LARS P. SYLL

‘New Keynesian’ models are not too simple. They are just wrong.

Simon Wren-Lewis has a nice post discussing Paul Romer’s critique of macro. In Simon’s words:

“It is hard to get academic macroeconomists trained since the 1980s to address [large scale Keynesian models] , because they have been taught that these models and techniques are fatally flawed because of the Lucas critique and identification problems … But DSGE models as a guide for policy are also fatally flawed because they are too simple. The unique property that DSGE models have is internal consistency … Take a DSGE model, and alter a few equations so that they fit the data much better, and you have what could be called a structural econometric model. It is internally inconsistent, but because it fits the data better it may be a better guide for policy.”

Nope! Not too simple. Just wrong!

I disagree with Simon. NK models are not too simple. They are simply wrong. There are no ‘frictions’. There is no Calvo Fairy. There are simply persistent nominal beliefs.

Period.

Roger Farmer

Yes indeed. There really is something about the way macroeconomists construct their models nowadays that obviously doesn’t sit right.

Empirical evidence only plays a minor role in neoclassical mainstream economic theory, where models largely function as a substitute for empirical evidence. One might have hoped that humbled by the manifest failure of its theoretical pretences during the latest economic-financial crisis, the one-sided, almost religious, insistence on axiomatic-deductivist modeling as the only scientific activity worthy of pursuing in economics would give way to methodological pluralism based on ontological considerations rather than formalistic tractability. That has, so far, not happened.

Fortunately — when you’ve got tired of the kind of macroeconomic apologetics produced by “New Keynesian” macroeconomists and other DSGE modellers — there still are some real Keynesian macroeconomists to read. One of them — Axel Leijonhufvud — writes:

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 …

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 … are about how to view our responsibilities and how to approach our subject.

If macroeconomic models — no matter of what ilk — build on microfoundational assumptions of 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. Incompatibility between actual behaviour and the behaviour in macroeconomic models building on representative actors and rational expectations-microfoundations is not a symptom of “irrationality”. It rather shows the futility of trying to represent real-world target systems with models flagrantly at odds with reality.

A gadget is just a gadget — and no matter how brilliantly silly DSGE models you come up with, they do not help us working with the fundamental issues of modern economies. Using DSGE models only confirms Robert Gordon‘s  dictum that today

rigor competes with relevance in macroeconomic and monetary theory, and in some lines of development macro and monetary theorists, like many of their colleagues in micro theory, seem to consider relevance to be more or less irrelevant.

Has macroeconomics — really — progressed?

A typical DSGE model has a key property that from my work seems wrong. A good example is the model in Galí and Gertler (2007). In this model a positive price shock—a ‘‘cost push” shock — is explosive unless the Fed raises the nominal interest rate more than the increase in the inflation rate. In other words, positive price shocks with the nominal interest rate held constant are expansionary (because the real interest rate falls). In my work, however, they are contractionary. If there is a positive price shock like an oil price increase, nominal wages lag output prices, and so the real wage initially falls. This has a negative effect on consumption. In addition, household real wealth falls because nominal asset prices don’t initially rise as much as the price level. This has a negative effect on consumption through a wealth effect. There is little if any offset from lower real interest rates because households appear to respond more to nominal rates than to real rates. Positive price shocks are thus contractionary even if the Fed keeps the nominal interest rate unchanged. This property is important for a monetary authority in deciding how to respond to a positive price shock. If the authority used the Galí and Gertler (2007) model, it would likely raise the nominal interest rate too much thinking that the price shock is otherwise expansionary. Typical DSGE models are thus likely to be misleading for guiding monetary policy if this key property of the models is wrong.

Ray C. Fair

Deirdre McCloskey’s shallow and misleading rhetoric

This is not new to most of you of course. You are already steeped in McCloskey’s Rhetoric. Or you ought to be. After all economists are simply telling stories about the economy. Sometimes we are taken in. Sometimes we are not.

Unfortunately McCloskey herself gets a little too caught up in her stories. As in her explanation as to how she can be both a feminist and a free market economist:

“The market is the great liberator of women; it has not been the state, which is after all an instrument of patriarchy … The market is the way out of enslavement from your dad, your husband, or your sons. … The enrichment that has come through allowing markets to operate has been a tremendous part of the learned freedom of the modern women.” — Quoted in “The Changing Face of Economics – Conversations With Cutting Edge Economists” by Colander, Holt, and Rosser

Notice the binary nature of the world in this story. There are only the market (yea!) and the state (boo!). There are no other institutions. Whole swathes of society vanish or are flattened into insignificance. The state is viewed as a villain that the market heroically battles against to advance us all.

It is a ripping tale.

It is shallow and utterly misleading.

Peter Radford

Top universities — preserves of bad economics

There are certainly some things that the top institutions offer which lower-ranked once simply can’t: great buildings and history for starters. To walk around Cambridge, to see its grand architecture, and to feel drenched in its history, is an amazing experience …

But the quality of the education you get at University depends very much on the individual people you are taught by, and here University rankings are far from a perfect guide. Extremely gifted teachers and researchers can be at lower ranked Universities, for a multitude of reasons from personal preferences to sheer lock-in: a capable person can start in a lower-ranked institution, and find that the “Old Boys Network” locks them out of the higher ranked ones.

In my own field of economics, there is also a paradox at play: in many ways the top universities have become preserves of bad economics, both in content and in teaching quality, while the best education in economics often comes from the lower ranked Universities.

In fact, there’s a case to be made that the better the University is ranked, the worse the education in economics will be. And before you think I’m just flogging my own wares here, consider what the American Economics Association had to say about the way that economics education appeared to be headed in the USA back in 1991:

“The Commission’s fear is that graduate programs may be turning out a generation with too many idiots savants, skilled in technique but innocent of real economic issues.” (“Report of the Commission on Graduate Education in Economics”, American Economic Association 1991)

The graduates of 1991 have become the University lecturers of today, and thanks to them, the trend the report identified at the graduate level has trickled down to undergraduate education at the so-called leading Universities.

Steve Keen/Forbes

Things economists could learn from kids

Kids, somehow, seem to be more in touch with real science than can-opener-assuming economists …

A physicist, a chemist, and an economist are stranded on a desert island. One can only imagine what sort of play date went awry to land them there. Anyway, they’re hungry. Like, desert island hungry. And then a can of soup washes ashore. Progresso Reduced Sodium Chicken Noodle, let’s say. Which is perfect, because the physicist can’t have much salt, and the chemist doesn’t eat red meat.

But, famished as they are, our three professionals have no way to open the can. So they put their brains to the problem. The physicist says “We could drop it from the top of that tree over there until it breaks open.” And the chemist says “We could build a fire and sit the can in the flames until it bursts open.”

Those two squabble a bit, until the economist says “No, no, no. Come on, guys, you’d lose most of the soup. Let’s just assume a can opener.”

Robert Solow kicking Lucas and Sargent in the pants

McNees documented the radical break between the 1960s and 1970s. The question is: what are the possible responses that economists and economics can make to those events?

One possible response is that of Professors Lucas and Sargent. They describe what happened in the 1970s in a very strong way with a polemical vocabulary reminiscent of Spiro Agnew. Let me quote some phrases that I culled from thepaper: “wildly incorrect,” “fundamentally flawed,” “wreckage,” “failure,” “fatal,” “of no value,” “dire implications,” “failure on a grand scale,” “spectac- ular recent failure,” “no hope” … I think that Professors Lucas and Sargent really seem to be serious in what they say, and in turn they have a proposal for constructive research that I find hard to talk about sympathetically. They call it equilibrium business cycle theory, and they say very firmly that it is based on two terribly important postulates — optimizing behavior and perpetual market clearing. When you read closely, they seem to regard the postulate of optimizing behavior as self-evident and the postulate of market-clearing behavior as essentially meaningless. I think they are too optimistic, since the one that they think is self-evident I regard as meaningless and the one that they think is meaningless, I regard as false. The assumption that everyone optimizes implies only weak and uninteresting consistency conditions on their behavior. Anything useful has to come from knowing what they optimize, and what constraints they perceive. Lucas and Sargent’s casual assumptions have no special claim to attention …

It is plain as the nose on my face that the labor market and many markets for produced goods do not clear in any meaningful sense. Professors Lucas and Sargent say after all there is no evidence that labor markets do not clear, just the unemployment survey. That seems to me to be evidence. Suppose an unemployed worker says to you “Yes, I would be glad to take a job like the one I have already proved I can do because I had it six months ago or three or four months ago. And I will be glad to work at exactly the same wage that is being paid to those exactly like myself who used to be working at that job and happen to be lucky enough still to be working at it.” Then I’m inclined to label that a case of excess supply of labor and I’m not inclined to make up an elaborate story of search or misinformation or anything of the sort. By the way I find the misinformation story another gross implausibility. I would like to see direct evidence that the unemployed are more misinformed than the employed, as I presume would have to be the case if everybody is on his or her supply curve of employment. Similarly, if the Chrysler Motor Corporation tells me that it would be happy to make and sell 1000 more automobiles this week at the going price if only it could find buyers for them, I am inclined to believe they are telling me that price exceeds marginal cost, or even that marginal revenue exceeds marginal cost, and regard that as a case of excess supply of automobiles. Now you could ask, why do not prices and wages erode and crumble under those circumstances? Why doesn’t the unemployed worker who told me “Yes, I would like to work, at the going wage, at the old job that my brother-in-law or my brother-in-law’s brother-in-law is still holding”, why doesn’t that person offer to work at that job for less? Indeed why doesn’t the employer try to encourage wage reduction? That doesn’t happen either. Why does the Chrysler Corporation not cut the price? Those are questions that I think an adult person might spend a lifetime studying. They are important and serious questions, but the notion that the excess supply is not there strikes me as utterly implausible.

Robert Solow

No unnecessary beating around the bush here.

The always eminently quotable Solow says it all.

The purported strength of New Classical macroeconomics is that it has firm anchorage in preference-based microeconomics, and especially the decisions taken by inter-temporal utility maximizing “forward-loooking” individuals.

To some of us, however, this has come at too high a price. The almost quasi-religious insistence that macroeconomics has to have microfoundations – without ever presenting neither ontological nor epistemological justifications for this claim – has put a blind eye to the weakness of the whole enterprise of trying to depict a complex economy based on an all-embracing representative actor equipped with superhuman knowledge, forecasting abilities and forward-looking rational expectations. It is as if – after having swallowed the sour grapes of the Sonnenschein-Mantel-Debreu-theorem – these economists want to resurrect the omniscient walrasian auctioneer in the form of all-knowing representative actors equipped with rational expectations and assumed to somehow know the true structure of our model of the world.

That anyone should take that kind of stuff seriously is totally and unbelievably ridiculous. Or as Solow has it:

Suppose someone sits down where you are sitting right now and announces to me that he is Napoleon Bonaparte. The last thing I want to do with him is to get involved in a technical discussion of cavalry tactics at the battle of Austerlitz. If I do that, I’m getting tacitly drawn into the game that he is Napoleon. Now, Bob Lucas and Tom Sargent like nothing better than to get drawn into technical discussions, because then you have tacitly gone along with their fundamental assumptions; your attention is attracted away from the basic weakness of the whole story. Since I find that fundamental framework ludicrous, I respond by treating it as ludicrous – that is, by laughing at it – so as not to fall into the trap of taking it seriously and passing on to matters of technique.

Robert Solow

General equilibrium theory — a gross misallocation of intellectual resources and time

General equilibrium is fundamental to economics on a more normative level as well. A story about Adam Smith, the invisible hand, and the merits of markets pervades introductory textbooks, classroom teaching, and contemporary political discourse. The intellectual foundation of this story rests on general equilibrium, not on the latest mathematical excursions. If the foundation of everyone’s favourite economics story is now known to be unsound — and according to some, uninteresting as well — then the profession owes the world a bit of an explanation.

Frank Ackerman

Almost a century and a half after Léon Walras founded general equilibrium theory, economists still have not been able to show that markets lead economies to equilibria.

We do know that — under very restrictive assumptions — equilibria do exist, are unique and are Pareto-efficient.

But after reading Frank Ackerman’s article — or Franklin M. Fisher’s The stability of general equilibrium – what do we know and why is it important? — one has to ask oneself — what good does that do?

As long as we cannot show that there are convincing reasons to suppose there are forces which lead economies to equilibria — the value of general equilibrium theory is nil. As long as we cannot really demonstrate that there are forces operating — under reasonable, relevant and at least mildly realistic conditions — at moving markets to equilibria, there cannot really be any sustainable reason for anyone to pay any interest or attention to this theory.

A stability that can only be proved by assuming Santa Claus conditions is of no avail. Most people do not believe in Santa Claus anymore. And for good reasons. Santa Claus is for kids, and general equilibrium economists ought to grow up, leaving their Santa Claus economics in the dustbin of history.

Continuing to model a world full of agents behaving as economists — “often wrong, but never uncertain” — and still not being able to show that the system under reasonable assumptions converges to equilibrium (or simply assume the problem away), is a gross misallocation of intellectual resources and time. As Ackerman writes:

The guaranteed optimality of market outcomes and laissez-faire policies died with general equilibrium. If economic stability rests on exogenous social and political forces, then it is surely appropriate to debate the desirable extent of intervention in the market — in part, in order to rescue the market fromits own instability.