What has Keynes got to do with New Keynesian Macroeconomics? Nothing!

24 Jul, 2013 at 17:39 | Posted in Economics | 1 Comment

Paul Krugman has a post on his blog discussing “New Keynesian” macroeconomics and the definition of neoclassical economics:

So, what is neoclassical economics? … I think we mean in practice economics based on maximization-with-equilibrium. We imagine an economy consisting of rational, self-interested players, and suppose that economic outcomes reflect a situation in which each player is doing the best he, she, or it can given the actions of all the other players …

Some economists really really believe that life is like this — and they have a significant impact on our discourse. But the rest of us are well aware that this is nothing but a metaphor; nonetheless, most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point or baseline, which is then modified — but not too much — in the direction of realism.

This is, not to put too fine a point on it, very much true of Keynesian economics as practiced … New Keynesian models are intertemporal maximization modified with sticky prices and a few other deviations …

Why do things this way? Simplicity and clarity. In the real world, people are fairly rational and more or less self-interested; the qualifiers are complicated to model, so it makes sense to see what you can learn by dropping them. And dynamics are hard, whereas looking at the presumed end state of a dynamic process — an equilibrium — may tell you much of what you want to know.

Being myself sorta-kinda Keynesian I  find this analysis utterly unconvincing. Why? Let me try to explain.

Macroeconomic models may be an informative tool for research. But if practitioners of “New Keynesian” macroeconomics do not investigate and make an effort of providing a justification for the credibility of the assumptions on which they erect their building, it will not fulfill its tasks. There is a gap between its aspirations and its accomplishments, and without more supportive evidence to substantiate its claims, critics will continue to consider its ultimate argument as a mixture of rather unhelpful metaphors and metaphysics. Maintaining that economics is a science in the “true knowledge” business, I remain a skeptic of the pretences and aspirations of “New Keynesian” macroeconomics. So far, I cannot really see that it has yielded very much in terms of realistic and relevant economic knowledge.

The marginal return on its ever higher technical sophistication in no way makes up for the lack of serious under-labouring of its deeper philosophical and methodological foundations. The rather one-sided emphasis of usefulness and its concomitant instrumentalist justification cannot hide that “New Keynesians” cannot give supportive evidence for their considering it fruitful to analyze macroeconomic structures and events as the aggregated result of optimizing representative actors. After having analyzed some of its ontological and epistemological foundations, I cannot but conclude that “New Keynesian” macroeconomics on the whole has not delivered anything else than “as if” unreal and irrelevant models.

If we are going to be able to show that the mechanisms or causes that we isolate and handle in our microfunded macromodels are stable in the sense that they do not change when we “export” them to our “target systems”, they do only hold under ceteris paribus conditions and are a fortiori of limited value to our understanding, explanations or predictions of real economic systems. Or as the always eminently quotable Keynes wrote in Treatise on Probability(1921):

The kind of fundamental assumption about the character of material laws, on which scientists appear commonly to act, seems to me to be [that] the system of the material universe must consist of bodies … such that each of them exercises its own separate, independent, and invariable effect, a change of the total state being compounded of a number of separate changes each of which is solely due to a separate portion of the preceding state … Yet there might well be quite different laws for wholes of different degrees of complexity, and laws of connection between complexes which could not be stated in terms of laws connecting individual parts … If different wholes were subject to different laws qua wholes and not simply on account of and in proportion to the differences of their parts, knowledge of a part could not lead, it would seem, even to presumptive or probable knowledge as to its association with other parts … These considerations do not show us a way by which we can justify induction … /427 No one supposes that a good induction can be arrived at merely by counting cases. The business of strengthening the argument chiefly consists in determining whether the alleged association is stable, when accompanying conditions are varied … /468 In my judgment, the practical usefulness of those modes of inference … on which the boasted knowledge of modern science depends, can only exist … if the universe of phenomena does in fact present those peculiar characteristics of atomism and limited variety which appears more and more clearly as the ultimate result to which material science is tending.

Science should help us penetrate to “the true process of causation lying behind current events” and disclose “the causal forces behind the apparent facts” [Keynes 1971-89 vol XVII:427]. We should look out for causal relations. But models can never be more than a starting point in that endeavour. There is always the possibility that there are other variables – of vital importance and although perhaps unobservable and non-additive not necessarily epistemologically inaccessible – that were not considered for the model.

This is a more fundamental and radical problem than the celebrated “Lucas critique” have suggested. This is not the question if deep parameters, absent on the macro-level, exist in “tastes” and “technology” on the micro-level. It goes deeper. Real world social systems are not governed by stable causal mechanisms or capacities. It is the criticism that Keynes first launched against the “atomistic fallacy” already in the 1920s:

The atomic hypothesis which has worked so splendidly in Physics breaks down in Psychics. We are faced at every turn with the problems of Organic Unity, of Discreteness, of Discontinuity – the whole is not equal to the sum of the parts, comparisons of quantity fails us, small changes produce large effects, the assumptions of a uniform and homogeneous continuum are not satisfied. Thus the results of Mathematical Psychics turn out to be derivative, not fundamental, indexes, not measurements, first approximations at the best; and fallible indexes, dubious approximations at that, with much doubt added as to what, if anything, they are indexes or approximations of.

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 real world social target systems 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-existant. Unfortunately that also makes most of the achievements of econometrics – as most of contemporary endeavours of economic theoretical modeling – rather useless.

Keynes basically argued that it was inadmissible to project history on the future. Consequently an economic policy cannot presuppose that what has worked before, will continue to do so in the future. That macroeconomic models could get hold of correlations between different “variables” was not enough. If they could not get at the causal structure that generated the data, they were not really “identified”. Dynamic stochastic general euilibrium (DSGE) macroeconomists – including “New Keynesians” – has drawn the conclusion that the problem with unstable relations is to construct models with clear microfoundations where forward-looking optimizing individuals and robust, deep, behavioural parameters are seen to be stable even to changes in economic policies. As yours truly has argued in a couple of post (e. g. here and here), this, however, is a dead end.

So here we are getting close to the heart of darkness in “New Keynesian” macroeconomics. Where “New Keynesian” 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 characterize 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 idividual level. Macroeconomic structures and phenomena have to be analyzed also on their own terms. And although one may easily agree with Krugman’s emphasis on simple models, the simplifications used may have to be simplifications adequate for macroeconomics and not those adequate for microeconomics.

“New Keynesian” macromodels 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 analyzing 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. 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 generalizable 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 an open real world target system.

In microeconomics we know that aggregation really presupposes homothetic an identical preferences, something that almost never exist in real economies. The results given by these assumptions are therefore not robust and do not capture the underlying mechanisms at work in any real economy. And models that are critically based on particular and odd assumptions – and are neither robust nor congruent to real world economies – are of questionable value.

Even if economies naturally presuppose individuals, it does not follow that we can infer or explain macroeconomic phenomena solely from knowledge of these individuals. Macroeconomics is to a large extent emergent and cannot be reduced to a simple summation of micro-phenomena. Moreover, as we have already argued, even these microfoundations aren’t immutable. The “deep parameters” of  “New Keynesian” DSGE models– “tastes” and “technology” – are not really the bedrock of constancy that they believe (pretend) them to be.

So I cannot concur with Krugman – and other sorta-kinda “New Keynesians” – when they try to reduce Keynesian economics to “intertemporal maximization modified with sticky prices and a few other deviations”. “New Keynesian” macroeconomics is a gross misnomer, since it has nothing to do with the fundamentals of Keynes’s economic thoughts. As John Quiggin so aptly writes:

If there is one thing that distinguished Keynes’ economic analysis from that of his predecessors, it was his rejection of the idea of a unique full employment equilibrium to which a market economy will automatically return when it experiences a shock. Keynes argued that an economy could shift from a full-employment equilibrium to a persistent slump as the result of the interaction between objective macroeconomic variables and the subjective ‘animal spirits’ of investors and other decision-makers. It  is this perspective that has been lost in the absorption of New Keynesian macro into the DSGE framework.

1 Comment

  1. “Economic theory will have to deal with all the relevant factors if it wants to
    be realistic; general economic analysis will have to become social theory”
    (Gunnar Myrdal, Economic Theory and Underdeveloped Regions ,1957, p. 100)

    “Valuations are thus necessarily involved already at the stage when we observe
    facts and carry on theoretical analysis, and not only at the stage when we draw
    political inferences from facts and valuations”
    (Gunnar Myrdal, Objectivity in Social Research, 1970, p. 9)

    “The notion of stable equilibrium is normally a false analogy to choose when
    constructing a theory to explain the changes in a social system. What is wrong
    with the stable equilibrium assumption as applied to social reality is the very idea
    that a social process follows a direction – though it might move towards it in a
    circuitous way – towards a position which in some sense or other can be described as a state of equilibrium between forces. Behind this idea is another and still more
    basic assumption, namely that a change will regularly call forth a reaction in the
    system in the form of changes which on the whole go in the opposite direction to
    the first change. The idea I want to expound in this book is that, on the contrary,
    in the normal case there is no such a tendency towards automatic self-stabilisation
    in the social system. The system is by itself not moving towards any sort of balance
    between forces, but is constantly on the move away from such a situation. In the normal case a change does not call forth countervailing changes but, instead, supporting changes,which move the system in the same direction as the first change but
    much further. Because of such circular causation as a social process tends to
    become cumulative and often gather speed at an accelerating rate”
    (Gunnar Myrdal- Economic Theory and Underdeveloped Regions 1957,
    pp. 12–13).

    “Let me also add that I have no illusions that it will ever be possible to fit such a
    general theory into a neat econometric model. The relevant variables and the
    relevant relations between them are too many to permit that sort of heroic
    simplification. This does not mean, however, that particular problems could not
    with advantage be treated in this way – provided that the variables and
    assumptions were selected on the basis of such insight into essential facts and
    relations as only a general theory can furnish”
    (Gunnar Myrdal, Economic Theory and Underdeveloped Regions 1957, p. 101).

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