LARS P. SYLL

Modern macroeconomics – like Hamlet without the Prince

Something is rotten in the state of macroeconomics … 

And its miserable state should come as no surprise for those of you who regularly follow yours truly’s blog.

Forecasting is by its nature a hit-and-miss affair; economics is not—despite the apparent dogmatic certainty of some of its practitioners—an exact science. But the track record of the profession in recent years—and last year in particular —is dire. Few economists spotted the boom and most hopelessly underestimated the bust. And it’s not as if the profession’s troubles in 2012 were limited to longer-range forecasts; it was getting it wrong virtually in real time with most forecasters forced to slash their projections every few months as each quarter turned out worse than expected …

What the dismal science’s dismal record suggests is that there is something profoundly wrong with the mainstream economics profession’s understanding of how modern economies work. The models on which its forecasts are built are clearly badly flawed …

But the most important contribution to the debate is an essay by Claudio Borio, deputy head of the monetary and economics department at the Bank for International Settlements, published last moth and titled: “The Financial Cycle and Macroeconomics: What have we learned?”

In Mr. Borio’s view, the “New Keynesian Dynamic Stochastic General Equilibrium” model used by most mainstream forecasters is flawed because it assumes the financial system is frictionless: Its role is simply to allocate resources and therefore can be ignored. Although many economists now accept these assumptions are wrong, efforts to modify their models amount to little more than tinkering. What is needed is a return to out-of-fashion insights influential before World War II and kept alive since by maverick economists such as Hyman Minsky and Charles Kindleberger that recognized the central importance of the financial cycle.

Mainstream economists have been so fixated on understanding ordinary business cycles that they ignored the role that years of rising asset prices and financial sector liberalization can play in fueling credit booms. They lost sight of the fact that the financial system does more than allocate resources: It creates money—and therefore purchasing power—every time it extends a loan.

“Macroeconomics without the financial cycle is like Hamlet without the Prince,” to Mr. Borio.

Simon Nixon

New Keynesianism and DSGE – intellectually bankrupt enterprises

In modern neoclassical macroeconomics – Dynamic Stochastic General Equilibrium (DSGE), New Synthesis, New Classical and “New Keynesian” – variables are treated as if drawn from a known “data-generating process” that unfolds over time and on which we therefore allegedly have access to heaps of historical time-series.

Modern macroeconomics obviously did not anticipate the enormity of the problems that unregulated “efficient” financial markets created. Why? Because it builds on the myth of us knowing the “data-generating process” and that we can describe the variables of our evolving economies as drawn from an urn containing stochastic probability functions with known means and variances.

In the end this is what it all boils down to. We all know that many activities, relations, processes and events are genuinely uncertaint. The data do not unequivocally single out one decision as the only “rational” one. Neither the economist, nor the deciding individual, can fully pre-specify how people will decide when facing uncertainties and ambiguities that are ontological facts of the way the world works.

Some macroeconomists, however, still want to be able to use their hammer. So they decide to pretend that the world looks like a nail, and pretend that uncertainty can be reduced to risk. So they construct their mathematical models on that assumption.

Fortunately – when you’ve got tired of  the kind of gobsmacking macroeconomics apologetics produced by so called “New Keynesian” macroeconomists – there still are some  real Keynesian macroeconomists to read!

One of them, Axel Leijonhufvud, I last met  a couple of years ago in Copenhagen, where we were invited keynote speakers at the conference “Keynes 125 Years – What Have We Learned?” Axel’s speech was later published as Keynes and the crisis and contains some very profound insights and antidotes to DSGE modeling and New “Keynesianism” :

So far I have argued that recent events should force us to re-examine recent monetary policy doctrine. Do we also need to reconsider modern macroeconomic theory in general? I should think so. Consider briefly a few of the issues.

The real interest rate … The problem is that the real interest rate does not exist in reality but is a constructed variable. What does exist is the money rate of interest from which one may construct a distribution of perceived real interest rates given some distribution of inflation expectations over agents. Intertemporal non-monetary general equilibrium (or finance) models deal in variables that have no real world counterparts. Central banks have considerable influence over money rates of interest as demonstrated, for example, by the Bank of Japan and now more recently by the Federal Reserve …

The representative agent. If all agents are supposed to have rational expectations, it becomes convenient to assume also that they all have the same expectation and thence tempting to jump to the conclusion that the collective of agents behaves as one. The usual objection to representative agent models has been that it fails to take into account well-documented systematic differences in behaviour between age groups, income classes, etc. In the financial crisis context, however, the objection is rather that these models are blind to the consequences of too many people doing the same thing at the same time, for example, trying to liquidate very similar positions at the same time. Representative agent models are peculiarly subject to fallacies of composition. The representative lemming is not a rational expectations intertemporal optimising creature. But he is responsible for the fat tail problem that macroeconomists have the most reason to care about …

For many years now, the main alternative to Real Business Cycle Theory has been a somewhat loose cluster of models given the label of New Keynesian theory. New Keynesians adhere on the whole to the same DSGE modeling technology as RBC macroeconomists but differ in the extent to which they emphasise inflexibilities of prices or other contract terms as sources of shortterm adjustment problems in the economy. The “New Keynesian” label refers back to the “rigid wages” brand of Keynesian theory of 40 or 50 years ago. Except for this stress on inflexibilities this brand of contemporary macroeconomic theory has basically nothing Keynesian about it.

The obvious objection to this kind of return to an earlier way of thinking about macroeconomic problems is that the major problems that have had to be confronted in the last twenty or so years have originated in the financial markets – and prices in those markets are anything but “inflexible”. But there is also a general theoretical problem that has been festering for decades with very little in the way of attempts to tackle it. Economists talk freely about “inflexible” or “rigid” prices all the time, despite the fact that we do not have a shred of theory that could provide criteria for judging whether a particular price is more or less flexible than appropriate to the proper functioning of the larger system. More than seventy years ago, Keynes already knew that a high degree of downward price flexibility in a recession could entirely wreck the financial system and make the situation infinitely worse. But the point of his argument has never come fully to inform the way economists think about price inflexibilities …

I began by arguing that there are three things we should learn from Keynes … The third was to ask whether events provedt hat existing theory needed to be revised. On that issue, I conclude that dynamic stochastic general equilibrium theory has shown itself an intellectually bankrupt enterprise. But this does not mean that we should revert to the old Keynesian theory that preceded it (or adopt the New Keynesian theory that has tried to compete with it). What we need to learn from Keynes, instead, are these three lessons about how to view our responsibilities and how to approach our subject.

Are economists rational?

Now consider what happened in November 2007. It was just one month before the Great Recession officially began …

Economists in the Survey of Professional Forecasters, a quarterly poll put out by the Federal Reserve Bank of Philadelphia, nevertheless foresaw a recession as relatively unlikely. Intead, they expected the economy to grow at a just slightly below average rate of 2.4 percent in 2008 … This was a very bad forecast: GDP actually shrank by 3.3 percent once the financial crisis hit. What may be worse is that the economists were extremely confident in their prediction. They assigned only a 3 percent chance to the economy’s shrinking by any margin over the whole of 2008 …

Indeed, economists have for a long time been much to confident in their ability to predict the direction of the economy … Their predictions have not just been overconfident but also quite poor in a real-world sense … Economic forecasters get more feedback than people in most other professions, but they haven’t chosen to correct for their bias toward overconfidence.

Macroeconomic fallacies

Fallacy 8

If deficits continue, the debt service would eventually swamp the fisc.

Real prospect: While viewers with alarm are fond of horror-story projections in which per capita debt would become intolerably burdensome, debt service would absorb the entire income tax revenue, or confidence is lost in the ability or willingness of the government to levy the required taxes so that bonds cannot be marketed on reasonable terms, reasonable scenarios protect a negligible or even favorable effect on the fisc … A fifteen trillion debt will be far easier to deal with out of a full employment economy with greatly reduced needs for unemployment benefits and welfare payments than a five trillion debt from an economy in the doldrums with its equipment in disrepair. There is simply no problem …

Fallacy 14

Government debt is thought of as a burden handed on from one generation to its children and grandchildren.

Reality: Quite the contrary, in generational terms, (as distinct from time slices) the debt is the means whereby the present working cohorts are enabled to earn more by fuller employment and invest in the increased supply of assets, of which the debt is a part, so as to provide for their own old age. In this way the children and grandchildren are relieved of the burden of providing for the retirement of the preceding generations, whether on a personal basis or through government programs.

This fallacy is another example of zero-sum thinking that ignores the possibility of increased employment and expanded output …

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These fallacious notions, which seem to be widely held in various forms by those close to the seats of economic power, are leading to policies that are not only cruel but unnecessary and even self-defeating in terms of their professed objectives …

We will not get out of the economic doldrums as long as we continue to be governed by fallacious notions that are based on false analogies, one-sided analysis, and an implicit underlying counterfactual assumption of an inevitable level of unemployment …

If a budget balancing program should actually be carried through, the above analysis indicates that sooner or later a crash comparable to that of 1929 would almost certainly result … To assure against such a disaster and start on the road to real prosperity it is necessary to relinquish our unreasoned ideological obsession with reducing government deficits, recognize that it is the economy and not the government budget that needs balancing in terms of the demand for and supply of assets, and proceed to recycle attempted savings into the income stream at an adequate rate, so that they will not simply vanish in reduced income, sales, output and employment. There is too a free lunch out there, indeed a very substantial one. But it will require getting free from the dogmas of the apostles of austerity, most of whom would not share in the sacrifices they recommend for others. Failing this we will all be skating on very thin ice.

William Vickrey Fifteen Fatal Fallacies of Financial Fundamentalism

Sweden’s equality fades away

           Source

Sweden, which has long been the shining example for liberal economists of what we should be aiming for, seems to be losing its luster.

That’s because the growth in Swedish inequality between 1985 and the late 2000s was the largest among all OECD countries, increasing by one third:

Sweden has seen the steepest increase in inequality over 15 years amongst the 34 OECD nations, with disparities rising at four times the pace of the United States, the think tank said.

Once the darling of the political left, heavy state control and wealth distribution through high taxes and generous benefits gave the country’s have-nots an enviable standard of living at the expense of the wealthiest members of society.

Although still one of the most equal countries in the world, the last two decades have seen a marked change. Market reforms have helped the economy become one of Europe’s best performers but this has Swedes wondering if their love affair with state welfare was coming to an end.

The real tipping point came in 2006 when the centre-right government swept to power, bringing an end to a Social Democratic era which stretched for most of the 20th century.

Swedes had grown increasingly weary of their high taxes and with more jobs going overseas, the new government laid out a plan to fine-tune the old welfare system. It slashed income taxes, sold state assets and tried to make it pay to work.

Spending on welfare benefits such as pensions, unemployment and incapacity assistance has fallen by almost a third to 13 percent of GDP from the early nineties, putting Sweden only just above the 11 percent OECD average.

At the other end of the spectrum, tax changes and housing market reforms have made the rich richer.

Since the mid-80s, income from savings, private pensions or rentals, jumped 10 percent for the richest fifth of the population while falling one percent for the poorest 20 percent.

David Ruccio

IS-LM basics in less than 16 minutes

Lars E O Svensson om penningpolitik och bostadsbubblor

I morgon gör Lars E O Svensson sin sista arbetsdag på Riksbanken. I den här intervjun ser Svensson – Sveriges internationellt mest ansedde nationalekonom – tillbaka på sina sex år som vice riksbankschef. Intressant!

Further suggestions for Krugman’s IS-LM reading list

The determination of investment is a four-stage process in The General Theory. Money and debts determine an “interest rate”; long-term expectations determine the yield – or expected cash flows – from capital assets and current investment (i.e., the capital stock); the yield and the interest rate enter into the determination of the price of capital assets; and investment is carried to the point where the supply price of investment output equals the capitalized value of the yield. The simple IS-LM framework violates the complexity of the investment-determning process as envisaged by Keynes …

The Hicks-Hansen model, by making explicit the interdependence of the commodity and money markets in Keynes’s thought, is a more accurate representation of his views than the simple consumption-function models. Nevertheless, because it did not explicitly consider the significance of uncertainty in both portfolio decisions and investment behavior, and becasue it was an equilibrium rather than a process interpretation of the model, it was an unfair and naïve representation of Keynes’s subtle and sophisticated views …

The journey through various standard models that embody elements derived from The General Theory has led us to the position that such Keynesian models are either trivial (the consumption-function models), incomplete (the IS-LM models without a labor market), inconsistent (the IS-LM models with a labor market but no real-balance effect), or indistinguishable in their results from those of older quantity-theory models (the neoclassical synthesis).

As we all know Paul Krugman is very fond of referring to and defending the old and dear IS-LM model.

John Hicks, the man who invented it in his 1937 Econometrica review of Keynes’ General Theory – Mr. Keynes and the ‘Classics’. A Suggested Interpretation – returned to it in an article in 1980 – IS-LM: an explanation – in Journal of Post Keynesian Economics. Self-critically he wrote:

I accordingly conclude that the only way in which IS-LM analysis usefully survives — as anything more than a classroom gadget, to be superseded, later on, by something better – is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of equilibrium methods, is not inappropriate …

When one turns to questions of policy, looking toward the future instead of the past, the use of equilibrium methods is still more suspect. For one cannot prescribe policy without considering at least the possibility that policy may be changed. There can be no change of policy if everything is to go on as expected-if the economy is to remain in what (however approximately) may be regarded as its existing equilibrium. It may be hoped that, after the change in policy, the economy will somehow, at some time in the future, settle into what may be regarded, in the same sense, as a new equilibrium; but there must necessarily be a stage before that equilibrium is reached …

It is well known that in later developments of Keynesian theory, the long-term rate of interest (which does figure, excessively, in Keynes’ own presentation and is presumably represented by the r of the diagram) has been taken down a peg from the position it appeared to occupy in Keynes. We now know that it is not enough to think of the rate of interest as the single link between the financial and industrial sectors of the economy; for that really implies that a borrower can borrow as much as he likes at the rate of interest charged, no attention being paid to the security offered. As soon as one attends to questions of security, and to the financial intermediation that arises out of them, it becomes apparent that the dichotomy between the two curves of the IS-LM diagram must not be pressed too hard.

Back in 1937 John Hicks said that he was building a model of John Maynard Keynes’ General Theory. He wasn’t.

What Hicks acknowledges in 1980 – confirming Minsky’s critique – is basically that his original review totally ignored the very core of Keynes’ theory – uncertainty. Ignoring uncertainty, he had actually contributed to turning the train of macroeconomics on the wrong tracks for decades.

It’s about time that neoclassical economists – as Krugman, Mankiw, or what have you – set the record straight and stop promoting something that the creator himself admits was a total failure. Why not study the real thing itself – General Theory – in full and without looking the other way when it comes to non-ergodicity and uncertainty?