PhD Economists like to say Economics is closer to being a natural science then any of the other social sciences.  Frequently, they will take this one step further and say Economics is a science.

Really?  Are there any facts to support either statement?

Consider for a moment macro-economics.  Macro-economists are among the first to say they cannot run a controlled experiment to test their theories.  Instead, they say the best they can do is “natural” experiments.

Ok.  Before the Great Financial Crisis entered its 2008 acute phase, Japan had been responding to its own financial crisis for almost 2 decades.  Japan’s response was driven by the idea of saving the banks at all costs.  Japan’s unwillingness to write off the debt that could not be repaid literally created “zombie” debtors.  At the same time, it adopted fiscal stimulus, zero interest rate and quantitative easing policies.  The result of all these policies was economic malaise and no sign of a self-sustaining recovery in sight.

While Japan struggled for 2 decades, Sweden had and recovered from its own financial crisis.  Sweden’s response was driven by the idea of saving the real economy.  Sweden forced its banks to recognize and write-off the losses on the debt to borrowers that would never be repaid.  Subsequently, Sweden experienced a self-sustaining recovery.

So here were two “natural” experiments in how to respond to a financial crisis.  So which country’s policies did the macro-economics profession champion and see the EU, UK and US adopt when facing a financial crisis.

Japan.

Hmmmm….

So what gives rise to the claim Economics has any resemblance to a natural science?

The use of math.

Macro-economists are particularly proud of their mathematical ability and the complex models it allows them to produce.

In 2008, the Queen of England asked the macro-economists why they hadn’t seen the financial crisis coming.  For the next decade, macro-economists have argued this failure didn’t reflect a problem with their models.  These models aren’t good at forecasting major macro-economic events, but rather the models are good at showing what will happen if some economic policy is changed and all else is held constant.

Is there any reason to think this is true?

No!  The use of math is actually at the heart of why this isn’t true.  In order to solve the underlying math for their models, Economists need to make a significant number of assumptions.

There is no reason to think all of these assumptions are accurate.

Consider, the macro-economists’ models showed cutting interest rates to zero during the acute phase of the financial crisis would spur economic growth.  These models all over-estimated the speed and strength of the economic recovery.

Was there reason to think these models might be wrong?

Yes.  In the 1870s, Walter Bagehot championed the creation of a lender of last resort (think modern central bank) as a way to reduce the severity of a financial crisis.  At this time, he noted John Bull could stand many things, but he couldn’t stand 2%.  So there was reason to think perhaps 2% was as low as a central bank should set interest rates without creating economic headwinds that would delay a self-sustaining recovery.

In the 1930s, John Maynard Keynes voiced his support for Bagehot’s 2% minimum interest rate.

Was this 2% minimum included in the macro-economists’ models?  In the early 1980s when I worked on these models at the Fed, the answer was no.  Given both the adoption of ZIRP/QE and my conversations with macro-economists, there is no reason to think the 2% minimum was subsequently added.

All macro-economic models make an order of magnitude bigger untrue assumption.  They all assume perfect information.  Without this assumption, their models are not mathematically solvable nor do they make any sense.

What is surprising is how few macro-economists realize their models make this assumption.  I have had any number of them start explaining to me why this is not true only to discover as they are giving their explanation that it is true.

Hmmm…. let’s file Economics as a science under PhD Economist Derp.