LARS P. SYLL

After the crisis — business as usual

In contrast to the experience of the Great Depression, which led to the emergence and acceptance of novel theoretical concepts on a large scale, the financial crisis and its consequences have, by and large, been rationalized with reference to existing theoretical concepts. Although we do observe a slight shift away from the idea that financial markets are efficient by default and prices only follow random walks, the basic conceptualization of (financial) markets as being efficient and equilibrating in principle seems unquestioned. On the contrary, the rising prominence of the concept of “liquidity” – understood as the availability of funds to absorb financial assets to be sold – in the aftermath of the crisis indicates that the financial crisis is seen by economists as a major external shock, unforeseen because of the limits imposed on rational behavior by asymmetric information, and not as something intrinsic to the economic process. Similarly, our analysis of the reception of major crisis-related books shows an only temporary increase of interest in classic contributions dealing with financial and economic instability, which was even weaker for more distinguished journals. These observations signify a key difference in terms of the ‘lessons learned’ from past crises when compared to the Great Depression, which gave rise to a broad consensus that capitalist economies are not self-sustaining, a consensus that eventually helped to forge the mixed economies dominating the richer parts of the planet.

E Aigler, M Aistleitner, F Glötzl & J Kapeller

When did you last hear an economist​ say something like this?

If the observations of the red shift in the spectra of massive stars don’t come out quantitatively​ in accordance with the principles of general relativity, then my theory will be dust and ashes.

Albert Einstein (1920)

The calibration hoax

There are many kinds of useless economics held in high regard within mainstream economics establishment today. Few — if any — are less deserved than the macroeconomic theory/method — mostly connected with Nobel laureates Finn Kydland, Robert Lucas, Edward Prescott and Thomas Sargent — called calibration.

In physics, it may possibly not be straining credulity too much to model processes as ergodic – where time and history do not really matter – but in social and historical sciences it is obviously ridiculous. If societies and economies were ergodic worlds, why do econometricians fervently discuss things such as structural breaks and regime shifts? That they do is an indication of the unrealisticness of treating open systems as analyzable with ergodic concepts.

The future is not reducible to a known set of prospects. It is not like sitting at the roulette table and calculating what the future outcomes of spinning the wheel will be. Reading Sargent and other calibrationists one comes to think of Robert Clower’s apt remark that

much economics is so far removed from anything that remotely resembles the real world that it’s often difficult for economists to take their own subject seriously.

Instead of just assuming calibration and rational expectations to be right, one ought to confront the hypothesis with the available evidence. It is not enough to construct models. Anyone can construct models. To be seriously interesting, models have to come with an aim. They have to have an intended use. If the intention of calibration and rational expectations is to help us explain real economies, it has to be evaluated from that perspective. A model or hypothesis without a specific applicability is not really deserving of our interest.

To say, as Edward Prescott, that

one can only test if some theory, whether it incorporates rational expectations or, for that matter, irrational expectations, is or is not consistent with observations

is not enough. Without strong evidence, all kinds of absurd claims and nonsense may pretend to be science. We have to demand more of a justification than this rather watered-down version of ‘anything goes’ when it comes to rationality postulates. If one proposes rational expectations one also has to support its underlying assumptions. None is given, which makes it rather puzzling how rational expectations has become the standard modelling assumption made in much of modern macroeconomics. Perhaps the reason is, as Paul Krugman has it, that economists often mistake

beauty, clad in impressive-looking​ mathematics, for truth.

But I think Prescott’s view is also the reason why calibration economists are not particularly interested in empirical examinations of how real choices and decisions are made in real economies. In the hands of Lucas, Prescott and Sargent, rational expectations has been transformed from an – in principle – testable hypothesis to an irrefutable proposition. Irrefutable propositions may be comfortable — like religious convictions or ideological dogmas — but it is not science.

Modern economics — a severe case of model Platonism

That is the great thing about abstraction. Working with what can be called ‘flex price’ models does not imply that you think price rigidity is unimportant, but instead that it can often be ignored if you want to focus on other processes.

Simon Wren-Lewis

When applying deductivist thinking to economics, mainstream economists like Wren-Lewis usually set up ‘as if’ models based on a set of tight axiomatic assumptions from which consistent and precise inferences are made. The beauty of this procedure is, of course,​ that if the axiomatic premises are true, the conclusions necessarily follow. The snag is that if the models are to be relevant, we also have to argue that their precision and rigour still holds when they are applied to real-world situations. They often do not. When addressing real economies, the idealizations necessary for the deductivist machinery to work — as e. g. ‘flex price’ models — simply do not hold.

If the real world is fuzzy, vague and indeterminate, then why should our models build upon a desire to describe it as precise and predictable? The logic of idealization is a marvellous tool in mathematics and axiomatic-deductivist systems, but a poor guide for action in real-world systems, in which concepts and entities are without clear boundaries and continually interact and overlap.

The neoclassical style of thought – with its emphasis on thought experiments, reflection on the basis of illustrative examples and logically possible extreme cases, its use of model construction as the basis of plausible assumptions, as well as its tendency to decrease the level of abstraction, and similar procedures — appears to have had such a strong influence on economic methodology that even theoreticians who strongly value experience can only free themselves from this methodology with difficulty …

Clearly, it is possible to interpret the ‘presuppositions’ of a theoretical system not as hypotheses, but simply as limitations to the area of application of the system in question. Since a relationship to reality is usually ensured by the language used in economic statements, in this case the impression is generated that a content-laden statement about reality is being made, although the system is fully immunized and thus without content. In my view that is often a source of self-deception in pure economic thought …

A further possibility for immunizing theories consists in simply leaving open the area of application of the constructed model so that it is impossible to refute it with counter examples. This of course is usually done without a complete knowledge of the fatal consequences of such methodological strategies for the usefulness of the theoretical conception in question, but with the view that this is a characteristic of especially highly developed economic procedures: the thinking in models, which, however, among those theoreticians who cultivate neoclassical thought, in essence amounts to a new form of Platonism.

 Hans Albert