In issue no. 76 of real-world economics review — published today — yours truly has an article on Paul Romer’s frontal attack on the New Classical and ‘New Keynesian’ theories that has put macroeconomics on a path of intellectual regress for more than two decades now.
It is often said that the error term in a regression equation represents the effect of the variables that were omitted from the equation. This is unsatisfactory …
There is no easy way out of the difficulty. The conventional interpretation for error terms needs to be reconsidered. At a minimum, something like this would need to be said:
The error term represents the combined effect of the omitted variables, assuming that
(i) the combined effect of the omitted variables is independent of each variable included in the equation,
(ii) the combined effect of the omitted variables is independent across subjects,
(iii) the combined effect of the omitted variables has expectation 0.
This is distinctly harder to swallow.
Yes, indeed, that is harder to swallow.
Those conditions on the error term actually means that we are being able to construct a model where all relevant variables are included and correctly specify the functional relationships that exist between them.
But that is actually impossible to fully manage in reality!
The theories we work with when building our econometric regression models are insufficient. No matter what we study, there are always some variables missing, and we don’t know the correct way to functionally specify the relationships between the variables (usually just assuming linearity).
Every regression model constructed is misspecified. There are always an endless list of possible variables to include, and endless possible ways to specify the relationships between them. So every applied econometrician comes up with his own specification and ‘parameter’ estimates. No wonder that the econometric Holy Grail of consistent and stable parameter-values is still nothing but a dream.
In order to draw inferences from data as described by econometric texts, it is necessary to make whimsical assumptions. The professional audience consequently and properly withholds belief until an inference is shown to be adequately insensitive to the choice of assumptions. The haphazard way we individually and collectively study the fragility of inferences leaves most of us unconvinced that any inference is believable. If we are to make effective use of our scarce data resource, it is therefore important that we study fragility in a much more systematic way. If it turns out that almost all inferences from economic data are fragile, I suppose we shall have to revert to our old methods …
A rigorous application of econometric methods in economics really presupposes that the phenomena of our real world economies are ruled by stable causal relations between variables. Parameter-values estimated in specific spatio-temporal contexts are presupposed to be exportable to totally different contexts. To warrant this assumption one, however, has to convincingly establish that the targeted acting causes are stable and invariant so that they maintain their parametric status after the bridging. The endemic lack of predictive success of the econometric project indicates that this hope of finding fixed parameters is a hope for which there really is no other ground than hope itself.
Real world social systems are not governed by stable causal mechanisms or capacities. As Keynes noticed when he first launched his attack against econometrics and inferential statistics 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 econom(etr)ics 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.
Regression models are widely used by social scientists to make causal inferences; such models are now almost a routine way of demonstrating counterfactuals. However, the “demonstrations” generally turn out to depend on a series of untested, even unarticulated, technical assumptions. Under the circumstances, reliance on model outputs may be quite unjustified. Making the ideas of validation somewhat more precise is a serious problem in the philosophy of science. That models should correspond to reality is, after all, a useful but not totally straightforward idea – with some history to it. Developing appropriate models is a serious problem in statistics; testing the connection to the phenomena is even more serious …
In our days, serious arguments have been made from data. Beautiful, delicate theorems have been proved, although the connection with data analysis often remains to be established. And an enormous amount of fiction has been produced, masquerading as rigorous science.
The theoretical conditions that have to be fulfilled for regression analysis and econometrics to really work are nowhere even closely met in reality. Making outlandish statistical assumptions does not provide a solid ground for doing relevant social science and economics. Although regression analysis and econometrics have become the most used quantitative methods in social sciences and economics today, it’s still a fact that the inferences made from them are invalid.
‘New Keynesian’ macroeconomists have for years been arguing (e.g. here) about the importance of the New Classical Counter Revolution in economics. ‘Helping’ to change the way macroeconomics is done today — with rational expectations, Euler equations, intertemporal optimization and microfoundations — their main critique of New Classical macroeconomics is that it didn’t incorporate price stickiness into the Real Business Cycles models developed by the New Classicals. So — the ‘New Keynesians’ adopted the methodology suggested by the New Classcials and just added price stickiness!
But does putting a sticky-price DSGE lipstick on the RBC pig really help?
It sure doesn’t!
I have elaborated on why not in chapter three of my On the use and misuse of theories and models in mainstream economics, and David Glasner gives some further reasons why a pig with lipstick is still a pig:
In the General Theory, Keynes argued that if you believed in the standard story told by microeconomics about how prices constantly adjust to equate demand and supply and maintain equilibrium, then maybe you should be consistent and follow the Mises/Robbins story and just wait for the price mechanism to perform its magic, rather than support counter-cyclical monetary and fiscal policies. So Keynes then argued that there is actually something wrong with the standard microeconomic story; price adjustments can’t ensure that overall economic equilibrium is restored, because the level of employment depends on aggregate demand, and if aggregate demand is insufficient, wage cutting won’t increase – and, more likely, would reduce — aggregate demand, so that no amount of wage-cutting would succeed in reducing unemployment …
The real problem is not that prices are sticky but that trading takes place at disequilibrium prices and there is no mechanism by which to discover what the equilibrium prices are. Modern macroeconomics solves this problem, in its characteristic fashion, by assuming it away by insisting that expectations are “rational.”
Economists have allowed themselves to make this absurd assumption because they are in the habit of thinking that the simple rule of raising price when there is an excess demand and reducing the price when there is an excess supply inevitably causes convergence to equilibrium. This habitual way of thinking has been inculcated in economists by the intense, and largely beneficial, training they have been subjected to in Marshallian partial-equilibrium analysis, which is built on the assumption that every market can be analyzed in isolation from every other market. But that analytic approach can only be justified under a very restrictive set of assumptions. In particular it is assumed that any single market under consideration is small relative to the whole economy, so that its repercussions on other markets can be ignored, and that every other market is in equilibrium, so that there are no changes from other markets that are impinging on the equilibrium in the market under consideration …
I regard the term “sticky prices” and other similar terms as very unhelpful and misleading; they are a kind of mental crutch that economists are too ready to rely on as a substitute for thinking about what are the actual causes of economic breakdowns, crises, recessions, and depressions. Most of all, they represent an uncritical transfer of partial-equilibrium microeconomic thinking to a problem that requires a system-wide macroeconomic approach. That approach should not ignore microeconomic reasoning, but it has to transcend both partial-equilibrium supply-demand analysis and the mathematics of intertemporal optimisation.
After almost forty years in Lund, yours truly has returned to the town where he was born and bred — Malmö. Living on the top floor of this grandiose building — next to The Magistrate’s Park, and with The Opera and The Municipal Art Gallery just across the street — makes it easy to convince me returning was a good decision …
A critique yours truly sometimes encounters is that as long as I cannot come up with some own alternative to the failing mainstream theory, I shouldn’t expect people to pay attention.
This is however to totally and utterly misunderstand the role of philosophy and methodology of economics!
As John Locke wrote in An Essay Concerning Human Understanding:
The Commonwealth of Learning is not at this time without Master-Builders, whose mighty Designs, in advancing the Sciences, will leave lasting Monuments to the Admiration of Posterity; But every one must not hope to be a Boyle, or a Sydenham; and in an Age that produces such Masters, as the Great-Huygenius, and the incomparable Mr. Newton, with some other of that Strain; ’tis Ambition enough to be employed as an Under-Labourer in clearing Ground a little, and removing some of the Rubbish, that lies in the way to Knowledge.
That’s what philosophy and methodology can contribute to economics — clear obstacles to science.
Every now and then I also get some upset comments from people wondering why I’m not always ‘respectful’ of people like Eugene Fama, Robert Lucas, Greg Mankiw, and others of the same ilk.
But sometimes it might actually, from a Lockean perspective, be quite appropriate to be disrespectful.
New Classical and ‘New Keynesian’ macroeconomics is rubbish that ‘lies in the way to Knowledge.’
And when New Classical and ‘New Keynesian’economists resurrect fallacious ideas and theories that were proven wrong already in the 1930s, then I think a less respectful and more colourful language is called for.
The crucial issue of macroeconomic theory today is the same as it was sixty years ago when John Maynard Keynes revolted against what he called the “classical” orthodoxy of his day. It is a shame that there are still “schools” of economic doctrine, but perhaps controversies are inevitable when the issues involve policy, politics, and ideology and elude decisive controlled experiments. As a lifelong Keynesian, I am quite dismayed by the prevalence in my profession today, in a particularly virulent form, of the macroeconomic doctrines against which I as a student enlisted in the Keynesian revolution. Their high priests call themselves New Classicals and refer to their explanation of fluctuations in economic activity as Real Business Cycle Theory. I guess “Real” is intended to mean “not monetary” rather than “not false,” but maybe both.
I am going to discuss the issues of theory, Keynesian versus Classical, both then and now … The doctrinal differences stand out most clearly in opposing diagnoses of the fluctuations in output and employment to which democratic capitalist societies like our own are subject, and in what remedies, if any, are prescribed. Keynesian theory regards recessions as lapses from full-employment equilibrium, massive economy-wide market failures resulting from shortages of aggregate demand for goods and services and for the labor to produce them. Modern “real business cycle theory” interprets fluctuations a moving equilibrium, individually and socially rational responses to unavoidable exogenous shocks. The Keynesian logic leads its adherents to advocate active fiscal and monetary policies to restore and maintain full employment. From real business cycle models, and other theories in the New Classical spirit, the logical implication is that no policy interventions are necessary or desirable …
Keynesians believe that the economy is sometimes in one regime, sometimes in the other. New Classicals model the economy as always supply-constrained and in supply-equals-demand equilibrium. In their real business cycle models, the shocks that move economic activity up and down are essentially supply shocks, changes in technology and productivity or in the bounty of nature or in the costs and supplies of imported products. Although external forces of those kinds, for example weather, harvests, natural catastrophes, have been the main sources of fluctuating fortunes for most of human history, and although events continually remind us that they still occur, Keynesians do not agree that they are the main source of fluctuations in business activity in modern capitalist societies …
Fancy econometrics is not needed to mobilize evidence against the real business cycle theory view that observed fluctuations in output and employment are movements in priced-cleared equilibrium. Here are a number of regularities of US business cycles which falsify that hypothesis:
1. Unemployment itself. If people are voluntarily choosing not to work at prevailing wages, why do they report themselves as unemployed, rather than as ‘not in the labour force’? Real business cycle theory explains fluctuatiuons of unemployment as intertemporal choice between work and leisure. Workers drop out when the real wages, the opportunity costs of leisure, are temporarily low relative to what they expect later …
2. Unemployment and vacancies. New classicals ask us to believe that the labour market is in equilibrium at 9 per cent unemployment just as truly as it is at 5 per cent. If so, there would be no reason to expect the balance between unemployment and job vacancies to differ. Both unemployment and vacancies would be higher in recession. However, a strong negative association between unemployment and vacancies — as would be expected in Keynesian theory — is obvious in the U.S. and other market capitalist economies.
3. Quits and layoffs. If recessions and prosperities are both supply-equals-demand equilibria, there is no reason to expect the relative frequencies of voluntary quits of jobs and involuntary ‘separations’ from jobs to vary over the business cycle. But of course there are regularly many more layoffs, relative to quits, when unemployment is high and vacancies are scarce. There are many more ‘job losers’ relative to ‘job leavers’ in recessions.
4. Excess capacity. Utilization of plant and equipment varies cyclically, parallel to utilization of labour. Presumably machines do not choose leisure voluntarily.
5. Unfilled orders and delays. These move pro-cyclically, again suggesting strongly that demand is much higher relative to supply in prosperities than in recessions.
6. Monetary effects on output. According to the ‘classical dichotomy,’ monetary events and policies should affect only nominal prices. Real outcomes should be independent of them. The evidence that this is not true is overwhelming.
The list could go on. Why do so many talented economic theorists believe and teach elegant fantasies so obviously refutable by plainly evident facts?
The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, usually — incorrectly — referred to as the Nobel Prize in Economics, is an award for outstanding contributions to the field of economics. The Prize in Economics was established and endowed by Sweden’s central bank Sveriges Riksbank in 1968 on the occasion of the bank’s 300th anniversary. The first award was given in 1969. The award this year is presented in Stockholm at a ceremony on Monday 10 October.
Avner Offer’s and Gabriel Söderberg’s new book — The Nobel factor: the prize in economics, social democracy, and the market turn (Princeton University Press 2016) — tells the story of how the prize emerged from a conflict between the Swedish central bank — Sveriges Riksbank — and social democracy. It is no pure coincidence that the ascendancy of market liberalism, Reagan and Thatcher, to a large part coincides with the creation and establishment of the prize. Especially during the despotic Assar Lindbeck’s long chairmanship — 1980-1994 — the prize was thought to take advantage of the connection with the true Nobel prizes and spearhead a market-oriented neoliberal reshaping of the world. Although not all economists who have got the prize have enlisted in the market-liberal crusade, it is still an undeniable fact that neoliberal and conservative leaning male economists are highly over-represented among the laureates. Their often ideologically biased doctrines have to a large extent motivated the neoliberal turn in economic policies for more than forty years.
Out of the 76 laureates that have been awarded “The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel,” 28 have been affiliated to The University of Chicago — that is 37 %. Of all laureates, 80% have been from the US (by birth or by naturalisation). Only 7% of the laureates have come from outside North America or Western Europe. Only 1 woman has got the prize. The world is really a small place when it comes to economics …
Looking at whom the prize is given to, says quite a lot about what kind of prize this is. Offer and Söderberg do that, but looking at whom the prize is not given to, says perhaps even more.
The great Romanian-American mathematical statistician and economist Nicholas Georgescu-Roegen (1906-1994) argued in his epochal The Entropy Law and the Economic Process (1971) that the economy was actually a giant thermodynamic system in which entropy increases inexorably and our material basis disappears. If we choose to continue to produce with the techniques we have developed, then our society and earth will disappear faster than if we introduce small-scale production, resource-saving technologies and limited consumption.
Following Georgescu-Roegen, ecological economists have argued that industrial society inevitably leads to increased environmental pollution, energy crisis and an unsustainable growth.
Georgescu-Roegen and ecological economics have turned against the neoclassical theory’s obsession with purely monetary factors. The monetary reductionism easily makes you ignore other factors having a bearing on human interaction with the environment.
I wonder if this isn’t the crux of the matter. To assert such a thing really is to swear in the neoclassical establishment church and nullifies any chances of getting the prestigious prize.
Twenty years ago, after a radio debate with one of the members of the prize committee — Ingmar Ståhl — I asked why Georgescu-Roegen hadn’t got the prize. The answer was – mirabile dictu – that he “never founded a school.” I was surprised, to say the least, and wondered if he possibly had heard of the environmental movement. Well, he had — but it was “the wrong kind of school”! Can it be stated much clearer than this what it’s all about? If you haven’t worked within the mainstream neoclassical paradigm — then you are more or less excluded a priori from being eligible for the The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel!
Three years ago — making an extraordinarily successful forecast — I told Swedish media the prize committee would show how in tune with the times it was and award the prize to Eugene Fama. Why? Well — I argued — he’s a Chicago economist and a champion of rational expectations and efficient markets. And nowadays freshwater economists seem to be the next to the only ones eligible for the prize. And, of course, an economist who has described the notion that finance theory was at fault as “a fantasy” and argued that “financial markets and financial institutions were casualties rather than causes of the recession” had to appeal to a prize committee with a history of awarding theories and economists totally lacking any real world relevance.
Well, my forecast turned out to be right — the Swedish Academy of Sciences awarded The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2013 to Eugene Fame. The prize committee really did show how in tune with the times it was …
I love to be right of course, but otherwise this is only saddening and shows what a joke this prize is, when someone like Fama can get it.
The ‘Nobel prize’ in economics is — and has always been — a total disaster from both a scientific and social point of view, and after having read Offer’s and Söderberg’s book, there is, at least to me, only one conclusion to draw, and that is: Drop it!
Submission to observed or experimental data is the golden rule which dominates any scientific discipline. Any theory whatever, if it is not verified by empirical evidence, has no scientific value and should be rejected.
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.
Mainstream — neoclassical — 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. Why? Simply because the premises of a valid argument do not have to be true, but a sound argument, on the other hand, is not only valid, but builds on premises that are true. Aiming only for validity, without soundness, is setting the economics aspirations level too low for developing a realist and relevant science.
We economists trudge relentlessly toward Asymptopia, where data are unlimited and estimates are consistent, where the laws of large numbers apply perfectly and where the full intricacies of the economy are completely revealed … Worst of all, when we feel pumped up with our progress, a tectonic shift can occur, like the Panic of 2008, making it seem as though our long journey has left us disappointingly close to the State of Complete Ignorance whence we began …
We may listen, but we don’t hear, when the Priests warn that the new direction is only for those with Faith, those with complete belief in the Assumptions of the Path. It often takes years down the Path, but sooner or later, someone articulates the concerns that gnaw away in each of us and asks if the Assumptions are valid …
It would be much healthier for all of us if we could accept our fate, recognize that perfect knowledge will be forever beyond our reach and find happiness with what we have …
Can we economists agree that it is extremely hard work to squeeze truths from our data sets and what we genuinely understand will remain uncomfortably limited? We need words in our methodological vocabulary to express the limits … Those who think otherwise should be required to wear a scarlet-letter O around their necks, for “overconfidence.”
Econometric theory promises more than it can deliver, because it requires a complete commitment to assumptions that are actually only half-heartedly maintained …
Our understanding of causal effects in macroeconomics is virtually nil, and will remain so. Don’t we know that? … The economists who coined the DSGE acronym combined in three terms the things economists least understand: “dynamic,” standing for forward-looking decision making; “stochastic,” standing for decisions under uncertainty and ambiguity; and “general equilibrium,” standing for the social process that coordinates and in uences the actions of all the players. I have tried to make this point in the title of my recent book Macroeconomic Patterns and Stories. That’s what we do. We seek patterns and tell stories.
As yours truly wrote last week, there has been much discussion going on in the economics academia on Paul Romer’s recent critique of ‘modern’ macroeconomics.
But the rhetorical swindle that New Classical and ‘New Keynesian’ macroeconomics have tried to impose upon us with their microfounded calibrations and DSGE models, has not gone unnoticed until Paul Romer came along:
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 … 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 … 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.
The eminently quotable Solow — as always — says it all.
The purported strength of New Classical and ‘New Keynesian’ macroeconomics is that they have 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.
That anyone should take that kind of ludicrous 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.