LARS P. SYLL

Why rational expectations is such a joke

Macroeconomics textbooks — how about checking the facts …

Among a couple of really good intermediate – neoclassical – macroeconomics textbooks, Chad Jones textbook Macroeconomics (3rd ed, W W Norton, 2014) stands out as perhaps the best alternative, by combining more traditional short-run macroeconomic analysis with a marvellously accessible coverage of the Romer model – the foundation of modern growth theory.

Unfortunately it also contains some utter nonsense!

In chapter 7 – on “The Labor Market, Wages, and Unemployment” – Jones writes (p. 181):

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.”

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.

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.

Unfortunately, Jones macroeconomics textbook is not the only one containing this kind of utter nonsense on Keynes. Similar distortions of Keynes views can be found in , e. g., the economics textbooks of the “new Keynesian” – a grotesque misnomer – Greg Mankiw. How is this possible? Probably because these economists have but a very superficial acquaintance with Keynes own works, and rather depend on second-hand sources like Hansen, Samuelson, Hicks and the likes.

But the problems don’t end here. The rather embarrassing history revision on Keynes is followed up a couple of pages later with the following gobsmacking remark:

In recent years, different countries in Europe have sought to reform their labor market institutions. As a result, unemployment rates in Spain, Ireland, and the Netherlands, for example, have decreased substantially from levels in the 1980s.

Checking up on Spain I get the following graph:

Hardly consistent with the textbook’s “have decreased substantially” …

Chicago economics out of touch with the real world

Tom Sargent is a bit out of touch with the real world up there in his office … Certain people have a capacity for ignoring facts which are patenty obvious, but are counter to their view of the world; so they just ignore them …

Sargent is a sort of tinkerer, playing an intellectual game. He looks at a puzzle to see if h ecan solve it in a particular way, exercising these fancy techniques.

Alan Blinder

Do you think this is too harsh? Well, then I suggest you read the following excerpt from the interview with Sargent in Arjo Klamer’s The New Classical Macroeconomics (1984):

People say that many of your assumptions are unrealistic.

It is true that these assumptions are unrealistic.

…

Do you feel comfortable with them?

Yes, about certain matters. I’m aware of all the problems with them. There are philosophical contradictions about using this methodoology. Deep down I don’t believe in them, but I don’t have a better method of understanding what’s going on out there.

But if the best is not good enough? Wittgenstein’s dictum in Tractatus Logico-Philosophicus comes to mind:

Wovon man nicht sprechen kann, darüber muss man schweigen.

On math and economics — a feeble-minded pseudo debate

Many mainstream economists have the unfounded and ridiculous idea that because heterodox people like yours truly often criticize the application of mathematics in mainstream economics, we are critical of math per se.

I don’t know how many times I’ve been asked to answer this straw-man objection to heterodox economics, but here we go again.

No, there is nothing wrong with mathematics per se.

No, there is nothing wrong with applying mathematics to economics.

Mathematics is one valuable tool among other valuable tools for understanding and explaining things in economics.

What is, however, totally wrong, are the utterly simplistic beliefs that

• “math is the only valid tool”

• “math is always and everywhere self-evidently applicable”

• “math is all that really counts”

• “if it’s not in math, it’s not really economics”

• “almost everything can be adequately understood and analyzed with math”

So — please — let’s have no more of this feeble-minded pseudo debate where heterodox economics is described as simply anti-math!

A common mistake amongst Ph.D. students is to place too much weight on the ability of mathematics to solve an economic problem.  They take a model off the shelf and add a new twist. A model that began as an elegant piece of machinery designed to illustrate a particular economic issue,  goes through five or six amendments from one paper to the next. By the time it reaches the n’th iteration it looks like a dog designed by committee.

Mathematics doesn’t solve economic problems. Economists solve economic problems. My advice: never formalize a problem with mathematics until you have already figured out the probable answer. Then write a model that formalizes your intuition and beat the mathematics into submission. That last part is where the fun begins because the language of mathematics forces you to make your intuition clear. Sometimes it turns out to be right. Sometimes you will realize your initial guess was mistaken. Always, it is a learning process.

Roger Farmer

Good advice — coming from a professor of economics and fellow of the Econometric Society and research associate of the NBER — well worth following.

Beat A Dead Horse Award

If I ask myself what I could legitimately assume a person to have rational expectations about, the technical answer would be, I think, about the realization of a stationary stochastic process, such as the outcome of the toss of a coin or anything that can be modeled as the outcome of a random process that is stationary. I don’t think that the economic implications of the outbreak of World war II were regarded by most people as the realization of a stationary stochastic process. In that case, the concept of rational expectations does not make any sense. Similarly, the major innovations cannot be thought of as the outcome of a random process. In that case the probability calculus does not apply.

Robert Solow

“Modern” macroeconomic theories are as a rule founded on the assumption of  rational expectations — where the world evolves in accordance with fully predetermined models where uncertainty has been reduced to stochastic risk describable by some probabilistic distribution.

The tiny little problem that there is no hard empirical evidence that verifies these models — cf. Michael Lovell (1986) & Nikolay Gertchev (2007) — usually doesn’t bother its protagonists too much. Rational expectations überpriest Thomas Sargent has the following to say on the epistemological status of the rational expectations hypothesis (emphasis added):

Partly because it focuses on outcomes and does not pretend to have behavioral content, the hypothesis of rational epectations has proved to be a powerful tool for making precise statements about complicated dynamic economic systems.

Precise, yes, in the celestial world of models. But relevant and realistic? I’ll be dipped!

And a few years later, when asked if he thought “that differences among people’s models are important aspects of macroeconomic policy debates”, Sargent replied (emphasis added):

The fact is you simply cannot talk about their differences within the typical rational expectations model. There is a communism of models. All agents within the model, the econometricians, and God share the same model.

Building models on rational expectations either means we are Gods or Idiots. Most of us know we are neither. So, God may share Sargent’s and Lucas’s models, but they certainly aren’t my models.

Post-Keynesian Conference

Yours truly is off to a conference in Aalborg on 22-23 May. Only sporadic blogging until the weekend.

How to reform the teaching of economics

To what extent has – or should – the teaching of economics be modified in the light of the current economic crisis? … For macroeconomists in particular, the reaction has been to suggest that modifications of existing models to take account of ‘frictions’ or ‘imperfections’ will be enough …

However, other economists such as myself feel that we have finally reached the turning point in economics where we have to radically change the way we conceive of and model the economy … Rather than making steady progress towards explaining economic phenomena professional economists have been locked into a narrow vision of the economy. We constantly make more and more sophisticated models within that vision until, as Bob Solow put it, ‘the uninitiated peasant is left wondering what planet he or she is on’ …

Every student in economics is faced with the model of the isolated optimising individual who makes his choices within the constraints imposed by the market. Somehow, the axioms of rationality imposed on this individual are not very convincing … But the student is told that the aim of the exercise is to show that there is an equilibrium, there can be prices that will clear all markets simultaneously. And, furthermore, the student is taught that such an equilibrium has desirable welfare properties. Importantly, the student is told that since the 1970s it has been known that whilst such a system of equilibrium prices may exist, we cannot show that the economy would ever reach an equilibrium nor that such an equilibrium is unique.

The student then moves on to macroeconomics and is told that the aggregate economy or market behaves just like the average individual she has just studied. She is not told that these general models in fact poorly reflect reality. For the macroeconomist, this is a boon since he can now analyse the aggregate allocations in an economy as though they were the result of the rational choices made by one individual. The student may find this even more difficult to swallow when she is aware that peoples’ preferences, choices and forecasts are often influenced by those of the other participants in the economy. Students take a long time to accept the idea that the economy’s choices can be assimilated to those of one individual …

We owe it to our students to point out difficulties with the structure and assumptions of our theory. Although we are still far from a paradigm shift, in the longer run the paradigm will inevitably change. We would all do well to remember that current economic thought will one day be taught as history of economic thought.

Alan Kirman