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Economics is not physics

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From ‘India and the Global Financial Crisis What Have We Learnt?’, by Dr Duvvuri Subbarao, Governor, Reserve Bank of India, as the K R Narayanan Oration, at the South Asia Research Centre of the Australian National University, Canberra on June 23, 2011.

A few months into the crisis [the 2008-09 financial crisis], the Queen happened to be at the London School of Economics and asked a perfectly sensible question: ‘how come none of the economists saw the crisis coming’. The Queen’s question resonated with people around the world who felt that they had been let down by economics and economists. As economists saw their profession discredited and their reputations dented, the economic crisis soon turned into a crisis in economics.

What went wrong with economics? It now seems that by far the most egregious fault of economics, one that led it astray, has been to project it like an exact science. The charge is that economists suffered from ‘physics envy’ which led them to formulate elegant theories and models – using sophisticated mathematics with impressive quantitative finesse –  deluding themselves and the world at large that their models have more exactitude than they actually did.

Admittedly, in a limited sense there may be some parallels between economics and physics. But similarity in a few laws does not mean similarity in the basic nature of the academic discipline. The fundamental difference between physics and economics is that physics deals with the physical universe which is governed by immutable laws, beyond the pale of human behaviour. Economics, in contrast, is a social science whose laws are influenced by human behaviour. Simply put, I cannot change the mass of an electron no matter how I behave but I can change the price of a derivative by my behaviour.

The laws of physics are universal in space and time. The laws of economics are very much a function of the context. Going back to the earlier example, the mass of an electron does not change whether we are in the world of Newton or of Einstein. But in the world of economics, how firms, households and governments behave is altered by the reigning economic ideology of the time. To give another example, there is nothing absolute, for example, about savings being equal to investment or supply equalling demand as maintained by classical economics but there is something absolute about energy lost being equal to energy gained as enunciated by classical physics.

In natural sciences, progress is a two way street. It can run from empirical findings to theory or the other way round. The famous Michelson-Morley experiment that found that the velocity of light is constant led to the theory of relativity – an example of progression from practice to theory. In the reverse direction, the ferocious search now under way for the Higgs Boson – the God particle – which has been predicted by quantum theory is an example of traversing from theory to practice. In economics, on the other hand, where the human dimension is paramount, the progression has necessarily to be one way, from empirical finding to theory. There is a joke that if something works in practice, economists run to see if it works in theory. Actually, I don’t see the joke; that is indeed the way it should be.

Karl Popper, by far the most influential philosopher of science of the twentieth century, propounded that a good theory is one that gives rise to falsifiable hypotheses. By this measure, Einstein’s General Theory was a good theory as it led to the hypothesis about the curvature of space under the force of gravity which indeed was verified by scientists from observations made during a solar eclipse from the West African islands of Sao Tome and Principe. Economics on the other hand cannot stand the scrutiny of the falsifiable hypothesis test since empirical results in economics are a function of the context.

The short point is that economics cannot lay claim to the immutability, universality, precision and exactitude of physics. Take the recent financial crisis. It is not as if no one saw the pressures building up. There were a respectable number of economists who warned of the perilous consequences of the build-up of global imbalances, said that this was simply unsustainable and predicted a currency collapse. In the event, we did have the system imploding but not as a currency collapse but as a melt down of the financial system.

We will be better able to safeguard financial stability both at global and national levels if we remember that economics is a social science and real world outcomes are influenced at a fundamental level by human behaviour.

[The entire oration is here.]

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