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Taking Stock

Economists and their fairy tale world of prognostication Add to ...

Former Federal Reserve chief Alan Greenspan opined the other day that higher stock prices would do a heck of a lot more for the U.S. economic recovery than further government stimulus.

It's hard to argue with that. Healthier equity markets would undoubtedly boost confidence, which often translates into higher consumer demand. That's something no amount of government meddling is going to accomplish, short of repealing the income tax laws.

And on that front, Mr. Greenspan is advocating higher taxes, even in a feeble economy. "There are risks, but our choice is not between good and bad, it's between terrible and worse." And this from the central banker who played no small part in making things terrible in the first place and who publicly supported the Bush tax cuts he now says are unsustainable.

During his long tenure at the Fed's helm, Mr. Greenspan was lavishly praised for his role in fostering the booms of the 1990s and early 2000s and then vilified when the whole house of credit cards collapsed in 2007. Yet through it all, an increasingly perplexed Mr. Greenspan remained what he had always been: a traditional economist with an ardent belief that markets would always remain stable, behave rationally and operate efficiently if left to their own devices.

"It's not easy to give up (such a cherished theory) without changing your entire world view," says David Orrell, a Canadian mathematician who has delved deeply into the world of economics and found more holes in it than in your average slice of Swiss cheese. Even its most revered rules, like the law of supply and demand, don't hold up to scientific scrutiny, he says. "Like unicorns, the plot of supply and demand is a mythological beast that is often drawn, but never actually seen," he argues in his latest book, Economyths.

As behavioural economists have long insisted, markets are not inherently stable, rational or particularly efficient. "If you were going to say markets are not efficient, you would have to say markets are [also]not rational and they're not at equilibrium. So you can't really relax one of them without getting yourself into trouble, if you're a mainstream thinker."

So it was no surprise when Mr. Greenspan told a Manhattan business audience: "We would be far better off to allow the normal market forces to operate." The old invisible hand may be shaking with palsy, but apparently it still works for the ancient economist.

"It seems to me the economy is very similar to a biological system. It has a lot of the same properties. It's complex, it's non-linear and it's full of complicated networks," says Mr. Orrell, an Edmonton native who toils for a small consulting firm in Oxford, England, designing mathematical models of cancer tumours. To get these right, he employs such powerful new tools as network and complexity theory. He sees economics heading down the same road, and sooner than many tradition-bound economists realize.

"Current economic theory is less a science than an ideology peculiar to a certain period of history, which may well be nearing an end," he concludes in his book.

Many of the discredited economic ideas we know today largely date from the 19th century, when they were constructed on top of what was considered a solid structure, with strong supporting columns. "They're all starting to crumble now. When they break, the whole thing is going to come down and you're going to see a different approach coming through."

He describes economists as "the jilted lovers of the science world - the more rigidly they approach their subject, the more it mocks them with spurious and headstrong behaviour."

He compares the market crashes to large earthquakes, because they follow a similar pattern. Most earthquakes are tiny, but a small number are huge. So the probability of having one of extremely high magnitude is more than zero. "Financial crashes exhibit exactly the same kind of power-law behaviour. It's very different from a normal distribution. If a normal distribution were true, you would never really have a [market]crash. You would just have continuous random fluctuations."

If economists brought their current tool kit to geophysics, they would have to conclude that earthquakes don't exist. And that shaking would be interpreted as nothing more than a low-level hum that could be safely ignored.

His main criticism is not that economists can't predict the future, because no one can. "The problem is that they pretended to be able to measure risk." As a result, they underestimated it. And that in turn made the system riskier. "So the issue is not that they didn't see the crisis coming, but that they helped make it happen."

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