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Economics and BI – Part 1

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It may be the worst of times for traditional economists. It may also be the best of times for economists who've dared to be different. Homo economicus is under siege. The tenets of economic thinking that have driven economics for the last 40 years – the rationality of consumers and the efficiency of markets – is now viewed with suspicion, having failed to predict or explain the biggest market collapse since the Great Depression.

Two recent articles, one from BusinessWeek (What Good Are Economists Anyway), the other from the British cultural magazine Prospect (Goodbye, homo economicus), detail the woes of economics and offer advice on how to fix the discipline. Noting that economists not only missed predicting the current crisis, but seem to have little to offer for its resolution, BusinessWeek pulls no punches: “The rap on economists, only somewhat exaggerated, is that they are overconfident, unrealistic, and political. They claim a precision that neither their raw material nor their skill warrants. Too many assume that people behave like the mythical homo economicus, who is hyperrational and omniscient. And they take sides in quarrels that freeze the progress of research. Those few who defy the conventional wisdom are ignored.” Ouch.

Economists distinguish between normative economics, which incorporates value judgments of how economies ought to be, from positive analysis, which focuses on the description, explanation and cause and effect relationships of economic phenomena.  The BusinessWeek critique attacks economics on both fronts. The political or normative problems revolve on how wealth should be distributed in society. Liberal-leaners who support a more equitable distribution  promote government or fiscal intervention to achieve that goal. Conservative let-the-chips-fall-as-they-may types, on the other hand, have a laissez-faire attitude towards the markets, and demand that the government steer clear. The in-favor paradigm for the last 40 years has been rational expectations and efficient markets – a conservative, laissez-faire approach. Positive analysis takes a hit as well, given economics' obsession with abstract mathematical models that have proven too simplistic for the real world. Indeed, models seem to have taken on a life of their own: those not supporting  the mathematical approach have had little voice in recent developments of economic thought.

Goodbye author Anatole Kaletsky is even more stinging in criticism than BusinessWeek, blaming economists for actually producing the economic weapons that enabled the seemingly suicidal behavior by bankers, financiers and consumers. Quoting British economist John Maynard Keynes: “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.” In this case, the academic scribblers of a few years back touted “rational expectation” agents and “efficient” markets that would, in the absence of specific anti-competitive forces, deliver optimal economic results. And, according to Kaletsky, this hands-off thinking quashed the prospect of regulatory or other government intervention that might have prevented the current perfect  financial storm. The strategy, embodied by former Fed chairman Alan Greenspan, was let the markets govern themselves. 

Kaletsky argues that economics as an academic discipline is now broken and must undergo an intellectual revolution if it is to be relevant going forward. The hegemony and bravado of the mathematical approach built on shaky assumptions must be enhanced by a more speculative range of thinking outside current thinking that includes insight from history and other social sciences such as psychology, political science and sociology. For economics to recover, the analytical pendulum must swing from mathematics and the simple models that glorify it to the broader social sciences in all their complexity.

The good news for economics and for business intelligence as well is that help's on the way, with renewed emphasis by new thinkers on positive, value-free methods useful for BI. Experimental economics, the application of rigorous experimental methods in controlled laboratory settings to the study of such economically-related questions as games, decision-making, bargaining and auctions, is continuing to gain traction. Economists are also increasingly deploying field experiments, a marriage of laboratory and naturally-occurring data that combine control rarely found in nature with realism generally not achieved in the lab, to test their hypotheses. 

Finally, behavioral economics, an amalgam of psychology and economics driven by the experimental method, rejects the careful calculation of rational expectations that's the basis of homo economicus for predictable human irrationality or animal spirits. It has now reached  critical mass of credibility in the economics discipline. I'll have more to say about behavioral economics and BI in Part 2.

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