Whig Theories of the History of Thought

Yesterday, Paul Krugman had a post in which he pontificated on the Stock Flow Consistent (SFC) models of the economy used by Wynne Godley (and generally by post-Keynesians). These models focus on simple flows of funds between sectors, use endogenous money mechanics and are consistent with accounting identities, making them highly suitable for modelling financial crises. Krugman, however, is not impressed. He seems to see these simple mechanics – with relationships between sectors determined by coefficients – as not quite ‘rigorous’ in the same way as the type of optimising, equilibrium model he favours. He believes that “Hydraulic” approaches like Godley’s have been supplanted by superior models, and so it would be a step backward to take another look at them.

It is worth noting that Krugman’s dismissal of these “hydraulic” models is strange given his zealous promotion of IS/LM, which is surely a hydraulic model if there ever was one: variables are simply determined by coefficients and left largely unexplained in terms of typical ‘optimising’ behaviour. More importantly, though, I think Krugman has quite an ignorant conception of how economic theory has developed. He tries to paint picture of economics as continually discovering new and interesting insights, but the reality is far more complex. In fact, many of the ‘insights’ mainstream economics claims to have discovered were already known; what’s more, their solutions to the purported problems with “hydraulic” models leave a lot to be desired. Often the only problems with a theory resulted from misinterpretations of particular thinkers, and, properly interpreted, the model offered a credible alternative to the neoclassical approach. Overall the history of economic thought is not really a clear cut story of scientific progression.

Yet Krugman sees things through a ‘Whig‘ perception of the history (of thought), where everything has progressed over time and culminated naturally in what we have now. He thinks that macroeconomics in the 1950s and 60s was similar to Godley’s work, but that it was abandoned for good reasons:

What you might not realize from this passage is that Godley’s notion that we should represent behavior by rules of thumb isn’t something new — it’s something old, which got driven out of macroeconomics. The “hydraulic Keynesianism” of the 1950s was all about viewing the economy as a kind of mechanism in which consumer behavior could be represented by an ad hoc consumption function, investment behavior by an ad hoc investment function, and so on. This produced a more or less mechanistic view of the economy, and AW Phillips famously represented hydraulic macro with a literal hydraulic mechanism.

I’m glad Krugman knows about Phillips’ wonderful MONIAC model. However, economists really misinterpreted Phillips, as this is clear in Krugman’s discussion of his work. His ‘curve‘ – which Krugman goes on to reference – was supposed to be a dynamic model of how unemployment and inflation change over the business cycle, not a static trade off between the two. Furthermore, Phillips’ models also included expectations, one of the supposed strengths of the models that displaced his. What’s more, Phillips was well aware of the problem of how the economy may evolve and change over time or with policy – as he put it:

In my view it cannot be too strongly stated that in attempting to control economic fluctuations we do not have two separate problems of estimating the system and controlling it, we have a single problem of jointly controlling and learning about the system, that is, a problem of learning control or adaptive control.

Krugman doesn’t reference this point – known by the mainstream as the Lucas Critique – explicitly, but this is the major reason “hydraulic” models were abandoned in favour of the ‘microfounded’ models Krugman endorses: it was thought that the latter would not be as susceptible to change with policy. However, this insight had been stated by many long before Lucas – not only Phillips above, but also Keynes – and it is a continual problem, so we cannot ‘immunise’ ourselves from it with microfoundations or anything else. The heterodox economists Krugman dismisses so blithely were actually more alert to the problem than he was, because they didn’t think they had – or could – supersede it.

Krugman now discusses why his favoured ‘optimising’ approach took centre stage in the 1970s and 80s:

So why did hydraulic macro get driven out? Partly because economists like to think of agents as maximizers — it’s at the core of what we’re supposed to know — so that other things equal, an analysis in terms of rational behavior always trumps rules of thumb.

I’m not sure this even counts as a defense of economist’s approach, because it is hopelessly question-begging. Economists shouldn’t model a certain way “because [they] like to”; they should do it because it is more consistent with observed phenomenon. Rational behaviour doesn’t really “trump” anything, as it is largely unobserved in the real world, whether on the part of firms, consumers, governments or what have you. All this point actually demonstrates is how economists can be predisposed toward a certain framework, regardless of predictive success or failure.

However, Krugman thinks that the neoclassical approach has been largely a predictive success when compared with its “hydraulic” counterpart, and puts forward two major points to show this:

First involved consumption spending. Conventional Keynesian consumption functions suggested that the savings rate would rise as incomes rose — and this wasn’t just the Keynesian interpreters, Keynes himself made the same claim….In fact, however, savings rates don’t seem to follow the naive consumption function at all; they rise in booms, and are higher for the wealthy, but exhibit no secular trend. And Milton Friedman appeared to explain this paradox by arguing that people are more less rational: they base consumption on “permanent income”, a reasonable estimate of long-run income, and save temporary fluctuations in income.

First, as Ramanan quickly noted, Wynne Godley’s model did not suggest the savings rate would rise as incomes rose; in fact, it was the opposite. So his model was perfectly consistent with observed behaviour, and there was no need to invoke optimising agents to ‘explain’ anything.

Second, if we were looking for a model of consumption based on human behaviour, Friedman’s permanent income hypothesis – where people spent money as a function of their total lifetime, rather than current income – was not the first or best theory for the job. In fact, it actually displaced a better theory, the relative income hypothesis. This suggested that people’s expenditure was a function of what people around them were spending, or the norms in a society. Poor people’s consumption would be a higher percentage of their income because they were trying to “keep up with the Joneses”; however, as incomes as a whole rose, so would the socially acceptable level of income, so savings rates would not rise with total income. This kind of airy-fairy explanation is like nails on a blackboard for many mainstream economists, but it is more consistent with both the statistical evidence and observed human behaviour.

Krugman’s second point in favour of neoclassical economics is the role of the 1970s stagflation as a vindication of the ‘rational agent’ approach:

In came Friedman and Phelps to argue that rational price-setters would build expected inflation into their choices, so that sustained low unemployment would produce accelerating inflation. And the stagflation of the 70s seemed to vindicate their argument.

Friedman and Phelps’ model may “seem” consistent with stagflation, but there are alternative explanations for stagflation, too, and the question is which one is most closely consistent with the mechanics of the phenomenon. In fact, Friedman and Phelps’ NAIRU theory’s major prediction – that past a certain level of unemployment, inflation will start to increase dramatically – actually has little evidence behind it. On the other hand, Andrew Lainton has pointed out that in Wynne Godley’s Magnum Opus, Monetary Economics, he developed a full model of stagflation that dealt with the 1970s quite competently. On top this this, Godley’s model, as well as similar ones like Steve Keen’s, are also well equipped to explain the recent financial crisis. As Noah Smith once argued, the best theories are those which can explain all phenomena within their domain, and models like Godley’s simply fit this description more closely. But Krugman doesn’t realise this, because he knows very little about the work of Godley and people like him – after all, why bother when they’ve been relegated to the dustbin of progress?

The only problems with economist’s 1950s view of inflation and unemployment stemmed from the ‘bastard Keynesianism’ of the 1950s and 60s, which resulted from misinterpreting Keynes and Phillips and trying to shoehorn them into the neoclassical approach. However, even if we accept ‘bastard Keynesianism’, Krugman’s point is questionable, as the prominent post-war economists Robert Solow and Paul Samuleson were also aware of the potential for the relationship between inflation and unemployment to become unstable. Therefore, claiming that Friedman and Phelps swept in with new, largely successful insights is a stretch to say the least.

Essentially, Krugman believes in a Whiggish conception of the history of thought, where good ideas have driven out the bad, and economics has slowly made better and better predictions. But like all Whig history, Krugman’s opinion rests on arbitrarily placing current theory as the inevitable goal of complex and fractured processes, ignorance of things that don’t seem immediately relevant to these theories, and above all, a good old bit of self-aggrandisation. While I don’t want to tar too many with this brush, judging from the way I was taught, and what I’ve seen elsewhere, it seems that a large part of the discipline thinks this way. But the development of economics has been far more complex, and alternative theories are far more credible, than such a narrative would have you believe.

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  1. #1 by Max Stirner on September 14, 2013 - 4:12 pm

    Congatulations. This is an excellent post. Krugman is an example of the most basic of economic principles:there are 24 hours in a day, so if you are writing all day each day, inevitably you don’t have enough time to read and think in depth about the ideas others have written and thought, and consequently your opinions on them are obviously shallow.

    • #2 by TACJ on September 14, 2013 - 4:43 pm

      This is particularly ironic given his reasons for not using Twitter:

      it turns out that many prominent people have inner demons of one kind or another — often homophobia, but also racism, sexism, or just some kind of generalized contempt for large numbers of other people. And social media make it all too easy for those demons to slip out in front of a large audience.

      I don’t think I have any demons like that, but who knows?

      Maybe whiggishness is Krugman’s inner demon?

      http://krugman.blogs.nytimes.com/2013/09/13/death-by-tweet/

      • #3 by Unlearningecon on September 15, 2013 - 3:07 pm

        I think the “inner demon” of many liberals is something of a reactionary bent: yeah, let’s do this, but let’s not go too far! This means that when they argue leftward they simply end up sounding conservative. So I wouldn’t be surprised if Krugman has quite a Whiggish conception of history (recall his discussion of the Domar model on my last post).

  2. #4 by Tokyo Torquemada on September 14, 2013 - 9:06 pm

    Excellent post. One reason that economists such as Krugman distrust Godley-esque approaches is that they deal with ‘real numbers’ – that is generally available economic data is the base of the approach (precisely, of course, why some of us like the SFC approach). Though it may seem extreme to say so, they don’t actually know anything about such mundane categories of data, and regard it as an impertinence that they be introduced into ‘economic’ argument. So I am not sure ‘Whig’ is the correct description of their type of perspective. It’s actually a much deeper difference in view as to what constitutes ‘sophistication’.

    • #5 by Unlearningecon on September 15, 2013 - 3:21 pm

      That’s an interesting point. For some economists, the Lucas Critique has rendered building a theory on observed data completely invalid. Yet they insist that we build up from mathematical relationships such as utility functions, which we are told represent people’s behaviour to a sufficient degree, even though their relationship to observed behaviour is limited at best. I struggle to see which problems this approach solves.

      • #6 by Min on September 17, 2013 - 2:23 am

        Well, it solves the problem of not conforming to data. ;)

  3. #7 by Don Shaughnessy on September 15, 2013 - 3:29 am

    Fine post. Thank you. As with physicists, the theories tell us more about how economists think than they do about the real world.

  4. #10 by Lord on September 15, 2013 - 4:43 am

    Rational is a non sequitar; if it exists, it is rational, and if it doesn’t seem so, you just haven’t figured why. However Krugman has called out the dark age of macro before, he just may have missed its start.

    • #11 by Unlearningecon on September 15, 2013 - 3:22 pm

      When you say ‘non sequitur’ do you perhaps mean ‘circular’? As in, similar to Joan Robinson’s point that rationality or utility maximisation is defined by what people do, and we can only verify it by…looking at what people do!

  5. #12 by Rizwan on September 15, 2013 - 6:42 am

    Excellent post once again. Maybe economics only progress one funeral at a time.

    • #13 by Unlearningecon on September 15, 2013 - 3:02 pm

      That’s certainly an optimistic view :)

  6. #14 by Ramanan on September 15, 2013 - 6:23 pm

    Good post.

    I think Krugman got everything wrong starting from the title.

    Coddington was referring to Samuelson and IS/LM when he talked of Hydraulic Keynesianism. Also, the hydraulic analogy is misleading. Morris Copeland who discovered/invented the flow of funds analysis and around which PKEism is added in the G&L models actually wrote on this and used the phrase Money Circuit instead, saying hydraulic is misleading.

    http://www.nber.org/chapters/c0838.pdf

    • #15 by Unlearningecon on September 15, 2013 - 8:47 pm

      I agree, though as @austerity_sucks has pointed out on twitter, Godley himself did use the idea of hydraulics too. However, he considered it only a starting point and was more concerned with other key points, something you note in one of your posts on this matter.

  7. #16 by Roman P. on September 16, 2013 - 9:32 am

    Sometimes I entertain a thought that Krugman is actually a closeted Post-Keynesian and sleeps with ‘Stabilizing an Unstable Economy’ under his pillow. Mostly he tries to put a facade of a mainstream economist, but sometimes (i.e. here and there in the popular books) the heterodoxy shines through. If I remember correctly, ‘The Return of Depression Economics and the Crisis of 2008′ contained some sensible Minskian ideas and gave an impression that Krugman understands the mechanics and dangers of leveraging debt.
    Nah, probably just wishful thinking. Still, I can imagine Krugman strangling his liberal consciousness and writing certain things (debt doesn’t matter in the aggregate? banks just re-lend?) because he has to maintain a reputation of being a heterodox but not TOO heterodox.

    • #17 by Unlearningecon on September 17, 2013 - 11:47 am

      Yes, Krugman’s approach is really just to throw a fish to us heterodox economists every so often, so that we’ll bark and clap our flippers together while he gets back to his maximisation and equilibrium. Dan Gay had similar comments when Krugman mentioned Kalecki.

  8. #18 by Noah Smith on September 17, 2013 - 3:34 am

    Good post.

    But you give SFC models too easy a pass.

    This is a claim without evidence: “On top this this, Godley’s model, as well as similar ones like Steve Keen’s, are also well equipped to explain the recent financial crisis.”

    As is this: “models like Godley’s simply fit this description more closely”

    I want quantitative proof of data-fitting before I believe claims like this. And as Stephen Kinsella has noted, quantitative proof of this does not yet exist.

    • #19 by Roman P. on September 17, 2013 - 9:09 am

      Noah,

      What exactly do you mean by SFC models here? Do you mean it as the content (the inner mechanics) of theories of those who employ SFC models, or as the form in which they are expressed? I’d argue that SFC models as popularized by Godley are inherently better than anything else just as double-entry bookkeeping is inherently better than a single entry accounting. They are more error-proof, allow to properly distinguish between the stocks and flows, assets and liabilities in macro-accounting.

      The SFC models as method of modelling economy do tend to exclude certain things (that violate double-entry accounting identities), but are otherwise suited to accommodate different theories on how economies work. Steve Keen (yeah, I know you won’t like this example) in one of his lectures made two SFC models of how banking works: one in which banks follow the exogenous money theory and act as warehouses for money, and the other where they are factories of money in an endogenous money fashion. Just how banks works and which model is a better one is, of course, an empirical question. There is no THE SFC model out there.

    • #20 by Unlearningecon on September 17, 2013 - 11:31 am

      Hi Noah, thanks for your comment.

      First, I appreciate I didn’t provide enough evidence for that claim – I started to write about it in depth and realised it would simply go on too long. However, I’m not really claiming that there exists an SFC model – or any credible macro model – that fits the data remarkably well (I’m aware you linked to one on your blog, but I don’t find that model’s internal mechanics particularly enlightening).

      Bearing this in mind, I merely look for models which have key causal mechanics correct, simply on the grounds that economics should not run before it can walk. Godley’s book is available online, and in chapter 9 they develop their theory of inflation. It’s not fitted to the data there, but it is shown to be consistent with the general trends of the 1970s (inflation, deficits, growth etc.) Also, unlike neoclassical models, it implies deflation in real wages will not achieve much.

      • #21 by Ramanan on September 17, 2013 - 7:25 pm

        “economics should not run before it can walk.”

        Right!

        Morris Copeland who created the U.S. Federal Reserve’s Flow of Funds said this:

        “The subject of money, credit and moneyflows is a highly technical one, but it is also one that has a wide popular appeal. For centuries it has attracted quacks as well as serious students, and there has too often been difficulty in distinguishing a widely held popular belief from a completely formulated and tested scientific hypothesis.

        I have said that the subject of money and moneyflows lends itself to a social accounting approach. Let me go one step farther. I am convinced that only with such an approach will economists be able to rid this subject of the quackery and misconceptions that have hitherto been prevalent in it.”

  9. #22 by Boatwright on September 19, 2013 - 4:05 pm

    The ongoing debate between Krugman and Keen on the IS/LM model is worthy of study. Keen convincingly demolishes IS/LM, finding it, when examined “nonsense”.

    Krugman’s reply, in his NY Times blog was an unconvicing, ad-hominen piece, in which he completely failed to answer Keen and then unilaterally declared victory.

    Keen’s critique asks: How can Krugman’s and other neo-classical economists’ too simple model of banking and their completely ignoring the role of debt in economic cycles possibly tell us anything?

    Interesting interview with Keen here: youtube.com/watch?v=iWEq27Ai6ZU

    • #23 by Boatwright on September 20, 2013 - 1:38 pm

      It should be noted as well that the original hydraulic model criticized by Krugman was an actual hydraulic setup with tanks of colored water, tubes, valves,orifices, etc. that attempted to model the economy by physical analogy. Called the MONIAC by its inventor, Wm. Phillips it was a strange Rube Goldberg affair. Phillips also developed the Phillips Curve which found a relationship between the level of employment and the rate of inflation. Both have been justifiably criticized as over-simplifications.

      The idea was advanced by Godley, using real-world data. Present day work by Steve Keen, using a multi-variable, heuristic, computer based system similar to that used in engineering analysis of complex physical systems has been yielding interesting results that closely model actual economic events. Keen’s math produces chaotic (Lorenztian) curves that show emergent properties WHEN FED ACTUAL ECONOMIC DATA………………………….

      Without actually addressing Godley & Keens’ work, Krugman seems to have lumped them together with Phillips’. It seems now that Phillips & Godley were men before their time, and perhaps Krugman needs to broaden his outlook to include actually reading those he criticizes.

      The votes are still out on Keen, but rejecting him out-of-hand is uncalled for.

      • #24 by Unlearningecon on September 24, 2013 - 10:50 am

        However, as Keen points out in his book, Phillip’s work was far more dynamic than economists gave it credit for, and had a role for expectations and changing relationships over time. Economists like Krugman don’t bother to examine original thinkers too carefully because they don’t think it’s ‘science’. But history shows over and over that this just leads to sloppy thinking and wrong turns, as with the ‘Phillips Curve’ of the 1950s/60s.

      • #25 by Boatwright on September 24, 2013 - 12:04 pm

        It’s interesting to contrast attitudes when a paradigm is challenged by original thinking. Mainstreamers like Krugman claim that newer and more complex ways of modelling a problem are ‘unscientific’ while falling back on moldy old thinking themselves.

        Meanwhile the more open-minded, willing to see new possibilities, modify, cut, improve, and above all EXPERIMENT and TEST a new direction. Phillips’ fundamental insight was to see the need for an inter-related, multi-variable, multi-dimensional set-up that could model over time. His problem was he didn’t have high-speed digital computing to build his model, not his fundamental insight.

        Keen’s math is dense. (Spend a few hours with Minsky, his downloadable computer program, and you will see it is both elegant, and I suspect way above Krugman and fellows’ math skills.)

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