This article appeared originally in Gulf News: link to original article
Economics is not rocket science. It is, in fact, more complicated than that. The thing with economics is that you cannot shoot it into space – even though I know a few who would like to.
For all of my friends in engineering, some of whom have successfully switched to careers in finance, the approach to problem solving, unlike with economics, is pretty straightforward. For example, when chemical X is mixed with chemical Y, the result is a specific mixture with a specific colour. Else, having the right safety protocol and measures when operating a nuclear reactor can prevent a nuclear disaster.
In both examples, methodology also means predictability of what would happen if the wrong chemicals are mixed together, or if human error results in nuclear meltdown.
In other words, if everything is done and maintained right, human error can be the one that unwinds all the good work done initially. With economics, that can also be the case… except with a different kind of tally.
A different ballgame
In order to elaborate on that thought, consider for instance the impact of a currency devaluation on the domestic economy and the livelihoods of its citizens. Theoretically, when the value of a currency drops, or is devalued, exporters in that country benefit as their products and services become more competitive. This is subject to exports being quoted in the country’s domestic currency and not in any other international currency.
On the not so bright side of things, a drop in a currency’s value dilutes purchasing power for everyone who gets paid in that currency. Economics, as a social science, differs here in that the above is subject to how the drop or devaluation is perceived by those benefiting and those who are not.
That is, a small drop in a currency value can encourage exporters to ramp up production and to sell more into existing and new markets. However, a larger drop would insinuate that there are more serious monetary issues at play here, especially if the decline spirals out of control.
Eventually, this will fuel speculation around the currency’s future value and act as a catalyst for capital flight out of the economy, more so if capital controls were considered by policymakers. On the individual level, a huge drop in the currency’s value can reduce purchasing power to the brink of poverty in extreme cases, and sometimes to food insecurity too.
Before elaborating, allow me to summarise what makes economics different than other sciences. For starters, there are two issues with the understanding of economics and how it affects everyone, rather literally. First, when you mix the right policy ingredients in economics, the result is not compound X with colour Y. The result varies with human reaction and behaviour.
Secondly, human error, by policymakers in economics, does not result in an immediate disaster. Not for lack of trying, but because policies in the various fields of economics can be modified or revoked altogether, if and when needed.
While markets and individuals do take their time to adjust, the practicality here in making a U-turn, without risking an economic Chernobyl, makes experimenting with economic policies fairly appealing.
To illustrate further, consider the earlier example of food insecurity. Food insecurity can lead to protests that would trigger a government response. Such a response could entail one or more of the following: an introduction of a food subsidy or an increase in an existing one; a ban on food exports; a cash transfer programme to alleviate the negative ramifications of a currency devaluation.
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Whatever the case is, policies will be modified, hopefully based on proper economic modelling that is built on decades of data analysis. The policy is then examined and assessed in accordance to human reaction, which is where a better understanding of behavioural economics can go a long way. In all cases, what makes economics harder, i.e., human psychology, can also be the way to unlock its potential in supporting policymakers when planning and executing policies.
For that to happen, foreseeing the issues that policy implementation is likely to run into will inform better scenario planning to deal with them. This way, policymakers will have a range of solutions to handle the resulting ramifications, and to make sure that the enacted policy achieves its desired and most optimal impact.
Not a direct line
Another example that can be mentioned here is the introduction of a Value-Added Tax (VAT) or hiking an existing one. If the decision is based solely on how much VAT money can be made, without accounting for the negative impact on consumption, revenue targets ought to disappoint.
Therefore, introducing VAT, or increasing its rate, should not be on the account of multiplying the rate with the value of taxed goods and services. Instead, VAT-related deliberations must take into account its impact on domestic consumption and on imported consumption if tourists’ VAT is not refunded. If both drop substantially, domestic production will be harmed as well.
To summarise, human psychology cannot be satisfactorily modelled. However, and without delving into the technical details here, the right economic model, when followed, would provide ample room for policymakers to manoeuvre when it comes to policy implementation. This can be done by foreseeing a range of solutions and well-thought of scenarios when carrying out the policy and in anticipation of human reaction.
Regardless of the field into which the policy is being introduced, policies cannot be enacted in the most efficient and effective ways without predicting human reaction to the policy and being prepared to react accordingly.
The last thought that I want to leave you with: How can human psychology be incorporated into economic models?