The Alchemy of Economics: Understanding What Economists Get Wrong

In economics, we often encounter the term "universal laws," rules that are assumed to be universally applicable, guiding our understanding of complex economic systems. Yet, history shows us that these so-called universal laws are only sometimes as reliable as we might hope. This blog will explore the idea of the "alchemy" of economics, a process of questioning, exploring, and sometimes even refuting the accepted economic wisdom to better comprehend the intricacies of economic phenomena.

Our journey begins by interpreting a unique phrase: "Alchemy is the science of knowing what economists are wrong about." This intriguing sentence suggests a thorough investigation into the misconceptions and errors found within traditional economic theory. Historically, alchemy was the precursor to modern chemistry and involved considerable trial and error, a fitting metaphor for understanding complex systems like economies. There is a science - or system - to identifying where economists might fall short.

But what is the trick to being an alchemist? It lies "not in understanding universal laws, but in spotting the many instances where those laws do not apply." This statement underlines the importance of discovery and exploration over strictly adhering to established norms. Like the alchemists of old, we should focus less on accepting the "universal laws" of economics without question and more on identifying where these laws might not hold true.

Moreover, the alchemy of economics "lies not in narrow logic, but in the equally important skill of knowing when and how to abandon it." This implies that understanding economic phenomena requires more than rigid logical thinking. It demands the ability to appreciate the complexities and nuances of real-world situations that don't neatly fit into pre-established economic models and theories.

To better grasp these concepts, let's dive into some examples:

The Great Depression of the 1930s:

Classical economic theory, which advocated for limited government intervention, was the prevailing thought during this era. But as the economic crisis deepened, it became evident that these theories didn't apply to such extreme conditions. The economy began to recover only through Roosevelt's New Deal, a significant government intervention initiative. Here, the alchemy lay in recognizing that universal economic laws were only sometimes applicable.

The Dot-Com Bubble of the late 1990s:

Traditional economic theory holds that a company's stock price should reflect its inherent value, typically its ability to generate profits. However, many internet companies' stock prices were hugely inflated during the dot-com bubble, despite never turning a profit. This was an instance where investors and economists needed to recognize that the "universal law" did not apply as market behavior was dictated by speculation rather than fundamental economic principles.

The 2008 Financial Crisis:

Before the crisis, many economists, subscribing to the Efficient Market Hypothesis, believed the housing market and the related financial instruments were stable and correctly priced. This assumption was a glaring misstep. It led to one of the most significant economic downturns in history when the "universal laws" did not apply. The alchemy in this situation recognized the underlying risks masked by complex financial derivatives and understood that rigid adherence to economic theories could not account for human behavior's unpredictable nature.

The Rise of Behavioral Economics:

Traditional economic theory often assumes humans are rational actors, making decisions to maximize their utility. However, behavioral economics emerged from recognizing this "universal law" often did not hold. People frequently behave irrationally due to a range of cognitive biases. This deviation from the norm marked an essential shift in economic thinking, reinforcing that the psychology of decision-making can't be ignored in economic modeling.

These examples illustrate that studying economics is far from a strictly logical process; it is an alchemical practice. It requires a willingness to question accepted wisdom, the curiosity to explore the unknown, and the wisdom to acknowledge when to abandon traditional beliefs in favor of a more nuanced understanding.

Understanding the alchemy of economics provides a deeper insight into the economic world, recognizing the need for flexibility, skepticism, and an open mind. It encourages us to question the norm, consider the exceptions, and appreciate the real-world complexities that define our economic landscape.

Economics, like alchemy, is as much an art as a science. Knowing when to apply the laws, when to question them, and when to abandon them for a broader perspective is the key to deciphering the complex equations of our economies. By adopting this alchemical approach, we challenge traditional economic wisdom and open the doors to a richer, more comprehensive understanding of the economic world around us.