ECONOMICS AND THE RETURN OF HISTORY?

In Friday's edition of NY Times, David Brooks wrote a very interesting column (link) discussing the state of economics. Although subtle and rigorous in its assertions I doubt that the field of economics needs a fundamental change in the philosophical origins of economic methodology. I agree with the author that economists often ignore the notion of moral philosophy and history in economic analysis but that doesn't mean that old textbooks on classical microeconomics need to be disposed. The author points out the role of economic forecasters who often appear on the TV, essentially trying to forecast economy's future path. Econometrics, which constitutes time-series forecasts on which most economic projections are based, is a real discipline to which numerous new scientific articles are devoted, published mostly in The Econometrics Journal and Econometrica. In his famous 1983 article (link) Let's take the con out of econometrics, Ed Leamer wrote how econometric modelling can be misused if a researchers ditch the true role and significance of assumptions. A prominent example is the study of death penalty on crime deterrence. As you can read in more detail in Leamer's article, one study found out that each capital punishment deters more than 9 murders while another one found out that each additional capital punishment causes more murders.

The contradicting evidence doesn't imply the falsification of the scientific method in economics. It merely reveals the hidden difference in how economists set assumptions regarding the behavior of individuals, firms and countries. David Brooks pointed out that economists failed to predict the recent financial crisis. However, many economists (myself included) pointed out the true dangers of an over-leveraged economy and monetary easing which led to subprime mortgage crisis and the consequential aftermath.

Many of us have had clear evidence, models and studies that showed how an over-leveraged financial sector can induce a significant economic downturn. However, many policymakers ignored the evidence of the behavior of the financial system which could be easily compared with chaos theory in mathematics. In my recent paper on Iceland's financial crisis I showed that the depository banks' overall leverage and indebtedness in the small country was growing exponentially, beyond the limit of capital adequacy.

As Paul Krugman recently noted, lessons from the Great Depression were not learned because people forgot it too quickly. Although mainstream economics, as every field within economic science, needs some major cures, I disagree with author's assertion that economics is not a real science but a moral philosophy. True, economics is not exact science because human behavior is not as experimental as particle analysis in physics but economics tries to resemble the scientific methodology through models, data, statistical inference and evidence. In fact, new interdisciplinary fields within economics are emerging such as behavioral economics, neuroeconomics and transport economics in which economic analysis is combined with other disciplines such as law, psychology, sociology and neuroscience.

The limits of mathematical recourse in economics were already discussed by economic thinkers such as John Maynard Keynes. And agreeably, mathematical reasoning is bounded by economic reasoning. However, from the real point of view, we need models to address human behavior mostly because, as F.A Hayek noted, it's too complex to capture its essence in a scientific entirety. If the neccesity of assumptions, models and evidence were not the case, hardly any lessons would be learned from the episodes of crises, booms, busts and periods of economic advancement in human history.

CONSUMPTION, WELFARE AND ECONOMIC PERFORMANCE

The OECD recently released a new international comparsion of GDP and consumption per capita (link).

GDP is the most frequently used measure of economic activity of the country. It is difficult to estimate income levels across countries. Using exchange rates is not always the best and most appropriate way to compare GDP per capita between two or more countries. For example, Denmark and the United States differ dramatically in this respect. Using exchange rates conversion of the GDP per capita, Denmark has a higher nominal GDP per capita than the United States. However, using purchasing power parity as a method of conversion, the real GDP per capita of the United States is higher than Denmark's GDP per capita. When currency conversion rates are taken into account, Denmark's GDP per capita turns out to be lower than that of the United States. That is because price level is higher in Denmark than in the U.S.

True, purchasing power parity provides a clearer picture of a relative economic performance of selected countries. To compare living standard, consumption per capita is equally important. Higher level of the GDP does not neccesarily mean higher level of household consumption because savings-to-GDP ratio is variable in a cross-country comparision. But the consumption can be misleading, depending on different distribution of government services in different countries. Thus, it is more appropriate to measure the relative household consumption levels and see what households consume actually. It should be noted that there is, however, no static relationship between household consumption and GDP per capita. A GDP of the particular country may be high above the average, while the actual household consumption may be just below or slightly above the average.

Nonetheless, GNI (gross national income) also takes into account international flows and transfer payments. In Switzerland's case, moving from GNI to GDP can respectively change the entire picture. According to OECD's figures, Swiss GNI per capita is 30 percent over the OECD average, which means that net transfer payment pour into Switzerland. The GDP per capita of Switzerland is, for instance, 122 percent of the OECD average. In case of Ireland, the GNI per capita is 146 percent of the OECD. In terms of GDP per capita, the ratio falls to 110 percent of the OECD average. The investigation of GDP and GNI in Luxembourg is similar. In GDP per capita terms, the GNi per capita falls from 246 to 200 percent of the OECD average. This shows the presence of significant net transfers out of the country.

Consumption and Real GDP per capita; An International Perspective