The Independent Market Observer

Schools of Economic Thought: Theory Vs. Reality

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Oct 26, 2021 2:26:42 PM

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economic thoughtI have been writing this blog for going on 10 years now and have been in this business for longer than that, so I have been asked a lot of questions. They tend to come in cycles. At this point, unless something like the pandemic comes along, which really is new, they also tend to be variations on a theme.

But every so often, a new and fundamental question does make me stop and think, and I got one this morning from an advisor. A new client of his wanted to know which school of economics Commonwealth and I subscribed to. As a self-described adherent of one well-known school of economics, the client may have wanted to be sure that we saw the world the same way he did. I don’t think my answer was what he was looking for.

Which School Do I Subscribe To?

Well, there are any number of schools of economic thought, with considerable variation within each of them and even more between them. Each school, or group of ideas, is also typically associated with a political camp. In general, Democrats tend to be Keynesians, while Republicans lean more toward the supply-side camp. (You can find a lot of information about different schools of thought here.)

So, of these different schools of thought—with their different prescriptions for economic problems and associated political leanings—which one do I subscribe to? None of them.

The Pragmatic Camp

Instead, I would put myself in the pragmatic camp. That is, I am very familiar with and use all of the techniques of the major schools of economic thought. Most, if not all, have valuable insights into the ways the world works and are worth being familiar with. But I do not consider myself a devotee of any.

The reason for this is that just as all of them have valid insights, they all have significant failures in either modeling or prediction. Since my task is to respond to the economy and markets (including policy) as they are and not as they should be, I cannot get locked into one point of view or one way of viewing the world.

Let’s take one school and one current problem as an example. From an Austrian economic perspective, you could argue that deficit spending will inevitably lead to significant inflation. I would certainly agree that is a risk, particularly now. I would also agree that risk is something we need to keep an eye on. So far, I am an Austrian. But, the fact of the matter is that Japan, in particular, is a counterexample to that view, and therefore this is not an inevitable outcome. Rather than be a full Austrian and assume I know the outcome, I am going to be practical, rather than theoretical, and keep an eye on what is really happening. In this case, I understand the argument. But the fact is that reality does not consistently play out in accordance with theory. My job is to work with reality, not to stay with a theory.

This isn’t to pick on the Austrians. Keynesians have their own good arguments and bad results to contend with, as do each of the other schools. The point is that by identifying with a school, my personal opinion is that it can slant how you see the evidence, and a slanted perception of evidence is never good.

Theory Vs. Reality

The bigger point, given what I do, is that as investors, we are judged on results, while economists are judged on theories. It is not my job, or an advisor’s job, to be an economist, but instead to help clients achieve their financial goals. I would note that economists, in general, agree with this stance, as neither Harvard nor Chicago has its endowments managed by the economic faculties, and there is a good reason for that. Long-Term Capital Management famously blew up despite the Nobel economists who founded it, because markets didn’t work the way that theory said they should. Theories are one thing—reality another.

As someone tasked not with theory but the reality of helping people achieve their goals, then, I am a pragmatist, not a theorist. As such, I will watch but not subscribe to any of the schools. Economics—from all schools—should inform our thinking, but not control it.

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