There is something about the way macroeconomists construct their models nowadays that obviously doesn’t sit right.
Empirical evidence only plays a minor role in neoclassical mainstream economic theory, where models largely function as a substitute for empirical evidence. One might have hoped that humbled by the manifest failure of its theoretical pretences during the latest economic-financial crisis, the one-sided, almost religious, insistence on axiomatic-deductivist modeling as the only scientific activity worthy of pursuing in economics would give way to methodological pluralism based on ontological considerations rather than formalistic tractability. That has, so far, not happened.
Fortunately — when you’ve got tired of the kind of macroeconomic apologetics produced by “New Keynesian” macroeconomists and other DSGE modellers — there still are some real Keynesian macroeconomists to read. One of them — Axel Leijonhufvud — writes:
For many years now, the main alternative to Real Business Cycle Theory has been a somewhat loose cluster of models given the label of New Keynesian theory. New Keynesians adhere on the whole to the same DSGE modeling technology as RBC macroeconomists but differ in the extent to which they emphasise inflexibilities of prices or other contract terms as sources of shortterm adjustment problems in the economy. The “New Keynesian” label refers back to the “rigid wages” brand of Keynesian theory of 40 or 50 years ago. Except for this stress on inflexibilities this brand of contemporary macroeconomic theory has basically nothing Keynesian about it …
I conclude that dynamic stochastic general equilibrium theory has shown itself an intellectually bankrupt enterprise. But this does not mean that we should revert to the old Keynesian theory that preceded it (or adopt the New Keynesian theory that has tried to compete with it). What we need to learn from Keynes … are about how to view our responsibilities and how to approach our subject.
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 no matter how brilliantly silly DSGE models you come up with, they do not help us working with the fundamental issues of modern economies. Using DSGE models only confirms Robert Gordon‘s dictum that today
rigor competes with relevance in macroeconomic and monetary theory, and in some lines of development macro and monetary theorists, like many of their colleagues in micro theory, seem to consider relevance to be more or less irrelevant.
In an often cynical world, standard ﬁnancial and macroeconomic quantitative models give people the beneﬁ t of the doubt. Fundamental economic theory assumes the best of us, supposing that human beings are perfectly rational, know all the facts of a given situation, understand the risks, and optimize our behavior and portfolios accordingly. Reality, of course, is quite different. While a signiﬁcant portion of individual and market behavior can be modeled reasonably well, the human emotions that drive cycles of fear and greed are not predictable and can often defy historical precedent. As a result, quantitative models sometimes fail to anticipate major macroeconomic turning points. The ongoing debt crisis in Europe is the most recent example of an extreme event shattering historical norms.
Once an extreme event occurs, standard models offer limited insight as to how the ensuing crisis could play out and how it should be managed, which is why policy responses can seem disjointed. The latest policy responses to the European crisis have been no exception. To understand and respond to a crisis like the one in Europe, perhaps we need to consider some new models that include the “human factor.” Economic historian Charles Kindleberger can offer some insight. In his book Manias, Panics, and Crashes, Kindleberger explores the anatomy of a typical ﬁnancial crisis and provides a framework that considers the impact of the powerful human dynamics of fear and greed. Kindleberger’s descriptive process of the boom and bust liquidity cycle can help shed light on the current European sovereign debt saga, and perhaps illuminate whether we have in fact turned the corner on this ﬁnancial crisis.
Kindleberger analyzed hundreds of ﬁnancial crises dating back centuries and found them to share a common sequence of events, one that followed monetary theorist Hyman Minsky’s model of the instability of a credit system. Fundamentally, the more stable and prosperous an economic structure appears, the more leverage and speculative ﬁnancing will build within the system, eventually making it highly vulnerable to a surprising, extreme collapse. Kindleberger provided the qualitative (as opposed to quantitative!) description of the Minsky Model, shown below, which is a useful snapshot of the liquidity cycle. It can be applied to Europe and any potential boom/bust candidate, including Chinese real estate, commodity prices, or investors’ recent love affair with emerging markets. Kindleberger famously dubbed this sequence a “hardy perennial,” probably because the galvanizing human conditions of fear and greed are more often than not prone to overshoot fundamental values compared to the behavior of a rational individual, which exists only in macroeconomic theory.
For more on Minsky, listen to BBC 4 where Duncan Weldon tries to explain in what way Hyman Minsky’s thoughts on banking and finance offer a radical challenge to mainstream economic theory.
As a young research stipendiate in the U.S. thirty years ago, yours truly had the great pleasure and privelege of having Hyman Minsky as teacher. He was a great inspiration at the time. He still is.
The correlation between unemployment and suicide has been observed since the 19th century. People looking for work are about twice as likely to end their lives as those who have jobs.
In the United States, the suicide rate, which had slowly risen since 2000, jumped during and after the 2007-9 recession. In a new book, we estimate that 4,750 “excess” suicides — that is, deaths above what pre-existing trends would predict — occurred from 2007 to 2010. Rates of such suicides were significantly greater in the states that experienced the greatest job losses. Deaths from suicide overtook deaths from car crashes in 2009.
If suicides were an unavoidable consequence of economic downturns, this would just be another story about the human toll of the Great Recession. But it isn’t so. Countries that slashed health and social protection budgets, like Greece, Italy and Spain, have seen starkly worse health outcomes than nations like Germany, Iceland and Sweden, which maintained their social safety nets and opted for stimulus over austerity. (Germany preaches the virtues of austerity — for others.) …
Our research suggests that investing $1 in public health programs can yield as much as $3 in economic growth. Public health investment not only saves lives in a recession, but can help spur economic recovery. These findings suggest that three principles should guide responses to economic crises.
First, do no harm: if austerity were tested like a medication in a clinical trial, it would have been stopped long ago, given its deadly side effects. Each nation should establish a nonpartisan, independent Office of Health Responsibility, staffed by epidemiologists and economists, to evaluate the health effects of fiscal and monetary policies.
Second, treat joblessness like the pandemic it is. Unemployment is a leading cause of depression, anxiety, alcoholism and suicidal thinking. Politicians in Finland and Sweden helped prevent depression and suicides during recessions by investing in “active labor-market programs” that targeted the newly unemployed and helped them find jobs quickly, with net economic benefits.
Finally, expand investments in public health when times are bad. The cliché that an ounce of prevention is worth a pound of cure happens to be true. It is far more expensive to control an epidemic than to prevent one. New York City spent $1 billion in the mid-1990s to control an outbreak of drug-resistant tuberculosis. The drug-resistant strain resulted from the city’s failure to ensure that low-income tuberculosis patients completed their regimen of inexpensive generic medications.
One need not be an economic ideologue — we certainly aren’t — to recognize that the price of austerity can be calculated in human lives. We are not exonerating poor policy decisions of the past or calling for universal debt forgiveness. It’s up to policy makers in America and Europe to figure out the right mix of fiscal and monetary policy. What we have found is that austerity — severe, immediate, indiscriminate cuts to social and health spending — is not only self-defeating, but fatal.
In economic theory, there is no true sense of government’s central role in a nation’s economy and in every aspect of its citizen’s lives. I call this Friedman’s Folly …
Modern economics has not made a positive case for what government must and can do. Government, after all, is society; it is all of us getting together. The economy is not. But prevailing orthodox economics would have us believe, following Friedman at least to a degree, and with only a little exaggeration, that it is …
Economists across the spectrum were influenced by the extremist Friedman, I’d argue, because he always defended himself by being consistent with the beautiful idea of the Invisible Hand. By the time the financial crisis of 2008 hit, Americans did not feel themselves part of a great national enterprise, a democracy of opportunity and social justice. They were busy reinventing a modern materialistic individualism, unaware of and apparently not caring how lacking they were in community. The failure to sense an obligation to each other is the worst consequence of Friedman’s Folly. There have been intelligent critics of his economic ideas, but economists in general are Friedman’s handmaidens.
One of the main ideas underlining the book is that “being an economist” in the XXI century requires a radical change in the training of economists and such change requires a global effort. A new economics curriculum is needed in order to improve the understanding of the deep interactions between economics and the political forces and the historical processes of social change. The need for trans-disciplinary and interdisciplinary work is highlighted.
Discussions include the following. Main critiques of current practices on theory, methods and structures. Current gaps in the economics curriculum. What should economics graduates know? The contributors are: Nicola Acocella, Sheila Dow, David Hemenway, Arturo Hermann, Grazia Ietto-Gillies, Maria Alejandra Madi, Lars Pålsson Syll, Constantine Passaris, Paul Ormerod, Jack Reardon, Alessando Roncaglia, Asad Zaman.
Yours truly’s contribution to the collection is on “Economics textbooks – anomalies and transmogrification of truth.”
Balliol Croft, Cambridge
27. ii. 06
My dear Bowley,
I have not been able to lay my hands on any notes as to Mathematico-economics that would be of any use to you: and I have very indistinct memories of what I used to think on the subject. I never read mathematics now: in fact I have forgotten even how to integrate a good many things.
But I know I had a growing feeling in the later years of my work at the subject that a good mathematical theorem dealing with economic hypotheses was very unlikely to be good economics: and I went more and more on the rules — (1) Use mathematics as a short-hand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life. (5) Burn the mathematics. (6) If you can’t succeed in 4, burn 3. This last I did often.
I believe in Newton’s Principia Methods, because they carry so much of the ordinary mind with them. Mathematics used in a Fellowship thesis by a man who is not a mathematician by nature — and I have come across a good deal of that — seems to me an unmixed evil. And I think you should do all you can to prevent people from using Mathematics in cases in which the English language is as short as the Mathematical …
Thomas Piketty’s book Capital in the Twenty-First Century has already attracted more serious attention than any economics book published in the last 75 years. This collection of 17 essays by some of the world’s most prominent economists explores Piketty’s book in depth and from various vantage points.
Yours truly’s contribution to the collection is on “Piketty and the limits of marginal productivity theory.”
At last something worth watching for our youngsters — a website on Keynes for kids!
On the theoretical side, there is a long tradition in economics arguing that acting to reduce inequality could be counterproductive. Yale University economist Arthur Okun summarized this view in his 1975 book, Equality and Efficiency: The Big Tradeoff, where he posited that income equality and economic efficiency are in tension. Inequality provides incentives for work and investment …
Okun’s view is based on the idea that monetary rewards and penalties drive productive activity, that is, if you pay people more (or, perhaps, pay them at all), they will work harder and be more productive. These rewards and penalties are optimal for growth. In this view, any intervention is distortionary and will, therefore, lower economic growth …
To be clear, Okun was not opposed to policymakers acting to reduce inequality. “The market needs a place, and the market needs to be kept in its place,” he said. Rather, he was concerned with how policymakers should act, given the economic realities of the supposed trade-off. His main concern was what he termed, “the leaky bucket,” that is, how much of redistributive policy leaks out of the system due to administrative costs, reduction in work effort, effects on saving and investment, and “socio-economic leakages” such as claims that extending unemployment benefits will reduce efforts to find a job …
While the idea that there is a trade-off between equality and efficiency as Okun put forth in 1975 may have been a widely accepted idea at the time, it is not the case that theory points entirely to this conclusion … However, strong simplifying assumptions limit the utility of the predictions from many of these theories and economists have been developing new approaches to account for a more realistic level of complexity … It is not the purpose of this paper to summarize this sub-field of economics, yet it is critical to understand that inequality may not always provide sufficient incentives for people to work harder despite the implications from some branches of theory.
The econometric analysis suggests that income inequality has a sizeable and statistically significant negative impact on growth, and that redistributive policies achieving greater equality in disposable income has no adverse consequences …
These findings have relevant implications for policymakers concerned about slow growth and rising inequality. On one hand it points to the importance of carefully assessing the potential consequences of pro-growth policies on inequality: focusing exclusively on growth and assuming that its benefits will automatically trickle down to the different segments of the population may undermine growth in the long run inasmuch as inequality actually increases. On the other hand it indicates that policies that help limiting or — ideally — reversing the long-run rise in ineqauality would not only make societies less unfair, but also richer.