: garbage in, garbage out.

In economics, it's better to look at the real world first, gather data and examples, look for patterns, and then set up a model using these pattern examples. This is empirical, inductive logic. In practice, if the model is correct, additional real world examples will fit the pattern, providing additional proof for the model. If the additional examples do not fit, then it's time to modify the pattern. Or, as Abraham Lincoln is reputed to have said, "When the facts change, so do my opinions. It shows I have learned something."

Much of economic theory is based on the ceteris paribus assumption: "Other things equal." That is, take a set of circumstances, change one, and see what happens. This also assumes that that one item, and only that one item, changes. All other items in the set do not change. The problem is that in the real world, this never happens: You can't step into the same river twice.

Another problem is in the Law of Supply and Demand, when theoreticians say that when the Supply curve and the Demand curve intersect, "the market clears," which is to say that at that point, there are no unsold goods and no unemployment. Again, in the real world, this never happens.

Both assumptions are valid when used in developing an abstract economic theory. Some of that validity -- but not all -- is lost when the theory is applied to reality.

Economists lose touch with reality when they rely too heavily on abstract theory. So also with financial economics. The wizards of Wall Street built elegant mathematical models based on assumptions that things would not change, or if they did, it would not matter. But things do change, and changes do matter.