On the cover of the July 18, 2009 edition of “The Economist” is a picture of a book labeled “Modern Economic Theory” melting down, with the sub-title, “Where it went wrong — and how the crisis is changing it.”

One of the tenets of Capital Flow Analysis is “Follow the horsemen“, referring to the “Five Horsemen of the Investment Apocalypse”, one of which is “New Economic Theory”.

Just because “The Economist” has finally figured out that something is radically wrong with “Modern Economic Theory”, doesn’t mean that a New Economic Theory has been born that will replace the old, nor that lecture fees for Nobel laureates in “Economic Science” will suddenly dry up.

I would say that it might take another twenty years before “Modern Economic Theory” is completely dead — and that would be an optimistic estimate.

“Economic Science” — the oxymoron

One of the most revealing paragraphs in the lead editorial of “The Economist” starts as follows:

But economists were hardly naive believers in market efficiency. Financial academics have spent much of the past 30 years poking holes in the “efficient market hypothesis”.

Now, what is interesting about this comment is the idea that it is necessary to “poke holes” in a hypothesis. If economics were really a “science”, the proper order of things would be:

1. Someone advances a “hypothesis” — an idea based on some facts, but not yet “proved”. It is the job of the promoter of the hypothesis to try to provide the proof.
2. After a “hypothesis” is extensively tested against real world evidence, it advances to the level of being called a “theory”. At this stage, scientists from across the globe turn their withering skeptical gaze on this newcomer, calling for further evidence and proof.
3. Finally, after a “theory” has been extensively tested and no “holes” can be found, it is accepted as being “true”. If it is of sufficient importance, it may even be called a “law”.

Now, the “Efficient Market Hypothesis” never went through this process.

Instead, it jumped from the paper of a doctoral candidate to being generally accepted, without any proof whatsoever.

Although it continued to be called a “hypothesis”, it was treated as a “law” and incorporated into the development of further hypotheses by other economists and major real world applications (like Index Funds).

Economics as a religion

Most of modern economics is not really a science, but rather a belief system, like a religion.

There are different “schools” of economics, like various branches of a church — each claiming to know the “truth” based on the writings of some earlier economic prophet, like John Maynard Keynes, Joseph Schumpeter, or Ludwig von Mises.

Some years ago, I was speaking at a seminar in Washington DC on the topic of capital market development. After the lecture, a young academic came up to me, eagerly asking, “How does what you say square with the paper of Dr. Goobledegook on the Reverse Potential of Hysterical Demand?” Of course, since I didn’t have the foggiest idea of what he was talking about, I politely declined to criticize the illustrious Dr. Goobledegook. Furthermore, I had only made, what seemed to me the obvious point, that it is difficult to create liquid markets in jurisdictions with very small populations.

But that is how “Modern Economics” works. Rather than appeal to real world evidence or commonsense, the economist is trained to base his or her “proof” on the writings of other economists.

The futile search for “economic laws”

In the final analysis, economics is a social “science” related to the constantly changing behavior of large populations.

It is one thing to document such behavior and try to understand how certain things came about. It is another to assume that society is somehow constant — like the number of protons in a gold atom — and that a universal law may be derived from the behavior of people in Southern France in 1913.

The problem that economics faces is that Nobel prizes are given not to those who merely observe and document economic history, explaining how and why things happened at a particular point of time, but rather to those who sit in ivory towers, spinning fanciful theories based on theories spun by other inhabitants of similar towers.

In general, Modern Economics seems to rush to draw conclusions based on insufficient evidence and faulty data, and then to vigorously defend such conclusions on purely theoretical grounds.

One might say that Economic Science is to Real Science what Creationist Theory is to the Theory of Evolution.

The failure of Modern Economics is nothing new

Paul Omerod published “The Death of Economics” in 1994 — over a decade ago — stating that modern economics was largely “an empty box”.

Initially shunned by mainstream economists, his thoughts are now echoed by Nobel laureates like Paul Krugman, who was quoted in “The Economist” article as saying that much of the past 30 years of macroeconomics was “spectacularly useless at best and positively harmful at worst”.

Of course, Professor Krugman does not advocate any real change in the direction of “economic science”, only a return to the writings of John Maynard Keynes.

On this website, there are numerous essays decrying the failure of modern economics, including “Fallacies of the Nobel Gods“, published in 2004.

However, as already stated, the death of one set of erroneous beliefs (perhaps prematurely declared) does not portend substitutions by new and better beliefs.

We shall have to see what emerges as a substitute for “Modern Economic Theory” before celebrating.