Paul Krugman gets it (mostly) wrong again

2 April, 2012 at 20:55 | Posted in Economics | 4 Comments

In his latest comment in the Keen-Krugman debate, Krugman today writes:

Oh dear. Nick Rowe sends me to Keen’s latest, which asserts the following about New Keynesian models:

“Firstly, there are similar underlying principles to the DSGE models that now dominate Neoclassical macroeconomics, and as with Ptolemaic Astronomy, these underlying principles clearly fail to describe the real world. They are:

-All markets are barter systems which are in equilibrium at all times in the absence of exogenous shocks—even during recessions—and after a shock they will rapidly return to equilibrium via instantaneous adjustments to relative prices;

-The preferences of consumers and the technology employed by firms are the “deep parameters” of the economy, which are unaltered by any policies set by economic policy makers; and

-Perfect competition is universal, ensuring that the equilibrium described in (1) is socially optimal.”

What on earth? Point 1 is all wrong — NK models are all about sticky prices, so what’s that about “instantaneous adjustments”? (And who said anything about rapid return to equilibrium?) Point 3 is also completely wrong: NK models almost always assume imperfect competition, so that we can talk about price-setting agents.

This is all in Eggertsson and Krugman, by the way.

Yes, in deed, it’s all in Eggertsson and Krugman, but let’s sort out some basics first of all.

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

Back in 1994 leading “new Keynesian” economists Laurence Ball and Greg Mankiw argued that

although traditionalists are often called ‘new Keynesians,’ this label is a misnomer. They could just as easily be called ‘new monetarists.’

That is still true today. “New Keynesianism” is a gross misnomer. The macroeconomics of people like Greg Mankiw has a lot to do with Milton Friedman, Robert Lucas and Thomas Sargent – and very little, or next to nothing, to do with the founder of macroeconomics, John Maynard Keynes.

In a more recent paper on modern macroeconomics, Greg Mankiw writes:

The real world of macroeconomic policymaking can be disheartening for those of us who have spent most of our careers in academia. The sad truth is that the macroeconomic research of the past three decades has had only minor impact on the practical analysis of monetary or fiscal policy. The explanation is not that economists in the policy arena are ignorant of recent developments. Quite the contrary: The staff of the Federal Reserve includes some of the best young Ph.D.’s, and the Council of Economic Advisers under both Democratic and Republican administrations draws talent from the nation’s top research universities. The fact that modern macroeconomic research is not widely used in practical policymaking is prima facie evidence that it is of little use for this purpose. The research may have been successful as a matter of science, but it has not contributed significantly to macroeconomic engineering.

So, then what is the raison d’être of macroeconomics, if it has nothing to say about the real world and the economic problems out there?

The final court of appeal for macroeconomic models is the real world, and as long as no convincing justification is put forward for how the inferential bridging de facto is made, macroeconomic modelbuilding is little more than “hand waving” that give us rather little warrant for making inductive inferences from models to real world target systems. If substantive questions about the real world are being posed, it is the formalistic-mathematical representations utilized to analyze them that have to match reality, not the other way around. As Keynes has it:

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 natural science, the material to which it is applied is, in too many respects, not homogeneous through time.

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.

Being a “new-Keynesian” it ought to be of interest to know what Keynes had to say on the issue. In General Theory he writes:

The classical school [maintains that] while the demand for labour at the existing money-wage may be satisfied before everyone willing to work at this wage is employed, this situation is due to an open or tacit agreement amongst workers not to work for less, and that if labour as a whole would agree to a reduction of money-wages more employment would be forthcoming. If this is the case, such unemployment, though apparently involuntary, is not strictly so, and ought to be included under the above category of ‘voluntary’ unemployment due to the effects of collective bargaining, etc …

The classical theory … is best regarded as a theory of distribution in conditions of full employment. So long as the classical postulates hold good, unemployment, which is in the above sense involuntary, cannot occur. Apparent unemployment must, therefore, be the result either of temporary loss of work of the ‘between jobs’ type or of intermittent demand for highly specialised resources or of the effect of a trade union ‘closed shop’ on the employment of free labour. Thus writers in the classical tradition, overlooking the special assumption underlying their theory, have been driven inevitably to the conclusion, perfectly logical on their assumption, that apparent unemployment (apart from the admitted exceptions) must be due at bottom to a refusal by the unemployed factors to accept a reward which corresponds to their marginal productivity …

Obviously, however, if the classical theory is only applicable to the case of full employment, it is fallacious to apply it to the problems of involuntary unemployment – if there be such a thing (and who will deny it?). The classical theorists resemble Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight – as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry. Something similar is required to-day in economics. We need to throw over the second postulate of the classical doctrine and to work out the behaviour of a system in which involuntary unemployment in the strict sense is possible.

Krugman’s comments in the Keen-debate 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 citation above, where he refers to the work he has done with 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.

On most macroeconomic policy discussions I find myself in agreement with Krugman. To me that just shows that Krugman is right in spite of and not thanks to those models he ultimately refers to. When he is discussing austerity measures, ricardian equivalence or problems with the euro, he is actually not using those models, 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 or constructing 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.

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4 Comments

  1. […] Paul Krugman gets it (mostly) wrong again « Lars P Syll’s Blog Docendo discimus […]

  2. Well said. Thanks…

    • Well comin from Economic Sociological perspective,this methodenstreit, is not in anyway new.But i think it´s sad.Well i know old Gunnar Grassman and how he was very shamefully abolished from any decent treatment Lars..
      Writing books on a Island outside Stockholm.He was banned.One of our more bright Keynsian,credited all over the world.My frIend Gunnar Adler Karlsson was even worser treated i guess.,something is rotten in Kingdoom
      of Sweden i guess.But keep up the good work and all the best to you Lars!

      • Thanks, Jan. And, yes, the way the überpriest of the Swedish economics establishment, Assar Lindbeck, treated Sven Grassman was a disgrace.


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