A remarkable characteristic of economics is the sheer staying power of theories, even with a lack of empirical evidence to corroborate the propositions of these theories. In my experience, it is not uncommon for lecturers to remark that the lack of evidence for a theory has been a ‘problem’ for economists (though apparently not enough of a problem for them to throw out said theory). Often textbooks, lectures and discussions of theory make no reference to evidence whatsoever, and where they do it is trivial (for example, representative agent intertemporal macroeconomic theory predicts that governments will run periods of deficits followed by periods of surplus).
In the paragraphs that follow, I’ll examine a few cases of where I believe economics has gone off the mark in this respect. Specifically, I evaluate Marginal Productivity Theory, Walrasian Equilibrium, and The Solow Growth Model. I avoid theories such Real Business Cycle models and the Efficient Markets Hypothesis, partly because they have been done to death, but more importantly to demonstrate that the bad theories in economics are not merely the result of a few ‘wild cards’ at Chicago. On the contrary, I believe an anti-empirical approach is institutionalised within mainstream economics and that economics must undergo a paradigmatic shift to move away from these theories.
Marginal Productivity Theory (MPT)The common interpretation of MPT is that it predicts workers will be paid ‘what they’re worth.’ In fact, this is not correct; the theory predicts that average productivity of workers will be positively related to wages, rather than each worker getting precisely their ‘just desserts.’ In any case, the result is that MPT predicts that compensation will increase as productivity increases. Hence, graphs such as this one – which you have likely seen before – pose a problem for MPT:
(Clicky for piccy!)I have seen several responses to the problems presented by graphs like this. The first is that non-wage benefits have risen, which isn’t shown in this data. The second is that the adjustments for relative prices have been incorrectly applied, and consumers have more purchasing power than it first seems. However, estimates exist which take all of these things into account, and they still come to the same conclusions: most people’s overall real compensation is not increasing, even though their productivity is.
Another response would be that marginal productivity did well until the 70s, so maybe it remains useful. This is special pleading. A theory must be equipped to explain all phenomenon within its domain (in this case the labour market), rather than selectively applied where it suits the economist. If the laws of physics suddenly stopped working, can you imagine physicists making this defence? Saying ‘MPT will work except when it doesn’t and if it doesn’t we will throw our hands up in the air and carry on’ is not science. The fact is that such a sudden and clear decoupling of wages and productivity poses a clear problem for advocates of MPT, one which requires either a thorough explanation or discarding the theory altogether.
Walrasian EquilibriumWalrasian equilibrium is one of the more absurd pieces of theory in economics (which is saying something). There are two (rational) agents with endowments of two factors of production, which they hire out to two profit-maximising producers. The producers use these factors of production to create two consumer goods, then the consumers purchase them. Everyone behaves as if they are perfectly competitive (they can’t influence prices) and everything happens simultaneously. There is no direct trade; instead individuals trade through the market (which comes from god outside the model).
The behaviour of consumers in this model is tautological. They consume based on a predetermined utility function that cannot be observed. Hence, they consume what they were always going to consume based on the chosen, non-empirical parameters of the model. This doesn’t tell us anything.
The behaviour of producers in this model is observable in the real world and hence not tautological. It is also not what happens in the real world. Some firms maximise profits, but most don’t; those firms that do maximise profits equate MC and MR is clearly false.
The only prediction this model as a whole makes is that the initial distribution of endowments will affect what is produced, how it is distributed, how much is produced and the price of what is produced. In other words: the initial resource distribution of a market economy affects its subsequent workings. This is trivial, and easily shown by theories that are based on more realistic assumptions (such as Sraffa).
The Solow Growth ModelThe Solow model, to me, seems to be a textbook case of ‘bad science.’ This is clear from the story of its development (a story anyone who has taken development or macroeconomics will know).*
The Solow model predicts that, due to diminishing returns to capital, developing countries will catch up with developed countries in terms of GDP. At a low level of capital stock, the potential returns to investment are high (e.g. irrigating/ploughing a previously unkempt field). As the stock of capital increases, the returns to investment decrease and the growth rate of a country balances out. Hence, all countries will converge to a similar long term growth rate.
That this prediction is false is no longer debated. In the 1980s, William Baumol provided evidence that seemed to support the hypothesis. This was quickly disputed by Brad Delong, who noted that Baumol had used a sampling bias – he only included countries which were developed, effectively assuming his conclusion. Delong included more countries and found no evidence of convergence.
However, economists weren’t ready to give up. The prediction of the Solow model was reframed as conditional convergence: that is, provided countries have the right institutions, social cohesion, etc. they will converge in terms of growth. This, to me, seems trivial. The entire point of development economics is that the conditions in poor countries are not conducive for them to develop and so catch up with the developed countries. The Solow model doesn’t ask how a country might achieve this, but only says that it is a necessary condition for development, something development economists have always known. Hence, the Solow model is irrelevant for the immediate problem of development economics, which is how exactly we can help poverty-stricken countries get off the ground.
Is Economics That Bad?In the interests of balance, it is worth noting some predictions made in economics that have been either empirically verified or dropped subsequent to falsification. Quantity of money targeting was tried, and failed, in a few countries, which led to Milton Friedman himself repudiating it (though economists still erroneously use the same framework which led to it). The lifetime consumption hypothesis (and non-utility based consumer theory in general) display good empirical corroboration and have all the hallmarks of a ‘good‘ scientific approach. The Phillips Curve as used by economists was modified in light of evidence in the 1970s. Both the multiplier and the Giffen Good are good examples of non-trivial, clear, falsifiable predictions, though I will not comment on evidence for them because that would take a post for each one.
Nevertheless, the record as a whole is not good. Theories from over a century ago look, and are taught, the same way as they were when they were initially adopted. New ideas that are not even disputed by economists, such as behavioural economics, are slow to be adopted, and when they are adopted are presented as a ‘special case’ and in a way amenable to the core framework, which is, of course, still taught alongside them. As far as I’m aware, there is no clear cut case of a neoclassical theory being completely thrown out and never mentioned again. This alone should be an indicator that the scientific method is not at work in economics.
Topic: Falsification in Economics