Debunking Economics, Part VIII: Macroeconomics, or Applied Microeconomics?

Chapter 10 of Steve Keen’s Debunking Economics explores the reduction of macroeconomics to ‘applied microeconomics:’ representative agents, the macroeconomic supply/demand (IS-LM), Say’s Law and more. The Chapter is aptly titled ‘Why They Didn’t See It Coming’ – the reason, of course, being that the very premises of their models assumed away major episodes of instability.

Say’s Law

Say’s Law is the proposition – first put forward by its namesake, Jean-Baptiste Say – that:

Every producer asks for money in exchange for his products, only for the purpose of employing that money again immediately in the purchase of another product.

In other words: money is neutral, and the economy operates as if people are directly bartering goods between one another. Whilst individual markets may not clear, there cannot be a net deficiency of demand in all markets, and employment is largely voluntary, save perhaps that induced by ‘frictions’ as markets adjust. Say’s Law is rarely referenced explicitly by modern neoclassical economics, but it still lives on at the heart of many models – for example, the ‘equilibrium’ in Dynamic Stochastic General Equilibrium (DSGE) models assumes that all markets clear.

Keen notes that Keynes’ own formulation and refutation of Say’s Law was clumsy and turgid. Instead, Keen opts for Marx’s critique, which was far more concise and lucid. Keynes actually included Marx’s critique in his 1933 draft of The General Theory, but eventually eliminated it, probably for political reasons.

Say’s Law relies on a simple claim: the structure of a market economy is Commodity-Money-Commodity (C-M-C), where people primarily desire commodities and only hold money for want of another commodity. But Marx pointed out that, under capitalism, there are a group of people who quite clearly do not fit this formulation. These people are called capitalists.

Capitalist production does not take the form of C-M-C, but of M-C-M: a capitalist will invest money in production in the hope of accumulating more. As Marx put it, “[the capitalist's] aim is not to equalise his supply and demand, but to make the inequality between them as great as possible.” Say’s Law could be said to apply in a productionless economy, but capitalism is characterised by the value or quantity of produced goods and services exceeding the value or quantity of the inputs. Hence, there will always be a surplus of money needed to satisfy capitalist accumulation, and the economy will continually be characterised by excess demand for money, and hence insufficient demand for commodities.

Keen continues by noting the obvious accounting reality that, in order for the economy to expand, credit must fill this gap, and quotes both Schumpeter and Minsky saying the same. This, along with the logic of capital accumulation, is a major spanner in the works for Say’s Law. However, I will not explore the ‘credit gap’ any further here, as Keen goes into far more detail in later chapters.

IS/LM

IS/LM is a diagram that looks a lot like demand supply, and proposes that the interest rate and level of output in an economy are determined by two schedules: the equilibriums between the different levels of investment and saving, and the equilibriums between the money supply and the desire to hold money (liquidity preference). It was originally proposed as an interpretation of Keynes’ General Theory by Hicks in his 1937 review of the book, entitled Keynes and the Classics.

There are many problems with IS/LM. The model was a complete misinterpretation of Keynes, and basically an attempt to pass off Hicks’ own model – that was developed independently from Keynes* – as Keynes’ model. Hicks himself pointed out many of the substantive problems in his 1980 ‘explanation’ (Keen suggests it is really an apology).

The major problems are uncertainty and changing expectations. Hicks’ formulation of IS/LM uses a period of about a week, during which it is reasonable to suppose that expectations are constant. But if expectations are constant and therefore not uncertain, there is no room for liquidity preference, which Keynes justified as “a barometer of the degree of our distrust of our own calculations a conventions concerning the future.” So we must extend the time period.

Keynes’ original intent for the time period of his analysis was the ‘Marshallian’ definition of a short period – about a year. The problem is that at this point equilibrium analysis falls apart. Both curves are partially derived from expectations, and once these start changing, the curves are constantly shifting. Not only this, but since they both depend on expectations, a movement in one will affect the other, and they can no longer move independently.**

Ultimately, IS/LM reduced Keynes to a call for fiscal stimulus in the ‘special case’ that the LM curve was flat or close to flat (demand for money is ‘very high’ or infinite). ‘Later Hicks’ argued that the model should really not be intended as anything other than a “classroom gadget” – we might consider it a heuristic assumption, later to be replaced by something else (it is, in fact, replaced by DSGE past the undergraduate level). Personally I’m not sure that a model with internal inconsistencies should be used as a heuristic (and neither is Keen), and to be honest students have enough trouble understanding IS/LM that I don’t even think it qualifies as a potent tool for communication. In any case, we certainly don’t want to be referring to it in policy discussions.

Macroeconomics after IS/LM

The neoclassical economists didn’t like IS/LM either, but that was because it was not built up from the point of view of optimising microeconomic agents. Keen catalogues the ‘Rational Expectations‘ overthrowing of IS/LM and the ‘Keynesians,’ making the obvious observation that the idea people can, on average, predict the future, is stupid, and ironically completely fails to take into account Keynes’ concept of uncertainty. He notes that, while the broad thrust of the Lucas Critique is correct, it does not justify the idea that a policy change will be completely neutralized by changes in behaviour, and neither does it justify reductionism – microeconomic models are as ‘vulnerable’ to the critique as macroeconomic ones.

Keen then documents that the first attempt to model macroeconomics based on the ‘revelations’ of what he calls the ‘rational expectations mafia:’ Real Business Cycle models. Again, the original author of these models – Bob Solow – later repudiated them. In his words:

What emerged was not a good idea. The preferred model has a single representative consumer optimizing over infinite time with perfect foresight or rational expectations, in an environment that realizes the resulting plans more or less flawlessly through perfectly competitive forward-looking markets for goods and labor, and perfectly flexible prices and wages.  How could anyone expect a sensible short-to-medium-run macroeconomics to come out of that set-up?

This is obviously ridiculous. There have, of course, been developments since the core RBC model was invented – the New Keynesian DSGE models include elements such as sticky prices, bounded rationality, imperfect (though as far as I know, not  asymmetric) information and oligopolistic market structures. However, all of these preserve the neoclassical core of preference driven individualism, assume equilibrium, and keep one or two representative agents (any more and many of the core assumptions fall apart, in a clear and ironic example of emergent properties). The models also suppose that the economy has ‘underlying‘ tendencies towards stability, masked only by the pesky aforementioned real world ‘imperfections.’

Even despite all these developments, neoclassical economists continued to be led to absurd conclusions, such as the idea that unemployment during the Great Depression was voluntary (Prescott), the recession predated the collapse of the housing bubble (Fama), and blaming business cycles on the Fed suddenly deviating from its previous mandate for no reason (Taylor, Sumner, Friedman). And, of course, none of them foresaw the crisis and can only model it with some serious post-hoc ad-hocery.

It’s worth noting that representative agents, in and of themselves, are not a problem – the problem is that neoclassicism must stick to a small amount to preserve its assumptions, and for some reason refuses to use class as a distinction. Keen’s own models could be said to use representative agents, but the fact that he doesn’t build his model up from microfoundations means that he is far less hamstrung when adding new aspects and dynamics to the model. The idea that the macroeconomy cannot be studied separately from the microeconomy is deeply ascientific – the kind of thing that the real sciences learned to abandon long ago. It’s time economists caught up.

*Actually it was developed largely in opposition to Keynes – by Hicks, Dennis Robertson and others.

**Readers might notice a similarity between this ‘small scale versus large scale’ critique of IS/LM and Piero Sraffa’s argument against diminishing marginal returns.

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  1. #1 by pontus on August 26, 2012 - 9:33 pm

    “Hence, there will always be a surplus of money needed to satisfy capitalist accumulation, and the economy will continually be characterised by negative demand.”

    I have a really difficult time to understand

    1, What that sentence means

    and

    2, How that follows from the above

    Does a “surplus” of money mean that there must be more money than that needed to buy all goods (consumption and investment goods). What does “capitalist accumulation” refer to? Is that a concept or does it mean “capitalists’ accumulation”. Why does this lead to “negative demand”? What does “negative demand” mean? Is that the same as “excess supply” or “general glut”?

    I simply have no idea what that sentence is supposed to say, it it appears imperative to understand why Say’s law fails.

    • #2 by Unlearningecon on August 27, 2012 - 2:05 pm

      That was a poorly constructed sentence, I have changed it to:

      Hence, there will always be a surplus of money needed to satisfy capitalist accumulation, and the economy will continually be characterised by excess demand for money, and hence insufficient demand for commodities.

      The point being that since capitalists are constantly accumulating money, it is entirely feasible that money will not be employed merely for the purpose of buying another commodity, but as a goal in its own right.

      • #3 by pontus on August 27, 2012 - 2:45 pm

        Ok, that makes more sense.

        So I guess that the problem is that capitalists are holding money, and therefore Say’s law is broken? That’s fine, and was the argument in Mill (1874). (see, for instance, here for a nice summary: http://delong.typepad.com/sdj/2011/03/is-economics-a-discipline.html)

        That is all fine. But that is also the argument in virtually every economic model at the zero lower bound (see Krugman (1998), or Eggertson and Woodford (2003)).

        But I’m not sure if that’s a valid argument in “normal times”. If capitalists are chasing profits, they would be fools hoarding currency which pays no interest. And just looking at the return capitalists get on wealth, this does not really square right to me. How do you explain this pattern?

        In addition a sudden rise in money demand can be offset (and this is pure accounting!) by an internal devaluation in which prices and wages fall in unison. Now, this may be hard to attain, but that just begs the question why it’s hard to attain.

        Sticky prices? Sticky wages? I believe Keynes said none of these, but he was very vague as to why.

        Any ideas?

      • #4 by Unlearningecon on August 27, 2012 - 11:33 pm

        I alluded to the fact that Say’s Law is not particularly central to neoclassical economics, though still alive in some respects with ‘market clearing’ assumptions etc.

        Surely deflation makes money an even better asset, and would increase liquidity preference further?

        (I responded to the comment about hoarding below).

  2. #5 by ivansml on August 26, 2012 - 11:04 pm

    So the problematic elements of microfoundations are utility maximization, equilibrium and representative agent. We discussed equilibrium before, you admit that RA can sometimes be justifiable, so I’m curious about the first one. Why exactly is modelling agent’s objective function problematic?

    To the extent that economics is a social science about people who act purposefully (damn, I’m starting to sound like an austrian), this seems to me like a key element. How else do you capture the fact that people respond to incentives, make decisions over tradeoffs, etc.? Of course, in some situations it may be preferable (e.g. for tractability) to skip this step and postulate behavioral rules directly – but even then one should surely care about theoretical justification behind those rules.

    Also, maybe because I’m from part of world which directly experienced the “joys” of marxism-leninism, I don’t get this fascination with class. Everybody can be a capitalist nowadays – just invest in a mutual fund – so the distinction is pointless. Of course, many people will not invest anything, not because they belong to the working class, but because they are poor and have no savings. Analyzing heterogeneity in wealth and income seems much more important than analyzing class, whatever that is supposed to mean, and that’s also one of directions modern macroeconomics is shifting towards.

    Finally, you can include “class”, or something like that, in microfounded model if you want to. For example, Guvenen’s 2009 Econometrica paper (and certainly bunch of other papers too) has two agents, one who can own stocks and bonds, and the other who can only hold bonds (this is given exogenously), and studies impact of this limited participation on asset prices. Or, from a different field, work by Acemoglu and Robinson on political economy explicitly assumes two classes, elites vs. citizens (theirs is not a macro model, but still uses game theory and utility maximization).

    • #6 by Roman P. on August 27, 2012 - 6:59 am

      You are aware that perfect rationality is impossible for the real consumers/producers? Preferences usually couldn’t be complete due to the computational limits of real actors, their asymmetry could break down because of the framing, etc. (Kreps 1990) Those are not problems that could be assumed away.

      Even K. Arrow, who gets a lot of bashing for his GE model, never was so foolish as some of his critiques paint him. He acknowledged the problems of his own models and suggested (Arrow 1986) to try something new. For example, he notes, why stick to the optimization based on the utility and budget lines? “Let me dismiss a point of view that is perhaps not always articulated but seems implicit in many writings. It seems to be asserted that a theory of the economy must be based on rationality, as a matter of principle… Not only is it possible to devise complete models of the economy on hypotheses other than rationality, but in fact virtually every practical theory of macroeconomics is partly so based”. He proposes a model of optimization through habit formation: the budget constraint has to be satisfied, but the consumers chooses the bundle that requires the least amount of change from the previous consumption bundle, however defined. Plausible? Maybe.

      Really, just read Arrow 1986, I am not as eloquent as him.

      • #7 by ivansml on August 27, 2012 - 8:21 am

        Arrow rises some valid points, although most of them are not really about utility maximization, but about other assumptions. And many behavioral deviations from standard theory (such as habit formation, nonexpected utility, hyperbolic discounting…) can be accounted for, in some form, by modifying the utility function.

        I was never persuaded by complexity argument. N-body problem is also computationally hard, yet planets “solve” it without any problems. How do those dumb pieces of rock and gas do it?

    • #8 by Min on August 27, 2012 - 1:39 pm

      How do you operationalize utility maximization?

    • #9 by Unlearningecon on August 27, 2012 - 2:02 pm

      The fact is that people don’t always have some end preference in mind when they act, and behavioural economics has revealed that ‘preferences’ in general are quite vague and people have a hard time judging how much they enjoyed something even afterwards. This is why economists reject Steve Keen’s models – he has agents acting in ways that are either determined from past correlations, or simply an intuitive ‘guess’ (e.g. a worker spending all his income would be an example). He doesn’t invoke preferences, and this is why economists shout ‘Lucas Critique!!’ But really there’s nothing holy or sacred about the preference driven model.

      An ideological position shouldn’t impact whether class is analytically useful. Assuming every can be a capitalist is not the same as everyone being a capitalist – the reason for splitting into class is that different classes clearly act in certain ways: recipients of profits are less likely to consume their income than recipients of wages, for example.

      I’m not sure those papers you cite are ‘class’ in the sense I meant, and they also seem to fit my characterisation of post-hoc modifications to a model that try to bend it to create a crisis that the original model didn’t predict.

      • #10 by pontus on August 27, 2012 - 2:53 pm

        Does Keen’s model rely on the fact that he abstracts from preferences? If not, what is so damn bad with using preferences? If so, wouldn’t it be interesting to know to what extent this assumption is important, and to what extent his assumption receives some empirical support?

        One thing which puzzles me with the criticism raised on this blog and from other “heterodox economists” is the tendency to “shoot” at anything that moves. Part of your blogpost criticises the idea that macroeconomics should derive from microeconomics (anything else is unscientific!). And in the same breath macro models are criticised for not being microeconomic enough (representative agents are bad as we know there is no such thing! more disaggregation please!)

        Agent based modelling, which often leads to chaotic or complex behavior, is to a large extent much much more microfounded than the current vintage of macro models.

      • #11 by Unlearningecon on August 27, 2012 - 3:54 pm

        I have problems with preferences but I don’t reject the idea completely – it’s just that economists reject models like Keen’s based on the idea that preferences are the only feasible way to model things.

        Note that I said in this post that RAs are not in and of themselves a bad thing. I just think 1 is indefensible, and 2 is still not enough. Also neoclassical ones rely on the preference driven behaviour we have been discussing.

      • #12 by ivansml on August 27, 2012 - 9:23 pm

        re: preferences
        Newtonian physics doesn’t provide causal explanation for gravity – instead it just provides equations such that the movement of planets looks as if it was described by such equations. Nobody finds this problematic, so why is it so hard to accept the possibility that behavior of people _could_ be described as if it was an outcome of utility maximization, even if utility maximization is not a literal description of human behavior? The “as if” part should be of course subject to empirical testing, and behavioral economics can provide such tests. Some of them contradict the neoclassical theory, and some of them actually support it.

        re: class
        Recipients of wages are more likely to consume their whole income because of their low wealth and binding borrowing constraints, not because of class. And they have low wealth because of lower human capital, or lower patience, or bad luck, or some other reason, not because of an ad-hoc label such as “class”. Thinking in terms of class at best obscures underlying fundamental causes of heterogeneity across households, and thus I don’t see how it can be analytically useful.

      • #13 by Mathieu Dufresne on August 27, 2012 - 10:27 pm

        Newton’s gravitation does provide a causal relationship since the force of gravity depends on mass and distance. I think you’re confusing Copernicus and Galileo with Newton.

        Aggregating groups who have similar behaviour together is useless because of heterogeneity of preferences, so it’s better to aggregate everyone together and assume homothetic prefrences, thus ruling out heterogeneity by assumption! I’m sorry but this is nonsense.

      • #14 by ivansml on August 27, 2012 - 11:54 pm

        @Mathieu:

        Isaac Newton would not agree:
        “I have not as yet been able to discover the reason for these properties of gravity from phenomena, and I do not feign hypotheses.” (from General Scholium, an essay appended to his Principia)

        My point was that _if_ you want to disaggregate, class is not a useful concept. There are plenty of papers which don’t have representative agent, I’m sure you’re able to use Google Scholar if you’re interested. These often even assume not two or three, but uncountable infinity of agents, which should satisfy Unlearning as well ;)

      • #15 by Mathieu Dufresne on August 28, 2012 - 2:53 am

        Newton’s model does imply a causality, that’s the meaning of “properties”. He says he doesn’t understand by which phenomenon the mass is the source of the gravity. For example, not understanding the mechanism of combustion at the molecular level doesn’t mean you can’t calculate the amout of the gas consumption of a car because you’re working at a higher level of aggregation.

        If you want to model an economy with one, two or four agents, you need to aggragate unless you want to model an economy who includes only one, two or four individuals. If an engineer comes up with a model of a brige made of four atoms, I woudn’t waste time listening to him. Now if you want aggregate different groups, you need… to regroud them. Classical economists used to call those groups class. Regrouping workers and firm owners together just make sense and you don’t have to bother if someone is in both group since you’re working at a higher level of aggragation. The profits goes in one account and wages in another and you can add investments coming from wages (you have to model the financial system in order to do that). I think you’re rejecting “class” because interpet it as an ideologically loaded word.

        Agent-based models are an improvement and aren’t about equilibrium but I woudn’t consider them as mainstream since those are marginal and underdevelopped. Still, I don’t put to much faith in those, I expect their robustness will be nearly nil. I don’t think modeling a structure from the behaviour of elementary particles is the best research strategy…

      • #16 by ivansml on August 28, 2012 - 11:45 am

        Newton’s theory doesn’t explain what mechanism causes gravity. And some of Newton’s contemporaries criticized his theory precisely for this, for postulating existence of “occult”, unexplained mechanisms such as immediate action at distance. Newton’s reply was that his theory matches reality, and speculating about “true” causes on purely theoretical level was useless. Now I’m no philosopher of science, but this sounds not that far from instrumentalism and Milton Friedman’s “only predictions matter” methodology.

        Whether you like it or not, due to its history, class _is_ an ideologically loaded word (and I’ve yet to find a free-market marxist). And even if it wasn’t, it’s up to its proponents to justify that this is the best way to disaggregate and distinguish groups of economic actors. Above I wrote some reasons why I think it’s not, and so far I haven’t read anything that would change my mind.

      • #17 by Mathieu Dufresne on August 28, 2012 - 9:52 pm

        You said :

        Newtonian physics doesn’t provide causal explanation for gravity – instead it just provides equations such that the movement of planets looks as if it was described by such equations.

        I’m sorry but this is a false claim, Newton’s equation isn’t descriptive but imply a causation running from mass and distance to the force of gravity. It’s not an “as if” model and the force of gravity truely depends on mass and distance. That’s why it’s predictive and allowed Le Verrier to predict the existence of Neptune. Not understanding the mechanism underlying this causality doesn’t mean there’s none.

        Friedman was basically saying absurdity of assumptions doesn’t matter as long as the model fits the datas. Unlearning already explained how Friedman failed to understand scientific methodology, which is not the case of Newton. If the assumption itself is known to be false, it’s a counter-factual assumption and it does matter. Although it looked absurd to Newton, assuming immediate action at distance isn’t a counter-factual assumption since the gravity truely act “as if”, he doesn’t assume it knowing it’s false, it just follows from empirical datas. Friedman instead argue that you can derive a theory using absurd assumptions in armchair theorizing mode and juge the theory according to it’s predictions. This is just wrong, the theory won’t be predictive. If you derive a theory by assuming the earth is the center of the universe and everything revolves around it or that everyone has the same expectations about the future and the gap between expected inflation and actual inflation is zero, the only way you can make it fit the datas is by arbitrarily adjusting the parameters. Of course, this theory has no predictive power and any deviations of actual datas from the predictions is “explained” by exogenous shocks and less than optimal adjustments that are all arbitrarily manipulated to make the model fit the datas. It’s just like having Ptolemy arguing that the deviation of planets from their predicted trajectory is caused by exogenous shocks and the model is still valid, we just have to adjust the epicycles.

        Regarding classes, you have three choices:

        1. Assume profits and wages are spent the same way
        2. Assume profits and wages are spent differently
        3. Ignore the issue

        I could start from 3 since you gotta start somewhere but in a more sophisticated model, I’m gonna definitely choose 2.

      • #18 by ivansml on August 28, 2012 - 10:51 pm

        And mass is defined how? As a constant of proportionality between force and acceleration. You cannot measure mass independently without referring to forces caused by it. You can use the theory to make predictions (like how would Earth’s movement change if Moon was suddenly sucked away by a wormhole), but it doesn’t answer the question what causes gravity in the first place, which is what I meant by “doesn’t provide causal explanation”.

        As I said, I don’t feel as an expert on methodology and philosophy of science, so I don’t want to get into long discussion about Friedman (1953). But here are few uninformed thoughts anyway:

        – there is no official methodology of science (otherwise, all the philosophers working in the field would be out of work). There are different approaches that can be argued about or criticized, but it doesn’t make sense to say that “Friedman failed to understand scientific methodology”

        – as always, everything is a matter of degree. Sure, if you interpret Friedman’s arguments in extreme way, you can criticize them easily. But his main point, that every model contains some false assumptions (otherwise it wouldn’t be a model), and thus dismissing the model solely because of this is not reasonable, is hard to argue with.

        – if, as you say, theory is based on false assumptions and its fit with data is obtained only through overfitting, then it will be sooner or later rejected out of sample and thus its predictions will no longer match the data; according to Friedman’s methodology, it will be then rejected. Problem solved.

      • #19 by Min on August 29, 2012 - 12:56 am

        On Newtonian gravity and causality:

        Newtonian gravity lacks what Aristotle called an efficient cause. Newton did not posit a graviton or other mechanism to carry the gravitational force between objects. Hence the objections of “action at a distance”.

      • #20 by Min on August 29, 2012 - 1:06 am

        ivansml: “- as always, everything is a matter of degree. Sure, if you interpret Friedman’s arguments in extreme way, you can criticize them easily. But his main point, that every model contains some false assumptions (otherwise it wouldn’t be a model), and thus dismissing the model solely because of this is not reasonable, is hard to argue with.”

        As you say, everything is a matter of degree. :) It would perhaps be better, then to say that each model contains some approximations, rather than that it contains some false assumptions. Then a model may indeed be criticized if its assumptions are a bad fit for observations.

      • #21 by Unlearningecon on August 30, 2012 - 4:59 pm

        ivansml, OT but Chris Dillow is as close as you’ll get to a ‘free market’ marxist.

        The problem with utility is that it doesn’t really make testable predictions. As Mathieu pointed out, Newton’s Laws predicted the existence of neptune. Utility theory generally predicts that people act to maximise ‘utility,’ which doesn’t have units afaik. So how do we test it?

        And class needn’t be about ideology. Richard Wolff made the point that ‘class’ is really about ‘classification’ – in science, we must classify between different groups. Again, Mathieu already pointed out that it’s more about the distinction between different types of income (interest, profit, wages). Many business owners earn wages and as such could simultaneously be considered capitalists and workers.

        As for Arrow-Debreu styles models, well yes they aren’t really RA but consumers are very similar, to the extent it could be argued they are identical. Obviously A-D has problems elsewhere, which I alluded to in the previous post on Debunking Economics.

        Science does not have an explicit methodology but your average scientist would recoil in horror at the assumptions of economics. Basically, they learned long ago where to draw the line. Economists just don’t see it.

      • #22 by ivansml on August 30, 2012 - 7:27 pm

        That’s not a valid comparison. Newton’s laws predict existence of Neptune not on their own but only once you feed in data about motions and masses of Sun and other planets. In the same way, utility maximization has weak implications by itself (though it has some, like symmetry of Slutsky matrix), but once you specify preferences, technologies and endowments, your model will have specific predictions.

        Arrow-Debreu allows you to include as many and as heterogeneous consumers as you want, so I really don’t see in which sense they’re suposed to be identical. With more complicated model, you may (or may not) run into problems (non-uniqueness, instability,…), but that’s life.

        Natural scientists know probably even less about formal methodology than economists – their fields are less messy than social sciences, so they don’t need it. But when they venture into situations where empirical evidence is scarce, they’re not immune from controversies either (e.g. string theory).

  3. #23 by Roman P. on August 27, 2012 - 10:40 am

    “How do those dumb pieces of rock and gas do it?”
    I am not sure if you are trolling here or or what… Planets don’t calculate anything by themselves, their movement is deterministic (in terms of the Newton’s Laws) if chaotic. But for the neoclassical consumer choice theory to work, consumers have to be able to make economic calculations themselves to make a meaningful distinction of their choices. If they can’t do that, neoclassical theory does not describe realistic consumers’ choices.

    The inability to make necessary calculations to make a choice in a realistic amount of time is the reality we all have to live in. You just can’t solve problems of exponential complexity with a few milliFLOPS of computing power available to the human minds. Actually, not even supercomputers can solve them. All that is left to us are rules of thumb, habits and educated guesses. In light of that fact, I don’t understand why perfectly rational models are so persistent.

  4. #24 by Min on August 27, 2012 - 1:42 pm

    ivansml: “N-body problem is also computationally hard, yet planets “solve” it without any problems. How do those dumb pieces of rock and gas do it?”

    The planets do not solve the N-body problem, they are part of the problem.

    • #25 by Unlearningecon on August 27, 2012 - 2:07 pm

      I have learned repeatedly that economists make far too many physics analogies to areas that they don’t really understand/know about.

  5. #26 by Min on August 27, 2012 - 5:21 pm

    pontus: “If capitalists are chasing profits, they would be fools hoarding currency which pays no interest.”

    I think that the point is that they lend it out at compound interest, which is not in itself productive.

    • #27 by pontus on August 27, 2012 - 8:17 pm

      But doesn’t the recipient of that lending spend it on something? Otherwise, wouldn’t they be fools to pay interest on something they’re not planning to use?

      And if capitalists lend out money to someone who spends it (on commodities supposedly), how can there be “insufficient demand for commodities”?

      • #28 by Unlearningecon on August 27, 2012 - 11:30 pm

        Regardless of whether we think capitalists are fools (as a quasi-marxist, I might even agree there!), history teaches us that they do accumulate wealth. Just look at corporate holdings at the moment.

      • #29 by pontus on August 28, 2012 - 9:32 am

        First, accumulating wealth and accumulating currency are different things. The idea that rich people tend to hold a lot of currency is testable, and my suspicion is that it receives very little empirical support.

        Second, that corporations (and individuals) tend to hold cash right now is a different story. Nominal returns on “safe” bonds is virtually zero, and holding cash is part of an optimal portfolio strategy. But that’s a liquidity trap, and that’s a different thing. There is nothing marxist or heterodox about this idea.

        Third, it should also be noted that these corporate cash holdings to 90% (or more) take the form of “cash equivalents”. That’s a different story. A cash equivalent is an asset, and when these are bought, currency switches hands.

        So my questions to you are:

        1, Are you claiming that Say’s law is violated because capitalists are continuously sitting on a big pile of cash? (let’s call this the Uncle Scrooge hypothesis)

        2, If so, are there any evidence of this type of behaviour going on beyond the precarious situation of 2008-2012?

        3, Why couldn’t an internal devaluation offset this stock piling behaviour?

        and lastly, what is wrong with the neoclassical story here? That is, that economic agents tend to hoard cash in periods of low nominal interest rates and an uncertain future. These stock pilings reduces nominal demand, and if prices are rigid, also real demand. The fall in real demand chokes economic activity and we fall into a crisis.

      • #30 by Unlearningecon on August 30, 2012 - 5:03 pm

        1. Yes, well that is one reason. It doesn’t have to be ‘big,’ though.

        2. I have responded to that with links below.

        3. Because devaluation makes cash an even better asset to hoard! Also, ‘global capitalism’ as a whole cannot devalue.

      • #31 by rf on August 28, 2012 - 4:48 pm

        I’m sensing a lot of confusion between the nominal and really real variables (that is, actual commodities instead of nominal / price level) as well as between stocks and flows. Here’s my take on things (probably incorrect):

        Capitalists borrow money (M) to invest in commodities (C) in order to sell those commodities later at a profit (M’). Suppose the capitalist borrows an amount i (nominal $). The money is entirely spent on capital and labour. If we assume that the income generated is entirely spent, then aggregate demand is i. However, the capitalist wants to make a profit, so the total price of the commodities sold is i + p > i. If p is not entirely spent, then the market will not clear – there will be an over-supply.

        Now, I’m not sure to what extent this refutes Say’s law since, as you point out, hoarding (of p) will take the form of assets – money lent. p is lent out until the final borrower spends it, at which point supply and demand are brought into equilibrium. As long as the government is willing to act as a borrower of last resort (banks hold “reserves” as bonds which are cash equivalents) then I see no reason why there would be a positive cash hoarding flow.

      • #32 by Min on August 28, 2012 - 5:51 pm

        pontus: “The idea that rich people tend to hold a lot of currency is testable, and my suspicion is that it receives very little empirical support.”

        In the modern world, the gov’t sells bonds to the rich so that they won’t have to hold or spend money. Right? (Among other reasons.)

      • #33 by pontus on August 28, 2012 - 8:00 pm

        “In the modern world, the gov’t sells bonds to the rich so that they won’t have to hold or spend money. Right?”

        Right. I don’t think that’s the purpose of debt accumulation, but the government does sell bonds. But that money goes somewhere, right? And when it does, it’s spent. The bottomline is that, for the story to hold, there has to be some uncle scrooge somewhere bathing in currency. And that sucker must sit on cash earning zero nominal interest. Who’s the idiot?

        And even if that story goes through, there are indeed uncle scrooges, why doesn’t prices and wages just fall (or increase less), so that it wouldn’t have any effect on the macroeconomy (spending $80 will entertain as many goods as spending $100 if prices and wages fall by 20%). And if prices and wages do adjust, people should salute these scrooges — they are the ones being hit by the inflation tax. The rest of us benefit.

        Neoclassical economics emphasises internal consistency. I believe heterodox theories should adhere to this ideal as well.

      • #34 by Min on August 29, 2012 - 1:10 am

        Moi: “In the modern world, the gov’t sells bonds to the rich so that they won’t have to hold or spend money. Right?”

        pontus: “Right. I don’t think that’s the purpose of debt accumulation, but the government does sell bonds. But that money goes somewhere, right? And when it does, it’s spent. The bottomline is that, for the story to hold, there has to be some uncle scrooge somewhere bathing in currency. And that sucker must sit on cash earning zero nominal interest. Who’s the idiot?”

        The idiot is the gov’t. Or the central bank. (Or actual idiots. ;))

      • #35 by pontus on August 29, 2012 - 6:34 am

        If it’s the central bank, that’s a monetary contraction. And I agree that contractionary monetary policy can have an, ehh, contractionary effect. So no disagreement here.

        So I suppose the reasoning is that capitalists make profits, they wish to invest this profits, and buys government bonds. The central bank then contracts the money supply and the economy is always plagued by insufficient demand.

        Isn’t this argument a little strained? Is it really correct to “blame” the capitalists?

      • #36 by Min on August 29, 2012 - 4:40 pm

        pontus: “Isn’t this argument a little strained? Is it really correct to “blame” the capitalists?”

        I don’t think that it is a question of blame. What happens, maybe in every monetary system, is that money flows from those with a high propensity to spend to those with a low propensity to spend. In our society the latter are capitalists. In the extreme, as Nick Rowe has pointed out, the central bank owns everything. ;) In the practical extreme, we get a caste society, which, as we know from history, can last for centuries. In a democratic society we need to keep money flowing through the system. The only institution that can guarantee that is the gov’t.

      • #37 by pontus on August 30, 2012 - 9:13 pm

        Unlearning,

        1, Ok. But you should pity them a little too. They are the ones being hit by the inflation tax, and that’s non-negligible.

        2, No, you answered with links concerning the current situation. As I said, cash hoardings in a liquidity trap is a very mainstream view. What I wanted to see was evidence of the ongoing process of stuffing the mattresses with cash and the continuous deficiency of nominal demand.

        3, No it doesn’t! Given a future path of prices, a fall in the current price level increases inflation, and doesn’t decrease it! The return on money therefore falls. Jeez … you’ve really unlearnt a little too much.

      • #38 by Unlearningecon on August 31, 2012 - 8:43 pm

        1. It’s not really about feeling sorry for them, hating them or whatever – I’m just describing how the system works.

        2. I don’t think that’s true? Dillow’s graph shows the UK has oscillated; Thoma’s and the final one show historic positive corporate surpluses.

        3. OK I really don’t get this. If there is a fall in the general price level, cash increases its real value, no?

      • #39 by pontus on September 1, 2012 - 10:27 am

        1, Fair enough. So I guess that you agree with the statement that the capitalists are hit the most by the inflation tax.

        2, I was not convinced at all by Dillow’s graph. That just shows a moderately oscillating line with no apparent relation to recessions (apart from the latest, but what macroeconomic time series doesn’t have that!). Rebecca Wilder (not Thoma) “backs out” the corporate savings rate from the current account. This sounds like very shady business to me, and is much more likely to be driven by exports.

        And if you really want evidence for some paradox of thrift, should savings actually fall, not rise, in recessions. I mean, isn’t that the core of the argument? By an increased desire to save, we end up saving less? From that perspective, all these graphs goes the wrong direction.

        3, Yes, if prices fall, the value of money increases. But that’s a contemporaneous effect. If you are planning to store money, you’re probably interested what the value of that money will be in a year (or whatever). If that is held constant a fall in the price level today increases inflation, and makes people less willing to save. For your story to work, you will need the fall in prices today to happen simultaneously with an even larger expected fall in the future.

        It’s the same with any asset, for instance. If bond prices rise, the value of bonds increases, but their return fall. And so on.

      • #40 by Unlearningecon on September 3, 2012 - 3:29 pm

        1. I’d argue that bankers are hit harder – capitalists have nominal debts too and as such might benefit somewhat. This is besides the point, anyhow.

        2. There needn’t be a relationship to recessions? Anyway, I think at least the last link shows a positive corporate surplus across time, which is all Im trying to show.

        3. I’m really not getting this. A fall in the price level is deflation, so how can it cause inflation?

        For your story to work, you will need the fall in prices today to happen simultaneously with an even larger expected fall in the future.

        Not sure why it must be larger, but this is precisely what I’m saying, no? General deflation causes an increase in demand for cash, rather than correcting an imbalance arising from said demand.

      • #41 by Diarmid Weir on September 1, 2012 - 11:46 am

        @ pontus

        ‘And if you really want evidence for some paradox of thrift, should savings actually fall, not rise, in recessions. I mean, isn’t that the core of the argument? By an increased desire to save, we end up saving less? From that perspective, all these graphs goes the wrong direction.’

        This is about corporate ‘saving’, is it not? If corporate revenue flow exceeds corporate spending flow over some defined period, the resultant stock increase is saving. The form of the net saving will be as liabilities of other sectors so generally bank deposits, govt bonds, foreign corporate bonds and foreign shares. If the reduction in overall spending includes a reduction in investment, then for this sector, whatever else is going on, increased saving accompanies reduced investment.

        Of course none of this says anything about causation – although the standard Keynesian view would be that corporate investment (or lack of it) is the most discretionary part of economic activity.

      • #42 by pontus on September 5, 2012 - 11:09 am

        Unlearning,

        You seem to agree that a rise in the real return of an asset increases the desire to hold that asset.

        The real return on money is p/p’, where p is the price level (cpi) today, and p’ the price level at the end of the planning horizon (say in one year).

        Now, we both seem to agree that an increase in cash hoarding will lead to a fall in the contemporaneous price level, p. I agree with this. You claim that this will cause deflation, and therefore raise the return on money and just incite even more cash hoardings and so on. I do not agree with this.

        Let’s check.

        If p falls, then p/p’ falls given a certain value of p’. Thus, the return on money falls, and people wish to hoard less, not more, cash. So, the only way your story can go through is if [expected] p’ fall by more than p. Only then will the fall in current prices cause expected deflation.

        I think the misunderstand springs from a careless usage of the word “deflation” and “inflation” on my part. When it comes to investments (in cash, or in any other assets), these are determined by future, and not current returns. So the real return on money is determined by expected inflation, not present inflation.

      • #43 by Unlearningecon on September 9, 2012 - 5:51 pm

        You claim that this will cause deflation, and therefore raise the return on money and just incite even more cash hoardings and so on. I do not agree with this.

        I do not claim hoarding money leads to deflation – I claim deflation leads to hoarding money. I think this was a misunderstanding. However i think deflation itself creates expectations of future deflation, which seems to be the missing link.

  6. #44 by BFWR on August 27, 2012 - 7:29 pm

    Money is basically accountancy. That is bedrock commercial REALITY, NOT theory which is an abstract of varying point from that reality. Cost accounting ENFORCES the convention that the rate of flow of total incomes will always be less than the rate of flow of total prices. Just compile the numbers for any given period of time and equate prices with incomes by supplementing incomes in an utterly democratic way like with a citizen’s dividend and a general discount on prices to eliminate any demand push inflation for the same period and Voila! stability…..and economic democracy and INDIVIDUAL economic sovereignty to boot.

    The Quantity THEORY of money and the velocity of its “circulation” are undercut, superceded and nullified by the REALITIES of cost accounting which are ever present for EVERY dollar that enters or re-enters the actual economy.

    C. H. Douglas SOOOOOO needs to be re-visited.

    Synthesize the power of the temporal universe, i.e. money and the the power of the inward, eternal world i.e. Human Wisdom by forthrightly crafting concrete policies accurately reflecting the condensation of Human Wisdom in the form of the ideas, values and experiences of Faith as in Confidence, Hope, Love and a sense of Grace….and you’ll have evolved profit making systems and based them on ADULT thinking and acting.

    It’s what I call my Monetary/Spiritual Synthesis Theory (MSST) Not a bit religious or mystical, just valid human psychological insight and accountancy based.

    • #45 by Unlearningecon on August 30, 2012 - 5:10 pm

      I believe a citizen’s income will never occur under capitalism for the very reasons its proponents endorse it.

      I liked the first part of your comment, not entirely sure what you’re saying in the second part!

      • #46 by BFWR on August 30, 2012 - 6:04 pm

        Hi, What I’m actually talking about in the second part is the philosophy of economics, in fact philosophy of all human systems. Our problem is that we are not committing to philsophy in any of our systems, or rather that the philosophies of each particular discipline like economics in the modern world are all compartmentalized. We need to integrate them all under the most humane philosophy possible. Until we do the world will remain fragmented, chaotic and manipulated and dominated primarily by wealthy interests.

      • #47 by Unlearningecon on September 4, 2012 - 11:27 pm

        Absolutely – I consider a broader social, historical and political context a vital part of reforming economics.

  7. #48 by Diarmid Weir on August 28, 2012 - 9:35 pm

    In response to pontus #32

    ‘Are you claiming that Say’s law is violated because capitalists are continuously sitting on a big pile of cash? (let’s call this the Uncle Scrooge hypothesis)’

    They don’t have to be ‘sitting on it’. They may just be circulating it amongst themselves and the central bank/government. You’ll then get high monetary aggregates and high bond holdings and low levels of productive economic activity.

    ‘…what is wrong with the neoclassical story here? That is, that economic agents tend to hoard cash in periods of low nominal interest rates and an uncertain future. These stock pilings reduces nominal demand, and if prices are rigid, also real demand. The fall in real demand chokes economic activity and we fall into a crisis.’

    Where’s the neoclassical explanation for price rigidity?

    • #49 by pontus on August 29, 2012 - 4:08 pm

      Diarmid,

      Granted, the money could be passed around as a hot potato. But the facts do remain: This is money, and it pays no interest. And it is not in the interest of “capitalists” to hold that type of asset. Again, this seems to me to be a testable story. But I doubt it will receive any empirical support.

      “Where’s the neoclassical explanation for price rigidity?”

      What do you mean? The original Island model by Lucas displays rigid prices because of asymmetric information. See here: http://en.wikipedia.org/wiki/Lucas_Island_Model

      • #50 by Unlearningecon on August 29, 2012 - 4:31 pm

        Capitalists don’t only have to hold the money as cash – they can save it, too. And the hoarding of cash predates the recession.

      • #51 by pontus on August 29, 2012 - 4:54 pm

        But what does it mean “saving” it? They have to save it in such a way that it is not being lent out to someone else.

        Does the hoarding of cash predate recessions? If so, where can I find the data? I’m seriously interested.

      • #52 by Unlearningecon on August 30, 2012 - 1:54 pm

        Of course, as always, the debate would now collapse into endogenous versus exogenous money (or loanable funds versus double-entry bookkeeping), so I’m going to evade the saving comment.

        There have been numerous discussions of corporate surpluses preceeding the recession in the blogosphere: here is Chris Dillow, Mark Thoma (if you look at the graph you will see it is historically almost always positive). Here is a historic graph.

      • #53 by Diarmid Weir on August 29, 2012 - 5:35 pm

        Holding an asset with zero return is better than making a loss. After all there are plenty of UK and US govt bonds being held at negative real rates right now.

        The Lucas Islands model may be neoclassical in structure, but its result is driven by an ad hoc communication failure, that in long-run neoclassical equilibrium would of course have been solved!

      • #54 by Diarmid Weir on August 29, 2012 - 6:41 pm

        In response to your question about ‘saving’.

        Aggregate deposits will remain the same irrespective of whether that money is circulating or not. In general, therefore, whether it is being spent (circulating rapidly) or saved (circulating slowly, or not at all) shouldn’t have much direct effect on lending. It doesn’t alter banks’ reserves.

        Of course, indirectly, faster money circulation implies more economic activity so lending has a greater return – so there should actually be a positive correlation between ‘spending’ and lending.

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