Krugman’s fuddy duddy defense of economic orthodoxy

1 Dec, 2013 at 18:38 | Posted in Economics | 1 Comment

“Sorta-kinda New Keynesian” economist Paul Krugman now has learned from Francesco Saraceno — who links to yours truly — that “some people are attacking” him for “defending an economic orthodoxy that has failed.” Krugman writes:

It’s kind of an odd place to find myself, given how critical I’ve been of the way the economics profession has dealt with the crisis. But it’s not entirely unfair: I am quite skeptical of people whose response to the sorry state of affairs is to declare that what we need is a whole new field …

My answer, to put it in technical terms, is “Well, duh.” Maybe grad students at some departments, who are several generations into the law of diminishing disciples, really don’t know that rational behavior is at best a useful fiction, that markets aren’t perfect, etc, etc …

The question is what you do with this insight.

[W]hat I do … plus many others does, is a more modest, more eclectic form of analysis. You use maximization and equilibrium where it seems reasonably consistent with reality, because of its clarifying power, but you introduce ad hoc deviations where experience seems to demand them — downward rigidity of wages, balance-sheet constraints, bubbles (which are hard to predict, but you can say a lot about their consequences).

You may say that what we need is reconstruction from the ground up — an economics with no vestige of equilibrium analysis. Well, show me some results. As it happens, the hybrid, eclectic approach I’ve just described has done pretty well in this crisis, so you had better show me some really superior results before it gets thrown out the window.

Does this mean that nothing should change in the way we teach economics? By no means — it’s quite clear that the teaching of macroeconomics has gone seriously astray. As Saraceno says, the simple models that have proved so useful since 2008 are by and large taught only at the undergrad level — they’re treated as too simple, too ad hoc, whatever, to make it into the grad courses even at places that aren’t very ideological.

Let me just start with an observation on Krugman’s allusion (“simple models”) to IS-LM. This, 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. And 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?

Secondly, when it comes to modeling philosophy, Paul Krugman has in an earlier piece defended his position in the following words (my italics):

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 am however not convinced by the argument. 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. In his End This Depression Now — just to take one example — 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.”

When it comes to methodology and assumptions, Krugman obviously 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. Krugman has said these things before, but I am still waiting for him to really explain HOW the silly assumptions of hyperrationality and representative agents helps him work with the fundamental issues. If one can only use those assumptions with — as Krugman says, “tongue 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 tongue in cheek?

Thirdly, I notice again and again, that 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 neoclassical 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.

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 model building 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 macroeconomic 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.

Lastly, I think people — like Paul Krugman — calling themselves “New Keynesians” ought to be rather embarrassed by the fact that the kind of 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 Paul Krugman and other neoclassical macro economists 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 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 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 simple models — IS-LM included — do not help us working with the fundamental issues of modern economies any more than brilliantly silly complicated models — calibrated DSGE and RBC models included. That’s also a reason why I — unlike Paul Krugman — support the young economics students who ask for Rethinking Economics.