The economy is one of the most complex systems that exists in the world. Perhaps even the most complex system. I like to think of the monetary system like a car. There are very specific institutional structures that act as certain parts of this system and in a vacuum that car or system will do certain things. For instance, when someone borrows money from a bank to finance investment in a productive innovation it is much like pouring fuel into the car and stepping on the gas. This gas runs through a series of institutions/firms/households that are interconnected in a specific way that can be easily explained by understanding how the flows move through the system of accounting. In this simple example, innovation and the financing of productive investment is what makes our economy or car, “go”.
The problem is that the environment in which our car exists is unbelievably complex. There are so many external forces impacting the car that it’s very difficult to decipher what is causing what. Add behaviorally biased people inside the car and deciphering our car’s actions goes from very difficult to decipher to nearly impossible to decipher.
(Figure 1 – How the world works according to economists)
(Figure 2 – How the world actually works)
I write this post in reference to the rise of empirical economics that we see in many places. I think this is a fantastic development. Testing economics is very important for its future progress and certainly an improvement over hand waving theory. But I hope that these experimenters don’t lose sight of the fact that they involve serious limitations given the uniqueness of each experiment within its own environment. For instance, this Tweet by Tim Duy, who is excellent by the way, is a nice example:
We really some some country to test the hypothesis that raising interest rates raises inflation.
— Tim Duy (@TimDuy) March 18, 2016
