"Economics is harder than physics." That’s Justin Fox commenting on this year’s “Economic Sciences” Nobels. Two of the winners, Fama and Shiller, have seemingly opposing views on markets, and coverage of that issue can clarify what economics does. We aren’t as well behaved as atoms. And markets aren’t like gravity.
Fama is famous for “The Efficient Markets Hypothesis,” which “is misnamed” says Noah Smith. “It's not really a hypothesis, it's not about ‘efficiency’ in the economic sense...and it's not unique...Some of this miswording was...semantic clumsiness…Some was sloppy science.” Fama’s “efficient” is neither “econo-efficient” nor the ordinary meaning. Internal economist jargon is their business. But what is preached to the masses about markets is ours.
“Markets,” the only word in Fama’s phrase Smith doesn’t decry, is also sloppy. Fama meant specifically financial markets. His lax language worsens the ambient error that a general efficiency creating “market mechanism” exists. Economists once treated markets less homogeneously (markets in land, labor and capital had different economic and ethical effects). Then the “marginal revolution” physicsified economics. As Debra Satz notes "Guns, butter, human organs… sex” all looked “the same in the economist's equations." Key distinctions got lost in the algebra. Equations and models crystallized a single structure through which to see the world. But models should supplement not supplant thinking. Alan Greenspan testified a “flaw in [the prevailing financial-market] model” contributed to the last financial crisis. And Shiller asked economists to "make this reality a better part of their models."
Why is marketism—the faith that markets are “efficient”—such a popular belief? We didn’t evolve with markets, so market-style thinking isn’t innate, in fact as Steven Pinker says it’s “cognitively unnatural." Its version of “rational” must be learned. Markets are amazing. They miraculously coordinate multitudes to get you your coffee. But some market outcomes aren’t in any ordinary sense efficient (40% of food produced in US is wasted). And despite marketism’s preaching, markets vary. Some create pressures encouraging waste (see “Darwin’s Wedge”, “Dumb as Trees”).
Many prefer the distributed decisions of markets. But as Justin Wolfers says Fama and Shiller show that markets can have the wisdom of crowds—or their madness. Crowds can be wise if people make decisions independently. But they frequently don't. It’s time we got less aspirational and more empirical about market behaviors. Faith in Marketism doesn’t prevent herd decisions from crashing markets. And many markets work much less well than financial markets.
I’m a market realist. They’re essential and amazingly powerful. Markets can move mountains. But we must guide their power, using empirical behaviors. They should serve us, not we them.
Many envy the precision of physics. But physics has it easy. Nothing in physics chooses. Or changes its reactions. Physics needs no police or judges. Nothing breaks its laws. But economics is different, it must deal with precisely such choosing and changing. And with law-making, not only law-discovering.
Pop-physics doesn’t change how nature works. But pop-economics shapes our democracy. And influences the laws within which we allow “market forces” to operate. False beliefs—that can be shown empirically to be errors—shouldn’t be lent the shield of science. Markets are like fire. If we don’t control them they will consume everything in their paths. As they did America’s once vast forests and herds.
Illustration by Julia Suits, The New Yorker Cartoonist & author of The Extraordinary Catalog of Peculiar Inventions.