Or ‘Why we can’t blame Galileo for the latest financial crisis!’ 🙂
Modern science can be roughly said to begin with Galileo Galilei. One of the commonly used methods in science is sometimes referred to as the Galilean Style. This style refers to, among other things, the idealizations and abstractions that scientists use in modeling the world out there. Scientific models do not aim to accurately describe the world. Rather, the idea is (Galileo’s idea) to try and abstract away ‘superfluous’ aspects, and also to use idealizations where possible. As an example of an idealization, consider the fact that Newton in his law of gravitation supposed that the entire mass of the object is concentrated on its center. Similarly, Galileo used ‘frictionless’ planes for performing thought experiments, etc.
But what does all this have to do with Economics? There are many concepts and theories used by mainstream economists that have been influenced directly by the Galilean style. Consider the rational actor model. Under this model, the actor (economic agent, person, entity) has perfect information about all angles of the market and is perfectly self-interested and always makes the optimal economic decisions. Obviously, this is a gross idealization. Firstly, we can’t have perfect information about the market. There are way too many details and way too many factors. Secondly, people do not have the computational ability to optimize. In all probability, in the words of Herbert Simon, they follow simple, common sense adaptive rules in reaching economic decisions.
A related assumption is of ‘rational expectations’ according to which economic actors have perfect foresight about the future state of the economy. And finally, based on the above is the infamous ‘efficient market hypothesis’: markets know best; they allocate resources in the best way, etc.
All these concepts and models are totally unrealistic. But it could be claimed (often is) that most sane economists already know that*. But then why, people might ask, would they persist in using such unrealistic models?
Well, because this is what Galileo has taught us! This is the scientific way of doing things; this is the Galilean style remember**? Frictionless planes, ideal gases…rational actors, efficient markets! What’s the problem?
If things could be left at that, then no fault could be found with our economist brothers. But unfortunately for them, their models do not work for practical purposes. If despite all the idealizations and abstractions, the models managed to work for the real world, I am sure no one would have a problem. But the system does not work. So here we may ask, what is it that Galileo got right but our economist friends didn’t?
The short answer is that the Galilean style is not a magic wand. If it is pursued sensibly, it abstracts the crucial operating features. If it is not pursued sensibly, it abstracts features that have little relation to reality.
Frictionless planes made sense because Galileo wanted to discover the effects of gravity without the confounding effects of the force of friction. Rational models do not make sense because there is NO benefit of understanding actions of agents (people) with perfect information because people simply do not have perfect information and are not super-computational beings who can optimize for all situations. Therefore, the actions undertaken by the economists’ rational, omniscient beings, would be wildly different from the actions taken by ordinary, limited human beings. Similarly it makes no conceptual sense for the rational expectations assumption that calls for perfect foresight of the future: ordinary mortals can barely predict what will happen during the next few minutes, (even if they are given perfect information). And lastly, there is no empirical support for the “efficient market” hypothesis.
Imagine a world (not our world obviously) in which friction was directly linked to gravity. If in such a world, Galileo was obstinate enough to stick to his frictionless planes, despite all evidence to the contrary, despite no empirical support, then Galileo too would have suffered the same fate as our present day economists: Boom, bust, CRASH!
What economists end up doing is studying highly abstract systems that have got nothing to do with the real world. So while they follow the Galilean style, they do so insensibly and the results are out there for all to see!
(Endnote: The above naturally does not apply to all of economics but rather to the dominant, widely used, rational models)
*Apparently, only the sane ones. Some end up believing their own voodoo.
**Of course, the harsher judgment would be that what economists do has got nothing to do with Galileo but is rather a very virulent form of ideological fanaticism!