LARS P. SYLL

Krugman on methodology

“New Keynesian” macroeconomic models are at heart based on the modeling strategy of DSGE – representative agents, rational expectations, equilibrium and all that. They do have some minor idiosyncracies (like “menu costs” and “price rigidities” preferably in a monopolistic competition setting ), but the differencies are not really that fundamental. The basic model assumptions are the same.

If macoeconomic 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.

People calling themselves “New Keynesians” ought to be rather embarrassed by the fact that the kind of microfounded 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.

From a methodological and theoretical point of view Paul Krugman’s comments in the debate on microfounded macromodels is really interesting because they shed light on a kind of inconsistency in his own art of argumentation.

During a couple of years Krugman has in more than one article criticized mainstream economics for using to 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. This shows up also in the microfoundations debate, where he refers to the work he has done with Gauti Eggertsson – work that actually, when it comes to methodology and assumptions, has a lot in common with the kind of model-building he otherwise criticizes.

In 1996 Krugman was invited to speak to the European Association for Evolutionary Political Economy. I think reading the speech gives more than one clue on the limits of Krugman’s critique of modern mainstream economics (italics added): 

I like to think that I am more open-minded about alternative approaches to economics than most, but I am basically a maximization-and-equilibrium kind of guy. Indeed, I am quite fanatical about defending the relevance of standard economic models in many situations.
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I won’t say that I am entirely happy with the state of economics. But let us be honest: I have done very well within the world of conventional economics. I have pushed the envelope, but not broken it, and have received very widespread acceptance for my ideas. What this means is that I may have more sympathy for standard economics than most of you. My criticisms are those of someone who loves the field and has seen that affection repaid. I don’t know if that makes me morally better or worse than someone who criticizes from outside, but anyway it makes me different.
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To me, it seems that what we know as economics is the study of those phenomena that can be understood as emerging from the interactions among intelligent, self-interested individuals. Notice that there are really four parts to this definition. Let’s read from right to left.
1. Economics is about what individuals do: not classes, not “correlations of forces”, but individual actors. This is not to deny the relevance of higher levels of analysis, but they must be grounded in individual behavior. Methodological individualism is of the essence.
2. The individuals are self-interested. There is nothing in economics that inherently prevents us from allowing people to derive satisfaction from others’ consumption, but the predictive power of economic theory comes from the presumption that normally people care about themselves.
3. The individuals are intelligent: obvious opportunities for gain are not neglected. Hundred-dollar bills do not lie unattended in the street for very long.
4. We are concerned with the interaction of such individuals: Most interesting economic theory, from supply and demand on, is about “invisible hand” processes in which the collective outcome is not what individuals intended.
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Gould is the John Kenneth Galbraith of his subject. That is, he is a wonderful writer who is beloved by literary intellectuals and lionized by the media because he does not use algebra or difficult jargon. Unfortunately, it appears that he avoids these sins not because he has transcended his colleagues but because he does not seem to understand what they have to say; and his own descriptions of what the field is about – not just the answers, but even the questions – are consistently misleading. His impressive literary and historical erudition makes his work seem profound to most readers, but informed readers eventually conclude that there’s no there there.
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Personally, I consider myself a proud neoclassicist. By this I clearly don’t mean that I believe in perfect competition all the way. What I mean is that I prefer, when I can, to make sense of the world using models in which individuals maximize and the interaction of these individuals can be summarized by some concept of equilibrium. The reason I like that kind of model is not that I believe it to be literally true, but that I am intensely aware of the power of maximization-and-equilibrium to organize one’s thinking – and I have seen the propensity of those who try to do economics without those organizing devices to produce sheer nonsense when they imagine they are freeing themselves from some confining orthodoxy.

On many macroeconomic policy discussions I often 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/methodology/theories he ultimately refers to. When he is discussing austerity measures, ricardian equivalence or problems with the euro, he is actually not using those neoclassical models/methodology/theories, but rather simpler and more adequate and relevant thought-constructions in the vein of Keynes.

As all students of economics know, time is limited. Given that, there has to be better ways to optimize its utilization than spending hours and hours working through, constructing or adding tweaks to irrelevant “New Keynesian” DSGE macroeconomic models. I would rather recommend my students allocating their time into constructing better, real and relevant macroeconomic models – models that really help us to explain and understand reality.

Mainstream economics and neoliberalism

Unlearning economics has an interesting post on some important shortcomings of neoclassical economics and libertarianism (on which I have written e. g. here, here, and  here ):

I’ve touched briefly before on how behavioural economics makes the central libertarian mantra of being ‘free to choose’ completely incoherent. Libertarians tend to have a difficult time grasping this, responding with things like ‘so people aren’t rational; they’re still the best judges of their own decisions’. My point here is not necessarily that people are not the best judges of their own decisions, but that the idea of freedom of choice – as interpreted by libertarians – is nonsensical once you start from a behavioural standpoint.

The problem is that neoclassical economics, by modelling people as rational utility maximisers, lends itself to a certain way of thinking about government intervention. For if you propose intervention on the grounds that they are not rational utility maximisers, you are told that you are treating people as if they are stupid. Of course, this isn’t the case – designing policy as if people are rational utility maximisers is no different ethically to designing it as if they rely on various heuristics and suffer cognitive biases.

This ‘treating people as if they are stupid’ mentality highlights problem with neoclassical choice modelling: behaviour is generally considered either ‘rational’ or ‘irrational’. But this isn’t a particularly helpful way to think about human action – as Daniel Kuehn says, heuristics are not really ‘irrational’; they simply save time, and as this video emphasises, they often produce better results than homo economicus-esque calculation. So the line between rationality and irrationality becomes blurred.

For an example of how this flawed thinking pervades libertarian arguments, consider the case of excessive choice. It is well documented that people can be overwhelmed by too much choice, and will choose to put off the decision or just abandon trying altogether. So is somebody who is so inundated with choice that they don’t know what to do ‘free to choose’? Well, not really – their liberty to make their own decisions is hamstrung.

Another example is the case of Nudge. The central point of this book is that people’s decisions are always pushed in a certain direction, either by advertising and packaging, by what the easiest or default choice is, by the way the choice is framed, or any number of other things. This completely destroys the idea of ‘free to choose’ – if people’s choices are rarely or never made neutrally, then one cannot be said to be ‘deciding for them’ any more than the choice was already ‘decided’ for them. The best conclusion is to push their choices in a ‘good’ direction (e.g. towards healthy food rather than junk). Nudging people isn’t a decision – they are almost always nudged. The question is the direction they are nudged in.

It must also be emphasised that choices do not come out of nowhere – they are generally presented with a flurry of bright colours and offers from profit seeking companies. These things do influence us, as much as we hate to admit it, so to work from the premise that the state is the only one that can exercise power and influence in this area is to miss the point.

The fact is that the way both neoclassical economists and libertarians think about choice is fundamentally flawed – in the case of neoclassicism, it cannot be remedied with ‘utility maximisation plus a couple of constraints’; in the case of libertarianism it cannot be remedied by saying ‘so what if people are irrational? They should be allowed to be irrational.’ Both are superficial remedies for a fundamentally flawed epistemological starting point for human action.

Mistaking beauty for truth – Real Business Cycle models and the quest for external validity

Most models in science are representations of something else. Models “stand for” or “depict” specific parts of a “target system” (usually the real world). A model that has neither surface nor deep resemblance to important characteristics of real economies ought to be treated with prima facie suspicion. How could we possibly learn about the real world if there are no parts or aspects of the model that have relevant and important counterparts in the real world target system? The burden of proof lays on the theoretical economists thinking they have contributed anything of scientific relevance without even hinting at any bridge enabling us to traverse from model to reality. All theories and models have to use sign vehicles to convey some kind of content that may be used for saying something of the target system. But purpose-built assumptions, like invariance, made solely to secure a way of reaching deductively validated results in mathematical models, are of little value if they cannot be validated outside of the model.

All empirical sciences use simplifying or unrealistic assumptions in their modeling activities. That is (no longer) the issue – as long as the assumptions made are not unrealistic in the wrong way or for the wrong reasons.

Theories are difficult to directly confront with reality. Economists therefore build models of their theories. Those models are representations that are directly examined and manipulated to indirectly say something about the target systems.

There are economic methodologists and philosophers that argue for a less demanding view on modeling and theorizing in economics. And to some theoretical economists it is deemed quite enough to consider economics as a mere “conceptual activity” where the model is not so much seen as an abstraction from reality, but rather a kind of “parallel reality”. By considering models as such constructions, the economist distances the model from the intended target, only demanding the models to be credible, thereby enabling him to make inductive inferences to the target systems.
But what gives license to this leap of faith, this “inductive inference”? Within-model inferences in formal-axiomatic models are usually deductive, but that does not come with a warrant of reliability for inferring conclusions about specific target systems. Since all models in a strict sense are false (necessarily building in part on false assumptions) deductive validity cannot guarantee epistemic truth about the target system. To argue otherwise would surely be an untenable overestimation of the epistemic reach of “surrogate models”.

Models do not only face theory. They also have to look to the world. But being able to model a credible world, a world that somehow could be considered real or similar to the real world, is not the same as investigating the real world. Even though all theories are false, since they simplify, they may still possibly serve our pursuit of truth. But then they cannot be unrealistic or false in any way. The falsehood or unrealisticness has to be qualified (in terms of resemblance, relevance etc). At the very least, the minimalist demand on models in terms of credibility has to give away to a stronger epistemic demand of “appropriate similarity and plausibility” (Pålsson Syll 2001:60). One could of course also ask for a sensitivity or robustness analysis, but the credible world, even after having tested it for sensitivity and robustness, can still be a far way from reality – and unfortunately often in ways we know are important. Robustness of claims in a model does not per se give a warrant for exporting the claims to real world target systems.

Questions of external validity are important more specifically also when it comes to microfounded macromodels. It can never be enough that these models somehow are regarded as internally consistent. One always also has to pose questions of consistency with the data. Internal consistency without external validity is worth nothing.

“New Keynesian” macroeconomist Simon Wren-Lewis has an interesting post on his blog on these topics and how they may be related to ideology:

I want to raise [the] problem that some researchers might select facts on the basis of ideology. The example that I find most telling here is unemployment and Real Business Cycle models.

Why is a large part of macroeconomics all about understanding the booms and busts of the business cycle? The answer is obvious: the consequences of booms – rising inflation – and busts – rising unemployment – are large macroeconomic ‘bads’. No one disagrees about rising inflation being a serious problem. Almost no one disagrees about rising unemployment. Except, it would appear, the large number of macroeconomists who use Real Business Cycle (RBC) models to study the business cycle.

In RBC models, all changes in unemployment are voluntary. If unemployment is rising, it is because more workers are choosing leisure rather than work. As a result, high unemployment in a recession is not a problem at all. It just so happens that (because of a temporary absence of new discoveries) real wages are relatively low, so workers choose to work less and enjoy more free time. As RBC models do not say much about inflation, then according to this theory the business cycle is not a problem at all …

Now the RBC literature is very empirically orientated. It is all about trying to get closer to the observed patterns of cyclical variation in key macro variables. Yet what seems like a rather important fact about business cycles, which is that changes in unemployment are involuntary, is largely ignored. (By involuntary I mean the unemployed are looking for work at the current real wage, which they would not be under RBC theory.) There would seem to be only one defence of this approach (apart from denying the fact), and that is that these models could be easily adapted to explain involuntary unemployment, without the rest of the model changing in any important way. If this was the case, you might expect papers that present RBC theory to say so, but they generally do not …

What could account for this particular selective use of evidence? One explanation is ideological. The commonsense view of the business cycle, and the need to in some sense smooth this cycle, is that it involves a market failure that requires the intervention of a state institution in some form. If your ideological view is to deny market failure where possible, and therefore minimise a role for the state, then it is natural enough (although hardly scientific) to ignore inconvenient facts …

Do these biases matter? I think they do for two reasons. First from a purely academic point of view they distort the development of the discipline. As I keep stressing, I do think the microfoundations project is important and useful, but that means anything that distorts in energies is a problem. Second, policy does rely on academic macroeconomics, and both the examples of bias that I use in this post … could have been the source of important policy errors.