Oh dear, oh dear, Krugman gets it so wrong, so wrong, on the state of macroeconomics

21 Dec, 2012 at 11:30 | Posted in Economics, Theory of Science & Methodology | 2 Comments

Back in 1938 Keynes wrote in a letter to Harrod:

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. The object of a model is to segregate the semi-permanent or relatively constant factors from those which are transitory or fluctuating so as to develop a logical way of thinking about the latter, and of understanding the time sequences to which they give rise in particular cases … Good economists are scarce because the gift for using “vigilant observation” to choose good models, although it does not require a highly specialised intellectual technique, appears to be a very rare one.

I came to think of this passage when I read “sort of  New Keynesian” economist Paul Krugman’s blog yesterday. Krugman  weighs in on the ongoing discussion on the state of macro, arguing that even though he and other “sort of New Keynesian” macroeconomists use the same “equipment” as RBC-New-Classical-freshwater macroeconomists, he resents the allegation that they are a fortiori sharing the the same endeavour. Krugman writes:

The real test came when the financial crisis struck, and pretty much to a man freshwater economists not only argued against fiscal stimulus — which is a defensible position — but insisted that there was no possible way to justify stimulus, that such ideas had been refuted and that “nobody” believed in them anymore  … I’m not saying that the [“New Keynesian”] NK approach is necessarily right; but it’s a serious intellectual effort, undertaken by people who thought they were part of an open professional dialogue. Oh, and there’s a lot of evidence for the price stickiness that is central to NK models; again, maybe it doesn’t mean what the theorists think, but surely that evidence ought to be part of any discussion.

Here we get a view that all macroeconomists more or less share the same (mainstream neoclassical) basic theory and “techniques”, so when we discuss and argue it’s only about which special assumptions we choose to make (sticky wages or not). But people like Hyman Minsky, Michal Kalecki, Sidney Weintraub, Johan Åkerman, Gunnar Myrdal, Paul Davidson, Axel Leijonhufvud – and yours truly – do not share any theory or models with Real Business Cycle theorists and  “sort of New Keynesians” like Greg Mankiw or Paul Krugman.

It’s nice to see that Krugman explicitly acknowledges what I have argued for many years now – “New Keynesian” macroeconomic models are at heart based on the modelling strategy of RBC and DSGE – representative agents, rational expectations, equilibrium and all that. And yes, they do have some minor idiosyncracies like “menu costs,” “price rigidities” and “sticky wages.” But the differencies are not really that fundamental. The basic model assumptions are the same.

Talking of Krugman, this really shouldn’t come as a surprise. In 1996 Krugman was invited to speak to the European Association for Evolutionary Political Economy. So here – right from the horse’s mouth – I quote from the speech (emphasis 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 …

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 …

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 … 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 … 

If anything, this shows what a gross misnomer “New Keynesianism” is. The macroeconomic modelling strategy of people like Greg Mankiw and Paul Krugman has a lot to do with Robert Lucas and Thomas Sargent – and very little, or next to nothing, to do with the founder of macroeconomics, John Maynard Keynes. “New Keynesian” macroeconomic models build on Real Business Cycle foundations,  regularly assuming representative actors, rational expectations, market clearing and equilibrium. But if 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.

For those of us who have not forgotten the history of our discipline, and not bought the freshwater nursery tale of Lucas et consortes that Keynes was not “serious thinking,” we can easily see that there exists a macroeconomic tradition inspired by Keynes – a tradition that has absolutely nothing to do with any New Synthesis or “New Keynesianism” to do. Its ultimate building-block is the perception of genuine uncertainty and that people often “simply do not know.” Real actors can’t know everything and their acts and decisions are not simply possible to sum or aggregate without the economist risking to succumb to “the fallacy of composition”.

Instead of basing macroeconomics on unreal and unwarranted generalizations of microeconomic behaviour and relations, it is far better to accept the ontological fact that the future to a large extent is uncertain, and rather conduct macroeconomics on this fact of reality.

The real macroeconomic challenge is to accept uncertainty and still try to explain why economic transactions take place – instead of simply conjuring the problem away by assuming uncertainty to be reducible to stochastic risk. That is scientific cheating. And it has been going on for too long now.

The Keynes-inspired building-blocks are there. But it is admittedly a long way to go before the whole construction is in place. But the sooner we are intellectually honest and ready to admit that “modern” neoclassical macroeconomics – “New Keynesian” or not – has come to way’s end – the sooner we can redirect are aspirations and knowledge in more fruitful endeavours.

Building models based on an “equipment” that assumes the equivalent of portraying people as being green and coming from Mars is not a sound foundation. There has to be better ways to optimize are time and scientific endeavours than spending hours and hours working through or constructing irrelevant “New Keynesian” RBC and DSGE macroeconomic models. I would rather recommend macroeconomists reallocating their time and endeavours into constructing better, real and relevant macroeconomic models – models that really help us to explain and understand reality.

2 Comments

  1. I think you push Krugman to much into the RBC?DSGE camp. He has some affinities but he is much more skeptical of axiomatic assumptions than you suggest. He is more like Romer, Coase, and others who want to keep some neo-classical goodies but recognize multi-equilbria and other issues – hence they bring in things like sticky prices, contract bargaining, etc.

  2. Although Varoufakis Modern Political Economy books makes some claims similar to yours and provides an explanation why Saltwater and Freshwater types aren’t that different!


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