LARS P. SYLL

The problem of reductionism in economics

The kinds of laws and relations that economics has established, are laws and relations about entities in models that presuppose causal mechanisms being atomistic and additive. When causal mechanisms operate in the real world they only do it in ever-changing and unstable combinations where the whole is more than a mechanical sum of parts. If economic regularities obtain they do it (as a rule) only because we engineered them for that purpose. Outside man-made “nomological machines” they are rare, or even non-existent. Unfortunately that also makes most of the achievements of contemporary economic theoretical modelling — rather useless.

When mainstream 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 characterise 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 individual level. Macroeconomic structures and phenomena have to be analysed also on their own terms.

I concetti di eterogeneità e interazione portano necessariamente alla questione della non linearità. Si dice che un sistema è lineare se può essere suddiviso in più parti che sono autonome l’una dall’altra, cioè indipendenti. Quando invece le varie componenti interagiscono direttamente tra loro, parliamo di non linearità. Il comportamento emergente di un sistema è dovuto alla non linearità. Le proprietà di un sistema lineare sono davvero particolari: l’effetto di un insieme di elementi è la somma degli effetti considerati separatamente, e nel suo insieme non appaiono nuove proprietà che non sono già presenti nei singoli elementi. Ma se ci sono elementi combinati, che dipendono l’uno dall’altro, il complesso è diverso dalla somma delle parti e compaiono nuovi effetti.

Mainstream macro models describe imaginary worlds using a combination of formal sign systems such as mathematics and ordinary language. The descriptions made are extremely thin and to a large degree disconnected to the specific contexts of the targeted system than one (usually) wants to (partially) represent. This is not by chance. These closed formalistic-mathematical theories and models are constructed for the purpose of being able to deliver purportedly rigorous deductions that may somehow by be exportable to the target system. By analysing a few causal factors in their “macroeconomic laboratories” they hope they can perform “thought experiments” and observe how these factors operate on their own and without impediments or confounders.

Unfortunately, this is not so. The reason for this is that economic causes never act in a socio-economic vacuum. Or as Mauro Gallegati puts it:

Benché il riduzionismo abbia avuto successo in un gran numero di situazioni in fisica – dal nucleo dell’atomo, al moto di un razzo nello spazio, alle galassie – la sua validità non è universale … L’interazione tra elementi ci obbliga a passare dal riduzionismo all’olismo, e quindi a cambiare metodo … Come la biologia, e a differenza della fisica che cerca di semplificare i fenomeni con l’obiettivo di formulare leggi generali, l’economia dipende da specifici eventi storici e poiché la capacità di apprendere dall’esperienza è fondamentale, l’economia studia sistemi complessi evoluzionistici di tipo adattativo.

Causes have to be set in a contextual structure to be able to operate. This structure has to take some form or other, but instead of incorporating structures that are true to the target system, the settings made in these macroeconomic models are rather based on formalistic mathematical tractability. In the models they appear as unrealistic assumptions, usually playing a decisive role in getting the deductive machinery deliver “precise” and “rigorous” results. This, of course, makes exporting to real-world target systems problematic, since these models — as part of a deductivist covering-law tradition in economics — are thought to deliver general and far-reaching conclusions that are externally valid. But how can we be sure the lessons learned in these theories and models have external validity, when based on highly specific unrealistic assumptions? As a rule, the more specific and concrete the structures, the less generalisable the results. Admitting that we in principle can move from (partial) falsehoods in theories and models to truth in real world target systems does not take us very far, unless a thorough explication of the relation between theory, model and the real world target system is made. If models 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. To have a deductive warrant for things happening in a closed model is no guarantee for them being preserved when applied to the real world.

The permanent income hypothesis

Almost all mainstream macroeconomic theories are based on Milton Friedman’s permanent income hypothesis (PIH). It is mostly used in formulating the consumption Euler equations that make up a vital part of ‘modern’ New Classical and ‘New Keynesian’ macro models.

So, what’s the problem with PIH? Well, only that empirical evidence have — again and again — falsified it!

One implication of PIH is that current consumption is modelled as not being influenced by predictable changes in incomes changes. Heaps of empirical consumption studies — going back for decades — however show that this is not the case.

Given this, it is rather disappointing to see how this falsified hypothesis is treated in mainstream economics.

Let me give just one example.

Wendy Carlin’s and David Soskice’s macroeonomics textbook Macroeconomics: Institutions, Instability, and the Financial System (Oxford University Press) builds more than most other intermediate macroeconomics textbooks on supplying the student with a ‘systematic way of thinking through problems’ with the help of formal-mathematical models.

They explicitly adapt a ‘New Keynesian’ framework including price rigidities and adding a financial system to the usual neoclassical macroeconomic set-up. But although I find things like the latter amendment an improvement, it’s definitely more difficult to swallow their methodological stance, and especially their non-problematized acceptance of the need for macroeconomic microfoundations.

From the first page of the book they start to elaborate their preferred 3-equations ‘New Keynesian’ macro model. And after twenty-two pages they have already come to specifying the demand side with the help of the Permanent Income Hypothesis and its Euler equations.

But if people — not the representative agent — at least sometimes can’t help being off their labour supply curve — as in the real world — then in what way are these hordes of Euler equations that you find ad nauseam in these ‘New Keynesian’ macro models gonna help us?

My doubts regarding macroeconomic modellers’ obsession with Euler equations is basically that, as with so many other assumptions in ‘modern’ macroeconomics, Euler equations, and the PIH that they build on, don’t fit reality.

In the standard neoclassical consumption model — underpinning Carlin’s and Soskice’s microfounded macroeconomic modelling — people are basically portrayed as treating time as a dichotomous phenomenon – today and the future — when contemplating making decisions and acting. How much should one consume today and how much in the future? The Euler equation used implies that the representative agent (consumer) is indifferent between consuming one more unit today or instead consuming it tomorrow. Further, in the Euler equation we only have one interest rate, equated to the money market rate as set by the central bank. The crux is, however, that — given almost any specification of the utility function – the two rates are actually often found to be strongly negatively correlated in the empirical literature!

From a methodological perspective yours truly has to conclude that Carlin’s and Soskice’s microfounded macroeconomic model is a rather unimpressive attempt at legitimizing using fictitious idealizations — such as PIH and Euler equations — for reasons more to do with model tractability than with a genuine interest of understanding and explaining features of real economies.

Limiting model assumptions in economic science always have to be closely examined since if we are going to be able to show that the mechanisms or causes that we isolate and handle in our models are stable in the sense that they do not change when we ‘export’ them to our ‘target systems,’ we have to be able to show that they do not only hold under ceteris paribus conditions and hence only are of limited value to our understanding, explanations or predictions of real economic systems.

Mainstream economists usually do not want to get hung up on the assumptions that their models build on. But it is still an undeniable fact that theoretical models building on piles of known to be false assumptions — such as PIH and the Euler equations that build on it — in no way even get close to being scientific explanations.

So — mainstream macroeconomics, building on the standard neoclassical consumption model with its Permanent Income Hypothesis and Euler equations, has to be replaced with something else. Preferably with something that is both real and relevant, and not only chosen for reasons of mathematical tractability.

General equilibrium illusions

When I read in the 70s the publications of Sonnenschein, Mantel and Debreu I was deeply concerned. Up to the
time I had the naive illusion that the microeconomic foundation of the GE model, which I had admired so much,
does not only allow us to prove that the model and the concept of equilibrium are logically consistent (that
equilibrium exists), but also allow us to show that the equilibrium is well determined (unique and stable). This
illusion, or should I rather say, this hope, was destroyed, once and for all. I was tempted to repress this insight and continue to find satisfaction in proving existence of equilibrium for more general models under still weaker assumptions. However, I did not succeed in repressing the newly gained insight because I believe that a theory of economic equilibrium is incomplete if the equilibrium is not well determined.

Werner Hildenbrand

And so what? Why should we care about Sonnenschein-Mantel-Debreu?

Because  Sonnenschein-Mantel-Debreu ultimately explains 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 Hugo Sonnenschein (1972),​ Rolf Mantel (1976) and Gerard Debreu (1974) unequivocally showed that there did not exist any condition by which assumptions on individuals would guarantee neither stability nor uniqueness of the equilibrium​ solution. A century and a half after Léon Walras founded neoclassical general equilibrium theory, modern mainstream economics hasn’t been able to show that markets move economies to equilibria. This if anything shows that the whole Bourbaki-Debreu project of axiomatizing​ economics was nothing but a delusion.

Opting for cloned representative agents that are all identical is of course not a real solution to the fallacy of composition that the Sonnenschein-Mantel-Debreu theorem points to. Representative agent models are — as I have argued at length in my On the use and misuse of theories and models in mainstream economics — rather an evasion whereby issues of distribution, coordination, heterogeneity — everything that really defines macroeconomics — are swept under the rug.

Of course, most 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 …

MMT perspective on Biden’s $1.9-trillion big spend

MMT is about identifying the untapped potential in our economy, what we call our fiscal space … How we choose to utilize that fiscal space is a political matter …

The point is that we run our economy like a six-foot-tall guy who wanders around perpetually hunched over in a house with eight-foot ceilings because someone convinced him that if he tries to stand up tall he’ll suffer a massive head trauma. For too many years, we’ve been crouching down when we could have been standing strong. Irrational fears about government debt and fiscal deficits caused policy makers in the US, Japan, the UK, and elsewhere to pivot away from fiscal stimulus toward austerity in the years following the global financial crisis. This forced immeasurable pain on tens, if not hundreds, of millions worldwide.

The U.S. has a deficit. That’s true. But the problem is not the budget deficit. The real deficits are in the climate, healthcare and infrastructure. How do we tackle those deficits? By spending!

MMT rejects the traditional Phillips curve inflation-unemployment trade-off and has a less positive evaluation of traditional policy measures to reach full employment. Instead of a general increase in aggregate demand, it usually prefers more ‘structural’ and directed demand measures with less risk of producing increased inflation. At full employment deficit spendings will often be inflationary, but that is not what should decide the fiscal position of the government. The size of public debt and deficits is not — as already Abba Lerner argued with his ‘functional finance’ theory in the 1940s — a policy objective. The size of public debt and deficits are what they are when we try to fulfil our basic economic objectives — full employment and price stability.

Governments can spend whatever amount of money they want. That does not mean that MMT says they ought to — that’s something our politicians have to decide. No MMTer denies that too much of government spendings can be inflationary. What is questioned is that government deficits necessarily is inflationary.

Voyage en Amérique

L’annonce d’un plan de soutien à l’économie américaine de 1900 milliards de dollars US (soit environ 9% du PIB, après 4% décidés en décembre) a soulevé une controverse sur le bon calibrage des plans d’urgence et de relance. Pour Larry Summers et Olivier Blanchard, pourtant fervents partisans des politiques budgétaires expansionnistes, ce programme est excessif car il représente entre 2 et 4 fois l’écart de production attendu pour 2021 : avec un multiplicateur unitaire, sa mise en œuvre ferait bondir la demande bien-au-dessus des capacités de production du pays. L’inflation repartirait à la hausse, ce qui conduirait la Réserve Fédérale à remonter ses taux, amenuisant l’impact du plan de relance, conformément au bon vieux modèle IS-LM, ou bien, pire, déclenchant une crise financière. Le risque inflationniste serait d’autant plus grand que l’épargne accumulée par les ménages américains depuis le début de la crise représente environ le double du plan de relance envisagé par l’administration Biden : si la moitié de cette épargne était consommée, cela doublerait le stimulus apporté par ce nouveau plan de relance.

Ce point de vue est vigoureusement contesté par plusieurs économistes dont Gauti Eggertsson et Paul Krugman. Pour eux, l’objectif n’est pas d’amener le PIB au plus près de son niveau potentiel, mais plutôt d’accélérer la vaccination, de rouvrir les écoles, d’apporter un soutien au ménages fragilisés par la crise ainsi qu’aux Etats et aux municipalités pour les dissuader de licencier leur personnel et de fermer des services publics. Tout l’argent ne sera pas nécessairement dépensé (cela dépendra de l’évolution du chômage) et même si c’était le cas, il n’est pas du tout évident que cela déclenche de l’inflation tant sont incertaines les estimations de l’écart de production et de son lien avec l’inflation. Et puis finalement, ne serait-ce pas une bonne nouvelle si l’inflation repartait à la hausse ?

Agnès Bénassy-Quéré

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The absurd usage of words in economics

In identifying the economic phenomena, certain primitive concepts and terms have to be used … However, because of the freedom with which the mind can move, it happens frequently that the relation with reality is lost, and that purely hypothetical notions are introduced. In addition, there is often a change in the meaning of words. Consider “competition”: the common sense meaning is one of struggle with others, of fight, of attempting to get ahead, or at least to hold one’s place. It suffices to consult any dictionary of any language to find that it describes rivalry, fight, struggle, etc. Why this word should be used in economic theory in a way that contradicts ordinary language is difficult to see. No reasonable case can be made for this absurd usage which may confuse and must repel any intelligent novice.

In current equilibrium theory, there is nothing of this true kind of competition: there are only individuals, firms or consumers, facing given prices, fixed conditions, each firm or consumer for convenience insignificantly small and having no influence what-so-ever upon the existing conditions of the market (rather mysteriously formed by tâtonnement) and therefore solely concerned with maximizing utility or profit — the latter then being exactly zero. The contrast with reality is striking; the time has come for economic theory to turn around and to “face the music.”

Oskar Morgenstern

Keynes on models and economics

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 typical natural science, the material to which it is applied is, in too many respects, not homogeneous through time … I also want to emphasise strongly the point about economics being a moral science. I mentioned before that it deals with introspection and with values. I might have added that it deals with motives, expectations, psychological uncertainties. One has to be constantly on guard against treating the material as constant and homogeneous. It is as though the fall of the apple to the ground depended on the apple’s motives, on whether it is worth while falling to the ground, and whether the ground wanted the apple to fall, and on mistaken calculations of the apple as to how far it was from the centre of the earth.

John Maynard Keynes (letter to Harrod, 1938)

Chicago economics — the triumph of empty formalism

Vielleicht ist diese Grundperspektive der radikalen Trennung von Form und Gehalt hilfreich, einige zunächst überaus paradoxe Äußerungen von Lucas etwas zu erhellen. Erinnert man sich der Forderungen von Lucas, die Makroökonomik zwingend auf Basis der klassischen Postulate, die Lucas und Sargent (1978) als (a) „Markträumung“ und (b) „Eigennutz“ umrissen hatten, zu errichten, so erstaunt man doch angesichts Passagen wie der folgenden:

“In recent years, the meaning of the term “equilibrium” has undergone such dramatic development that a theorist of the 1930s would not recognize it. It is now routine to describe an economy following a multivariate stochastic process as being “in equilibrium,” by which is meant nothing more than that at each point in time, postulates (a) and (b) above are satisfied. This development, which stemmed mainly from work by K. J. Arrow […] and G. Debreu […], implies that simply to look at any economic time series and conclude that it is a “disequilibrium phenomenon” is a meaningless observation. Indeed, a more likely conjecture […] is that the general hypothesis that a collection of time series describes an economy in competitive equilibrium is without con tent.” (Lucas und Sargent 1978: 58-9)”

Zunächst ist man erstaunt, weil die Argumentation nicht nur kontraintuitiv, sondern geradezu widersinnig erscheint: Wie passt das zusammen, dass Lucas und Sargent einerseits einfordern, jegliche Makrotheorie habe von den Prinzipien „Markträumung bzw. Gleichgewicht“ und „Eigennutz bzw. Optimierung“ auszugehen, wenn sie direkt anschließend konstatieren, dass solche Aussagen inhaltsleer und ohne Bedeutung sind? Die hier gelieferte Verteidigung der Gleichgewichtsannahme „geräumter Märkte“ hat demnach für Lucas gar nichts mit jener alltäglichen Bedeutung zu tun, wonach der Markt für Äpfel geräumt ist, wenn wie beobachten können, dass alle angebotenen Äpfel auch gekauft werden. Markträumung als Konzept ist somit kein Ereignis, dass mit der Realität korrespondiert, sondern ein Modellbaukonzept, mit dem Modellstrukturen erzeugt werden kön nen, die Zeitreihen nachbilden können. Die Begriffe „Markträumung“ und „Eigennutz“ haben eben in diesem Sinne keine empirische, oder reale Bedeutung, wie Lucas und Sargent klar herausstellen, sie dienen nur zur Erzeugung der formalen Struktur des Modells, sie sind jedoch losgelöst von ihrer (anschaulichen) Bedeutung oder Interpretation.

Roberto Cruccolini

In case your German isn’t to rusty, Cruccolini’s dissertation on the development of modern macroeconomics is highly recommended reading.

Some of us have for years been urging economists to pay attention to the ontological foundations of their assumptions and models. Sad to say, economists have not hearkened the appeal — and so modern economics has become increasingly irrelevant to the understanding of the real world.

Within mainstream economics internal validity is still everything and external validity nothing. Why anyone should be interested in that kind of theories and models is beyond imagination. As long as mainstream economists do not come up with any export-licenses for their theories and models to the real world in which we live, they really should not be surprised if people say that this is not science.

Studying mathematics and logics is interesting and fun. It sharpens the mind. In pure mathematics and logics we do not have to worry about external validity. But — economics is not pure mathematics or logics. It’s about society. The real world. Forgetting that, economics is in dire straits.

The scientific method arose as a rejection of the axiomatic method used by the Greeks for scientific methodology. It was this rejection of axiomatics and logical certainty in favour of empirical and observational approach which led to dramatic progress in science. However, this did involve giving up the certainties of mathematical argumentation and learning to live with the uncertainties of induction. Economists need to do the same — abandon current methodology borrowed from science and develop a new methodology suited for the study of human beings and societies.

Asad Zaman

Models and laws in economics

Great lecture on how to do — and not to do — economics, delivered by Robert Skidelsky.