LARS P. SYLL

Economics textbooks — how to get away with scientific fraud

As is well-known, Keynes used to criticize the more traditional economics for making the fallacy of composition, which basically consists of the false belief that the whole is nothing but the sum of its parts. Keynes argued that in the society and in the economy this was not the case, and that a fortiori an adequate analysis of society and economy couldn’t proceed by just adding up the acts and decisions of individuals. The whole is more than a sum of parts.
This fact shows up already when orthodox – neoclassical – economics tries to argue for the existence of The Law of Demand – when the price of a commodity falls, the demand for it will increase – on the aggregate. Although it may be said that one succeeds in establishing The Law for single individuals it soon turned out – in the Sonnenschein-Mantel-Debreu theorem firmly established already in 1976 – that it wasn’t possible to extend The Law of Demand to apply on the market level, unless one made ridiculously unrealistic assumptions such as individuals all having homothetic preferences – which actually implies that all individuals have identical preferences.

This could only be conceivable if there was in essence only one actor – the (in)famous representative actor. So, yes, it was possible to generalize The Law of Demand – as long as we assumed that on the aggregate level there was only one commodity and one actor. What generalization! Does this sound reasonable? Of course not. This is pure nonsense!

How has neoclassical economics reacted to this devastating findig? Basically by looking the other way, ignoring it and hoping that no one sees that the emperor is naked.

Having gone through a handful of the most frequently used textbooks of economics at the undergraduate level today, I can only conclude that the models that are presented in these modern neoclassical textbooks try to describe and analyze complex and heterogeneous real economies with a single rational-expectations-robot-imitation-representative-agent.
That is, with something that has absolutely nothing to do with reality. And — worse still — something that is not even amenable to the kind of general equilibrium analysis that they are thought to give a foundation for, since Hugo Sonnenschein (1972) , Rolf Mantel (1976) and Gerard Debreu (1974) unequivocally showed that there did not exist any condition by which assumptions on individuals would guarantee neither stability nor uniqueness of the equlibrium solution.

So what modern economics textbooks present to students are really models built on the assumption that an entire economy can be modeled as a representative actor and that this is a valid procedure. But it isn’t — as the Sonnenschein-Mantel-Debreu theorem irrevocably has shown.

Of course one could say that it is too difficult on undergraduate levels to show why the procedure is right and to defer it to masters and doctoral courses. It could justifiably be reasoned that way – if what you teach your students is true, if The Law of Demand is generalizable to the market level and the representative actor is a valid modeling abstraction! But in this case it’s demonstrably known to be false, and therefore this is nothing but a case of scandalous intellectual dishonesty. It’s like telling your students that 2 + 2 = 5 and hope that they will never run into Peano’s axioms of arithmetics.

Or — just to take another example — let’s see how the important macroeconomic question of wage rigidity is treated.

Among a couple of really good intermediate – neoclassical – macroeconomics textbooks, Chad Jones textbook Macroeconomics (2nd ed, W W Norton, 2011) stands out as perhaps one of the better alternatives. Unfortunately it also contains some utter nonsense!

In chapter 7 – on “The Labor Market, Wages, and Unemployment” – Jones writes (p. 179):

The point of this experiment is to show that wage rigidities can lead to large movements in employment. Indeed, they are the reason John Maynard Keynes gave, in The General Theory of Employment, Interest, and Money (1936), for the high unemployment of the Great Depression.

But this is pure nonsense. For although Keynes in General Theory devoted substantial attention to the subject of wage rigidities, he certainly did not hold the view that wage rigidities were “the reason … for the high unemployment of the Great Depression.”

Since unions/workers, contrary to classical assumptions, make wage-bargains in nominal terms, they will – according to Keynes – accept lower real wages caused by higher prices, but resist lower real wages caused by lower nominal wages. However, Keynes held it incorrect to attribute “cyclical” unemployment to this diversified agent behaviour. During the depression money wages fell significantly and – as Keynes noted – unemployment still grew. Thus, even when nominal wages are lowered, they do not generally lower unemployment.

In any specific labour market, lower wages could, of course, raise the demand for labour. But a general reduction in money wages would leave real wages more or less unchanged. The reasoning of the classical economists was, according to Keynes, a flagrant example of the “fallacy of composition.” Assuming that since unions/workers in a specific labour market could negotiate real wage reductions via lowering nominal wages, unions/workers in general could do the same, the classics confused micro with macro.

Lowering nominal wages could not – according to Keynes – clear the labour market. Lowering wages – and possibly prices – could, perhaps, lower interest rates and increase investment. But to Keynes it would be much easier to achieve that effect by increasing the money supply. In any case, wage reductions was not seen by Keynes as a general substitute for an expansionary monetary or fiscal policy.

Even if potentially positive impacts of lowering wages exist, there are also more heavily weighing negative impacts – management-union relations deteriorating, expectations of on-going lowering of wages causing delay of investments, debt deflation et cetera.

So, what Keynes actually did argue in General Theory, was that the classical proposition that lowering wages would lower unemployment and ultimately take economies out of depressions, was ill-founded and basically wrong.

Where Keynes found it unproblematic to link flexible wages and prices to involuntary unemployment, modern “Keynesian” macroeconomists has turned his theory into different kinds of fix-price models. But to Keynes, flexible wages would only make things worse by leading to erratic price-fluctuations. The basic explanation for unemployment is insufficient aggregate demand, and that is mostly determined outside the labor market.

So — for almost forty years neoclassical economics has lived with a theorem that shows the impossibility of extending the microanalysis of consumer behaviour to the macro level (unless making patently and admittedly unrealistic and absurd assumptions). Still after all these years neoclassical economists pretend in their textbooks that this theorem does not exist. Most textbooks  don’t even mention the existence of the Sonnenschein-Mantel-Debreu theorem. And when it comes to Keynes and wage rigidities, Jones’s macroeconomics textbook is not the only one containing the kind of utter nonsense we’ve mentioned.  But here the solution to the problem is more easy. Keynes books are still in print. Read them.

The real scientific challenge — that also has to be reflected in textbooks — is to accept uncertainty and still try to explain why economic transactions take place — instead of simply conjuring the problem away by assuming rational expectations, representative actors, universal market clearing  and treating uncertainty as if it was possible to reduce it to stochastic risk. That is scientific fraud. And it has been going on for too long now.

Wren-Lewis and the chicken defence of rational expectations

Commenting on the critique of his earlier attempt at defending rational expectations, Simon Wren-Lewis has come up with a new line of defense — chickens:

The chicken that is fed by the farmer each morning may well have a theory that it will always be fed each morning – it becomes a ‘law’. And it works every day, until the day the chicken is instead slaughtered …

Now you might say that no chicken is an economist, but suppose that chickens were as intelligent as the farmer who keeps them, so they could be an economist … So if (the)  chicken had been an economist, they would not simply have observed that every morning the farmer brought them food, and therefore concluded that this must happen forever. Instead they would have asked a crucial additional question: why is the farmer doing this? … And of course trying to answer that question might have led them to the unfortunate truth …

You can see why the habit of introspection would make economists predisposed to assume rationality generally, and rational expectations in particular … It only works to use your own thought processes as a guide to how people in general might behave, if you think other people are essentially like yourself. So if your own thoughts lead you to postulate some theory about how the economy behaves, then others similar to yourself might be able to do something like the same thing …

Economists may also be fooled into thinking their introspection is representative, because they are surrounded by other economists. So this conjecture about introspection does little to show that assuming agents have rational expectations is right (or wrong), but it may be one reason why most economists find the concept of rational expectations so attractive.

This is actually the second example yours truly has come across this month where a mainstream economist uses story-telling trying to defend rational expectations.

Earlier this month Mark Thoma — in an article in The Fiscal Times  — argued like this (emphasis added):

The rationality assumption is reasonable in some cases. For example, even young children have rational expectations in the sense that economists use the term. Think, for example, of a game where a parent is tickling a child and following a fixed rule. Tickle the armpit, tickle the knee, tickle the armpit, tickle the knee, and so on in a repeating pattern.

If the child is following the simplest type of adaptive expectations in trying to cover up and avoid being tickled, i.e. expect whatever happened last period, he or she will always be one step behind and will never block a tickle. But if the child understands the rule the parent is following and also fully understands the nature of the game, it is easy to rationally anticipate where the next tickle attempt will be and take evasive action.

Although there is some healthy skepticism on rational expectations  in both Wren-Lewis’s and Thoma’s storytelling, I still think that their picture of the extent to which the assumption of rational expectations is useful and valid, is inadequate and unwarranted.

When John Muth first developed the concept of rational expectations — in  an Econometrica article in 1961 — he framed rational expectations in terms of probability distributions:

Expectations of firms (or, more generally, the subjective probability distribution of outcomes) tend to be distributed, for the same information set, about the prediction of the theory (or the “objective” probability distributions of outcomes).

To Muth the hypothesis of rational expectations was useful because it was general and applicable to all sorts of situations, irrespective of the concrete and contingent circumstances at hand. The concept was later picked up by New Classical Macroeconomics, where it soon became the dominant model-assumption and has continued to be a standard assumption made in many neoclassical (macro)economic models – most notably in the fields of (real) business cycles and finance (being a cornerstone of the “efficient market hypothesis”).

The rational expectations hypothesis basically says that people on the average hold expectations that will be fulfilled — which of course makes the economist’s analysis enormously simple, since it means that the model used by the economist is the same as the one people use to make decisions and forecasts of the future.

The perhaps most problematic part of Wren-Lewis’s and Thoma’s argument is that they both maintain that chicken-economists and young children (emphasis added)

have rational expectations in the sense that economists use the term.

This is the heart of darkness. Of course Wren-Lewis’s and Thoma’s portrayal of the economists’s meaning of rational expectations — which actually is far from real people’s common sensical meaning — is not as innocent as it may look. Rational expectations in the neoclassical economists’s world implies that relevant distributions have to be time independent. This amounts to assuming that an economy is like a closed system with known stochastic probability distributions for all different events. In reality it is straining one’s beliefs to try to represent economies as outcomes of stochastic processes. An existing economy is a single realization tout court, and hardly conceivable as one realization out of an ensemble of economy-worlds, since an economy can hardly be conceived as being completely replicated over time. It’s really straining one’s imagination trying to see any similarity between these modelling assumptions and the expectations of rational chicken-economists or children playing the “tickling game.” In the world of the rational expectations hypothesis we are never disappointed in any other way than as when we lose at the roulette wheels. But real life is not an urn or a roulette wheel.

So — the rational expectations modeled by economists are not at all the kind of expectations real youngsters — and chickens — have. That also means that — if we want to have anything of interest to say on real economies, financial crisis and the decisions and choices real people make — we have to replace the rational expectations hypothesis with more relevant and realistic assumptions concerning economic agents and their expectations. And that goes for chickens and children too …

Krugman disses students that want to rethink economics

Paul Krugman today rides out — like his brother in arms, Simon Wren-Lewis — to defend mainstream economics. According to Krugman, yours truly and others of that ilk are wrong in blaming mainstream economics for not being relevant and not being able to foresee the crisis. To Krugman there is nothing wrong with “standard theory” and “economics textbooks.” If only policy makers and economists stick to “standard economic analysis” everything would be just fine.

I’ll be dipped! If there’s anything the last five years have shown us, it is that economists have gone astray in their shed of tools. Krugman’s “standard theory” — neoclassical economics – has contributed to causing todays’s economic crisis rather than to solving it.
Reading Krugman’s post, I guess a lot of the young economics students in UK and US that today are looking for alternatives to the autistic mainstream neoclassical theory are deeply disappointed. Rightly so. But — although Krugman, especially on his blog, certainly tries to present himself as a kind of radical and anti-establishment economics guy — when it really counts, he shows what he is —  a die-hard teflon-coated neoclassical economist.

Perhaps this becomes less perplexing to grasp when one considers what Krugman said already in 1996, when he 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 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.

…

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.

…

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.

So now all you young economics students that want to see a real change in economics and the way it’s taught — now you know where you have Krugman & Co. If you really want something other than the same old neoclassical catechism, if you really don’t want to be force-fed with neoclassical mumbo jumbo, you have to look elsewhere. 

Is economics a science?

As yours truly has reported repeatedly during the last months, university students all over Europe are increasingly beginning to question if the kind of economics they are taught — mainstream neoclassical economics — really is of any value. Some have even started to question if economics really is a science.

Two Nobel laureates in economics — Robert Shiller and Paul Krugman — have lately tried to respond.

This is Robert Shiller‘s answer:

I am one of the winners of this year’s Nobel Memorial Prize in Economic Sciences, which makes me acutely aware of criticism of the prize by those who claim that economics – unlike chemistry, physics, or medicine, for which Nobel Prizes are also awarded – is not a science. Are they right? …

The problem is that once we focus on economic policy, much that is not science comes into play. Politics becomes involved, and political posturing is amply rewarded by public attention. The Nobel Prize is designed to reward those who do not play tricks for attention, and who, in their sincere pursuit of the truth, might otherwise be slighted …

Critics of “economic sciences” sometimes refer to the development of a “pseudoscience” of economics, arguing that it uses the trappings of science, like dense mathematics, but only for show. For example, in his 2004 book Fooled by Randomness, Nassim Nicholas Taleb said of economic sciences: “You can disguise charlatanism under the weight of equations, and nobody can catch you since there is no such thing as a controlled experiment” …

My belief is that economics is somewhat more vulnerable than the physical sciences to models whose validity will never be clear, because the necessity for approximation is much stronger than in the physical sciences, especially given that the models describe people rather than magnetic resonances or fundamental particles. People can just change their minds and behave completely differently. They even have neuroses and identity problems, complex phenomena that the field of behavioral economics is finding relevant to understanding economic outcomes.

But all the mathematics in economics is not, as Taleb suggests, charlatanism. Economics has an important quantitative side, which cannot be escaped. The challenge has been to combine its mathematical insights with the kinds of adjustments that are needed to make its models fit the economy’s irreducibly human element.

The advance of behavioral economics is not fundamentally in conflict with mathematical economics, as some seem to think, though it may well be in conflict with some currently fashionable mathematical economic models. And, while economics presents its own methodological problems, the basic challenges facing researchers are not fundamentally different from those faced by researchers in other fields. As economics develops, it will broaden its repertory of methods and sources of evidence, the science will become stronger, and the charlatans will be exposed.

Robert Shiller

And this is what Paul Krugman says on the question:

[S]omething is deeply wrong with economics. While economists using textbook macro models got things mostly and impressively right, many famous economists refused to use those models — in fact, they made it clear in discussion that they didn’t understand points that had been worked out generations ago. Moreover, it’s hard to find any economists who changed their minds when their predictions, say of sharply higher inflation, turned out wrong.

Nor is this a new thing. My take on the history of macro is that the notion of equilibrium business cycles had, by the standards of any normal science, definitively failed by any normal scientific standard by 1990 at the latest … Yet there was no backing off on this approach. On the contrary, it actually increased its hold on the profession.

So, let’s grant that economics as practiced doesn’t look like a science. But that’s not because the subject is inherently unsuited to the scientific method. Sure, it’s highly imperfect — it’s a complex area, and our understanding is in its early stages. And sure, the economy itself changes over time, so that what was true 75 years ago may not be true today …

No, the problem lies not in the inherent unsuitability of economics for scientific thinking as in the sociology of the economics profession — a profession that somehow, at least in macro, has ceased rewarding research that produces successful predictions and rewards research that fits preconceptions and uses hard math instead.

Paul Krugman

My own take on the issue is that economics – and especially mainstream neoclassical economics – has as a science lost immensely in terms of status and prestige during the last years. Not the least because of its manifest inability to foresee the latest financial and economic crisis – and its lack of constructive and sustainable policies to take us out of the crisis.

We all know that many activities, relations, processes and events are uncertain and that 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.

Neoclassical economists, however, have wanted to use their hammer, and so decided to pretend that the world looks like a nail. Pretending that uncertainty can be reduced to risk and construct models on that assumption have only contributed to financial crises and economic havoc.

How do we put an end to this intellectual cataclysm? How do we re-establish credence and trust in economics as a science? Five changes are absolutely decisive.

(1) Stop pretending that we have exact and rigorous answers on everything. Because we don’t. We build models and theories and tell people that we can calculate and foresee the future. But we do this based on mathematical and statistical assumptions that often have little or nothing to do with reality. By pretending that there is no really important difference between model and reality we lull people into thinking that we have things under control. We haven’t! This false feeling of security was one of the factors that contributed to the financial crisis of 2008.

(2) Stop the childish and exaggerated belief in mathematics giving answers to important economic questions. Mathematics gives exact answers to exact questions. But the relevant and interesting questions we face in the economic realm are rarely of that kind. Questions like “Is 2 + 2 = 4?” are never posed in real economies. Instead of a fundamentally misplaced reliance on abstract mathematical-deductive-axiomatic models having anything of substance to contribute to our knowledge of real economies, it would be far better if we pursued “thicker” models and relevant empirical studies and observations.

(3) Stop pretending that there are laws in economics. There are no universal laws in economics. Economies are not like planetary systems or physics labs. The most we can aspire to in real economies is establishing possible tendencies with varying degrees of generalizability.

(4) Stop treating other social sciences as poor relations. Economics has long suffered from hubris. A more broad-minded and multifarious science would enrich today’s altogether too autistic economics.

(5) Stop building models and making forecasts of the future based on totally unreal micro-founded macromodels with intertemporally optimizing robot-like representative actors equipped with rational expectations. This is pure nonsense. We have to build our models on assumptions that are not so blatantly in contradiction to reality. Assuming that people are green and come from Mars is not a good – not even as a “successive approximation” – modeling strategy.

“Free markets” — a poisonous term

Rethinking economics curriculum

For economists 2008 was a nightmare. The people who teach and research the discipline mocked by Thomas Carlyle, a 19th-century polemicist, as “the dismal science”, not only failed to spot the precipice, many forecast exactly the opposite—a tranquil stability they called the “great moderation”. While the global economy is slowly healing, the subject is still in a state of flux, with students eager to learn what went wrong, but frustrated by what they are taught. Some bold new projects to retune economics aim to change this …

For a start there is fresh blood coming into the subject. The numbers taking economics A-level—over 26,000 in June 2013—are at an all-time high. Many university students, however, are disappointed by what follows. At Manchester University, a student society has been set up to challenge the current syllabus. Among the demands are fewer lectures bogged down in detailed maths, and more time discussing important historical thinkers …

A new group of teachers is now listening. Led by Wendy Carlin, an economist at University College London, they are designing a new university-level curriculum. The project, which aims to launch for the 2014-15 academic year, will change things in a number of ways …

The academic contributors to Ms Carlin’s project are spread across nine countries … No one following the course will have to buy expensive books: the materials will be distributed to university departments without charge …

Brevan Howard, a hedge fund with assets of $40 billion, has founded a new financial stability research centre at Imperial College. On November 11th it announced that Franklin Allen and Douglas Gale, professors at Wharton Business School and New York University respectively, will be co-heads …

Ms Carlin’s project has benefited from hedge fund money too, with cash coming from the Institute for New Economic Thinking (INET) a think-tank set up by George Soros, an investor, in 2009. INET now funds $4m in economics projects per year, including a new research centre at Oxford University. Keynes too was an active investor who thought the role of economics was to protect the good things in life—music, art and intellectual life. He would have thoroughly approved.

The Economist