LARS P. SYLL

Deductivism — the original sin of ‘modern’ economics

For many people, deductive reasoning is the mark of science: induction – in which the argument is derived from the subject matter – is the characteristic method of history or literary criticism. But this is an artificial, exaggerated distinction. Scientific progress … is frequently the result of observation that something does work, which runs far ahead of any understanding of why it works.

Not within the economics profession. There, deductive reasoning based on logical inference from a specific set of a priori deductions is “exactly the right way to do things”. What is absurd is not the use of the deductive method but the claim to exclusivity made for it. This debate is not simply about mathematics versus poetry. Deductive reasoning necessarily draws on mathematics and formal logic: inductive reasoning, based on experience and above all careful observation, will often make use of statistics and mathematics …

The belief that models are not just useful tools but are capable of yielding comprehensive and universal descriptions of the world blinded proponents to realities that had been staring them in the face. That blindness made a big contribution to our present crisis, and conditions our confused responses to it.

John Kay

Kay’s article is essential reading for all those who want to understand why mainstream – neoclassical – economics actively have contributed to causing todays’s economic crisis rather than to solving it.

Perhaps this becomes less perplexing to grasp when considering what one of its main proponents today – Robert Lucas – maintained already in 2003:

My thesis in this lecture is that macroeconomics in this original sense has succeeded: its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.

And this comes from an economist who has built his whole career on the assumption that people are hyper rational “robot imitations” with rational expectations and (stochastically) perfect ability to process information. Mirabile dictu!

Limits of formalization in economics

A complete modeling system which yields definitive predictions (or at least multiple equilibria) requires the following conditions: given structures with fixed (or at least predictably random) interrelations between separable parts (e.g., economic agents) and predictable (or at least predictably random) outside influences. Such a system is … a‘closed’ system. Such a system, correctly applied, promotes internal consistency but risks inconsistency with the nature of the economic system unless that too is closed …

An open system is not the opposite of a closed system, since there is a range of possibilities for openness, depending on which conditions are not met and to what degree … Deviating from a closed system, and thus from certainty or certainty equivalence, does not mean abandoning theory or formal models. On the contrary, Keynes was concerned to identify the logical grounds on which we habitually form beliefs, make judgments and take decisions (both as economists and as economic agents) in spite of uncertainty. The question was what view on probability would be logically justified, in relation to the evidence, within an open system …

Any formal model is a closed system. Variables are specified and identified as endogenous or exogenous, and relations are specified between them. This is a mechanism for separating off some aspect of an open-system reality for analysis. But, for consistency with the subject matter, any analytical closure needs to be justified on the grounds that, for the purposes of the analysis, it is not unreasonable to treat the variables as having a stable identity, for them to have stable interrelations and not to be subject to unanticipated influences from outside … But in applying such an analysis it is important then to consider what has been assumed away …

Keynes’s argument is that any formal model is bound to be an incomplete representation of an open-system reality … Models are inevitably partial representations, invoking closures which are both porous and provisional. They can only be approximated in reality and even then cannot be presumed to persist …

This methodology explains why Keynes’s general theory did not take the form of a single large model, including formal microfoundations … It was not that Keynes lacked a microeconomic analysis, but rather that his study of individual behavior concluded that it was organic rather than atomistic.

Sheila Dow

Är svenska nationalekonomers Törnrosasömn äntligen över?

När det brinner i köket är det dags att använda brandsläckaren. Det är ingen mening att spara pulvret tills det brinner i hela huset. I debatten om statsbudgeten tycks både regering och opposition ha glömt denna enkla insikt.

Vi föreslår att regeringen – allra helst i samförstånd med oppositionen – snarast möjligt gör betydande utbetalningar till alla invånare i Sverige … Årets budgetunderskott skulle öka i motsvarande grad. Regeringen bör dessutom signalera att den inte har för avsikt att i nära framtid återbetala denna skuld. Med andra ord, summan av statsobligationer, sedlar och mynt bör höjas permanent.

Förslaget kan tyckas radikalt och oseriöst. Under de tjugo år som passerat sedan nittiotalskrisen har ”sunda finanser” varit ett mantra bland svenska finansministrar. Att ta ansvar för Sverige har inneburit en stram budget – fulla lador, torrt krut! Men det finns lägen då det är skadligt att budgetera alltför stramt, och dagens läge är ett sådant. Anledningen är enkel. Penningpolitiken klarar bevisligen inte av att på egen hand att bekämpa lågkonjunkturen eller ens att någorlunda uppnå inflationsmålet. Hårdare begränsningar av hushållens lånemöjligheter medför en ytterligare press nedåt på konsumentpriserna. Finanspolitiken bör därför hjälpa till att ge konsumentprisindex en skjuts uppåt. Att i detta läge spara för framtiden framstår lika missriktat som att träna hårt med influensa i kroppen.

Vi är naturligtvis inte de första som förespråkar expansiv finanspolitik för att råda bot på de ekonomiska obalanserna i Sverige liksom i övriga världen. Men tills nyligen har vi, liksom många av våra kolleger, hoppats och trott att det skulle vara möjligt för Riksbanken att på egen hand sköta konjunkturpolitiken, om den bara helhjärtat ägnat sig åt uppgiften. Vi tog fel. Negativa räntor räcker inte för att nå inflationsmålet. Då finns ingen annan utväg än att trycka pengar, vilket alltså är vårt förslag. Med en större mängd pengar blir varje krona mindre värd, såvida det inte finns så mycket lediga resurser att produktionen går upp utan att priserna gör det. I båda fallen uppnås en önskad effekt.

David Domeij & Tore Ellingsen

Nej, de här herrarna är verkligen inte de första att förespråka expansiv finanspolitik …

Men bättre sent än aldrig! Denna föredömliga självkritik hoppas vi får se mer av från landets alla mainstream ekonomer som glatt traskat patrull och i årtionden salufört mantrat om “sunda statsfinanser” och penningpolitisk självtillräcklighet.

Economic models as knowledge-surrogates

The standard way in which time is introduced into economic theory is by having models with time lags in the equations. Shackle quickly disposes of this by pointing out that it poses a question rather than answers one …

One way out of these difficulties is simply to abandon time; to confine one’s attention to the ‘momentary world of perfect pre-reconciled choice’ … In the method of statics, one might expect, there is some hope of keeping things sufficiently watertight for the agent’s reason to have something definite to work on: the impoverishment of the framework of thought by the exclusion of time may be compensated for by the rigour with which one can formulate the now self-contained static theory …

The second possibility is what I will call ‘the de-naturing of time’. Thus, one can consider agents choosing not a self-contained, momentary act of conduct, but rather a whole time-path or plan for future conduct. But this brings us immediately up against the … simultaneity problem. And this, in turn, means that the theory can only be made workable by supposing that these plans or time paths have somehow been pre-reconciledso that they are all mutually consistent and realisable. Accordingly, in such a situation, the expectations on which plans were based could all be fulfilled (or, more precisely, would be ‘self-generating’). This would then mean that the future produced no surprises: ‘time’ elapses but bears no novelty and no uncertainty. It is a future about which all agents have the perfect knowledge-surrogates for achieving the appearance of being ‘fully informed’. It will be no surprise to learn that in such a situation market prices (including now certain inter-temporal prices) are perfect knowledge-surrogates …

Alan Coddington

A Website Anniversary

Ten years ago (September 2005) I launched my website. To mark this anniversary, here are ten postings that I think got it right. Many of them are included in my book, The Economic Crisis: Notes From The Underground (2012).

1. Keynesianism: what it is and why it still matters (September 18, 2005). My first post. What was intellectually unfashionable back then is now in.

2. The Questionable Legacy of Alan Greenspan (October 16, 2005). Raining on the Maestro’s parade was not popular.

3. Winner’s curse: The Torment of Chairman-designate Bernanke (November 4, 2005). I suspect Mrs. Bernanke wishes Mr. Bernanke read this before accepting the job.
…

Thomas Palley

Relevance is not irrelevant

What is science? One brief definition runs: “A systematic knowledge of the physical or material world.” Most definitions emphasize the two elements in this definition: (1) “systematic knowledge” about (2) the real world. Without pushing this definitional question to its metaphysical limits, I merely want to suggest that if economics is to be a science, it must not only develop analytical tools but must also apply them to a world that is now observable or that can be made observable through improved methods of observation and measurement. Or in the words of the Hungarian mathematical economist Janos Kornai, “In the real sciences, the criterion is not whether the proposition is logically true and tautologically deducible from earlier assumptions. The criterion of ‘truth’ is, whether or not the proposition corresponds to reality” …

One of our most distinguished historians of economic thought, George Stigler, has stated that: “The dominant influence upon the working range of economic theorists is the set of internal values and pressures of the discipline. The subjects of study are posed by the unfolding course of scientific developments.” He goes on to add: “This is not to say that the environment is without influence …” But, he continues, “whether a fact or development is significant depends primarily on its relevance to current economic theory.” What a curious relating of rigor to relevance! Whether the real world matters depends presumably on “its relevance to current economic theory.” Many if not most of today’s economic theorists seem to agree with this ordering of priorities …

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 … The theoretical analysis in much of this literature rests on assumptions that also fly in the face of the facts … Another related recent development in which theory proceeds with impeccable logic from unrealistic assumptions to conclusions that contradict the historical record, is the recent work on rational expectations …

I have scolded economists for what I think are the sins that too many of them commit, and I have tried to point the way to at least partial redemption. This road to salvation will not be an easy one for those who have been seduced by the siren of mathematical elegance or those who all too often seek to test unrealistic models without much regard for the quality or relevance of the data they feed into their equations. But let us all continue to worship at the altar of science. I ask only that our credo be: “relevance with as much rigor as possible,” and not “rigor regardless of relevance.” And let us not be afraid to ask — and to try to answer the really big questions.

Robert A. Gordon

What went wrong with economics?

Internal coherence is one way of adjudicating among theories, but so is correspondence to everyday life. Too much realism may kill analysis, but too little realism is unscientific. If theoretical coherence alone were all that mattered, then the only constraint on theoretical exercises would be the human imagination. Interesting
puzzles would replace pragmatic solutions to problems encountered in the world — arguably, an accurate characterization of most contemporary economic theory. Economists must steer a course between (allegedly) pure description and the mere recording of events, on the one side, and self-indulgent mental gymnastics on the other …

Parsimony won out over thoroughness … By myopically pursuing only the formal aspects of the discipline, economics was reduced to its present state, in which we continually know more and more about less and less.

Peter Boettke

Mainstream economic theory today is in the story-telling business whereby economic theorists create make-believe analogue models of the target system – usually conceived as the real economic system. This modeling activity is considered useful and essential. To understand and explain relations between different entities in the real economy the predominant strategy is to build models and make things happen in these “analogue-economy models” rather than engineering things happening in real economies.

Formalistic deductive “Glasperlenspiel” can be very impressive and seductive. But in the realm of science it ought to be considered of little or no value to simply make claims about the model and lose sight of reality. Although the deductivist mathematical modeling method makes conclusions follow with certainty from given assumptions, that should be of little interest to scientists, since what happens with certainty in a model world is no warrant for the same to hold in real world economies.

Mainstream economics has since long given up on the real world and contents itself with proving things about thought up worlds. Empirical evidence only plays a minor role in economic theory, where models largely function as a substitute for empirical evidence. Hopefully humbled by the manifest failure of its theoretical pretences, the one-sided, almost religious, insistence on axiomatic-deductivist modeling as the only scientific activity worthy of pursuing in economics will give way to methodological pluralism based on ontological considerations rather than formalistic tractability.

To have valid evidence is not enough. What economics needs is sound evidence. Theories and models being “coherent” or “consistent with” data do not make the theories and models success stories.

No realism please. We’re Chicago economists!

Samuelson’s reconciliation of the micro-economic ideal type with involuntary unemployment was repudiated, along with Keynesian prescriptions, in favor of a view that there could be no involuntary unemployment , hence that government action was unnecessary. The result was a doctrinaire derivation of the laissez-faire conclusions that had been overturned by the formalist revolution; economics was now cleansed of Keynesian impurities that had been introduced in the interest of realism.

Peter Boettke

Efficient Market Hypothesis — an intellectually lazy ideology

Both Brad DeLong and Noah Smith have posts up on their blogs commenting on the status of the Efficient Market Hypothesis. As so often the really interesting questions however drown in the usual mumbo jumbo “the model is the message” pseudo science of four-factor models with two mispricing factors being better-performing than three-factor models …

Diane Coyle has a much more accurate view of what it’s all about:

I would defend using the assumption of rational choice as long as one realises that it is not a description of reality.

But there is one area where for 30 years economists – and others – have been making that mistake. That is unfortunately, of course, in the financial markets. Practitioners and policy makers acted as if the strong form of the Efficient Markets Hypothesis held true – in other words that prices instantly reflect all relevant information about the future – even though this evidently defies reality …

I think an honest conventionally-trained economist has to at least acknowledge that we grew intellectually lazy about this. Although we all knew at some level that the rational choice assumption was being made to bear too much weight, very few economists openly challenged its everyday use in justifying public policy decisions. Very few of us put this weight on it in our own work. But not all that many economists challenged its pervasive use in the public policy world …

The financial and economic crisis also spells a crisis for certain areas of economics, or approaches to economics. Financial economics and macroeconomics are particularly vulnerable. They are the subject areas where the consequences of the standard assumptions have been most damaging, because they are actually least valid. Financial market traders are not remotely like Star Trek’s Mr Spock, making rational calculations unaffected by emotion or by the decisions of other people. Macroeconomics – the study of how millions of individual decisions aggregate into economy-wide measures – is essentially ideological. How macroeconomists answer a question like ‘What will be the effect of cutting the budget deficit on growth next year?’ depends on their political views. This is not remotely a scientific area of the discipline. The consensus about macroeconomics during what’s been described as ‘the Great Moderation’ of the 1990s has entirely broken down.

Diane Coyle

Backfiring expectations

Economist Brian Arthur has made important contributions to our understanding of inductive versus deductive approaches to problem solving. Arthur notes that you can solve only the easiest problems deductively … But humans are superb at recognizing and matching patterns. We’re inductive machines.

Arthur offers a model of inductive reasoning, effectively picking up where Lord Keynes left off. The model is based on the El Farol bar in Santa Fe, New Mexico … Attending the El Farol when it isn’t too crowded is fun … But the bar is a turn-off when it is packed.

To make the problem more concrete, Arthur suggests that the bar has a hundred-person capacity and that with sixty people or fewer it is not crowded and with more than sixty it is … This problem has two notable features. First, the problem is too complicated for a deductive solution. As individuals can only look at past attendance, there are a large number of legitimate expectational models. The potential bar goers must use an inductive approach. Second, common expectations backfire. If all believe most will go, nobody will go. And if all believe nobody will go, all will go. Like Keynes’s beauty contest, the issue is not just what you believe but rather what you believe others to believe.

Michael J. Mauboussin