Column: What crisis has taught economics

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: Paul Samuelson, who passed away recently, once said that funeral by funeral, economics advances. Talking of funerals, one of the many casualties of the recent financial crisis is the textbook macroeconomic model that assumed frictionless markets, flawless regulatory institutions, and fully rational agents. Once again, economists are back to the drawing board.

Was it the excessive formalism of economic models that led the economists astray, mistaking beauty for truth? It is a gloomy backdrop indeed for the legacy of Samuelson, who pioneered the use of formal models in economics.

The list of the most influential economists of the modern era is full of legendary names, such as John Maynard Keynes, John Hicks, John Nash, Kenneth Arrow and Milton Friedman. But what makes Samuelson stand out is that he, more than anyone else, helped unify and formalise the subject by the use of the language and tools of mathematics. He achieved this partly through his own path breaking research, which, as many have pointed out, could fetch him seven or eight Nobel Prizes. But a part of his legacy is through his best-selling textbook, Economics: An Introductory Analysis, which showed how the different branches of economics could all be integrated under a common analytical framework. To give a literary analogy, Samuelson helped invent the grammar of the language of modern analytical economics, and at the same time was one of its greatest writers of all times.

His doctoral dissertation from Harvard in 1941—when he was only twenty-six years old—was published as the Foundations of Economic Analysis in 1947 and is considered to be one of the all time classics in economics. In this he unified the theory of consumer behaviour and the theory of producer behaviour by noting that both—and pretty much any other economic decision—can be viewed as a mathematical problem of maximising a function subject to certain constraints. Once a decision-problem is formulated this way, a rich set of mathematical techniques allows us to derive a set of equations describing the behaviour of firms and consumers. These can then be solved together to find the equilibrium of the economy. Moreover, if the system is disturbed by some shock (say, technological change), Samuelson gave us some techniques that are in everyday use even today to figure the effect on individual and aggregate behaviour.