[h/t Jan Milch]
This is a fair presentation and critique of Austrian methodology. But beware! In theoretical and methodological questions it’s not always either-or. We have to be open-minded and pluralistic enough not to throw out the baby with the bath water — and fail to secure insights like this:
What is the problem we wish to solve when we try to construct a rational economic order? … If we possess all the relevant information, if we can start out from a given system of preferences, and if we command complete knowledge of available means, the problem which remains is purely one of logic …
This, however, is emphatically not the economic problem which society faces … The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is … a problem of the utilization of knowledge which is not given to anyone in its totality.
This character of the fundamental problem has, I am afraid, been obscured rather than illuminated by many of the recent refinements of economic theory … Many of the current disputes with regard to both economic theory and economic policy have their common origin in a misconception about the nature of the economic problem of society. This misconception in turn is due to an erroneous transfer to social phenomena of the habits of thought we have developed in dealing with the phenomena of nature …
To assume all the knowledge to be given to a single mind in the same manner in which we assume it to be given to us as the explaining economists is to assume the problem away and to disregard everything that is important and significant in the real world.
Compare this relevant and realist wisdom with the rational expectations hypothesis (REH) used by almost all mainstream macroeconomists today. REH presupposes – basically for reasons of consistency – that agents have complete knowledge of all of the relevant probability distribution functions. And when trying to incorporate learning in these models – trying to take the heat of some of the criticism launched against it up to date – it is always a very restricted kind of learning that is considered. A learning where truly unanticipated, surprising, new things never take place, but only rather mechanical updatings – increasing the precision of already existing information sets – of existing probability functions.
Nothing really new happens in these ergodic models, where the statistical representation of learning and information is nothing more than a caricature of what takes place in the real world target system. This follows from taking for granted that people’s decisions can be portrayed as based on an existing probability distribution, which by definition implies the knowledge of every possible event (otherwise it is in a strict mathematical-statistically sense not really a probability distribution) that can be thought of taking place.
The rational expectations hypothesis presumes consistent behaviour, where expectations do not display any persistent errors. In the world of rational expectations we are always, on average, hitting the bull’s eye. In the more realistic, open systems view, there is always the possibility (danger) of making mistakes that may turn out to be systematic. It is because of this, presumably, that we put so much emphasis on learning in our modern knowledge societies.
As Hayek wrote:
When it comes to the point where [equilibrium analysis] misleads some of our leading thinkers into believing that the situation which it describes has direct relevance to the solution of practical problems, it is high time that we remember that it does not deal with the social process at all and that it is no more than a useful preliminary to the study of the main problem.
[And just in case you're contemplating commenting on this post and think that Hayek is all bad -- read this first!]
Paul Krugman’s economic analysis is always stimulating and insightful, but there is one issue on which I think he persistently falls short. That issue is his account of New Keynesianism’s theoretical originality and intellectual impact … The model of nominal wage rigidity and the Phillips curve that I described comes from my 1990 dissertation, was published in March 1994, and has been followed by substantial further published research. That research also introduces ideas which are not part of the New Keynesian model and are needed to explain the Phillips curve in a higher inflation environment.
Similar precedence issues hold for scholarship on debt-driven business cycles, financial instability, the problem of debt-deflation in recessions and depressions, and the endogenous credit-driven nature of the money supply. These are all topics my colleagues and I, working in the Post- and old Keynesian traditions, have been writing about for years – No, decades!
Since 2008, some New Keynesians have discovered these same topics and have developed very similar analyses. That represents progress which is good news for economics. However, almost nowhere will you find citation of this prior work, except for token citation of a few absolutely seminal contributors (like Tobin and Minsky) …
By citing the seminal critical thinkers, mainstream economists lay claim to the intellectual lineage. And by overlooking more recent work, they capture the ideas of their critics.
This practice has enormous consequences. At the personal level, there is the matter of vain glory. At the sociological level, it suffocates debate and pluralism in economics. It is as if the critics have produced nothing so there is no need for debate, and nor are the critics deserving of a place in the academy …
For almost thirty years, New Keynesians have dismissed other Keynesians and not bothered to stay acquainted with their research. But now that the economic crisis has forced awareness, the right thing is to acknowledge and incorporate that research. The failure to do so is another element in the discontent of critics, which Krugman dismisses as just “Frustrations of the Heterodox.”
Added July 29: Krugman answers here.
What is science? One brief definition runs: “A systematic knowledge of the physical or material world.” Most definitions emphasize the two elements in this definition: (1) “systematic knowledge” about (2) the real world. Without pushing this definitional question to its metaphysical limits, I merely want to suggest that if economics is to be a science, it must not only develop analytical tools but must also apply them to a world that is now observable or that can be made observable through improved methods of observation and measurement. Or in the words of the Hungarian mathematical economist Janos Kornai, “In the real sciences, the criterion is not whether the proposition is logically true and tautologically deducible from earlier assumptions. The criterion of ‘truth’ is, whether or not the proposition corresponds to reality” …
One of our most distinguished historians of economic thought, George Stigler, has stated that: “The dominant influence upon the working range of economic theorists is the set of internal values and pressures of the discipline. The subjects of study are posed by the unfolding course of scientific developments.” He goes on to add: “This is not to say that the environment is without influence …” But, he continues, “whether a fact or development is significant depends primarily on its relevance to current economic theory.” What a curious relating of rigor to relevance! Whether the real world matters depends presumably on “its relevance to current economic theory.” Many if not most of today’s economic theorists seem to agree with this ordering of priorities …
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 … The theoretical analysis in much of this literature rests on assumptions that also fly in the face of the facts … Another related recent development in which theory proceeds with impeccable logic from unrealistic assumptions to conclusions that contradict the historical record, is the recent work on rational expectations …
I have scolded economists for what I think are the sins that too many of them commit, and I have tried to point the way to at least partial redemption. This road to salvation will not be an easy one for those who have been seduced by the siren of mathematical elegance or those who all too often seek to test unrealistic models without much regard for the quality or relevance of the data they feed into their equations. But let us all continue to worship at the altar of science. I ask only that our credo be: “relevance with as much rigor as possible,” and not “rigor regardless of relevance.” And let us not be afraid to ask — and to try to answer the really big questions.
Stage 0. Late 1960’s. The Phelps volume, and Milton Friedman’s paper (pdf), both thinking about the microfoundations of the Phillips Curve, the difference between actual and expected inflation, and the role of monetary policy. This was the ancestral homeland of both New Keynesian and New Classical macroeconomics, which could not be distinguished at this stage …
Stage 1. Mid 1970’s. Now we see the difference. A distinct New Keynesian approach emerges. New Keynesians assume that prices (and/or wages) are set in advance, at expected market-clearing levels, before the shocks are known. This means that monetary policy can respond to those shocks, and help prevent undesirable fluctuations in output and employment. Even under rational expectations …
Stage 2. Late 1980’s. New Keynesians introduce monopolistic competition. This has two big advantages. First, you can now easily model price-setting firms as choosing a price to maximize profit… Second, because if a positive demand shock hits a perfectly competitive market, where prices are fixed at what was the expected market-clearing level, firms would ration sales, and you get a drop in output and employment, rather than a boom. And the world doesn’t seem to look like that.
Stage 3. Early 2000’s. New Keynesians introduce monetary policy without money. They become Neo-Wicksellians … There were two advantages to doing this. First, it let them model households’ and firms’ choices without needing to model the demand for money and the supply of money. Second, it made it easier to talk to central bankers who already thought of central banks as setting interest rates.
Which brings us to the End of History.
What about microfoundations? Well, it was an underlying theme, but there is nothing distinctively New Keynesian about that theme …
Likewise with rational expectations. New Keynesians just went with the flow.
Although I find Rowe’s macro history interesting — and to a large extent in line with the one I give in my own history of economics books — I also think the fact that on microfoundations “there is nothing distinctively New Keynesian” and that “New Keynesians just went with the flow” on that theme, deserves a comment.
Where “New Keynesian” economists think that they can rigorously deduce the aggregate effects of (representative) actors with their reductionist microfoundational methodology, they have to put a blind eye on the emergent properties that characterize all open social systems – including the economic system. The interaction between animal spirits, trust, confidence, institutions etc., cannot be deduced or reduced to a question answerable on the idividual level. Macroeconomic structures and phenomena have to be analyzed also on their own terms. And although one may easily agree with e.g. Paul Krugman’s emphasis on simple models, the simplifications used may have to be simplifications adequate for macroeconomics and not those adequate for microeconomics.
In microeconomics we know that aggregation really presupposes homothetic an identical preferences, something that almost never exist in real economies. The results given by these assumptions are therefore not robust and do not capture the underlying mechanisms at work in any real economy. And models that are critically based on particular and odd assumptions – and are neither robust nor congruent to real world economies – are of questionable value.
Even if economies naturally presuppose individuals, it does not follow that we can infer or explain macroeconomic phenomena solely from knowledge of these individuals. Macroeconomics is to a large extent emergent and cannot be reduced to a simple summation of micro-phenomena. Moreover, even these microfoundations aren’t immutable. The “deep parameters” of “New Keynesian” DSGE models– “tastes” and “technology” – are not really the bedrock of constancy that they believe (pretend) them to be.
So — I cannot concur with Paul Krugman, Mike Woodford, Greg Mankiw and other sorta-kinda “New Keynesians” when they more or less try to reduce Keynesian economics to “intertemporal maximization modified with sticky prices and a few other deviations”. And I’m certainly not the only ones thinking in these terms:
In a world that is importantly indeterminate — a world in which even some central things, such as the ‘rate and direction’ of innovation, and thus of productivity advances, are not predetermined — some models are better than others in outlining the structure of relationships. But even our models cannot offer forecasts of the future levels of the real price … and the real wage … in relation to present levels … As Keynes, when writing on this point, put it, ‘we simply do not know’ …
Does this finding mean that the ‘natural’ level of (un)employment no longer exists? That depends on what we mean by ‘natural.’ If we mean some immutable central tendency, then it never existed … It is ironic that the originators of models of the natural rate, whose formulations did not explicitly exclude that background expectations of future capital goods prices and future wages might be quite wrong, stand accused of not appreciating that any sort of economic equilibrium is to some extent a social phenomenon—a creature of beliefs, optimism, the policy climate, and so forth—while today’s crude Keynesians, despite their mechanical deterministic approach, wrap themselves in the mantle of Keynes, who, with his profound sense of indeterminacy and, consequently, radical uncertainty, was worlds away from their thinking.
Thus your standard New Keynesian model will use Calvo pricing and model the current inflation rate as tightly coupled to the present value of expected future output gaps. Is this a requirement anyone really wants to put on the model intended to help us understand the world that actually exists out there? Thus your standard New Keynesian model will calculate The expected path of consumption as the solution to some Euler equation plus an intertemporal budget constraint, with current wealth and the projected real interest rate path as the only factors that matter. This is fine if you want to demonstrate that the model can produce macroeconomic pathologies. But is it a not-stupid thing to do if you want your model to fit reality?
I remember attending the first lecture in Tom Sargent’s evening macroeconomics class back when I was in undergraduate: very smart man from whom I have learned the enormous amount, and well deserving his Nobel Prize. But…
He said … we were going to build a rigorous, micro founded model of the demand for money: We would assume that everyone lived for two periods, worked in the first period when they were young and sold what they produced to the old, held money as they aged, and then when they were old use their money to buy the goods newly produced by the new generation of young. Tom called this “microfoundations” and thought it gave powerful insights into the demand for money that you could not get from money-in-the-utility-function models.
I thought that it was a just-so story, and that whatever insights it purchased for you were probably not things you really wanted to buy. I thought it was dangerous to presume that you understood something because you had “microfoundations” when those microfoundations were wrong. After all, Ptolemaic astronomy had microfoundations: Mercury moved more rapidly than Saturn because the Angel of Mercury left his wings more rapidly than the Angel of Saturn and because Mercury was lighter than Saturn…
Old love never rusts …
The search-and-matching model works like this: one class of agents, “workers,” is either searching for a job or employed while another class of agents, “firms,” is either vacant, meaning it has a vacancy posted, or filled, in which case it employs a worker and together they hum along productively. In the earliest formulation of the model, the only economic decision made by either agent was whether a firm would post a vacancy in an attempt to match with a worker or would choose not to, thus remaining inactive. Otherwise, both searching workers and vacant firms mindlessly wait until they match up, then commence a productive relationship that lasts until their match spontaneously dissolves. Then the worker goes back to searching and the firm makes its decision about whether to post a vacancy or not once again.
The reason why search-and-matching labor market models have something to say about the recent history of the labor market is because they are a good deal richer than the simple search-based story, which is the reason why Federal Reserve Bank of Richmond economist Karthik Athreya, whose book sparked this discussion, said that “search is not really about searching.” Specifically, they allow for alternative theories of wage-setting, a factual timeline for unemployment spells and what determines their duration, a rich set of labor market outcomes beyond employment and unemployment, and an implementable notion of power that is often a critical missing piece of economic modeling.
Like all economic models, the search-and-matching model is a simplification, even a ludicrous one … So do we search theorists have a big problem?
Notice that my summary of the model left out one big thing: how the fruits of the productive employment relationship are split between the worker and the firm. This is by far the biggest controversy in the field of search theory. The assumption made by the earliest search-and-matching models is that the “surplus” the two agents generate is split between the parties in the optimal way, where the optimality concept is defined within the model but with some relationship to a more general intuition about what each party would want (that optimal way is known as the “Nash Bargain” after the Nobel-Prize-winning mathematical theorist John Nash) …
The problem is that this theory of wage setting is an empirical disaster. Not only is it inconsistent with investigations into how actual wages are actually set, but it generates false predictions about unemployment spells that crucially fail to line up with what happens to unemployment during recessions (it goes up, and it stays high for a long time, when the optimal theory of wages says that wages should do the adjusting). Refinements that make the theory with Nash Bargaining consistent with the data on unemployment in recessions yield their own big empirical problem: those refinements imply that being unemployed isn’t really that bad for workers, which everyone who is sentient knows to be untrue.
So the search-and-matching model has a crazy theory about how wages are set, and that makes it a crazy model of how labor markets work, right? No. What the search-and-matching theory has, and what its alternatives lack for the most part, is indeterminacy about how wages are set. The “Nash Bargain” theory is optimal, but it’s not necessary—other wage-setting assumptions can be used to resolve the indeterminacy. And if economists can get their minds around the idea that the “market solution” is not always optimal then they can make real headway with the search-and-matching approach precisely because it’s consistent with those alternatives.
[h/t Brad DeLong & Dwayne Woods]
Advocates for choice-based solutions should take a look at what’s happened to schools in Sweden, where parents and educators would be thrilled to trade their country’s steep drop in PISA scores over the past 10 years for America’s middling but consistent results. What’s caused the recent crisis in Swedish education? Researchers and policy analysts are increasingly pointing the finger at many of the choice-oriented reforms that are being championed as the way forward for American schools. While this doesn’t necessarily mean that adding more accountability and discipline to American schools would be a bad thing, it does hint at the many headaches that can come from trying to do so by aggressively introducing marketlike competition to education.
There are differences between the libertarian ideal espoused by Friedman and the actual voucher program the Swedes put in place in the early ’90s … But Swedish school reforms did incorporate the essential features of the voucher system advocated by Friedman. The hope was that schools would have clear financial incentives to provide a better education and could be more responsive to customer (i.e., parental) needs and wants when freed from the burden imposed by a centralized bureaucracy …
But in the wake of the country’s nose dive in the PISA rankings, there’s widespread recognition that something’s wrong with Swedish schooling … Competition was meant to discipline government schools, but it may have instead led to a race to the bottom …
It’s the darker side of competition that Milton Friedman and his free-market disciples tend to downplay: If parents value high test scores, you can compete for voucher dollars by hiring better teachers and providing a better education—or by going easy in grading national tests. Competition was also meant to discipline government schools by forcing them to up their game to maintain their enrollments, but it may have instead led to a race to the bottom as they too started grading generously to keep their students …
Maybe the overall message is … “there are no panaceas” in public education. We tend to look for the silver bullet—whether it’s the glories of the market or the techno-utopian aspirations of education technology—when in fact improving educational outcomes is a hard, messy, complicated process. It’s a lesson that Swedish parents and students have learned all too well: Simply opening the floodgates to more education entrepreneurs doesn’t disrupt education. It’s just plain disruptive.
[h/t Jan Milch]
James Heckman, winner of the “Nobel Prize” in economics (2000), did an inteview with John Cassidy in 2010. It’s an interesting read (Cassidy’s words in italics):
What about the rational-expectations hypothesis, the other big theory associated with modern Chicago? How does that stack up now?
I could tell you a story about my friend and colleague Milton Friedman. In the nineteen-seventies, we were sitting in the Ph.D. oral examination of a Chicago economist who has gone on to make his mark in the world. His thesis was on rational expectations. After he’d left, Friedman turned to me and said, “Look, I think it is a good idea, but these guys have taken it way too far.”
It became a kind of tautology that had enormously powerful policy implications, in theory. But the fact is, it didn’t have any empirical content. When Tom Sargent, Lard Hansen, and others tried to test it using cross equation restrictions, and so on, the data rejected the theories. There were a certain section of people that really got carried away. It became quite stifling.
What about Robert Lucas? He came up with a lot of these theories. Does he bear responsibility?
Well, Lucas is a very subtle person, and he is mainly concerned with theory. He doesn’t make a lot of empirical statements. I don’t think Bob got carried away, but some of his disciples did. It often happens. The further down the food chain you go, the more the zealots take over.
What about you? When rational expectations was sweeping economics, what was your reaction to it? I know you are primarily a micro guy, but what did you think?
What struck me was that we knew Keynesian theory was still alive in the banks and on Wall Street. Economists in those areas relied on Keynesian models to make short-run forecasts. It seemed strange to me that they would continue to do this if it had been theoretically proven that these models didn’t work.
What about the efficient-markets hypothesis? Did Chicago economists go too far in promoting that theory, too?
Some did. But there is a lot of diversity here. You can go office to office and get a different view.
[Heckman brought up the memoir of the late Fischer Black, one of the founders of the Black-Scholes option-pricing model, in which he says that financial markets tend to wander around, and don’t stick closely to economics fundamentals.]
[Black] was very close to the markets, and he had a feel for them, and he was very skeptical. And he was a Chicago economist. But there was an element of dogma in support of the efficient-market hypothesis. People like Raghu [Rajan] and Ned Gramlich [a former governor of the Federal Reserve, who died in 2007] were warning something was wrong, and they were ignored. There was sort of a culture of efficient markets—on Wall Street, in Washington, and in parts of academia, including Chicago.
What was the reaction here when the crisis struck?
Everybody was blindsided by the magnitude of what happened. But it wasn’t just here. The whole profession was blindsided. I don’t think Joe Stiglitz was forecasting a collapse in the mortgage market and large-scale banking collapses.
So, today, what survives of the Chicago School? What is left?
I think the tradition of incorporating theory into your economic thinking and confronting it with data—that is still very much alive. It might be in the study of wage inequality, or labor supply responses to taxes, or whatever. And the idea that people respond rationally to incentives is also still central. Nothing has invalidated that—on the contrary.
So, I think the underlying ideas of the Chicago School are still very powerful. The basis of the rocket is still intact. It is what I see as the booster stage—the rational-expectation hypothesis and the vulgar versions of the efficient-markets hypothesis that have run into trouble. They have taken a beating—no doubt about that. I think that what happened is that people got too far away from the data, and confronting ideas with data. That part of the Chicago tradition was neglected, and it was a strong part of the tradition.
When Bob Lucas was writing that the Great Depression was people taking extended vacations—refusing to take available jobs at low wages—there was another Chicago economist, Albert Rees, who was writing in the Chicago Journal saying, No, wait a minute. There is a lot of evidence that this is not true.
Milton Friedman—he was a macro theorist, but he was less driven by theory and by the desire to construct a single overarching theory than by attempting to answer empirical questions. Again, if you read his empirical books they are full of empirical data. That side of his legacy was neglected, I think.
When Friedman died, a couple of years ago, we had a symposium for the alumni devoted to the Friedman legacy. I was talking about the permanent income hypothesis; Lucas was talking about rational expectations. We have some bright alums. One woman got up and said, “Look at the evidence on 401k plans and how people misuse them, or don’t use them. Are you really saying that people look ahead and plan ahead rationally?” And Lucas said, “Yes, that’s what the theory of rational expectations says, and that’s part of Friedman’s legacy.” I said, “No, it isn’t. He was much more empirically minded than that.” People took one part of his legacy and forgot the rest. They moved too far away from the data.
Yes indeed, they certainly “moved too far away from the data.”
In one of the more well-known and highly respected evaluation reviews made, Michael Lovell (1986) concluded:
it seems to me that the weight of empirical evidence is sufficiently strong to compel us to suspend belief in the hypothesis of rational expectations, pending the accumulation of additional empirical evidence.
And this is how Nikolay Gertchev summarizes studies on the empirical correctness of the hypothesis:
More recently, it even has been argued that the very conclusions of dynamic models assuming rational expectations are contrary to reality: “the dynamic implications of many of the specifications that assume rational expectations and optimizing behavior are often seriously at odds with the data” (Estrella and Fuhrer 2002, p. 1013). It is hence clear that if taken as an empirical behavioral assumption, the RE hypothesis is plainly false; if considered only as a theoretical tool, it is unfounded and selfcontradictory.
For even more on the issue, permit me to self-indulgently recommend reading my article Rational expectations — a fallacious foundation for macroeconomics in a non-ergodic world in real-world economics review no. 62.