Photo: Mint
Photo: Mint

Opinion | The disconnect between economists and the markets

If economists had some secret for making money, for example, in the stock market, they would likely be using those secrets to their own financial advantage

Economics is at least partly about understanding the present and forecasting the future. Or, at least, it’s supposed to be. The economics fraternity’s failure to predict the 2008 crisis has cast doubt on the notion. It shouldn’t be surprising, then, that this failure to read the market extends to economists’ own fortunes.

Economics deals with the detailed analysis of how individuals and business firms maximize their utility or wealth. It concerns itself with an array of areas, from refined decision-making to complex optimization. It isn’t unusual for economists to be polymaths, mainly because of the applicability of the subject to various fields—from environmental economics and financial economics to quantitative economics, behavioural economics and institutional economics.

Despite the versatility and normatively powerful prescriptions of the field, we rarely see economists among the truly wealthy—though the rich themselves might have internalized an economist’s skills over the course of their careers. Elon Musk, Bill Gates, the Ambanis and their ilk might have intuitively used those skills in building their fortunes—but it doesn’t quite work that way when it comes to economists themselves. The 9 million Swedish krona prize money for the economics Nobel might be a tidy sum, but that doesn’t propel even Nobel laureate economists into the ranks of their corporate and industrial counterparts. Even in the investment field, an economics major might provide a basic insight into the technical side of investing but the real picture, when it comes to Wall Street, is full of uncertainties.

There are four main reasons why the theoretical skills of an economist are not converted to market success. First, of course, it’s a matter of inclination. Economists are primarily engaged in expanding the discipline through model building and testing hypotheses in the marketplace, not capitalizing on it to make money. That has been the case with most of the pioneers in the field as well.

Second, too many assumptions in model building deprive many economic theories of practical relevance. Little wonder that economists often fail when they rely on these theories and models to predict economic outcomes.

For instance, one basic assumption that often fails the real world test is the rationality assumption. Classical economists built the entire edifice of their theories on this assumption. But it is being questioned extensively by modern behavioural economists. They have pointed out the weak foundations of this structure by empirically demonstrating that the assumption does not hold true in all situations.

In the late 1940s, economics started getting highly mathematical, thanks to Paul Samuelson, who would go on to win the Nobel Prize in economics in 1970. To maintain the tractability of these mathematical models of economic behaviour, the economic man has been assumed to be strictly rational. As Richard Thaler said: “It was basically because economists weren’t smart enough to write down models of real behaviour that they started writing down models of highly rational behaviour—and they kind of forgot about humans."

In the process of making the models more sophisticated and acceptable to their peers, economists ignored the complexity of human behaviour governed by multiple rationality. Economists as individuals are no exceptions, of course—which goes some way towards explaining their adherence to models that don’t work all that well and their failures to exploit economic opportunities effectively.

Third, economists are perhaps more concerned with intellectual battles among themselves than with providing realistic prescriptions. For instance, when it comes to oligopolies, Antoine Augustin Cournot, Joseph Bertrand and Paul Sweezy were all involved in intellectual battles in their time but failed to provide strategies for firms which could be used in a real world situation for maximizing profits.

This disconnect from reality is not rare. Economists are also faced with a contrast between their theories and the markets. The portfolio theory proposed by Harry Markowitz stands as the best illustration. He won the Nobel Prize in economics in 1990 for his sophisticated formula for portfolio management, but in real life he invested his money by using the weighted asset allocation method i.e., equally spreading the budget on all assets (1/n).

Fourth, multiple rationality comes into play here too. Perhaps some economists who are indeed more focused on real world problems than theoretical constructs are simply less interested in maximizing their individual benefits than in contributing to aggregate social benefit by way of finding solutions to problems such as poverty and inequality. Though economists are not, by and large, among the truly wealthy, they have the capability to prevent others from becoming poor. For instance, a timely and appropriate policy nudge by someone like India’s former chief economic adviser Arvind Subramanian might save millions from poverty.

Perhaps Robert Sexton had it right. In his book Exploring Economics, he wrote: “If becoming wealthy is your goal in studying economics, you may be disappointed. Although most economists make a good living, few have become rich from their knowledge of economics. In fact, if economists had some secret for making money, for example, in the stock market, they would likely be using those secrets to their own financial advantage. . . In short, economics won’t necessarily make you richer, but it may keep you from making some decisions that would make you poorer."

V. Praveen is studying economics at Madras Christian College, Chennai.

Comments are welcome at views@livemint.com

Close