A V Rajwade: The maths-economics duel

How relevant to the real world is economics dominated by mathematical formulae and abstract models?

Bertrand Russell, the great British philosopher/mathematician, believed that “music and mathematics are the two highest endeavours of human intellect”. As a lover of both, I totally agree. As a student of economics, however, I have wondered whether, over the last few decades, mathematics has been overused by economists; whether it creates an impression of certainty and inevitability where it does not exist; whether qualitative issues are not given much attention, indeed overlooked. Is it born out of “physics envy”, as some critics allege? It was Nobel Laureate Paul Samuelson and author of the standard textbook on the subject, who first explicitly argued that his work brings economics to the same category of precision and rigour as physical science.

Take the case of the recent award of the 2016 Nobel to two economists for their contributions to contract theory. From what I have read, the theory seems to be little more than common sense. While common sense is not very common among human beings, surely its utility does not need to be proved by “complex mathematical arguments”, as the two laureates have done, according to their two disciples in India? On the other hand, in the theory, I missed the discussion of the effects of difference in knowledge levels between the contracting parties about their rights and obligations embodied in the contract. One example: Having analysed hundreds of structured derivative contracts between banks and companies in India, I can testify from personal knowledge that, too often, banks have taken advantage of unsophisticated customers; the small print is rarely read, and even less understood. The old caution “caveat emptor” (buyer beware) remains valid, whatever the contract theory says.

But to come back to mathematics in economics, one problem with the use of deductive mathematical methods is that their outcome depends on the assumptions made at the start — and, therefore, the results need to be substantiated by empirical evidence. One example: One of the conclusions of Einstein’s General Theory of Relativity was that matter bends light. The empirical proof came more than a decade later through an expedition, especially launched to the Gulf of Guiana for the purpose, during a solar eclipse. His equivalence of mass and energy (E=mc2), perhaps the most famous equation in physics, was proved far more spectacularly (and destructively) by the atomic bomb (at least, in the popular mind). In contrast, all economic theories underlying market deregulation (efficient markets, banks’ ability to manage risks and measure credit quality through ever more complex models, etc) were disproved equally spectacularly in the 2008 crisis. One problem was the liberal award of AAA ratings to mortgage securities, by using complex mathematical models to quantify the credit risks. (In contrast, Standard & Poor’s recently gave India a BBB- sovereign rating. Obviously it considers us far less reliable and creditworthy than the CDOs and CDO2s). One assumption was that housing prices all over the US do not fall together. In other words, a diversified portfolio of mortgages is safe. The assumption turned out to be wrong. A “missing variable” in the analysis was that, since 2000, real US housing prices had doubled! The result was price collapse all over the US, a financial crisis, and the largest drop in global output since the 1930s Depression.

In macroeconomics, are the assumptions of rational expectations and diminishing utility really valid and are they equally applicable to the consumption and “asset” economies? One example: When prices of tomatoes go up, consumers buy less; when the price of a share goes up, the demand often increases. But the paradigm taught today is that of a “mechanical decision-maker seeking to optimise his utility within certain constraints… Mainstream economists have so misconstrued the nature of economics that nothing short of a revolution may salvage the practice of it”. (Yeomin Yoon, a US professor of finance and international business). But is this likely when “methodological dissent is routinely squashed as unscientific”, as argued by Mario J Rizzo (both quotes from recent letters to the Financial Times)? No wonder many students of the subject are asking “whether the economics they were learning, dominated by mathematical formula and abstract models, was relevant to the real world”. (David Pilling, “Crash and learn”, Financial Times, October 1). In the same article, Andrew Haldane, chief economist of the Bank of England, has been quoted as saying that “we all became overly enamoured of … a particular approach… a methodological monoculture”. Are students more “correct” than too many of their professors?
 

The author is chairman, A V Rajwade & Co Pvt Ltd; avrajwade@gmail.com