LARS P. SYLL

Herman Daly (1938-2022)

Ecological economist Herman Daly has passed away at the age of 84. Together with economists such as Kenneth Boulding and Nicholas Georgescu-Roegen, he was one of the founding fathers of ecological economics.

R.I.P.

Leontief and the sorry state of economics

Page after page of professional economic journals are filled with mathematical formulas leading the reader from sets of more or less plausible but entirely arbitrary assumptions to precisely stated but irrelevant theoretical conclusions …

Year after year economic theorists continue to produce scores of mathematical models and to explore in great detail their formal properties; and the econometricians fit algebraic functions of all possible shapes to essentially the same sets of data without being able to advance, in any perceptible way, a systematic understanding of the structure and the operations of a real economic system.

Wassily Leontief

Mainstream economics is, as noted by Leontief, hopelessly irrelevant to the understanding of the real world, and the main reason for this irrelevance is the failure of economists to match their methods with their subject of study. The fixation on constructing models showing the certainty of logical entailment has been detrimental to the development of relevant and realist economics. Insisting on formalistic-mathematical modeling forces the economist to give up on realism and real-world relevance.

It is — sad to say — a fact that within mainstream economics internal validity is everything and external validity next to nothing. Why anyone should be interested in that kinds of theories and models — as long as one does not come up with export licenses for the theories and models to the real world in which we live — is beyond comprehension.

Macroeconomic aspirations

Some economists seem to be überjoyed by the fact that they are using the same ‘language’ as real business cycles macroeconomists and that they therefore somehow can learn something from them.

James Tobin obviously did not find any need to speak the RBC ‘language’:

They try to explain business cycles solely as problems of information, such as asymmetries and imperfections in the information agents have. Those assumptions are just as arbitrary as the institutional rigidities and inertia they find objectionable in other theories of business fluctuations … I try to point out how incapable the new equilibrium business cycles models are of explaining the most obvious observed facts of cyclical fluctuations … I don’t think that models so far from realistic description should be taken seriously as a guide to policy … I don’t think that there is a way to write down any model which at one hand respects the possible diversity of agents in taste, circumstances, and so on, and at the other hand also grounds behavior rigorously in utility maximization and which has any substantive content to it.

Arjo Klamer, The New Classical Mcroeconomics: Conversations with the New Classical Economists and their  Opponents,Wheatsheaf Books, 1984

Using the same microfoundational ‘language’ as mainstream macroeconomists don’t take us very far. Far better than having a common ‘language’ is to have a well-founded, realist, and relevant theory:

Microfoundations for macroeconomics are fine in principle—not indispensable, but useful. The problem is that what passes for microfoundations in the universe of orthodox macro is crap …

It’s nothing more than robotic imitation of teaching exercises to improve math skills, without any consideration for such mundane matters as empirical verisimilitude …

Microfoundations means general equilibrium theory, but the flavor it uses is from the mid-1950s. The Sonnenschein-Debreu-Mantel demonstration (update to the 1970s)  that initial conditions and out-of-equilibrium trades alter the equilibrium itself has turned GET upside down.

Notice that I haven’t mentioned the standard heterodox criticisms of representative agents and ergodicity. You can add those if you want …

Like I said, their microfoundations are crap.

Peter Dorman

Macroeconomists have to have bigger aspirations than speaking the same ‘language.’ Rigorous models lacking relevance are not to be taken seriously. Truly great macroeconomists aspire to explain and understand the fundamentals of modern economies. As did e. g. John Maynard Keynes and Michal Kalecki.

The Nobel prize in economics — awarding popular misconceptions

This year’s Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel honours Ben Bernanke, Douglas Diamond and Philip Dybvig. In the view of the Royal Swedish Academy of Sciences, the laureates ‘have significantly improved our understanding of the role of banks in the economy’.

But what is the role of banks in the economy? The academy describes it this way: ‘To understand why a banking crisis can have such enormous consequences for society, we need to know what banks actually do: they receive money from people making deposits and channel it to borrowers.’ According to this view, banks are thus pure intermediaries or dealers of savings between saving households and investing companies. It is a view widespread in economics today but there has long been a completely different theory of the function of banks.

This was formulated, among others, by Joseph Schumpeter. In his Theory of Economic Development Schumpeter wrote: ‘The banker, therefore, is not so much primarily a middleman in the commodity “purchasing power” as a producer of this commodity.’

In this vein, in 2014 the Bank of England affirmed: ‘Money creation in practice differs from some popular misconceptions—banks do not act simply as intermediaries, lending out deposits that savers place with them.’ Three years later, the Deutsche Bundesbank similarly spoke of the ‘popular misconception that banks act simply as intermediaries at the time of lending—ie that banks can only grant loans using funds placed with them previously as deposits by other customers’ …

It is hard to understand how the Swedish academy could decide to honour a theory which—due to its ‘real analysis’—is unsuitable to represent monetary processes in reality. In terms of economic policy, it makes a fundamental difference whether banks are merely intermediaries of savings or insurance companies or whether they are producers of purchasing power. The ‘real analysis’ was an important factor in the inability of the economics profession to anticipate the Great Financial Crisis in time.

After that painful experience, to extol with the Nobel prize for economics the intermediation approach to banking is akin to posthumously offering Ptolemy the prize for physics—because he discovered that the sun revolved around the earth.

Peter Bofinger

Yes indeed — money doesn’t matter in mainstream macroeconomic models. That’s true. According to the ‘classical dichotomy,’ real variables — output and employment — are independent of monetary variables, and so enable 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)

What is also ‘forgotten’ in mainstream economic 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 afterward, simply isn’t enough.

All real economic activities nowadays depend on 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 channeling money/savings/credit — are more or less left in the dark in modern mainstream formalizations. Awarding people developing that kind of models is nothing short of gobsmacking!

55 Tufton Street and the people who crashed the British economy

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Charles Kindleberger v. Bernanke

In the papers of economist Charles Kindleberger, Perry Mehrling has found some interesting notes on the paper that won Ben Bernanke his ‘Nobel Prize’ in economics this year:

Dear Dr. Bernanke,

Thank you for sending me your paper on the great depression. You ask for comments, and I assume this is not merely ceremonial. I am afraid you will not in fact welcome them.

I think you have provided a most ingenious solution to a non-problem.The  necessity to demonstrate that financial crisis can be deleterious to production arises only in the scholastic precincts of the Chicago school with what Reder called in the last JEL its tight priors, or TP. If one believes in rational expectations, a natural rate of unemployment, efficient markets, exchange rates continuously at purchasing power parities, there is not much that can be explained about business cycles or financial crises. For a Chicagoan, you are courageous to depart from the assumption of complete markets.

You wave away Minsky and me for departing from rational assumptions. Would you not accept that it is possible for each participant in a market to be rational but for the market as a whole to be irrational because of the fallacy of composition? If not, how can you explain chain letters, betting on lotteries, panics in burning theatres, stock market and commodity bubbles as the Hunts in silver, the world in gold, etc …

Your rejection of money illusion (on the ground of rationality) throws out any role for price changes. I think this is a mistake on account at least of lags and dynamics. No one of the Chicago stripe pays attention to the sharp drop in commodity prices in the last quarter of 1929, caused by the banks, in their concern over loans on securities, to finance commodities sold in New York on consignment (and auto loans). This put the pressure on banks in areas with loans on commodities. The gainers from the price declines were slow in realizing their increases. The banks of the losers failed. Those of the ultimate winners did not expand …

In The World in Depression, 1929-1939, which you do not list, I make much of this structural deflation, the mirror analogue of structural inflation today from core inflation and the oil shock. But your priors do not permit you to think them of any importance.

Sincerely yours,

Charles P. Kindleberger

INET