What do we mean by “economics”?

Paul Krugman is one of my favourite economists. In 1996, he gave a talk entitled “What economists can learn from evolutionary theorists”. During the talk, he gave his own definition of economics. He also talked about how economists could learn from evolutionary theory, using an example about the behaviour of frogs. Here are the relevant extracts.

Paul Krugman on the definition of economics:

Let me give you my own personal definition of the basic method of economic theory. To me, it seems that what we know as economics is the study of those phenomena that can be understood as emerging from the interactions among intelligent, self-interested individuals. Notice that there are really four parts to this definition. Let's read from right to left. Economics is about what individuals do: not classes, not "correlations of forces", but individual actors. This is not to deny the relevance of higher levels of analysis, but they must be grounded in individual behavior. Methodological individualism is of the essence. The individuals are self-interested. There is nothing in economics that inherently prevents us from allowing people to derive satisfaction from others' consumption, but the predictive power of economic theory comes from the presumption that normally people care about themselves. The individuals are intelligent: obvious opportunities for gain are not neglected. Hundred-dollar bills do not lie unattended in the street for very long. We are concerned with the interaction of such individuals: Most interesting economic theory, from supply and demand on, is about "invisible hand" processes in which the collective outcome is not what individuals intended.

Paul Krugman

Paul Krugman on the behaviour of frogs:

William Hamilton's wonderfully named paper "Geometry for the Selfish Herd" imagines a group of frogs sitting at the edge of a circular pond, from which a snake may emerge - and he supposes that the snake will grab and eat the nearest frog. Where will the frogs sit? To compress his argument, Hamilton points out that if there are two groups of frogs around the pool, each group has an equal chance of being targeted, and so does each frog within each group - which means that the chance of being eaten is less if you are a frog in the larger group. Thus if you are a frog trying to maximize your choice of survival, you will want to be part of the larger group; and the equilibrium must involve clumping of all the frogs as close together as possible. Notice what is missing from this analysis. Hamilton does not talk about the evolutionary dynamics by which frogs might acquire a sit-with-the-other-frogs instinct; he does not take us through the intermediate steps along the evolutionary path in which frogs had not yet completely "realized" that they should stay with the herd. Why not? Because to do so would involve him in enormous complications that are basically irrelevant to his point, whereas - ahem - leapfrogging straight over these difficulties to look at the equilibrium in which all frogs maximize their chances given what the other frogs do is a very parsimonious, sharp-edged way of gaining insight.

Paul Krugman

I’ve been looking for a definition of economics for some time. The current economic crisis suggests that there is something fundamentally wrong with economics (or certainly with economists), so I thought it might be a good idea to go back to basics and look for an effective definition. I tried Wikipedia and a number of other sources, but it was Krugman’s definition that struck me as most interesting, and the fact that he gave his definition during a talk in which he contrasted economics with evolution suggested a link with complex systems.

Nevertheless, I have a problem with Krugman’s definition. A one word summary of his strap line is that economics is about “interactions”. His phrase “among intelligent, self-interested individuals” is merely delimiting the interactions. I agree with the focus on interactions. However, he then breaks his definition into four bullet points. The first three of these bullets are about individuals. Only the fourth is about interactions. This balance feels wrong.

When Isaac Newton saw an apple falling from a tree, he had the opportunity to think further about the apple or to think further about the movement of the apple. There are lots of things he could have thought about the apple: the way it grows, its shape, its size, its colour, its taste, the recipes through which it can be transformed into food and drink, how any of these things could be improved. Instead, Newton thought about the movement of the apple. In many ways, it would have been easier to think about the apple. For example, he would not have had to go to the trouble of inventing calculus. However, he thought about the movement of the apple and realised that the apple was not really important to his thinking. It could have been anything falling from the tree: a leaf, a branch, an animal or even Isaac himself. Incredibly, he realised that he could replace the apple with the moon, even though the moon doesn’t fall from a tree and the moon never hits the ground. Newton was smart but one of his most immense skills was the way he framed this problem and defined his area of study.

I don’t think that Newton would have defined his subject with a strap line about movement, and then expanded his definition with four bullet points, the first three of which were about apples.

This is what troubles me about Krugman’s definition of economics. Why are individuals so important that they warrant three bullet points? Surely the individuals are the equivalent of Newton’s apples. Individuals are not even the only actors in the economy. What about businesses, banks and governments? And why do the individuals need to be intelligent? When Krugman discusses frogs, he doesn’t indicate that they need to be intelligent, even though they display “intelligent” behaviour by arranging themselves in groups to protect themselves from the snake. And why does Krugman not say anything interesting about interactions if that is what he thinks economics is about? It would be better if he had said something like this.

Let me give you my own personal definition of the basic method of economic theory. To me, it seems that what we know as economics is the study of those phenomena that can be understood as emerging from the exchanges and interactions among self-interested economic actors. There are really five parts to this definition. Economics is about individual exchanges between actors. For example, I buy a bicycle from you for £20. The exchanges may involve assets, products or services. The actors may be individuals or businesses. Economics is about the exchanges themselves but also about the strategies used by the actors to promote their self-interest Economics is about the money used to facilitate these exchanges and related interactions. This includes physical notes and coins but also credit-based money. The inclusion of money also means that economics is about the banks who issue money and who manage money on behalf of other economic actors. As the banks are themselves involved in exchanges, they are also economic actors Economics is about the emerging properties of the totality of these exchanges and related interactions. When exchanges are viewed from the perspective of assets, products, services and money, we talk about markets. When exchanges are viewed from the perspective of the actors, we talk about wealth and debt, surpluses and deficits, profits and losses, winners and losers. When exchanges are viewed from the perspective of geography and government, we talk about international trade and exchange rates between currencies Economics is about the rules and regulations used in these exchanges and related interactions, and how these rules and regulations impact on the behaviour of the actors. The inclusion of rules means that economics is about the governments and other institutions which set the rules. As these institutions are themselves involved in exchanges, they too are economic actors Economics is about the emerging properties of this entire system, including the study of observed behaviours such as booms and busts of the entire economy; booms and busts in the prices of specific assets, products or services; and economic wealth and debt of individual actors. Economics is about the tools for managing this entire system in order to promote economic well-being, and to prevent and cure observed economic pathologies.

Jamie

Why do I believe that this would be a better definition, and that interactions are so much more important than individuals? There are two main reasons.

Firstly, as Krugman says in the fourth bullet point of his definition, many of the most interesting, and certainly the most destructive, phenomena in economics are about interactions:

1. If an individual buys shares, there is no problem. If everyone buys shares, there is an asset bubble. If an individual sells shares, there is no problem. If everyone sells shares, there is market panic
2. If an individual takes his money out of the bank, there is no problem. If everyone takes their money out of the bank, there is a bank run and the bank collapses
3. If an individual decides to stop spending and instead saves his income, or uses it to pay back his debt, there is no problem. If everyone does this at the same time then no-one is spending their income, so there is no demand for products and services, and the economy collapses. Keynes called this phenomenon “the paradox of thrift”. Why did he see it as a paradox though? It is only a paradox if you start by thinking from the perspective of an individual but not if you start by thinking about interactions
4. When Japan has a major earthquake not only does it disrupt the Japanese economy, but there are contagions to other regions. For example, when the earthquake generates a tsunami which overruns sea barriers and floods a single nuclear power station, Japan turns off all of its nuclear power stations and uses other energy sources instead. As a result of this, world demand for other types of energy increases. This increases the price of energy for everyone. In addition, other countries respond to the Japanese nuclear accident by re-considering their own use of nuclear power. This has further implications for energy prices and also for the employment of people in the nuclear industry in those countries.

Secondly, conventional macro-economic models focus on the behaviour of a single individual: a single, rational, representative agent. How do these models incorporate interactions? If there is only one individual then with whom does he interact? How do these models predict pathologies such as depressions and bank failures when these phenomena relate to interactions? Based on our experience in the current economic crisis, they don’t. Even though Krugman’s strap line emphasises interactions, mainstream macro-economic models seem to focus on the three bullet points about individuals.

One of the problems for a non-economist in trying to understand much of modern economics, and in trying to understand most modern economists, is that a lot of this economic thinking appears to be insane. As a result, a rational non-economist is tempted to conclude that it must be him who is insane. Surely, any sane economist would realise that models based on individual behaviour are unlikely to predict pathologies caused by interactions?

Here is a presentation (and slides) by Joseph Stiglitz, Nobel prize winner, at the 2010 INET conference, making similar points about the limitation of mainstream macro-economic models, particularly from 17:00 to 19:30 in the video. At least it’s comforting to know that if a sceptical non-economist is insane then so is Joseph Stiglitz.

When you start by thinking about interactions then some aspects of economics become obvious. For example, in world trade, when one country runs a trade surplus then some other country must have a deficit. The sum of all imports into all countries must equal the sum of all exports out of all countries. When many countries run a trade surplus at the same time then at least one country must act as “deficit of last resort”. If a country running a deficit decides to close its trade gap then the easiest way to do this is to stop importing goods from other countries. As a result, those countries’ trade surpluses will be threatened. You might suggest that this is obvious. I couldn’t possibly comment except to say that I’d expect to learn this in the first couple of weeks of an elementary economics course if that course were based on interactions. I cannot buy a product unless you sell it. I cannot borrow money unless you lend it. I cannot collect taxes unless you pay them.

What about mainstream economists though? Do they think this is obvious? Here is another presentation (and slides) by Joseph Stiglitz, this time at the 2012 INET conference where he makes precisely these same points. Good man! However, remember this is a Nobel prize-winning economist presenting to some of the world’s leading economists on state of the art economics. Stiglitz does include a number of more sophisticated points in his presentation, including some political points about possible solutions to current problems in international trade. However the key messages, particularly in his slides, are blindingly obvious to anyone who thinks about interactions.

It is a good job that it was Isaac Newton who saw the apple fall from the tree, and not an economist. The economist would have focused on the price of the apple and claimed that its movement was caused by an “invisible hand” which injected “animal spirits” into the apple! If only Newton had decided to sell the apple to a friend and used the proceeds to buy a new notebook. He might then have thought about that as well.