LARS P. SYLL

The state of ‘New Keynesian’ economics

The standard NK [New Keynesian] model, like most of its predecessors in the RBC literature, represents an economy inhabited by an infinitely-lived representative household. That assumption, while obviously unrealistic, may be justified by the belief that, like so many other aspects of reality, the finiteness of life and the observed heterogeneity of individuals along many dimensions … can be safely ignored for the purposes of explaining aggregate fluctuations and their interaction with monetary policy, with the consequent advantages in terms of tractability …

There is a sense in which none of the extensions of the NK model described above can capture an important aspect of most financial crises, namely, a gradual build-up of financial imbalances leading to an eventual “crash” characterized by defaults, sudden-stops of credit flows, asset price declines, and a large contraction in aggregate demand, output and employment. By contrast, most of the models considered above share with their predecessors a focus on equilibria that take the form of stationary fluctuations driven by exogenous shocks. This is also the case in variants of those models that allow for financial frictions of different kinds and which have become quite popular as a result of the financial crisis … The introduction of financial frictions in those models often leads to an amplification of the effects of non-financial shocks. It also makes room for additional sources of fluctuations related to the presence of financial frictions … or exogenous changes in the tightness of borrowing constraints​ … Most attempts to use a version of the NK models to explain the “financial crisis,” however, end up relying on a large exogenous shock that impinges on the economy unexpectedly, triggering a large recession, possibly amplified by a financial accelerator mechanism embedded in the model. It is not obvious what the empirical counterpart to such an exogenous shock is.

Jordi Gali

Gali’s presentation sure raises important questions that serious economists ought to ask themselves. Using ‘simplifying’ tractability assumptions such as “infinitely-lived representative household,” rational expectations, common knowledge, additivity, ergodicity, etc — because otherwise they cannot ‘manipulate’ their models or come up with ‘rigorous ‘ and ‘precise’ predictions and explanations, does not exempt — ‘New Keynesian’ or not — economists from having to justify their modelling choices. Being able to ‘manipulate’ things in models cannot per se be enough to warrant a methodological choice. If economists do not come up with any other arguments for their chosen modelling strategy than Gali’s “advantages in terms of tractability,” it is certainly a just question to ask for clarification of the ultimate goal of the whole modelling endeavour.

Gali’s article underlines that the essence of mainstream economic theory is its almost exclusive use of a deductivist methodology. A methodology that is more or less used without a smack of argument to justify its relevance.

The theories and models that mainstream economists construct describe imaginary worlds using a combination of formal sign systems such as mathematics and ordinary language. The descriptions made are extremely thin and to a large degree disconnected to the specific contexts of the targeted system than one (usually) wants to (partially) represent. This is not by chance. These closed formalistic-mathematical theories and models are constructed for the purpose of being able to deliver purportedly rigorous deductions that may somehow by be exportable to the target system. By analyzing a few causal factors in their “laboratories” they hope they can perform “thought experiments” and observe how these factors operate on their own and without impediments or confounders.

Unfortunately, this is not so. The reason for this is that economic causes never act in a socio-economic vacuum. Causes have to be set in a contextual structure to be able to operate. This structure has to take some form or other, but instead of incorporating structures that are true to the target system, the settings made in economic models are rather based on formalistic mathematical tractability. In the models they appear as unrealistic assumptions, usually playing a decisive role in getting the deductive machinery to deliver “precise” and “rigorous” results. This, of course, makes exporting to real-world target systems problematic, since these models – as part of a deductivist covering-law tradition in economics – are thought to deliver general and far-reaching conclusions that are externally valid. But how can we be sure the lessons learned in these theories and models have external validity when based on highly specific unrealistic assumptions? As a rule, the more specific and concrete the structures, the less generalizable the results. Admitting that we in principle can move from (partial) falsehoods in theories and models to truth in real-world target systems do not take us very far unless a thorough explication of the relation between theory, model and the real world target system is made. If models assume representative actors, rational expectations, market clearing and equilibrium, and we know that real people and markets cannot be expected to obey these assumptions, the warrants for supposing that conclusions or hypothesis of causally relevant mechanisms or regularities can be bridged, are obviously non-justifiable. To have a deductive warrant for things happening in a closed model is no guarantee for them being preserved when applied to an open real-world target system.

Henry Louis Mencken once wrote that “there is always an easy solution to every human problem – neat, plausible and wrong.” And mainstream economics has indeed been wrong. Very wrong. Its main result, so far, has been to demonstrate the futility of trying to build a satisfactory bridge between formalistic-axiomatic deductivist models and real-world d target systems. Assuming, for example, perfect knowledge, instant market clearing and approximating aggregate behaviour with unrealistically heroic assumptions of “infinitely-lived” representative actors, just will not do. The assumptions made, surreptitiously eliminate the very phenomena we want to study: uncertainty, disequilibrium, structural instability and problems of aggregation and coordination between different individuals and groups.

The punch line is that most of the problems that mainstream economics is wrestling with, issues from its attempts at formalistic modelling per se of social phenomena. If scientific progress in economics – as Robert Lucas and other latter days mainstream economists seem to think – lies in our ability to tell “better and better stories” without considering the realm of imagination and ideas a retreat from real-world target systems reality, one would, of course, think our economics journal being filled with articles supporting the stories with empirical evidence. However, I would argue that the journals still show a striking and embarrassing paucity of empirical studies that (try to) substantiate these theoretical claims. Equally amazing is how little one has to say about the relationship between the model and real-world target systems. It is as though thinking explicit discussion, argumentation and justification on the subject not required. Mainstream economic theory is obviously navigating in dire straits.

If the ultimate criterion for success of a deductivist system is to what extent it predicts and cohere with (parts of) reality, modern mainstream economics seems to be a hopeless misallocation of scientific resources. To focus scientific endeavours on proving things in models is a gross misapprehension of what an economic theory ought to be about. Deductivist models and methods disconnected from reality are not relevant to predict, explain or understand real-world economic target systems. These systems do not conform to the restricted closed-system structure the mainstream modelling strategy presupposes.

Mainstream economic theory still today consists mainly of investigating economic models. It has since long given up on the real world and contents itself with proving things about thought up worlds. Empirical evidence still only plays a minor role in mainstream economic theory, where models largely function as substitutes for empirical evidence.

What is wrong with mainstream economics is not that it employs models per se, but that it employs poor models. They are poor because they do not bridge to the real world target system in which we live. Hopefully humbled by the manifest failure of its theoretical pretences, the one-sided, almost religious, insistence on mathematical deductivist modelling as the only scientific activity worthy of pursuing in economics will give way to methodological pluralism based on ontological considerations rather than “consequent advantages in terms of tractability.”

Where modern macroeconomics went wrong

In issue 1-2 (2018) of Oxford Review of Economic Policy, the editors have invited some well-known contemporary mainstream macroeconomists (including e.g. Simon Wren-Lewis, Randall Wright, Olivier Blanchard, Ricardo Reis, Joseph Stiglitz) to give their views on how to rebuild macroeconomic theory for the future.

Some of the contributions are interesting to read. Others — like Wren-Lewis and Blanchard — seem to think that we can basically just go on with our microfounded DSGE models and complement them with one or other structural econometric model (SEM). Two bads, however, do not add up to one good.

Joseph Stiglitz article on Where Modern Macroeconomics Went Wrong acknowledges that his approach “and that of DSGE models begins with the same starting point: the competitive equilibrium model of Arrow and Debreu.” That is, however, probably also the reason why Stiglitz’ suggestions for rebuilding macroeconomics don’t go far enough.

It’s strange that mainstream macroeconomists still stick to a general equilibrium paradigm more than forty years after the Sonnenschein-Mantel-Debreu theorem — SMD — devastatingly showed that it  is an absolute non-starter for building realist and relevant macroeconomics:

SMD theory means that assumptions guaranteeing good behavior at the microeconomic level do not carry over to the aggregate level or to qualitative features of the equilibrium …

Given how sweeping the changes wrought by SMD theory seem to be, it is understandable that some very broad statements about the character of general equilibrium theory were made. Fifteen years after General Competitive Analysis, Arrow (1986) stated that the hypothesis of rationality had few implications at the aggregate level. Kirman (1989) held that general equilibrium theory could not generate falsifiable propositions, given that almost any set of data seemed consistent with the theory …

S. Abu Turab Rizvi

New Classical-Real Business Cycles-DSGE-New Keynesian microfounded macro models try to describe and analyze complex and heterogeneous real economies with a single rational-expectations-robot-imitation-representative-agent. That is, with something that has absolutely nothing to do with reality. And — worse still — something that is not even amenable to the kind of general equilibrium analysis that they are thought to give a foundation for since SMD unequivocally showed that there did not exist any condition by which assumptions on individuals would guarantee either stability or uniqueness of the equilibrium solution.

Opting for cloned representative agents that are all identical is of course not a real solution to the fallacy of composition that SMD points to. Representative agent models are — as I have argued at length here — rather an evasion whereby issues of distribution, coordination, heterogeneity — everything that really defines macroeconomics — are swept under the rug.

Of course, most macroeconomists know that to use a representative agent is a flagrantly illegitimate method of ignoring real aggregation issues. They keep on with their business, nevertheless, just because it significantly simplifies what they are doing. It reminds — not so little — of the drunkard who has lost his keys in some dark place and deliberately chooses to look for them under a neighbouring street light just because it is easier to see there.

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

Frank Ackerman

Almost a century and a half after Léon Walras founded general equilibrium theory, economists still have not been able to show that markets lead economies to equilibria. We do know that — under very restrictive assumptions — equilibria do exist, are unique and are Pareto-efficient. But — what good does that do? As long as we cannot show that there are convincing reasons to suppose there are forces which lead economies to equilibria — the value of general equilibrium theory is nil. As long as we cannot really demonstrate that there are forces operating — under reasonable, relevant and at least mildly realistic conditions — at moving markets to equilibria, there cannot really be any sustainable reason for anyone to pay any interest or attention to this theory.

A stability that can only be proved by assuming Santa Claus conditions is of no avail. Most people do not believe in Santa Claus anymore. And for good reasons — Santa Claus is for kids.

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

Bourdieu on neoliberalism

Economists may not necessarily share the economic and social interests of the true believers and may have a variety of individual psychic states regarding the economic and social effects of the utopia which they cloak with mathematical reason. Nevertheless, they have enough specific interests in the field of economic science to contribute decisively to the production and reproduction of belief in the neoliberal utopia. Separated from the realities of the economic and social world by their existence and above all by their intellectual formation, which is most frequently purely abstract, bookish, and theoretical, they are particularly inclined to confuse the things of logic with the logic of things.

These economists trust models that they almost never have occasion to submit to the test of experimental verification and are led to look down upon the results of the other historical sciences, in which they do not recognise the purity and crystalline transparency of their mathematical games, whose true necessity and profound complexity they are often incapable of understanding. They participate and collaborate in a formidable economic and social change. Even if some of its consequences horrify them (they can join the socialist party and give learned counsel to its representatives in the power structure), it cannot displease them because, at the risk of a few failures, imputable to what they sometimes call “speculative bubbles”, it tends to give reality to the ultra-logical utopia (ultra-logical like certain forms of insanity) to which they consecrate their lives.

Pierre Bourdieu

Mainstream economics and neoliberalism — what is the difference?

Oxford professor Simon Wren-Lewis had a post up some time ago commenting on traction gaining ‘attacks on mainstream economics’:

One frequent accusation … often repeated by heterodox economists, is that mainstream economics and neoliberal ideas are inextricably linked. Of course​ economics is used to support neoliberalism. Yet I find mainstream economics full of ideas and analysis that permits a wide ranging and deep critique of these same positions. The idea that the two live and die together is just silly.

The same Wren-Lewis has also felt it necessary to defend mainstream economics against critique waged against it from Phil Mirowski:

Mirowski overestimates the extent to which neoliberal ideas have become ’embedded in economic theory’, and underestimates the power that economic theory and evidence can have over even those academic economists who might have a neoliberal disposition. If the tide of neoliberal thought is going to be turned back, economics is going to be important in making that happen.

Wren-Lewis admits that “Philip Mirowski is a historian who has written a great deal about both the history of economics as a discipline and about neoliberalism’ and that Mirowski ‘knows much more about the history of both subjects than I do.”

Fair enough, but there are simple remedies for the lack of knowledge.

You could start by reading this essay, where yours truly try to further analyze — much inspired by the works of Amartya Sen — what kind of philosophical-ideological-political-economic doctrine neoliberalism is, and why it so often comes naturally for mainstream economists to embrace neoliberal ideals.

Or maybe — if your Swedish is not too rusty … — you could read this book-length argumentation for why there has been such a deep and long-standing connection between the dismal science and different varieties of neoliberalism.

The present state of economics

More and more often, confidence in the professional qualifications of individuals representing certain occupational groups which formerly were held in high esteem has started to erode. Dismissing scientific evidence and ignoring expert opinion has become a feature of political discourse around alternative truth. In part this is self-inflicted as various statements that are publicized with the aura of academic certainty do not stand up to closer scrutiny. Alas, this applies particularly to economics, which is often held up as the supreme discipline of social sciences. It suffices to take a look on page one of reasonably respectable printed media to recognize how important economics is in contemporary society. In this chapter, we highlight some issues from micro- and macroeconomics that are critical.

Against this background, one should expect that specialists in the field would have thoroughly analysed principles and functioning of modern economics in order to provide solid knowledge concerning the system’s operating mode. Far wrong! There hardly is any other branch of science where there is such a pronounced incongruity between the outstanding significance of the subject and the lack of expertise of most professors as in economics. This may seem particularly grotesque since for many years only those who have published numerous articles in the very best journals under the strictest peer review conditions normally have a chance in appointment procedures. With that said, the unbiased observer will wonder why there are still pressing economic problems.

Dirk Ehnts & Fritz Helmedag