Economists aren’t particularly renowned for our sense of humour. In fact, it has been said (cruelly) that economics was invented to make accountants look interesting and for astrologists to look accurate.

However, the recent economic uncertainty in Australia, and the unfolding implications of the Global Financial Crisis (GFC), means that an old joke I was told at university seems more relevant than ever. It goes something like this:

Economist 1: What do you think have been the economic consequences of the French Revolution?

Economist 2: I think it’s too early to tell.

This joke neatly encapsulates a great dilemma in economics. How can we possibly understand all of the complex social, financial, cultural, political, personal, historical, legal and other relationships which are continuously interacting in everyday life and which determine actual real-world economic outcomes?

Furthermore, how can we then predict these real-world relationships into the future when we don’t even fully understand how they work now?

This dilemma was faced by a well-respected economist with a major Australian financial institution at the end of 2007, who confidently predicted that in 2008 “Global growth will slow but should avoid a hard landing”. In a well researched and presented article, the author laid out a perfectly reasonable argument in support of this claim, and forecast that the ASX 200 index would be around 7300 points in December 2008 — it actually ended the year at 3720 points. As of December 2007, however, this was a relatively mainstream and uncontroversial view.

With the benefit of incredibly complex statistical and econometric software, and utilising the brightest minds in world economics, to my knowledge not one single major bank, global financial institution (e.g. World Bank, IMF) or government agency foresaw the GFC. Yet it is now obvious the GFC is one of the defining events of our lifetime.

The GFC, which started in mid-2008, was simply not considered as a factor in the analysis of these institutions. At least until after it actually occurred. This apparent lack of foresight highlights the distinction between economics as an abstract analytical tool, and economics as the study of real-world set of outcomes.

Ultimately, for all their apparent complexity, the world’s most powerful economic models had no concept of the very human emotions of fear and mistrust. Yet it is these emotions that were the catalyst for the shift in market sentiment we saw in late 2008, and which exposed the unsustainable nature of the worldwide credit boom.

The only specific prior warnings I remember in the lead-up to the GFC were from a small sample of economic practitioners, mainly academics, and a selection of (very brave) financial commentators — including in Crikey. These people looked at the available evidence and just knew that the massive growth in global debt was unsustainable. They didn’t need a complex model to tell them that.

In the end, economics is always about the real-world. It is as much about the mindset of Auntie Mavis (as she decides whether to buy her meat from the supermarket or from the slightly more expensive butcher next door), as it is about the Wall Street analyst (forecasting 10-year US Treasury bond yields). This is because ultimately, in some infinitesimally minor way, in our globalised world, each factor will have an influence on the other.

Furthermore, if you consider the meat purchasing mindsets of a few million Auntie Mavises across the world, you have a powerful economic force that, at the very least, influences the employment status and income of thousands of butchers and their suppliers.

The reality is that economics does not know the answer to everything.

Economics is too often considered in an abstract context where mathematical equations rather than real-world relationships are the determining factor. Mathematics and economic modeling are an important part of economist’s tool kit, but at the end of the day, it is the real world that matters.

Peter Fray

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Peter Fray
Editor-in-chief of Crikey

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