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Swamionics




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Here's an interesting article from The Times of India

Sunday 3 January 1999 


Swaminomics: Why economists need to study psychology 

By Swaminathan S Anklesariya Aiyar

1998 should go down as the year when economists proved that they do
not understand how the world works. It mattered not whether economists
belonged to the right, left or centre, none of them got it right. 

Of the many major events of 1998, few were predicted and some were
regarded as unthinkable. Consider the list. 

* Japan collapsed into the deepest recession since World War II.
Nobody predicted in 1997 that this would be one of the consequences of
the troubles in South-East Asia.

* Russia collapsed, and reneged brazenly on its huge foreign debts,
even at the cost of losing access to IMF assistance. Earlier analysts
and investors had assumed Russia was too big to fail, that it would be
kept afloat at all costs by the West because of its nuclear
importance. Think again.

* Economists have long believed you can revive a flagging economy by
pump-priming, a classical Keynesian remedy. But this solution failed
totally in Japan. The country has now spent a colossal $600 billion in
infrastructure projects in the 1990s in an attempt to revive demand,
but to no avail. 

* Economists have long believed that high-saving countries grow fast
as a reward for prudence, while spendthrift countries suffer economic
disaster for their sins. Yet in 1998 the biggest saver of all, Japan,
collapsed while the biggest spendthrift, the US, went from strength to
strength. The savings rate in the US turned negative late in the year,
with consumers spending more than their entire income. Yet this
profligacy was rewarded with rapid growth, while Japan's thriftiness
yielded no dividends. 

Japan has long been wedded to the notion of lifetime employment, while
the US has been the classic hire-and-fire economy. Yet in 1998 Japan's
unemployment rate (4.4 per cent) overtook the US unemployment rate
(4.3 per cent), something regarded as unthinkable earlier. 

European economies have long been regarded as so structurally decrepit
that their ailment has been called Eurosclerosis. Yet these supposed
sclerotics displayed such dynamism in 1998 that were able to shrug
aside very difficult conditions in Asia, Russia and Latin America.

*The price of oil almost halved. Nobody had predicted that, in this
25th anniversary of OPEC's rise to fame, oil would become cheaper than
it was at the end of 1973. 

*Despite running a record trade deficit, the dollar was one of the
strongest currencies in the world in 1998. Despite a huge trade
surplus, the Japanese yen weakened. So much for economic theory, which
suggests that trade deficits should normally lead to currency
depreciation, and surpluses to appreciation. 

* Lenders are, almost by definition, supposed to be more creditworthy
than borrowers. Yet in 1998 the credit rating of Japan, the biggest
creditor country in the world, fell below that of the biggest debtor
country, the US. 

What on earth is happening? Why is conventional economics suddenly so
poor at explaining what is going on? The issue is not one of left
versus right. Economists of all stripes have been exposed as having no
clothes. 

Of course, we have long known that all economic theories - left, right
or centre - are no more than approximations. Actual human behaviour is
far too complex to be captured comprehensively by any economic theory.
But economists have long believed that their economic models are
reasonable approximations of the real world, good enough to guide
policy at any rate. That assumption seems to have come unstuck in 1998. 

A recent research paper by Furman and Stiglitz investigates various
theories put forward to explain why the miracle economies of South and
South-East Asia suddenly collapsed in very non-miraculous fashion.
None of the explanations stands up to rigorous examination. Theories
that seem plausible in relation to one country fail in another.
Theories which look plausible for one period fail in another. A
variety of reasons have been given for the collapse, ranging from
corruption to the freeing of capital flows. None of them stands up to
rigorous statistical examination when asked to explain the earlier
miracle as well as the recent collapse. Research has been more
successful in shooting down theories than coming up with comprehensive
answers. Economists need to hang their heads in shame, or at least
sound humbler than usual. In this state of flux, forecasts by
economists have about as much credibility as those of astrologers.
Yet, despite their repeated failures, I am astonished to find that
economists are more in demand than ever, and are being paid more than
ever, for forecasts whose chances of success lag well behind that of
the meteorological office. What explains this? I think the parallel
with astrologers is a good one. In uncertain times, the demand for
forecasts is much greater than in settled times. This is why people
tend to consult astrologers in difficult times, and the same rule
seems to apply to economists. People do not expect astrologers to be
perfectly accurate. Indeed, they knew astrologers have very limited
powers. Yet they feel a psychological need for some guidelines in
uncertain times, and find the hazy ones of astrologers better than
none at all. 

Businessmen now seek economic forecasts for the same psychological
reason. That in turn provides a hint about the new direction in which
economics needs to develop. Given the herd behaviour of financial
markets, that play an increasing role in economic outcomes, I think
economics needs to learn much from psychology. We have always known
that if enough people expect a boom (or disaster), then a boom (or
disaster) will indeed occur. This is the old, oft-demonstrated
phenomenon of self- fulfilling expectations. We need now to know what
drives expectations. 

Strong economic fundamentals are no longer enough, it seems, to
inspire confidence in volatile markets. Some other psychological
tricks are need to calm panicky herds of financiers. Traditional
economics has few answers, and psychology may offer deeper insights.
So perhaps Bimal Jalan should turn to Sudhir Kakkar rather than IMF
economists to understand how best to plan the future of the Indian
rupee. 




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