Neoclassical economics – emperor without clothes

20 Jun, 2013 at 18:54 | Posted in Economics | 1 Comment

Almost a century and a half after Léon Walras founded neoclassical general equilibrium theory, economists still have not been able to show that markets move economies to equilibria.

We do know that – under very restrictive assumptions – equilibria do exist, are unique and are Pareto-efficient. After reading Franklin M. Fisher‘s masterly article The stability of general equilibrium – what do we know and why is it important? one, however, has to ask oneself – what good does that do?

As long as we cannot show, except under exceedingly special assumptions, that there are convincing reasons to suppose there are forces which lead economies to equilibria – the value of general equilibrium theory is nil. As long as we cannot really demonstrate that there are forces operating – under reasonable, relevant and at least mildly realistic conditions – at moving markets to equilibria, there cannot really be any sustainable reason for anyone to pay any interest or attention to this theory.

A stability that can only be proved by assuming “Santa Claus” conditions is of no avail. Most people do not believe in Santa Claus anymore. And for good reasons. Santa Claus is for kids, and general equilibrium economists ought to grow up, leaving their Santa Claus economics in the dustbin of history.

Continuing to model a world full of agents behaving as economists – “often wrong, but never uncertain” – and still not being able to show that the system under reasonable assumptions converges to equilibrium (or simply assume the problem away), is a gross misallocation of intellectual resources and time.

In case you think, even for a moment, that drawing this dismal conclusion is just an idiosyncracy of yours truly and other heterodox economists, you better think twice! Here is what one of the world’s greatest microeconomists – Alan Kirman  – writes in his thought provoking paper The intrinsic limits of modern economic theory:

If one maintains the fundamentally individualistic approach to constructing economic models no amount of attention to the walls will prevent the citadel from becoming empty. Empty in the sense that one cannot expect it to house the elements of a scientific theory, one capable of producing empirically falsifiable propositions …

Starting from ‘badly behaved’ individuals, we arrive at a situation in which not only is aggregate demand a nice function but, by a result of Debreu, equilibrium will be ‘locally unique. Whilst this means that at least there is some hope for local stability, the real question is, can we hope to proceed and obtain global uniqueness and stability?

The unfortunate answer is a categorical no! [The results of Sonnenchein (1972), Debreu (1974), Mantel (1976) and Mas Collel (1985)] shows clearly why any hope for uniqueness or stability must be unfounded … There is no hope that making the distribution of preferences or income ‘not to dispersed’ or ‘single peaked’ will help us to avoid the fundamental problem …

The problem seems to be embodied in what is an essential feature of a centuries-long tradition in economics, that of treating individuals as acting independently of each other …

To argue in this way suggests … that once the appropriate signals are given, individuals behave in isolation and the result of their behaviour may simply be added together …

The idea that we should start at the level of the isolated individual is one which we may well have to abandon … we should be honest from the outset and assert simply that by assumption we postulate that each sector of the economy behaves as one individual and not claim any spurious microjustification …

Economists therefore should not continue to make strong assertions about this behaviour based on so-called general equilibrium models which are, in reality, no more than special examples with no basis in economic theory as it stands.

From a macroeconomic point of view, the arguments of Fisher and Kirman also show why New Classical, Real Business Cycles, Dynamic Stochastic General Equilibrium (DSGE) and “New Keynesian” microfounded macromodels are such bad substitutes for real macroeconomic analysis.

These models try to describe and analyze complex and heterogeneous real economies with a single rational-expectations-robot-imitation-representative-agent. That is, with something that has absolutely nothing to do with reality. And – worse still – something that is not even amenable to the kind of general equilibrium analysis that they are thought to give a foundation for, since the Sonnenschein-Mantel-Debreu theorem unequivocally showed that there did not exist any condition by which assumptions on individuals would guarantee neither stability nor uniqueness of the equlibrium solution.

Opting for cloned representative agents that are all identical is of course not a real solution to the fallacy of composition that the theorem points to. After all – as Nobel laureate Robert Solow noted in “The State of Macroeconomics” (Journal of Economic Perspectives 2008:243-249) – “a modern economy is populated by consumers, workers, pensioners, owners, managers, investors, entrepreneurs, bankers, and others, with different and sometimes conflicting desires, information, expectations, capacities, beliefs, and rules of behavior.” So, representative agent models are rather an evasion whereby issues of distribution, coordination, heterogeneity – everything that really defines macroeconomics – are swept under the rug.

Conclusion – don’t believe a single thing of what these microfounders tell you until they have told you how they have coped with – not evaded – Sonnenschein-Mantel-Debreu!

Of course, most neoclassical macroeconomists know that to use a representative agent is a flagrantly illegitimate method of ignoring real aggregation issues. They keep on with their business, nevertheless, just because it significantly simplifies what they are doing. It reminds – not so little – of the drunkard who has lost his keys in some dark place and deliberately chooses to look for them under a neighbouring street light just because it is easier to see there!