## Keynes’ critique of econometrics — still valid after all these years

26 Mar, 2018 at 19:24 | Posted in Statistics & Econometrics | 2 CommentsTo apply statistical and mathematical methods to the real-world economy, the econometrician has to make some quite strong assumptions. In a review of Tinbergen’s econometric work — published in *The Economic Journal* in 1939 — John Maynard Keynes gave a comprehensive critique of Tinbergen’s work, focusing on the limiting and unreal character of the assumptions that econometric analyses build on:

**(1) Completeness**: Where Tinbergen attempts to specify and quantify which different factors influence the business cycle, Keynes maintains there has to be a complete list of *all* the relevant factors to avoid misspecification and spurious causal claims. Usually, this problem is ‘solved’ by econometricians assuming that they somehow have a ‘correct’ model specification. Keynes is, to put it mildly, unconvinced:

It will be remembered that the seventy translators of the Septuagint were shut up in seventy separate rooms with the Hebrew text and brought out with them, when they emerged, seventy identical translations. Would the same miracle be vouchsafed if seventy multiple correlators were shut up with the same statistical material? And anyhow, I suppose, if each had a different economist perched on his

a priori, that would make a difference to the outcome.

**(2) Homogeneity**: To make inductive inferences possible — and being able to apply econometrics — the system we try to analyse has to have a large degree of ‘homogeneity.’ According to Keynes most social and economic systems — especially from the perspective of real historical time — lack that ‘homogeneity.’ It is not always possible to take repeated samples from a fixed population when we were analysing real-world economies. In many cases, there simply are no reasons at all to assume the samples to be homogenous.

**(3) Stability:** Tinbergen assumes there is a stable spatio-temporal relationship between the variables his econometric models analyze. But Keynes argued that it was not really possible to make inductive generalisations based on correlations in one sample. As later studies of ‘regime shifts’ and ‘structural breaks’ have shown us, it is exceedingly difficult to find and establish the existence of stable econometric parameters for anything but rather short time series.

**(4) Measurability:** Tinbergen’s model assumes that all relevant factors are measurable. Keynes questions if it is possible to adequately quantify and measure things like expectations and political and psychological factors. And more than anything, he questioned — both on epistemological and ontological grounds — that it was always and everywhere possible to measure real-world uncertainty with the help of probabilistic risk measures. Thinking otherwise can, as Keynes wrote, “only lead to error and delusion.”

**(5) Independence**: Tinbergen assumes that the variables he treats are independent (still a standard assumption in econometrics). Keynes argues that in such a complex, organic and evolutionary system as an economy, independence is a deeply unrealistic assumption to make. Building econometric models from that kind of simplistic and unrealistic assumptions risk producing nothing but spurious correlations and causalities. Real-world economies are organic systems for which the statistical methods used in econometrics are ill-suited, or even, strictly seen, inapplicable. Mechanical probabilistic models have little leverage when applied to non-atomic evolving organic systems — such as economies.

Building econometric models can’t be a goal in itself. Good econometric models are means that make it possible for us to infer things about the real-world systems they ‘represent.’ If we can’t show that the mechanisms or causes that we isolate and handle in our econometric models are ‘exportable’ to the real-world, they are of limited value to our understanding, explanations or predictions of real-world economic systems.

**(6) Linearity:** To make his models tractable, Tinbergen assumes the relationships between the variables he study to be linear. This is still standard procedure today, but as Keynes writes:

It is a very drastic and usually improbable postulate to suppose that all economic forces are of this character, producing independent changes in the phenomenon under investigation which are directly proportional to the changes in themselves; indeed, it is ridiculous.

To Keynes, it was a ‘fallacy of reification’ to assume that all quantities are additive (an assumption closely linked to independence and linearity).

The unpopularity of the principle of organic unities shows very clearly how great is the danger of the assumption of unproved additive formulas. The fallacy, of which ignorance of organic unity is a particular instance, may perhaps be mathematically represented thus: suppose f(x) is the goodness of x and f(y) is the goodness of y. It is then assumed that the goodness of x and y together is f(x) + f(y) when it is clearly f(x + y) and only in special cases will it be true that f(x + y) = f(x) + f(y). It is plain that it is never legitimate to assume this property in the case of any given function without proof.

J. M. Keynes “Ethics in Relation to Conduct” (1903)

Real-world social systems are usually not governed by stable causal mechanisms or capacities. The kinds of ‘laws’ and relations that econometrics has established, are laws and relations about entities in models that presuppose causal mechanisms and variables — and the relationship between them — being linear, additive, homogenous, stable, invariant and atomistic. But — when causal mechanisms operate in the real world they only do it in ever-changing and unstable combinations where the whole is more than a mechanical sum of parts. Since statisticians and econometricians have not been able to convincingly warrant their assumptions of homogeneity, stability, invariance, independence, additivity as being ontologically isomorphic to real-world economic systems, Keynes’ critique is still valid.

In his critique of Tinbergen, Keynes points us to the fundamental logical, epistemological and ontological problems of applying statistical methods to a basically unpredictable, uncertain, complex, unstable, interdependent, and ever-changing social reality. Methods designed to analyse repeated sampling in controlled experiments under fixed conditions are not easily extended to an organic and non-atomistic world where time and history play decisive roles.

Econometric modelling should never be a substitute for thinking. From that perspective, it is really depressing to see how much of Keynes’ critique of the pioneering econometrics in the 1930s-1940s is still relevant today.

The general line you take is interesting and useful. It is, of course, not exactly comparable with mine. I was raising the logical difficulties. You say in effect that, if one was to take these seriously, one would give up the ghost in the first lap, but that the method, used judiciously as an aid to more theoretical enquiries and as a means of suggesting possibilities and probabilities rather than anything else, taken with enough grains of salt and applied with superlative common sense, won’t do much harm. I should quite agree with that. That is how the method ought to be used.

Keynes, letter to E.J. Broster, December 19, 1939

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“it was always and everywhere possible to measure real-world uncertainty with the help of probabilistic risk measures”

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Insurance can hedge against real-world uncertainty. Thus Goldman Sachs hedged Mortgage-backed securities with insurance against their devaluation. AIG should have hedged the insurance it sold GS with still future promises to pay circulating as money today; but AIG hedged MBS with MBS and when all MBS were devalued in an arbitrary panic, AIG couldn’t pay GS. But the Fed stepped in to give AIG generous terms on loans when no private sector money dealer would. It worked: GS got paid for insuring against MBS defaults and AIG is still around using future promises to guarantee payouts on insurance claims today. Apparently the mistake of insuring a security with other similar securities has been rectified …

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The point is that real-world uncertainty can be financially hedged. The Fed has proved it can create unlimited liquidity to pay out on insurance (and the dollar got stronger while the Fed was printing money).

Comment by Robert Mitchell— 26 Mar, 2018 #

Well, how did physics proceed when it did not know what mathematical forms to assume, because logically there could be countless alternative forms to consider. But this is a kind of logical fallacy. You have to proceed assuming some mathematical forms apply and then use additional assumptions combined with the basic assumptions to make predictions and test them. All thought has to presume some a priori structures join together experience and in that context make additional assumptions which can be tested aganst the data. And the a priori assumptions are also tested with the additional assumptions, although taken alone are neither true nor false. The problem is testing the theory.

Comment by stanislaus3— 3 Apr, 2018 #