More Oxford flimflam

1 May, 2014 at 15:41 | Posted in Economics | 9 Comments

3634flimOxford macroeconomist Simon Wren-Lewis is not too happy about the critique waged against him and other “New Keynesian” economists. In a post today on his blog he answers the critique put forward by yours truly and Thomas Palley:

We “use price and nominal wage rigidity to explain cyclical unemployment”. Now I admit to not being terribly concerned about what Keynes really meant, but I’m at a loss to see marginal productivity distribution theory at the centre of New Keynesian theory. What New Keynesian theory does need is that falls in real interest rates stimulate aggregate demand (i.e. some form of IS curve), and in the basic model this comes from changing the intertemporal pattern of consumption. Is that wrong? What explains cyclical unemployment is real interest rates being at the wrong level. Movements in wages and prices get us out of a recession because they lead the central bank to reduce real interest rates. At the zero bound they cannot do that, and in those circumstances wage and price flexibility could make things worse. Is that wrong?

Now it is true that the standard New Keynesian model assumes a labour market that clears, but a model that replaces this with labour market imperfect competition would not behave very differently. That is what I actually teach. Equally the basic New Keynesian model assumes rational expectations, but if we want to change this to a case where agents make predictable errors that is easy enough to do.

Is that wrong? Yes, indeed, almost everything here is wrong!

New Keynesianism. Let me start by saying that I find it rather disturbing that economics professors like Wren-Lewis and Krugman again and again show an unbefitting arrogance and even coquette about knowing next to nothing about the economics of the person who’s name they shamelessly profit on in calling themselves New Keynesians. “New Keynesianism” is a gross misnomer!

Rational expectations. Wren-Lewis’s portrayal of rational expectations is not as innocent as it may look. Rational expectations in the neoclassical economists’s world implies that relevant distributions have to be time independent. This amounts to assuming that an economy is like a closed system with known stochastic probability distributions for all different events. In reality it is straining one’s beliefs to try to represent economies as outcomes of stochastic processes. An existing economy is a single realization tout court, and hardly conceivable as one realization out of an ensemble of economy-worlds, since an economy can hardly be conceived as being completely replicated over time. It’s really straining one’s imagination trying to see any similarity between these modelling assumptions and the expectations of real persons. In the world of the rational expectations hypothesis we are never disappointed in any other way than as when we lose at the roulette wheels. But real life is not an urn or a roulette wheel. And that’s also the reason why allowing for cases where agents “make predictable errors” in the New Keynesian models doesn’t take us a single millimeter closer to a relevant and realist depiction of actual economic decisions and behaviours. If we really want to have anything of interest to say on real economies, financial crisis and the decisions and choices real people make we have to replace the rational expectations hypothesis with more relevant and realistic assumptions concerning economic agents and their expectations than childish roulette and urn analogies.

Unemployment. In the basic “New Keynesian” DSGE models the labour market is always cleared – responding to a changing interest rate, expected life time incomes, or real wages, the representative agent maximizes the utility function by varying her labour supply, money holding and consumption over time. Most importantly – if the real wage somehow deviates from its “equilibrium value,” the representative agent adjust her labour supply, so that when the real wage is higher than its “equilibrium value,” labour supply is increased, and when the real wage is below its “equilibrium value,” labour supply is decreased.

In this model world, unemployment is always an optimal choice to changes in the labour market conditions. Hence, unemployment is totally voluntary. To be unemployed is something one optimally chooses to be.

Although this picture of unemployment as a kind of self-chosen optimality, strikes most people as utterly ridiculous, there are also, unfortunately, a lot of “NewKeynesian” economists out there who still think that price and wage rigidities are the prime movers behind unemployment. DSGE models basically explains variations in employment (and a fortiori output) with assuming nominal wages being more flexible than prices – disregarding the lack of empirical evidence for this rather counterintuitive assumption.

Lowering nominal wages would not  clear the labour market. Lowering wages – and possibly prices – could, perhaps, lower interest rates and increase investment. It would be much easier to achieve that effect by increasing the money supply. In any case, wage reductions was not seen as a general substitute for an expansionary monetary or fiscal policy. And even if potentially positive impacts of lowering wages exist, there are also more heavily weighing negative impacts – management-union relations deteriorating, expectations of on-going lowering of wages causing delay of investments, debt deflation <em>et cetera</em>.

The classical proposition that lowering wages would lower unemployment and ultimately take economies out of depressions, was ill-founded and basically wrong. Flexible wages would probably only make things worse by leading to erratic price-fluctuations. The basic explanation for unemployment is insufficient aggregate demand, and that is mostly determined outside the labour market.

Obviously it’s rather embarrassing that the kind of DSGE models “New Keynesian” macroeconomists like Wren-Lewis 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. 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.

 

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9 Comments »

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  1. What about New Keynesian models beyond the “basic” one? I don’t think it’s fair to characterize a whole literature by its first simple model. If the framework cannot solve your problems, that’s different, but you only critique the econ 101 model.

  2. Thanks for this post, Mr. Sylls, especially the “An existing economy is a single realization tout court…”. It’d be interesting to read more about this.

    • Hello George – I write on this here http://mpra.ub.uni-muenchen.de/29780/
      “Why inferential statistics are inappropriate for development studies and how the same data can be better used”, which Lars has been kind enough to mention on his site before. Cheers, Clint

      • Thanks very much! I will check it out! It’s very encouraging to read such clear-headed criticisms of the New Keynesians and mainstream economics in general.

  3. Also, I got into a all-too-brief discussion on Naked Keynesian about this idea of “the economy as algorithm” similar to Hayek’s view.
    I pointed out to the Naked Keynesian person, that while the economy as “algorithm” or “computational device” is interesting, an economy “tout court” can not be algorithmic if as Keynes believed, radical uncertainty is the fundamental property of social or economic life. There is nothing computational about an economy in aggregate, since algorithms are procedures of a finite number of steps with a specific known outcome.
    Sadly, the Naked Keynesian person never replied.

  4. Wren-Lewis: [...] in those circumstances wage and price flexibility could make things worse.
    Syll: Flexible wages would probably only make things worse by leading to erratic price-fluctuations.
    .
    Wren-Lewis: [...] standard New Keynesian model assumes a labour market that clears, but a model that replaces this with labour market imperfect competition would not behave very differently.
    Syll: Obviously it’s rather embarrassing that the kind of DSGE models [...] cannot incorporate such a basic fact of reality as involuntary unemployment.
    .
    Wren-Lewis: if we want to change [rational expectations] to a case where agents make predictable errors that is easy enough to do.
    Syll: If we really want to have anything of interest to say on real economies [...] we have to replace the rational expectations hypothesis.
    .
    Wren-Lewis: Despite all this, I would like to have a debate about macroeconomics with heterodox economists.
    Syll: unbefitting arrogance and even coquette [...] shamelessly profit [...] utterly ridiculous [...]
    .
    One has to wonder – does adopting a heterodox view cause lack of civility and reading comprehension, or is there a selection effect at work?

    • Impressive quotations-scissors you have, Ivan. No random walk there … Fortunately our posts are still up, so I guess the readers can judge for themselves on the value of your “abbreviations”!

    • Ivan, I believe it’s a rare but powerful propagating effect of selection and Dunning-Kruger that gives the result. Something for anthropologists of the future!

  5. Wren Lewis has written some articles about microfoundations and frequently written about it in his blog. His position is non-dogmatic, he appreciates the advantages of microfoundations but also appreciates good ol’ ad hoc modelling. He has also pointed out that some CBs have a model with a DSGE core and an ad-hoc parameter in which they can add all the real-world stuff that is difficult to incorporate into a DSGE.

    Obviously this is somehow crude but nonetheless superior to the old models from the sixties in which the only dynamics came into via VARs … and this was just empirics without theory. Nowadays we have the other extreme, DSGE is theory without empirics so Wren-Lewis suggestion of merging the best of both worlds to get not just external or internal consistency but some of both at the same time seems reasonable to me.


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