Monday, October 18, 2010

The Nobel Prize and Economic Policy

The Nobel Prize and Economic Policy
United Daily News editorial (Taipei, Taiwan, ROC)
A Translation
October 18, 2010

The winners of the Nobel Prize in Economics have been announced. The 1.5 million USD prize will be divided equally among three candidates: Peter Diamond. Dale Mortensen, and Christopher Pissarides. But the prize money is a minor matter. The reputations of these Nobel laureates will be enhanced dramatically. That is a far greater reward. The Swedish Central Bank established the Noble Prize in Economics in 1968. Since then, controversy has raged over whether the awards criteria and even the science of economics are objective.

One best-selling author became famous when he warned of the financial tsunami in advance. The day before the award was announced, he filed a claim against the Swedish Central Bank. Nobel Prizes were awarded to scholars who invented a portfolio risk model. Their portfolio risk model received the blessing of the Nobel Prize Committee, and encouraged bankers to take their theory seriously. The result was a serious blow to the global economy. Investors suffered heavy losses, and taxpayers were compelled to bail investors out with their hard-earned money.

Worse still, after this prize-winning portfolio risk model failed, more heavyweight Nobel Laureates in Economics warned that the world would be plunged into a terrifying Great Depression. Their columns led to the collapse of public confidence in the world's governments, and the paralysis of the global economy. They worsened the financial tsunami by pouring gasoline on the fire.

Two years have passed since the 2008 financial tsunami. The economies of the United States, Europe, Japan and other countries have yet to fully recover. Constant fear of a second recession remains. Are economists attempting to stem the tide, or make larger waves? Actually, they are doing both. Another accomplice looks on, far from the crime scene. The Great Depression led to the development of Keynesian theory in the 70s. Keynesianism has been repudiated by three decades of experience. But when the global economy became paralyzed, governments the world over rallied behind the US and collectively adopted Keynesian deficit spending policies. They did everything possible to borrow, spend, and build. Mainland China was the most extravagant. In a single breath, it invested four trillion RMB in new highway construction, high-speed railway construction, and housing construction. The result was no improvement to the economies of many countries. Meanwhile, because the proportion of government debt was too high, they turned to tax increases and budget cuts, in accordance with Keynesian policies of austerity. Such on again, off again policies, operating in fits and starts, battered their economies. Government debt was so heavy, their political stability was at risk.

Not only that, economic experts painted such a terrifying picture of the financial tsunami, Keynesian deficit spending policies were taken to an extreme. Monetarists -- long time rivals of the Keynsians -- offered their own policies. They lowered interest rates to zero or historic lows. They resorted to loose money policies to save the market. This policy was tantamount to printing paper money, and pumped unlimited quanties of paper money into the market place. Industries supposedly helped by real investments remained in the doldrums. Instead, hot money scattered, creating trouble everywhere. Financial bubbles burst in every country.

These mutally contradictory policies were ineffective, even counterproductive. The Nobel Prize in Economics has been awarded for 32 years. The United States has a virtual monopoly on them. These leading economists have touted, advocated, and promoted failed policies. This proves one thing: The science of economics remains frozen at a primitive stage of development. Theories abound, but none of them has stood the test of reality. Contrast this with the Nobel Prize in Physics or Chemistry, first awarded in 1901. There is no comparision.

The biggest difficulty with economics, is that it studies the behavior of mortal human beings. To compare them to atoms, molecules, gravity, and other non-human entities, is to artificially impose a mechanistic model from physics, in order to give the study of economics a "scientific" veneer. In reality, doing so turns one's back on the unique nature of human behavior. Ironically, doing so moves economics further and further away from genuine science. Therefore the more economics resorts to models, abstractions, and quantification, the less its conclusions conform to reality, and the less useful they are to us in the real world.

The three new laureates' greatest contribution is their realization that the market does not conform to the world of economic theory. In the world of economic theory, information is complete and readily available to both buyers and sellers. In the world of economic theory, unemployment and lack of work never coexist. Diamond's 's search markets theory first discovered that consumers and job seekers must bear expensive search costs, before they can obtain satisfactory results. If we were to ask the man in the street, he would give us the same answer. Is it really necessary to construct an elaborate mathematical model?

The world will arrive at its own evaluation of economic theories, based on how well they fare during financial crises. Nobel laureates' halos may be tarnished, but this should not be considered a bad thing, After all, when 10 different economists offer 11 different opinions, it is dangerous to put too much stock in any one of them.











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