Nobel Prize winning (1992) economist Gary Becker, who died last weekend, extended economic theory into areas such as racism, crime, and family formation in which it hadn’t been thought relevant. Critics, whether of religious or other persuasions, complained that Becker’s analysis dehumanized us by leaving out many other factors that were of equal or greater importance. Yet that’s not just true in his areas; economic analysis even of purely economic buy/sell decisions leaves out non-economic factors and can lead us to false results. In reality, the science gives us very useful insights, but its conclusions should always be examined in a “big picture” context, to eliminate those that are not merely counter-intuitive but foolish.

Perhaps the extreme example of Becker’s approach to economics was his 2012 claim on the “Becker-Posner blog” that suicide was a rational act, by people who believed the net present value to them of their future existence was negative. One doesn’t need to be the soppiest of humanists to see this as an oversimplification. Why it may indeed be true in some cases (mostly the terminally ill) that a suicide has summed the utility of his future existence and found it negative, the reality is that most suicides are deeply disturbed, either temporarily or permanently, and unable to make such a rational evaluation of their future potential outcomes. This is surely therefore a case where Becker’s economic analysis adds only modestly to our understanding. Non-economic factors in most such cases are far more important than economic reasoning.

Nevertheless, suicide is an extreme case, in which Becker’s economic analysis is least useful. One of his other highly controversial applications of the technique, in family formation, is much more difficult to criticize. It is unquestionably the case that the full entry of women into the professional workforce has increased the costs of child rearing (and to an extent reduced its benefits, at least for the dual-career professional couple; if the child is left with minders for much of its existence, the parents’ joy in interacting with it must of necessity be reduced.) It’s also obviously the case that the increasing costs of college, and the apparent necessity of getting a college degree in today’s economy, further increase the cost of child rearing. Becker thus drew the conclusion that these increased costs would drive down the fertility rate. While there are many other factors beyond the economic in choosing whether to start a family, the decline in traditional marriage and childbearing are surely evidence that, on a big picture basis, Becker was right.

At the other extreme is the Efficient Market Hypothesis, beloved by modern finance economists examining investment outcomes, surely the human activity most purely rational, most wholly within the traditional economic sphere and furthest from the contemplation of suicide (except in a deep bear market!) Here economics tells us that the market price of each stock reflects all known information, so that no additional returns can be gained by investment selection or clever timing. However in practice exception after exception has been found to this rule. I have written at length on the problems with this model and with the remainder of modern financial theory; suffice it to say that it fits poorly with real life.

Thus just as in a highly non-economic setting economics proves to be useful, so too in the most extremely economic-oriented setting it proves to be inadequate.

An even more egregious example of the misuse of economic theory was Lord John Russell’s Whig government’s refusal in 1846-50 to provide food aid to starving Irish potato farmers, on the grounds that it would weaken their incentive to work. Charles Jenkinson, Trade Minister from 1786-1804, had pointed out the fallacy in the Russell government’s approach when faced with a similar situation almost half a century earlier, in the famine and high prices of 1800. He wrote: “In time of distress the Seller becomes Master of the Market, and it then becomes absurd to rest one’s confidence in Adam Smith, who has Pushed his Principles to an extravagant Length, and in some respects, has erred.” Again, the question under consideration was a purely economic one, of the grain market’s behaviour at a time of extreme supply shortage. Jenkinson, unlike the later Whigs, understood that traditional economic theory fell down in those circumstances.

Two current misuses of economic theory are in fiscal and monetary policy, but whereas in the above examples the economic principles being applied were more or less valid, in these cases even the underlying economics are spurious. Fiscally, the traditional belief that governments should balance their budgets has been overlain in recent decades by a belief in Keynesian stimulus. This theory was used vigorously in 2008-09, by both political parties in the U.S. and by the Labour government in Britain, in an effort to stave off the financial crash and recession that had been caused by previous economic errors.

Now a permanent budget deficit has resulted in both countries, and not much effort is being undertaken to reduce it. Doubtless when the next recession arrives, Keynesian stimulus theory will be trotted out again to justify even larger deficits. As in Japan since 1998, the time never arrives at which the deficits are reduced, let alone any effort being made to pay down the debts that have resulted. Common sense, which ruled budgeting before 1914, would have told governments on both sides of the Atlantic that the long-term effects of this spending would be fatal, but common sense has been overruled by spurious economic theory.

Similarly, in monetary policy a misguided reading of the lessons from the Great Depression has allowed monetary stimulus to be ratcheted up again and again, over a period of 20 years next February, to a level at which real short-term interest rates are permanently negative. Again, common sense would have told policymakers that policies so far out of the mix previously attempted would lead to ruin, but common sense was abandoned in the face of spurious monetary theory.

The difficulty here is that whereas we know the inevitable eventual outcome from excessive fiscal policies — debt default and repudiation – we don’t yet know the outcome from these excessively loose monetary policies. Economic theory (good economic theory this time!) would suggest that they should lead to hyperinflation, but so far this hasn’t happened. We shall no doubt find out the hard way what was wrong with the good economic theory, as well as why we should never have adopted the bad one.

There are three lessons to be drawn from all this. First, even when contemplating suicide, an economic analysis can be helpful. Second, even for the most obviously economic decisions, good economic theory should not be used when it contravenes observation or common sense. If the Irish potato farmers are starving because of a potato blight, feed them, and to hell with their incentive structure (at least until new food crops have been sown.) If statistical analysis shows that small stocks outperform large ones, even taking account of their higher risk and lower liquidity, then structure your portfolio accordingly, and to hell with the Efficient Market Hypothesis.

The third lesson, more important than the other two, is that while good economic theory is not always a fool-proof guide to life, bad economic theory can be an exceptionally poor guide, and should be avoided at all costs. If you are running a derivatives operation, don’t believe it when your theorists come and tell you that credit default swaps and subprime collateralized debt operations have only moderate risk, because their risk “tails” are Gaussian. If the products are new, with only a few years’ trading experience, then the chances are high that their risk profiles are non-standard as well.

Similarly, if as President your economic advisors tell you to spend $1 trillion on nothing in particular, because Maynard Keynes, in very different circumstances 80 years ago, thought this might be beneficial, tell them to go read a better textbook. Likewise, if your monetary manager tells you that the only way to get out of a depression is to drop $100 bills from helicopters onto Wall Street, tell him that the least he can do is poise his helicopter above those actually suffering from the depression, rather than rewarding only the bankers that caused it.

Hard scientists are fond of reminding us that economics isn’t physics, but these days modern physics is equally implausible, equally spurious and an equally fallible guide to real life. However when you’re aiming an 18th century cannon at an enemy, some 18th century physics is useful to calculate the trajectory of the shot. So too in economics the basic truths, of Smith through Malthus, Say, Bastiat and Ricardo, plus anything postulated by an economist with von in his name, can be a useful guide. If Becker taught us anything, he taught us that the guide, while helpful in all situations, should consist of general principles only, and should not be regarded as infallible.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)