Dr. D. Subbarao, Governor, RBI reflects on the economic crisis and the crisis in Economics in his speech at IISc, Bangalore. 

A few months into the crisis, the Queen happened to be at the London School of Economics and asked a perfectly sensible question: ‘how come none of the economists saw the crisis coming’. The Queen’s question resonated with people around the world who felt that they had been let down by economics and economists. As economists saw their profession discredited and their reputations dented, the economic crisis soon turned into a crisis in economics

The Governor, RBI has a delightful comparison between Economics and Physics. (Speech Link, You should read the entire speech)

Is Economics like Physics?
(i) The theory of rational expectations says that wages and prices adjust instantaneously to new conditions because of perfect information just as Newtonian physics says that the gravitational configuration of the universe will change instantaneously in response to any infinitesimal change in the system, an inference that Einstein found troubling because it conflicted with his special theory of relativity.

(ii) The centerpiece of Keynes’ theory is the existence of inescapable uncertainty about the future which implies that risk cannot be measured precisely beyond a point, and that taking uncertainty seriously has profound implications for how one applies economics. Look at the parallel in physics. The foundation of quantum mechanics is Heisenberg’s Uncertainty Principle which puts an irreducible limit on our ability to simultaneously determine the position and momentum of a particle.

(iii) Physicists know of ‘singularities’, or black holes if you will, where the laws of physics break down. In economics, the analogy would be Depression Economics. There is currently a fierce debate, especially in the US, about the quantum of fiscal stimulus and the timing of its withdrawal. Some economists, notably Krugman, have argued that the size of the stimulus should be much larger than what the models suggest simply because ‘in Depression Economics, the usual laws of economics do not apply’.

Why Economics cannot be like Physics

12. Striking as these comparisons are, I am sure, you have noticed an obvious flaw in this line of thinking. Similarity in a few laws does not mean similarity in the basic nature of the academic discipline. The fundamental difference between physics and economics is that physics deals with the physical universe which is governed by immutable laws, beyond the pale of human behaviour. Economics, in contrast, is a social science whose laws are influenced by human behaviour. Simply put, I cannot change the mass of an electron no matter how I behave but I can change the price of a derivative by my behaviour.

13. The laws of physics are universal in space and time. The laws of economics are very much a function of the context. Going back to the earlier example, the mass of an electron does not change whether we are in the world of Newton or of Einstein. But in the world of economics, how firms, households and governments behave is altered by the reigning economic ideology of the time. To give another example, there is nothing absolute, for example, about savings being equal to investment or supply equaling demand as maintained by classical economics but there is something absolute about energy lost being equal to energy gained as enunciated by classical physics.

14. In natural sciences, progress is a two way street. It can run from empirical findings to theory or the other way round. The famous Michelson-Morley experiment that found that the velocity of light is constant led to the theory of relativity – an example of progression from practice to theory. In the reverse direction, the ferocious search now under way for the Higgs Boson – the God particle – which has been predicted by quantum theory is an example of traversing from theory to practice. In economics, on the other hand, where the human dimension is paramount, the progression has necessarily to be one way, from empirical finding to theory. There is a joke that if something works in practice, economists run to see if it works in theory. Actually, I don’t see the joke; that is indeed the way it should be.

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