Krugman’s vindication of neoclassical macroeconomics – brilliantly silly

14 Jul, 2012 at 10:53 | Posted in Economics, Theory of Science & Methodology | 7 Comments

“Sorta-kinda New Keynesian” economist Paul Krugman has weighed in on the debate on the state of macroeconomics that yours truly and other heterodox economists are having with Oxford macroeconomist Simon Wren-Lewis. Krugman writes:

Wren-Lewis argues against the many people insisting that the crisis means that we must rebuild macroeconomics from the ground up; he argues, on the contrary, that the crisis doesn’t require a fundamental rethink of macro. And I am very much in agreement there. Basic sensible macro — what we learned from Keynes and Hicks — has actually held up very well in the crisis. To the extent that we have a crisis in macroeconomics as practiced, it comes from the way many economists chose to reject sensible macro. The crisis should (but won’t) kill fresh-water, equilibrium macroeconomics; but IS-LM is looking pretty good.

Let me just start with an observation on what is “basic sensible macro”. When it comes to Keynes I totally agree. But Hicks? No way.

Krugman referring to Hicks, of course, comes as no surprise, since we who have followed Krugman’s writings over the years, know that he is very fond of referring to and defending the old and dear IS-LM model.

What is perhaps less well-known is that John Hicks, the man who invented the IS-LM in his 1937 Econometrica review of Keynes’ General Theory – Mr. Keynes and the ‘Classics’. A Suggested Interpretation – returned to it in an article in 1980 – IS-LM: an explanation – in Journal of Post Keynesian Economics, and self-critically wrote:

I accordingly conclude that the only way in which IS-LM analysis usefully survives — as anything more than a classroom gadget, to be superseded, later on, by something better – is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of equilibrium methods, is not inappropriate. I have deliberately interpreted the equilibrium concept, to be used in such analysis, in a very stringent manner (some would say a pedantic manner) not because I want to tell the applied economist, who uses such methods, that he is in fact committing himself to anything which must appear to him to be so ridiculous, but because I want to ask him to try to assure himself that the divergences between reality and the theoretical model, which he is using to explain it, are no more than divergences which he is entitled to overlook. I am quite prepared to believe that there are cases where he is entitled to overlook them. But the issue is one which needs to be faced in each case.

When one turns to questions of policy, looking toward the future instead of the past, the use of equilibrium methods is still more suspect. For one cannot prescribe policy without considering at least the possibility that policy may be changed. There can be no change of policy if everything is to go on as expected-if the economy is to remain in what (however approximately) may be regarded as its existing equilibrium. It may be hoped that, after the change in policy, the economy will somehow, at some time in the future, settle into what may be regarded, in the same sense, as a new equilibrium; but there must necessarily be a stage before that equilibrium is reached …

I have paid no attention, in this article, to another weakness of IS-LM analysis, of which I am fully aware; for it is a weakness which it shares with General Theory itself. It is well known that in later developments of Keynesian theory, the long-term rate of interest (which does figure, excessively, in Keynes’ own presentation and is presumably represented by the r of the diagram) has been taken down a peg from the position it appeared to occupy in Keynes. We now know that it is not enough to think of the rate of interest as the single link between the financial and industrial sectors of the economy; for that really implies that a borrower can borrow as much as he likes at the rate of interest charged, no attention being paid to the security offered. As soon as one attends to questions of security, and to the financial intermediation that arises out of them, it becomes apparent that the dichotomy between the two curves of the IS-LM diagram must not be pressed too hard.

Back in 1937 John Hicks said that he was building a model of John Maynard Keynes’ General Theory. He wasn’t.

What Hicks acknowledges in 1980 is basically that his original review totally ignored the very core of Keynes’ theory – uncertainty. In doing this he actually turned the train of macroeconomics on the wrong tracks for decades. It’s about time that neoclassical economists – as Krugman, Mankiw, Wren-Lewis or what have you – set the record straight and stop promoting something that the creator himself admits was a total failure. Why not study the real thing itself – General Theory – in full and without looking the other way when it comes to fundamental aspects of reality such as non-ergodicity and uncertainty?

But as Krugman rightly notices, IS-LM macroeconomics is not at all what Wren-Lewis is describing when he talks about his “intertemporal optimising framework” being “the heart of modern macro”.

Paul Krugman has in an earlier piece criticized this microfounded framework in the following words (my italics):

I upset even New Keynesians, such as Simon Wren-Lewis, with my observation that the crusade for microfoundations has had only one success, the prediction of stagflation after an extended period of high inflation, and that this success is 35 years old.

Yet I stand by that statement.

Let me be clear about what I mean in saying that. I don’t mean that setting up and working out microfounded models is a waste of time. On the contrary, trying to embed your ideas in a microfounded model can be a very useful exercise — not because the microfounded model is right, or even better than an ad hoc model, but because it forces you to think harder about your assumptions, and sometimes leads to clearer thinking. In fact, I’ve had that experience several times: I was convinced that the liquidity trap was wrong until I did a miniature NK model and saw that it made sense, my work with Gauti Eggertsson on deleveraging also uses NK modeling to clarify matters.

But bear in mind what we’ve actually seen in academic economics: the development of an ethos in which only microfounded models are considered “real” theory, in which it’s basically impossible to publish a paper unless it’s intertemporal optimization all the way. That’s the kind of dominance a theory is only entitled to if it produces dramatically better predictions than the theory it has crowded out: Light bend! The sea floor spreads! And that just hasn’t happened; there has, I repeat, been only one significant predictive success of this kind from microfoundations, and that happened a very long time ago.

Although it is easy to agree with Krugman’s harsh judgement on microfoundations of macroeconomics – and it goes for both the “New Keynesian” and New Classical variety – I am however not convinced by the argument that “trying to embed your ideas in a microfounded model can be a very useful exercise — not because the microfounded model is right, or even better than an ad hoc model, but because it forces you to think harder about your assumptions, and sometimes leads to clearer thinking”. If people put that enormous amount of time and energy that they do into constructing macroeconomic models, then they really have to be substantially contributing to our understanding and ability to explain and grasp real macroeconomic processes. If not, they should – after somehow perhaps being able to sharpen our thoughts – be thrown into the waste-paper-basket (something the father of macroeconomics, Keynes, used to do), and not as today, being allowed to overrun our economics journals and giving their authors celestial academic prestige.

Krugman’s explications on this issue is really interesting also because they shed light on a kind of inconsistency in his art of argumentation. During a couple of years Krugman has in more than one article criticized mainstream economics for using too much (bad) mathematics and axiomatics in their model-building endeavours. But when it comes to defending his own position on various issues he usually himself ultimately falls back on the same kind of models. [Added: In his End This Depression Now Paul Krugman maintains that although he doesn’t buy “the assumptions about rationality and markets that are embodied in many modern theoretical models, my own included,” he still find them useful “as a way of thinking through some issues carefully.”] 

In 1996 Krugman was invited to speak to the European Association for Evolutionary Political Economy. I think reading the speech gives more than one clue on the limits of Krugman’s critique of modern mainstream economics:

I like to think that I am more open-minded about alternative approaches to economics than most, but I am basically a maximization-and-equilibrium kind of guy. Indeed, I am quite fanatical about defending the relevance of standard economic models in many situations.

…

I won’t say that I am entirely happy with the state of economics. But let us be honest: I have done very well within the world of conventional economics. I have pushed the envelope, but not broken it, and have received very widespread acceptance for my ideas. What this means is that I may have more sympathy for standard economics than most of you. My criticisms are those of someone who loves the field and has seen that affection repaid. I don’t know if that makes me morally better or worse than someone who criticizes from outside, but anyway it makes me different.

…

To me, it seems that what we know as economics is the study of those phenomena that can be understood as emerging from the interactions among intelligent, self-interested individuals. Notice that there are really four parts to this definition. Let’s read from right to left.

1. Economics is about what individuals do: not classes, not “correlations of forces”, but individual actors. This is not to deny the relevance of higher levels of analysis, but they must be grounded in individual behavior. Methodological individualism is of the essence.

2. The individuals are self-interested. There is nothing in economics that inherently prevents us from allowing people to derive satisfaction from others’ consumption, but the predictive power of economic theory comes from the presumption that normally people care about themselves.

3. The individuals are intelligent: obvious opportunities for gain are not neglected. Hundred-dollar bills do not lie unattended in the street for very long.

4. We are concerned with the interaction of such individuals: Most interesting economic theory, from supply and demand on, is about “invisible hand” processes in which the collective outcome is not what individuals intended.

…

Personally, I consider myself a proud neoclassicist. By this I clearly don’t mean that I believe in perfect competition all the way. What I mean is that I prefer, when I can, to make sense of the world using models in which individuals maximize and the interaction of these individuals can be summarized by some concept of equilibrium. The reason I like that kind of model is not that I believe it to be literally true, but that I am intensely aware of the power of maximization-and-equilibrium to organize one’s thinking – and I have seen the propensity of those who try to do economics without those organizing devices to produce sheer nonsense when they imagine they are freeing themselves from some confining orthodoxy.

It shows up also in the citation above, where he refers to the work he has done with Eggertsson – work that actually, when it comes to methodology and assumptions, has a lot in common with the kind of model-building he otherwise criticizes.

The same critique – that when it comes to defending his own position on various issues he usually himself ultimately falls back on the same kind of models that he otherwise criticize – can be directed against his new post, where he after rightly critizing Wren-Lewis “optimising framework” goes on to – rather incomprehensibly in my opinion – defend the framework – referring to his own use of the Dixit-Stiglitz model of monopolistic competition – as just a “gadget”, a “silly, but brilliant” model. Krugman has said this before, but I am still waiting for him to really explain HOW the silly assumptions of “hyperrationality, not to mention representative agents” helps him “work with the fundamental issues”. If you have to use those assumptions with “your tongue firmly in cheek” – well, why then use them at all? Wouldn’t it be better to use more adequately realistic assumptions and be able to talk clear without any firm tongue in cheek?

On most macroeconomic policy discussions I find myself in agreement with Krugman. To me that just shows that Krugman is right in spite of and not thanks to those models he ultimately refers to. When he is discussing austerity measures, ricardian equivalence or problems with the euro, he is actually not using those models, but rather simpler and more adequate and relevant thought-constructions in the vein of Keynes.

In a recent paper on modern macroeconomics, “New Keynesian” macroeconomist Greg Mankiw wrote:

The real world of macroeconomic policymaking can be disheartening for those of us who have spent most of our careers in academia. The sad truth is that the macroeconomic research of the past three decades has had only minor impact on the practical analysis of monetary or fiscal policy. The explanation is not that economists in the policy arena are ignorant of recent developments. Quite the contrary: The staff of the Federal Reserve includes some of the best young Ph.D.’s, and the Council of Economic Advisers under both Democratic and Republican administrations draws talent from the nation’s top research universities. The fact that modern macroeconomic research is not widely used in practical policymaking is prima facie evidence that it is of little use for this purpose. The research may have been successful as a matter of science, but it has not contributed significantly to macroeconomic engineering.

So, then what is the raison d’être of macroeconomics, if it has nothing to say about the real world and the economic problems out there?

The final court of appeal for macroeconomic models is the real world, and as long as no convincing justification is put forward for how the inferential bridging de facto is made, macroeconomic modelbuilding is little more than “hand waving” that give us rather little warrant for making inductive inferences from models to real world target systems. If substantive questions about the real world are being posed, it is the formalistic-mathematical representations utilized to analyze them that have to match reality, not the other way around. As Keynes has it:

Economics is a science of thinking in terms of models joined to the art of choosing models which are relevant to the contemporary world. It is compelled to be this, because, unlike the natural science, the material to which it is applied is, in too many respects, not homogeneous through time.

If macoeconomic models – no matter of what ilk – assume representative actors, rational expectations, market clearing and equilibrium, and we know that real people and markets cannot be expected to obey these assumptions, the warrants for supposing that conclusions or hypothesis of causally relevant mechanisms or regularities can be bridged, are obviously non-justifiable. Macroeconomic theorists – regardless of being “New Monetarist”, “New Classical” or ”New Keynesian” – ought to do some ontological reflection and heed Keynes’ warnings on using thought-models in economics:

The object of our analysis is, not to provide a machine, or method of blind manipulation, which will furnish an infallible answer, but to provide ourselves with an organized and orderly method of thinking out particular problems; and, after we have reached a provisional conclusion by isolating the complicating factors one by one, we then have to go back on ourselves and allow, as well as we can, for the probable interactions of the factors amongst themselves. This is the nature of economic thinking. Any other way of applying our formal principles of thought (without which, however, we shall be lost in the wood) will lead us into error.

People calling themselves “New Keynesians” ought to be rather embarrassed by the fact that the kind of microfounded dynamic stochastic general equilibrium models they use, cannot incorporate such a basic fact of reality as involuntary unemployment!

Of course, working with representative agent models, this should come as no surprise. If one representative agent is employed, all representative agents are. The kind of unemployment that occurs is voluntary, since it is only adjustments of the hours of work that these optimizing agents make to maximize their utility.

Being a “New Keynesian” it ought to be of interest to know what Keynes had to say on the issue. In General Theory he writes:

The classical school [maintains that] while the demand for labour at the existing money-wage may be satisfied before everyone willing to work at this wage is employed, this situation is due to an open or tacit agreement amongst workers not to work for less, and that if labour as a whole would agree to a reduction of money-wages more employment would be forthcoming. If this is the case, such unemployment, though apparently involuntary, is not strictly so, and ought to be included under the above category of ‘voluntary’ unemployment due to the effects of collective bargaining, etc …
The classical theory … is best regarded as a theory of distribution in conditions of full employment. So long as the classical postulates hold good, unemployment, which is in the above sense involuntary, cannot occur. Apparent unemployment must, therefore, be the result either of temporary loss of work of the ‘between jobs’ type or of intermittent demand for highly specialised resources or of the effect of a trade union ‘closed shop’ on the employment of free labour. Thus writers in the classical tradition, overlooking the special assumption underlying their theory, have been driven inevitably to the conclusion, perfectly logical on their assumption, that apparent unemployment (apart from the admitted exceptions) must be due at bottom to a refusal by the unemployed factors to accept a reward which corresponds to their marginal productivity …

Obviously, however, if the classical theory is only applicable to the case of full employment, it is fallacious to apply it to the problems of involuntary unemployment – if there be such a thing (and who will deny it?). The classical theorists resemble Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight – as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry. Something similar is required to-day in economics. We need to throw over the second postulate of the classical doctrine and to work out the behaviour of a system in which involuntary unemployment in the strict sense is possible.

So, these are some of my arguments for why I think that Simon Wren-Lewis, Paul Krugman and all other neoclassical macroeconomists ought to be even more critical of the present state of macroeconomics than they are. If macroeconomic models – no matter of what ilk –  build on microfoundational assumptions of representative actors, rational expectations, market clearing and equilibrium, and we know that real people and markets cannot be expected to obey these assumptions, the warrants for supposing that conclusions or hypothesis of causally relevant mechanisms or regularities can be bridged, are obviously non-justifiable. Incompatibility between actual behaviour and the behaviour in macroeconomic models building on representative actors and rational expectations-microfoundations is not a symptom of “irrationality”. It rather shows the futility of trying to represent real-world target systems with models flagrantly at odds with reality. 

A gadget is just a gadget – and brilliantly silly models do not help us working with the fundamental issues of modern economies.