DSGE models — unparalleled and spectacular failures

31 December, 2017 at 15:12 | Posted in Economics | 3 Comments

wpid-mmb9qajq9swpi8xxy76aThe unsellability of DSGE models — private-sector firms do not pay lots of money to use DSGE models — is one strong argument against DSGE.

But it is not the most damning critique of it.

To me the most damning critiques that can be levelled against DSGE models are the following two:

DSGE models are unable to explain involuntary unemployment

In the basic DSGE models the labour market is always cleared – responding to a changing interest rate, expected lifetime incomes, or real wages, the representative agent maximizes the utility function by varying her labour supply, money holding and consumption over time. Most importantly – if the real wage somehow deviates from its ‘equilibrium value,’ the representative agent adjust her labour supply, so that when the real wage is higher than its ‘equilibrium value,’ labour supply is increased, and when the real wage is below its ‘equilibrium value,’ labour supply is decreased.

In this model world, unemployment is always an optimal choice to changes in the labour market conditions. Hence, unemployment is totally voluntary. To be unemployed is something one optimally chooses to be.

The D WordAlthough this picture of unemployment as a kind of self-chosen optimality, strikes most people as utterly ridiculous, there are also, unfortunately, a lot of neoclassical economists out there who still think that price and wage rigidities are the prime movers behind unemployment. DSGE models basically explain variations in employment (and a fortiori output) with assuming nominal wages being more flexible than prices – disregarding the lack of empirical evidence for this rather counterintuitive assumption.

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

The classical proposition that lowering wages would lower unemployment and ultimately take economies out of depressions, was ill-founded and basically wrong. Flexible wages would probably 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 labour market.

Obviously, it’s rather embarrassing that the kind of DSGE models ‘modern’ macroeconomists use cannot incorporate such a basic fact of reality as involuntary unemployment. Of course, working with representative agent models, this should come as no surprise. The kind of unemployment that occurs is voluntary since it is only adjustments of the hours of work that these optimizing agents make to maximize their utility.

In DSGE models increases in government spending leads to a drop in private consumption

In the most basic mainstream proto-DSGE models one often assumes that governments finance current expenditures with current tax revenues.  This will have a negative income effect on the households, leading — rather counterintuitively — to a drop in private consumption although both employment an production expands. This mechanism also holds when the (in)famous Ricardian equivalence is added to the models.

Ricardian equivalence basically means that financing government expenditures through taxes or debts is equivalent since debt financing must be repaid with interest, and agents — equipped with rational expectations — would only increase savings in order to be able to pay the higher taxes in the future, thus leaving total expenditures unchanged.


In the standard neoclassical consumption model — used in DSGE macroeconomic modelling — people are basically portrayed as treating time as a dichotomous phenomenon  today and the future — when contemplating making decisions and acting. How much should one consume today and how much in the future? Facing an intertemporal budget constraint of the form

ct + cf/(1+r) = ft + yt + yf/(1+r),

where ct is consumption today, cf is consumption in the future, ft is holdings of financial assets today, yt is labour incomes today, yf is labour incomes in the future, and r is the real interest rate, and having a lifetime utility function of the form

U = u(ct) + au(cf),

where a is the time discounting parameter, the representative agent (consumer) maximizes his utility when

u'(ct) = a(1+r)u'(cf).

This expression – the Euler equation – implies that the representative agent (consumer) is indifferent between consuming one more unit today or instead consuming it tomorrow. Typically using a logarithmic function form – u(c) = log c – which gives u'(c) = 1/c, the Euler equation can be rewritten as

1/ct = a(1+r)(1/cf),


cf/ct = a(1+r).

This importantly implies that according to the neoclassical consumption model changes in the (real) interest rate and consumption move in the same direction. And — it also follows that consumption is invariant to the timing of taxes since wealth — ft + yt + yf/(1+r) — has to be interpreted as present discounted value net of taxes. And so, according to the assumption of Ricardian equivalence, the timing of taxes does not affect consumption, simply because the maximization problem as specified in the model is unchanged. As a result — households cut down on their consumption when governments increase their spendings. Mirabile dictu!

Benchmark DSGE models have paid little attention to the role of fiscal policy, therefore minimising any possible interaction of fiscal policies with monetary policy. This has been partly because of the assumption of Ricardian equivalence. As a result, the distribution of taxes across time become irrelevant and aggregate financial wealth does not matter for the behavior of agents or for the dynamics of the economy because bonds do not represent net real wealth for households.

Incorporating more meaningfully the role of fiscal policies requires abandoning frameworks with the Ricardian equivalence. The question is how to break the Ricardian equivalence? Two possibilities are available. The first is to move to an overlapping generations framework and the second (which has been the most common way of handling the problem) is to rely on an infinite-horizon model with a type of liquidity constrained agents (eg “rule of thumb agents”).

Camillo Tovar

out of the fryingSure, macroeconomic models have to abandon Ricardian equivalence nonsense. But replacing it with “overlapping generations” and “infinite-horizon” models — isn’t that — in terms of realism and relevance — just getting out of the frying pan into the fire? All unemployment is still voluntary. Intertemporal substitution between labour and leisure is still ubiquitous. And the specification of the utility function is still hopelessly off the mark from an empirical point of view.

As one Nobel laureate has it:

Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense.

Joseph E. Stiglitz, twitter 

And as one economics blogger has it:

DSGE modeling is taught in every graduate school in the country. It is also sheer nonsense.

Lars Syll, twitter 


Krugman’s misapplication of neoclassical growth models

30 December, 2017 at 11:11 | Posted in Economics | 5 Comments

The fallacies loanable funds theory commits might be explainable by the misapplication​ of some ideas and concepts of neoclassical growth models … to the sphere of money and finance …

The+Bankruptcy+of+Neoclassical+EconomicsThe Ramsey and Solow models are models of real investment only. Financial markets, financial assets and financial saving do not play any role in those models. There is only one good which, for simplicity, will be called “corn”. Corn has three functions: it can be consumed, invested and used as a means of payment since wages and interest payments are made with it. Full employment is assumed … Without money and other financial assets, the only way units can save is to increase their tangible assets, i.e. to invest …

Since the problems of different financial saving plans are not dealt with in Solow’s model, the model cannot be used to make any predictions about economic units’ financial saving behavior, its inconsistencies and thus about the paradox of thrift – neither in the short, medium or long run. There is no miraculous way of short-run financial saving somehow being transformed into long run investment in tangible assets. The two are simply quite different phenomena …

How pervasive this approach is, is shown by Eggertsson and Krugman (2012) who add some features … to a basic neoclassical model. Again, no money but goods are borrowed and lent. Naturally, potential lenders have to save some of their goods before they can lend them to borrowers. But since in the real world money is normally not eaten or planted and keeps circulating in the economy when it is spent or lent, those models cannot be any guide for the analysis of a monetary economy. Specifically, what is true in a one good economy – units have to consume less to lend and invest more – is fundamentally wrong in a monetary economy.

Fabian Lindner

This should come as no surprise. Paul Krugman has repeatedly over the years argued that we should continue to use neoclassical hobby horses like Ramsey style growth, IS-LM, and AS-AD models.

Money and finance don’t​ matter in mainstream neoclassical macroeconomic models. That’s true. According to the ‘classical dichotomy,’ real variables — output and employment — are independent of monetary variables, and so enables mainstream economics to depict the economy as basically a barter system.

But in the real world in which we happen to live, money certainly does matter. Money is not neutral and money matters in both the short run and the long run:

The theory which I desiderate would deal … with an economy in which money plays a part of its own and affects motives and decisions, and is, in short, one of the operative factors in the situation, so that the course of events cannot be predicted in either the long period or in the short, without a knowledge of the behaviour of money between the first state and the last. And it is this which we ought to mean when we speak of a monetary economy.

J. M. Keynes A monetary theory of production (1933)

Pseudo-vetenskapligt mumbo jumbo på svenska universitet

29 December, 2017 at 19:11 | Posted in Education & School | 5 Comments

Jag sprang nyligen på en sammanställning av genusdoktorsavhandlingar från 2014. Många godbitar. Men en av dem var särskilt anmärkningsvärd, nämligen nummer 19 i uppräkningen. Det handlar om doktors-avhandlingen “Rum, rytm och resande” från Linköpings universitet (pdf). Sammanställningen sammanfattar:

“Avhandlingen undersöker järnvägstationer som fysiska platser och sociala rum ur könsperspektiv. Kimstad pendeltågsstation, Norrköpings järnvägsstation och Stockholms Centralstation ingår i studien. Resultaten visar att järnvägs-stationerna reproducerar könsmaktsordningen och att detta påverkar både män som kvinnor som vistas där.”

krylboEn doktorand har alltså ägnat minst 4-5 år och flera miljoner skatte-kronor åt att besöka järnvägsstationer och komma fram till att “järnvägs-stationerna reproducerar könsmaktsordningen”. Doktorandens chef har planerat detta arbete och chefens chefer har godkänt det. Dessutom har en betygskommitté med externa granskare bedömt och skrivit under på att doktorsavhandlingen håller måttet.

Det var katten. Men det blir värre.

Doktorsavhandlingen sammanfattas på engelska. Det börjar med:

“Results from the study show that individuals in different ways are affected by gendered power relations that dwell in rhythms of collective believes and in shape of materialized objects that encounter the commuters when visiting the railway station. While the rhythms of masculine seriality contains believes of males as potentially violent, as defenders and as bread winners, the rhythms of female seriality contains believes of women as primary mothers and housewives, of women as primary victim of sexual violence and of objectification of women’s bodies as either decent or as sexually available to heterosexual men”.

Rytmer av könsmaktsordningen. Poetiskt.


Ja, inför sådant tyckmyckentrutat pseudo-vetenskapligt blaj kan man inte annat än taga sig för pannan.

Mitt eget favoritexempel på detta ‘vetenskapliga’ skojeri är hämtat ur ett nummer av Pedagogisk Forskning i Sverige (2-3 2014) där författaren till artikeln “En pedagogisk relation mellan människa och häst. På väg mot en pedagogisk filosofisk utforskning av mellanrummet” ger följande intressanta ‘programförklaring:

Med en posthumanistisk ansats belyser och reflekterar jag över hur både människa och häst överskrider sina varanden och hur det öppnar upp ett mellanrum med dimensioner av subjektivitet, kroppslighet och ömsesidighet.

elite-daily-sleeping-studentOch så säger man att svensk universitets-utbildning är i kris. Undrar varför …

Demystifying Trickle Down

28 December, 2017 at 20:01 | Posted in Economics | 1 Comment


The causes of secular stagnation and the loanable funds theory

28 December, 2017 at 09:34 | Posted in Economics | 6 Comments

What are the causes of secular stagnation? What are the solutions to revive growth and get the U.S. economy out of the doldrums? …

Growth_cartoon_05.19.2015_normalOne headline conclusion stands out: the secular stagnation is caused by a heavy overdose of savings … All these savings end up as deposits, or ‘loanable funds’ (LF), in commercial banks … The glut in savings supply is so large that banks cannot get rid of all the loanable funds even when they offer firms free loans—that is, even after they reduce the interest rate to zero, firms are not willing to borrow more in order to invest. The result is inadequate investment and a shortage of aggregate demand in the short run, which lead to long-term stagnation as long as the savings-investment imbalance persists …

This is clearly a depressing conclusion, but it is also wrong …

Ever since Knut Wicksell’s (1898) restatement of the doctrine, the loanable funds approach has exerted a surprisingly strong influence upon some of the best minds in the profession …

Due to our inability to free ourselves from the discredited loanable funds doctrine, we have lost the forest for the trees. We cannot see that the solution to the real problem underlying secular stagnation (a structural shortage of aggregate demand) is by no means difficult: use fiscal policy—a package of spending on infrastructure, green energy systems, public transportation and public services, and progressive income taxation—and raise (median) wages. The stagnation will soon be over, relegating all the scholastic talk about the ZLB to the dustbin of a Christmas past.

Servaas Storm

loanable_funds_curve-13FEC80C6110B93D6D9It is difficult not to agree with Servaas here. The loanable funds theory is in many regards nothing but an approach where the ruling rate of interest in society is — pure and simple — conceived as nothing else than the price of loans or credits set by banks and determined by supply and demand — as Bertil Ohlin put it — “in the same way as the price of eggs and strawberries on a village market.”

It’s a beautiful fairy tale, but the problem is that banks are not barter institutions that transfer pre-existing loanable funds from depositors to borrowers. Why? Because, in the real world, there simply are no pre-existing loanable funds. Banks create new funds — credit — only if someone has previously got into debt! Banks are monetary institutions, not barter vehicles.

Continue Reading The causes of secular stagnation and the loanable funds theory…

A Happy New Year to all my blog readers

27 December, 2017 at 23:31 | Posted in Varia | 2 Comments

Lars Pålsson Syll_06

Tired of the idea of an infallible mainstream neoclassical economics and its perpetuation of spoon-fed orthodoxy, yours truly launched this blog six years ago. The number of visitors has increased steadily, and with now having had my posts viewed more than 3 million times, I have to admit of still being — given the rather wonkish character of the blog, with posts mostly on economic theory, statistics, econometrics, theory of science and methodology — utterly astonished​  that so many are interested and take their time to read the often rather geeky stuff posted here.

In the 21st century, ​the blogosphere has without any doubts become one of the greatest channels for dispersing new knowledge and information. As a blogger, ​I can specialize in those particular topics an economist and professor of social science happens to have both deep knowledge of and interest in. That, of course, also means — in the modern long tail world — being able to target a segment of readers with much narrower and specialized interests than newspapers and magazines, as a rule,​ could aim for — and still attract quite a lot of readers.

Farewell to neoliberalism

27 December, 2017 at 09:58 | Posted in Politics & Society | 3 Comments

KR: The death of the centre-left has also led to the rise of the Right. You note … that working class white women overwhelmingly voted for Trump, while Clinton lost votes among African Americans and Latinos compared to Obama’s election in 2008. How have so many social groups associated with the Left – the working class, minorities, women – turned away?

Wolfgang Streeck: wolfThat’s a difficult question as the “racial” complexities of American politics in particular are endless. Basically I believe that at some point material deprivation trumps (if the word is allowed) cultural identification, especially if the alternative – in this case, Clinton – is so unattractive and indeed untrustworthy. Clinton’s hobnobbing with the Californian movie stars and other celebrities, let alone her material greed and the incredible sums she collected for her Wall Street appearances, must at some point have destroyed her claim to defend “hard-working Americans and their families”. What was left then was Trump. I think we have reasons to believe that had Bernie Sanders been allowed by the Democratic party machine to will the nomination, he could have defeated Trump handily, certainly in places like Iowa, Wisconsin and Ohio.

King’s Review

Facebook destroys democracy

26 December, 2017 at 12:13 | Posted in Politics & Society | 2 Comments

ZEIT: Die Monopolstellung ist also mehr als ein marktwirtschaftliches Problem?

Ferguson: Sie ist ein riesiges Problem. In der gesamten Menschheitsgeschichte galt der öffentliche Raum als nicht kommerziell. Heute haben wir daraus einen gigantischen Anzeigenmarkt gemacht. Die Suche nach Informationen ist wie der Gang in eine Bibliothek.20171104_LDD001_0Durch Google ist das jetzt ein weltweiter Verkaufsraum. Dasselbe sehen Sie in der Veränderung unserer sozialen Netzwerke. Früher hatten wir Clubs und Gesellschaften, den Marktplatz oder die Kneipe, um miteinander abzuhängen und uns auszutauschen. Dieser Raum gehört jetzt Facebook, und Facebook bombardiert uns mit Werbung. Kurz gefasst haben wir also zwei Firmen, Google und Facebook, die den globalen Werbemarkt bestimmen und zugleich auch die Macht haben, den öffentlichen Raum zu dominieren. Das ist ein Zustand, der langfristig nicht aufrechterhalten werden kann. Es kann nicht sein, dass ein Privatunternehmen ein Monopol über unsere persönlichen Daten besitzt und sie einfach weiterverkaufen kann. Das ist schlicht und einfach verrückt. Genauso wie die Tatsache, dass Facebook durch seinen Newsfeed der mit Abstand größte Herausgeber von Nachrichten in der Geschichte der USA ist. Das ist desaströs für den Fortbestand der westlichen Demokratie.

Never thought I would quote Niall Ferguson, but here — for once — he has something both intelligent and thoughtful to say.

Is it time to ditch the natural rate hypothesis?

25 December, 2017 at 12:00 | Posted in Economics | 1 Comment

Fifty years ago Milton Friedman wrote an (in)famous article arguing that (1) the natural rate of unemployment was independent of monetary policy, and (2) trying to keep the unemployment rate below the natural rate would only give rise to higher and higher inflation.

The hypothesis has always been controversial, and much theoretical and empirical work has questioned the real-world relevance of the ideas that unemployment really is independent of monetary policy and that there is no long-run trade-off between inflation and unemployment.

Although Olivier Blanchard also has his doubts — after having played around with a ‘toy model’ and looked at the data — he lands on the following advice:

iwf-chefvolkswirt-olivierFailure of either of the hypothesis leads to a more attractive trade-off​ between output and inflation, and, in the presence of shocks, suggests a stronger role for stabilization policy. If the independence hypothesis fails, adverse shocks are more costly, and stabilization policy more powerful. If the accelerationist hypothesis fails, there is more room for stabilization policy​ to be used at little inflation cost.

Where does this leave us? It would be good to have a sense of … the specific channels at work. The empirical part of this paper has shown that we are still far from it. Thus, the general advice must be that central banks should keep the natural rate hypothesis (extended to mean positive but low values of b and a) as their baseline, but keep an open mind and put some weight on the alternatives. For example, given the evidence on labor force participation and on the stickiness of inflation expectations presented earlier, I believe that there is a strong case, although not an overwhelming case, to allow U.S. output to exceed potential for some time, so as to reintegrate some of the workers who left the labor force during the last ten years.

My own view on the subject is that the natural rate hypothesis does not hold water simply because the relations it describes have never actually existed.

The only thing that amazes yours truly is that although this is pretty ‘common knowledge,’  so-called ‘New Keynesian’ macroeconomists still today use it — and its cousin the Phillips curve — as a fundamental building block in their models. Why? Because without it ‘New Keynesians’ have to give up their (again and again empirically falsified) neoclassical view of the long-run neutrality of money and the simplistic idea of inflation as an excess-demand phenomenon.

The natural rate hypothesis approach (NRH) is not only of theoretical interest. Far from it.

The real damage done is that policymakers that take decisions based on NRH models systematically implement austerity measures and kill off economic expansion. The unnecessary and costly unemployment that this self-inflicted and flawed illusion eventuates, is something its New Classical and ‘New Keynesian’ advocates should always be kept accountable for.

According to the  [NRH], unemployment differs from its natural rate only if expected inflation differs from actual inflation. If expectations are rational, we should see as many quarters when inflation is above expected inflation as quarters when it is below expected inflation. That suggests the following test of the [NRH]:

74-7495-LTNQ100ZBecause a decade contains 40 quarters, the probability that average expected inflation over a decade will be different from average​ actual inflation should be small. If the [NRH] and rational expectations are both true simultaneously, a plot of decade averages of inflation against unemployment should reveal a vertical line at the natural rate of unemployment … This prediction fails dramatically.

There is no tendency for the points to lie around a vertical line and, if anything, the long-run Phillips is upward sloping, and closer to being horizontal than vertical. Since it is unlikely that expectations are systematically biased over decades, I conclude that the  [NRH] is false.

Defenders of the [NRH] might choose to respond to these empirical findings by arguing that the natural rate of unemployment is time-varying​. But I am unaware of any theory which provides us, in advance, with an explanation of how the natural rate of unemployment varies over time. In the absence of such a theor, ​ the [NRH] has no predictive content. A theory like this, which cannot be falsified by any set of observations, is closer to religion than science.

Roger Farmer

So, yes, it is definitely time to ditch the natural rate hypothesis!

Trumpian trickle down

25 December, 2017 at 11:08 | Posted in Economics | 1 Comment


Trump and the GOP delivering a huge gift to US corporations and shareholders. The only trickle down to workers going on is probably best described in analogy to the above picture …

O holy night

24 December, 2017 at 18:23 | Posted in Varia | Comments Off on O holy night

Absolutely outstanding. Divine.

Oíche Chiúin

24 December, 2017 at 18:06 | Posted in Varia | Comments Off on Oíche Chiúin


A girl like you

22 December, 2017 at 20:28 | Posted in Varia | 3 Comments


Danskt hygge …

22 December, 2017 at 18:40 | Posted in Varia | Comments Off on Danskt hygge …


If only Trump had read Abba Lerner!

21 December, 2017 at 13:12 | Posted in Economics | 4 Comments

The first financial responsibility of the government (since nobody else can undertake that responsibility) is to keep the total rate of spending in the country on goods and services neither greater nor less than that rate which at the current prices would buy all the goods that it is possible to produce. If total spending is allowed to go above this there will be inflation, and if it is allowed to go below this there will be unemployment. The government can increase total spending by spending more itself or by reducing taxes so that taxpayers have more money left to spend. It can reduce total spending by spending less itself or by raising taxes so that taxpayers have less money left to spend …

1958_AbbaLerner-e1494319651425In applying this first law of Functional Finance, the government may find itself collecting more in taxes than it is spending, or spending more than it collects … In neither case should the government feel that there is anything especially good or bad about this result; it should merely concentrate on keeping the total rate of spending neither too small nor too great, in this way preventing both unemployment and inflation.

An interesting, and to many a shocking, corollary is that taxing is never to be undertaken merely because the government needs to make money payments. According to the principles of Functional Finance, taxation must be judged only by its effects … Taxation should therefore be imposed only when it is desirable that the taxpayers shall have less money to spend, for example, when they would otherwise spend enough to bring about inflation …

High income taxes need not discourage investment, because appropriate deductions for losses can diminish the capital actually risked by the investor in the same proportion as his net income from the investment is reduced.

Abba Lerner

Time for an economics reformation

21 December, 2017 at 08:42 | Posted in Economics | 4 Comments


Heretics and mainstream defenders

20 December, 2017 at 21:00 | Posted in Economics | 3 Comments

Larry Elliott wrote a Guardian article the other day criticizing mainstream economics, arguing that

math15we should stop treating economics as a science because it is nothing of the sort. A proper science involves testing a hypothesis against the available evidence. If the evidence doesn’t support the theory, a physicist or a biologist will discard the theory and try to come up one that does work empirically.

Economics doesn’t work like that. Theories can be shown to work only by making a series of highly questionable assumptions – such as that humans always behave predictably and rationally. When there is hard evidence that disputes the validity of the theory, there is no question of ditching the theory.

Mainstreamers, of course, were not too happy about this critique, and a bunch of them published a response:

Why do Elliott and many others have such a distorted view of economics?

The first answer to this question, we think, lies in a misunderstanding of the purpose of mathematical models. Critics complain that economists’ models are not realistic and make absurd assumptions. The London Tube map is not realistic and makes absurd assumptions. If it did not it would be illegible. And useless. The map is useful precisely because it abstracts from unnecessary details to show you the way. This is what economic models are for, they help us to find our way through complex data in a complex world.

When economists write a mathematical model they do so to highlight particular aspects of reality without confusing details. Take the infamous “homo economicus” theory, which says that humans are both selfish and rational. We think that this explains the behaviour of many corporations well. We also think that it does poorly at explaining how we treat our children—but it is useful precisely because it serves as a benchmark. Economists spend most of their time studying departures from this benchmark—altruism towards our children, irrational behaviour when drinking.

I’ve been doing economics for almost forty years now, and I don’t know how many times I’ve heard this silly nonsense map-and-benchmark defence of mainstream neoclassical modelling.

A map with a scale 1:1 is of course totally useless. No one — absolutely no one — is contesting that. But building models of economies that abstract from important facts of reality — such as people being ‘boundedly’ rational in a world permeated by genuine uncertainty — or distorting beyond recognition how real-world actors are supposed to act or decide in real-world contexts — is a completely different thing. On that, these mainstream defenders have absolutely nothing to say. And for good reasons. That kind of modelling is nothing but nonsense on stilts! And we ought to thank Elliott for telling that to Guardian readers .

Most mainstream economists seem to have no problem with the lack of fundamental diversity — not just path-dependent elaborations of the mainstream canon — and the vanishingly little real-world relevance that characterize modern macroeconomics. To these economists, there is nothing basically wrong with ‘standard theory.’ As long as policymakers and economists stick to ‘standard economic analysis’ — DSGE — everything is fine. Economics is just a common language and method that makes us ‘think straight’ and reach correct answers.

Mainstream economists today seem to maintain that new imaginative empirical methods — such as natural experiments, field experiments, lab experiments, RCTs — help us to answer questions concerning the validity of economic theories and models. Yours truly beg to differ. There are few real reasons to share this optimism on the alleged pluralist and empirical revolution in economics.

Heterodox critics are not ill-informed about the development of mainstream economics. Its methodology is still the same basic neoclassical one. It’s still non-pluralist. And although more and more economists work within the field of ’empirical’ economics, the foundation and ‘self-evident’ benchmark is still of the neoclassical deductive-axiomatic ilk.

Sad to say, but we still have to wait for the revolution that will make economics an empirical and truly pluralist and relevant science. But one thing we do know –mainstream economics belongs to the past.

Economists — nothing but a bunch of idiots savants

20 December, 2017 at 09:09 | Posted in Economics | 2 Comments

idsavLet’s be honest: no one knows what is happening in the world economy today …

Policymakers don’t know what to do. They press the usual (and unusual) levers and nothing happens. Quantitative easing was supposed to bring inflation “back to target.” It didn’t. Fiscal contraction was supposed to restore confidence. It didn’t …

Most economics students are not required to study psychology, philosophy, history, or politics. They are spoon-fed models of the economy, based on unreal assumptions, and tested on their competence in solving mathematical equations. They are never given the mental tools to grasp the whole picture …

Good economists have always understood that this method has severe limitations. They use their discipline as a kind of mental hygiene to protect against the grossest errors in thinking …

Today’s professional economists have studied almost nothing but economics. They don’t even read the classics of their own discipline. Economic history comes, if at all, from data sets. Philosophy, which could teach them about the limits of the economic method, is a closed book. Mathematics, demanding and seductive, has monopolized their mental horizons. The economists are the idiots savants of our time.

Robert Skidelsky

Yes indeed — modern economics has become increasingly irrelevant to the understanding of the real world. In his seminal book Economics and Reality (1997) Tony Lawson traced this irrelevance to the failure of economists to match their deductive-axiomatic methods with their subject. As shown by Skidelsky, it is as relevant today as it was twenty years ago.


It is still a fact that within mainstream economics internal validity is everything and external validity nothing. Why anyone should be interested in that kind of theories and models is beyond my imagination. As long as mainstream economists do not come up with any export-licenses for their theories and models to the real world in which we live, they really should not be surprised if people say that this is not science, but autism!

Studying mathematics and logics is interesting and fun. It sharpens the mind. In pure mathematics and logics we do not have to worry about external validity. But economics is not pure mathematics or logics. It’s about society. The real world. Forgetting that, economics is really in dire straits.

Already back in 1991, JEL published a study by a commission — chaired by Anne Krueger and including people like Kenneth Arrow, Edward Leamer, and Joseph Stiglitz — focusing on “the extent to which graduate education in economics may have become too removed from real economic problems.” The commission members reported from own experience “that it is an underemphasis on the ‘linkages’ between tools, both theory and econometrics, and ‘real world problems’ that is the weakness of graduate education in economics,”  and that both students and faculty sensed “the absence of facts, institutional information, data, real-world issues, applications, and policy problems.” And in conclusion they wrote:

The commission’s fear is that graduate programs may be turning out a generation with too many idiot savants skilled in technique but innocent of real economic issues.

Not much is different today. Economics education is still in dire need of a remake. How about bringing economics back into some contact with reality?

And, of course, Paul Krugman and fellow ‘New Keynesians’ have been fast to tell us that although Skidelsky is absolutely right, ‘basic macro’ (read: IS-LM ‘New Keynesianism’) has done just fine, and that it is only RBC and New Classical DSGE macroeconomics that has faltered. But that is, sad to say, but still, nothing but pure nonsense!

My philosophy of economics

19 December, 2017 at 19:00 | Posted in Economics | 6 Comments

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:

19557-004-21162361The 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​e 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.

respectEvery 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.

Tribute to Jan Johansson

19 December, 2017 at 18:48 | Posted in Varia | 1 Comment

A great pianist’s tribute to another great pianist. Absolutely magnificent !

Swedish jazz legends

19 December, 2017 at 18:43 | Posted in Varia | 1 Comment


Keynes’ intellectual revolution

18 December, 2017 at 17:08 | Posted in Economics | 1 Comment

keynesrevimageKeynes’ General Theory is both a critique and a replacement of classical
macroeconomic theory. Both are necessary for an intellectual revolution. On one hand, it is a critique and demolition of classical macroeconomics. On the other hand, it offers a novel alternative theory of the workings of a modern industrial capitalist economy …

Keynes’ argument involves sweeping away old theory and introducing new theory. First, Keynes rejected the loanable funds theory of interest rates. The loanable funds market is an intellectual fiction, and the market does not exist in reality …

The rejection of loanable funds theory totally negates classical macroeconomics because it means the economy has no mechanism for equilibrating full employment saving and full employment investment. That is why the theory of interest rates dominated discussion of The General Theory immediately after it was published.It is also why mainstream economics, with its classical bent, keeps circling back to interest rate theory – evidenced by the current revival of the natural rate of interest doctrine and appeal to the zero lower bound on nominal interest rates as the cause of unemployment and stagnation.

Thomas Palley

The loanable funds theory is in many regards nothing but an approach where the ruling rate of interest in society is — pure and simple — conceived as nothing else than the price of loans or credits set by banks and determined by supply and demand — as Bertil Ohlin put it — “in the same way as the price of eggs and strawberries on a village market.”

It’s a beautiful fairy tale, but the problem is that banks are not barter institutions that transfer pre-existing loanable funds from depositors to borrowers. Why? Because, in the real world, there simply are no pre-existing loanable funds. Banks create new funds — credit — only if someone has previously got into debt! Banks are monetary institutions, not barter vehicles.

loanIn the traditional loanable funds theory — as presented in mainstream macroeconomics textbooks — the amount of loans and credit available for financing investment is constrained by how much saving is available. Saving is the supply of loanable funds, investment is the demand for loanable funds and assumed to be negatively related to the interest rate. Lowering households’ consumption means increasing savings that via a lower interest.

That view has been shown to have very little to do with reality. It’s nothing but an otherworldly neoclassical fantasy. But there are many other problems as well with the standard presentation and formalization of the loanable funds theory:

1 As already noticed by James Meade decades ago, the causal story told to explicate the accounting identities used gives the picture of “a dog called saving wagged its tail labelled investment.” In Keynes’s view — and later over and over again confirmed by empirical research — it’s not so much the interest rate at which firms can borrow that causally determines the amount of investment undertaken, but rather their internal funds, profit expectations and capacity utilization.

2 As is typical of most mainstream macroeconomic formalizations and models, there is pretty little mention of real-world phenomena, like e. g. real money, credit rationing and the existence of multiple interest rates, in the loanable funds theory. Loanable funds theory essentially reduces modern monetary economies to something akin to barter systems — something they definitely are not. As emphasized especially by Minsky, to understand and explain how much investment/loaning/crediting is going on in an economy, it’s much more important to focus on the working of financial markets than staring at accounting identities like S = Y – C – G. The problems we meet on modern markets today have more to do with inadequate financial institutions than with the size of loanable-funds-savings.

3 The loanable funds theory in the ‘New Keynesian’ approach means that the interest rate is endogenized by assuming that Central Banks can (try to) adjust it in response to an eventual output gap. This, of course, is essentially nothing but an assumption of Walras’ law being valid and applicable, and that a fortiori the attainment of equilibrium is secured by the Central Banks’ interest rate adjustments. From a realist Keynes-Minsky point of view this can’t be considered anything else than a belief resting on nothing but sheer hope. [Not to mention that more and more Central Banks actually choose not to follow Taylor-like policy rules.] The age-old belief that Central Banks control the money supply has more an more come to be questioned and replaced by an ‘endogenous’ money view, and I think the same will happen to the view that Central Banks determine “the” rate of interest.

4 A further problem in the traditional loanable funds theory is that it assumes that saving and investment can be treated as independent entities. To Keynes this was seriously wrong:

genThe classical theory of the rate of interest [the loanable funds theory] seems to suppose that, if the demand curve for capital shifts or if the curve relating the rate of interest to the amounts saved out of a given income shifts or if both these curves shift, the new rate of interest will be given by the point of intersection of the new positions of the two curves. But this is a nonsense theory. For the assumption that income is constant is inconsistent with the assumption that these two curves can shift independently of one another. If either of them shifts​, then, in general, income will change; with the result that the whole schematism based on the assumption of a given income breaks down … In truth, the classical theory has not been alive to the relevance of changes in the level of income or to the possibility of the level of income being actually a function of the rate of the investment.

There are always (at least) two parts in an economic transaction. Savers and investors have different liquidity preferences and face different choices — and their interactions usually only take place intermediated by financial institutions. This, importantly, also means that there is no ‘direct and immediate’ automatic interest mechanism at work in modern monetary economies. What this ultimately boils done to is — iter — that what happens at the microeconomic level — both in and out of equilibrium —  is not always compatible with the macroeconomic outcome. The fallacy of composition (the ‘atomistic fallacy’ of Keynes) has many faces — loanable funds is one of them.

5 Contrary to the loanable funds theory, finance in the world of Keynes and Minsky precedes investment and saving. Highlighting the loanable funds fallacy, Keynes wrote in “The Process of Capital Formation” (1939):

Increased investment will always be accompanied by increased saving, but it can never be preceded by it. Dishoarding and credit expansion provides not an alternative to increased saving, but a necessary preparation for it. It is the parent, not the twin, of increased saving.

What is ‘forgotten’ in the loanable funds theory, is the insight that finance — in all its different shapes — has its own dimension, and if taken seriously, its effect on an analysis must modify the whole theoretical system and not just be added as an unsystematic appendage. Finance is fundamental to our understanding of modern economies, and acting like the baker’s apprentice who, having forgotten to add yeast to the dough, throws it into the oven afterwards, simply isn’t enough.

All real economic activities nowadays depend on a functioning financial machinery. But institutional arrangements, states of confidence, fundamental uncertainties, asymmetric expectations, the banking system, financial intermediation, loan granting processes, default risks, liquidity constraints, aggregate debt, cash flow fluctuations, etc., etc. — things that play decisive roles in channelling money/savings/credit — are more or less left in the dark in modern formalizations of the loanable funds theory.

It should be emphasized that the equality between savings and investment … will be valid under all circumstances.kalecki In particular, it will be independent of the level of the rate of interest which was customarily considered in economic theory to be the factor equilibrating the demand for and supply of new capital. In the present conception investment, once carried out, automatically provides the savings necessary to finance it. Indeed, in our simplified model, profits in a given period are the direct outcome of capitalists’ consumption and investment in that period. If investment increases by a certain amount, savings out of profits are pro tanto higher …

One important consequence of the above is that the rate of interest cannot be determined by the demand for and supply of new capital because investment ‘finances itself.’

The Greater Fool Theory

18 December, 2017 at 14:29 | Posted in Economics | Comments Off on The Greater Fool Theory

Guess those guys forgot to read Nassim Taleb’s Fooled by Randomness …​

Don’t believe economic myths. Get the truth!

17 December, 2017 at 20:05 | Posted in Economics | 2 Comments

The Efficient Markets Hypothesis

17 December, 2017 at 15:23 | Posted in Economics | 1 Comment

The really interesting questions about the Efficient Markets Hypothesis — at least when discussed by mainstream economists — usually drown in “the model is the message” pseudoscientific mumbo-jumbo of four-factor models with two mispricing factors being better-performing than three-factor models, blah, blah, blah …

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.

emhBut 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

Instead of assuming rational expectations and efficient markets to be right, one ought to confront the hypotheses with the available evidence. It is not enough to construct models. Without strong evidence, all kinds of absurd claims and nonsense may pretend to be science. We have to demand more of a justification than a rather watered-down version of “anything goes” when it comes to rationality postulates and markets. If one proposes rationality and efficiency hypotheses one also has to support their underlying assumptions. None is given, which makes it rather puzzling how REH and EMH have become standard modelling assumptions in modern macroeconomics.

We happy few

16 December, 2017 at 20:11 | Posted in Varia | Comments Off on We happy few


Big Data Bullshit

16 December, 2017 at 18:14 | Posted in Statistics & Econometrics | Comments Off on Big Data Bullshit

Trickle-down baloney

15 December, 2017 at 23:41 | Posted in Economics | 1 Comment


An unconquerable soul

15 December, 2017 at 19:35 | Posted in Varia | Comments Off on An unconquerable soul

Great poem that helped Nelson Mandela keep hope alive during 27 years in prison.

Nationalekonom varnar för bostadsbubbla

15 December, 2017 at 15:02 | Posted in Economics | Comments Off on Nationalekonom varnar för bostadsbubbla

lasseEn inte helt obekant ekonom uttalar sig här om situationen på dagens bomarknad.

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