This is part 2 in my series on why and how the 2008 financial crisis is relevant to economics. The first instalment discussed why the good times during the boom are no excuse for the bad times during the bust. This instalment discusses the use of the Efficient Markets Hypothesis (EMH) to defend economists’ inability to forecast the movements of financial markets, hereafter referred to as the ‘EMH-twist’.
Argument #2: ““The EMH claims that crises are unpredictable, so the fact that economists didn’t predict the crisis is not a problem for economics at all.”
As far as I’m aware, this argument was first used by John Cochrane, and it has reappeared multiple times since then: for example, it was more recently referenced by Andrew Lilco, who was sadly echoed by the generally infallible Chris Dillow. The idea is that financial markets process new information faster than any one individual, government or institution could, and so for most people they may seem to behave unpredictably. However, economists can not be expected to understand these sudden movements better than anyone else, so expecting them to foresee market crashes is absurd. As Cochrane puts it, “it makes no sense whatsoever to try to discredit efﬁcient market theory in ﬁnance because its followers didn’t see the crash coming”.
However, this logic is completely circular. The mere fact that a theory exists which claims crises are unpredictable does not mean that, if a crisis is not predicted – particularly by the proponents of said theory – this shows the theory is correct. If the EMH had, to the best of our knowledge, been shown to be correct, then the EMH-twist might hold some water, but we must establish this truth separately from the the fact its proponents didn’t predict the crisis (David Glasner recently made a similar point about the ubiquitous use of rational expectations in macroeconomics). While Cochrane does claim that the central tenet of the EMH “is probably the best-tested proposition in all the social sciences”, he fails to reference supporting evidence, and in fact goes on to add substantial qualifications to the empirical record of the EMH, admitting that market volatility might happen “because people are prey to bursts of irrational optimism and pessimism”.
It is not necessarily my aim to establish the truth or falsity of the EMH here: it has been discussed extensively elsewhere. However, there are a couple of key tests for whether or not it applies to 2008. The first is whether or not anybody - both adherents and detractors of the theory – foresaw the crisis. While the EMH claims nobody could, this is clearly wrong: some people in finance made a lot of money; some economists not only called it but had frameworks that explained it well once it happened; quite a few people (even mainstream economists) at least noted the existence of a housing bubble. The EMH can attribute these predictions to simple luck, but now we’re back to circularity: assume the EMH is true, then appeal to it to rationalise any possible market movement. The second test of the EMH, since it depends on new information to trigger volatility, is to ask exactly what new information became available just before the crash. However, the financial instruments key to 2008 were used by investment banks for a good few years prior to the crash, so it’s quite difficult to claim that new information about these suddenly became available in 2007-8. Instead, what happened was a collective realisation that everyone knew very little about the products they’d been trading, resulting in a classic panic.
In fairness, there is an element of truth to the EMH-twist. Financial markets are incredibly difficult to understand, and the argument that economists don’t yet understand them, along with a mea culpa, might be acceptable – there are many things natural scientists still don’t understand, such as dark matter, or what happened ‘before’ the big bang. However, the EMH-twist as used by Cochrane et al is phrased more strongly: it is the assertion that economists can’t and shouldn’t understand the movements of financial markets, simply because the EMH allows them to wash their hands of the task. We wouldn’t accept this kind of attitude from any other field, so I can’t help but feel Cochrane’s claim that “the economist’s job is not to ‘explain’ market ﬂuctuations after the fact” can only be met with: “then what is the economists’ job, exactly?”
The next instalment in the series will be part 3: econoracles.
For critics of mainstream economics, the 2008 financial crisis represents the final nail in the coffin for a paradigm that should have died decades ago. Not only did economists fail to see it coming, they can’t agree on how to get past it and they have yet to produce a model that can understand it fully. On the other hand, economists tend to see things quite differently – in my experience, your average economist will concede that although the crisis is a challenge, it’s a challenge that has limited implications for the field as a whole. Some go even further and argue that it is all but irrelevant, whether due to progress being made in the field or because the crisis represents a fundamentally unforeseeable event in a complex world.
I have been compiling the most common lines used to defend economic theory after the crisis, and will consider each of them in turn in a series of 7 short posts (it was originally going to be one long post, but it got too long). I’ve started with what I consider the weakest argument, with the quality increasing as the series goes on. Hopefully this will be a useful resource to further debate and prevent heterodox and mainstream economists (and the public) talking past each other. Let me note that I do not intend these arguments as simple ‘rebuttals’ of every point (though it is of some, especially the weaker ones), but as a cumulative critique. Neither am I accusing all economists of endorsing all of the arguments presented here (especially the weaker ones).
Argument #1: “We did a great job in the boom!”
I’ve seen this argument floating around, and it actually takes two forms. The first, most infamously used by Alan Greenspan – and subsequently mocked by bloggers – is a political defense of boom-bust, or even capitalism itself: the crisis, and others like it, are just noise around a general trend of progression, and we should be thankful for this progression instead of focusing on such minor hiccups. The second form is more of a defence of economic theory: since the theory does a good job of explaining/predicting the boom periods, which apply most of the time, it’s at least partially absolved of failing to ‘predict’ the behaviour of the economy. Both forms of the argument suffer from the same problems.
First, something which is expected to do a certain job – whether it’s an economic system or the economists who study it – is expected to do this job all the time. If an engineer designs a bridge, you don’t expect it to stand up most of the time. If your partner promises to be faithful, you don’t expect them to do so most of the time. If your stock broker promises to make money but loses it after an asset bubble bursts, you won’t be comforted by the fact that they were making money before the bubble burst. And if an economic system, or set of policies, promise to deliver stability, employment and growth, then the fact that it fails to do so every 7 years means that it is not achieving its stated objectives. In other words, the “invisible hand” cannot be acquitted of the charge of failing to do its job by arguing it only fails to do its job every so often.
Second, the argument implies there was no causal link between the boom and the bust, so the stable period can be understood as separate from the unstable period. Yet if the boom and the bust are caused by the same process, then understanding one entails understanding the other. In this case, the same webs of credit which fuelled the boom created enormous problems once the bubble burst and people found their incomes scarce relative to their accumulated debts. Models which failed to spot this process in its first phase inevitably missed (and misdiagnosed) the second phase. As above, the job of macroeconomic models is to understand the economy, which entails understanding it at all times, not just when nothing is going wrong – which is when we need them least.
As a final note, I can’t help but wonder if this argument, even in its general political form, has roots in economic theory. Economic models (such as the Solow Growth Model) often treat the boom as the ‘underlying’ trend, buffeted only by exogenous shocks or slowed/stopped by frictions. A lot of the major macroeconomic frameworks (such as Infinite Horizons or Overlapping Generations models) have two main possibilities: a steady-state equilibrium path, or complete breakdown. In other words, either things are going well or they aren’t – and if they aren’t, it’s usually because of an easily identifiable mechanism, one which constitutes a “notably rare exception” to the underlying mechanics of the model. Such a mentality implies problems, including recessions, are not of major analytical interest, or are at least easily diagnosed and remedied by a well-targeted policy. Subsequently, those versed in economic theory may have trouble envisaging a more complex process, whereby a seemingly tranquil period can contain the seeds of its own demise. This causes a mental separation of the boom and the bust periods, resulting in a failure to deal with either.
The next instalment in the series will be part 2: the EMH-twist
Recent posts by Noah Smith, David Henderson and Daniel Kuehn on the relationship between economics, ‘free markets’ and policy in general got me thinking about libertarians and how accepting they should be of marginalist economics, as well as how open they should be to non-marginalist alternatives. It seems to me there is an unspoken bond between marginalist economics and libertarianism (even Austrianism shares some major features with neoclassical economics), and so there may be a tendency for libertarians to have strong priors against post-Keynesian, Sraffian, Marxist, Behavioural, Ecological and other types of economics that dispute this general framework.
Let me note that I’m not accusing libertarians of being generally hostile to heterodox economics – I’m sure there are some who are and some who aren’t. Instead, I’m just warning against such a possibility, and offering some heterodox ideas to which libertarians might be receptive.
Behavioural/post-Keynesian consumer theory: behavioural economics sometimes elicits rebukes from libertarians, as it seems to imply that ordinary people are not able to make decisions rationally, and therefore that policy makers should help them along their way. Naturally, libertarians object to this idea, questioning the experimental methods of behavioural economics, pointing out that policy makers are themselves imperfect, and so forth. I’m not going to comment on the efficacy of these arguments here – sometimes they are fair, sometimes less so. Instead, what I want to point out is that while some behavioural economics implies a role for activist policy, it’s not necessarily the case that a view of consumers which differs from the optimising agent renders the agent somehow irrational and therefore ripe for intervention.
One such example is a version of the mental accounting model, used in post-Keynesian consumer theory, in which consumers organise their budget into categories before making spending decisions. Consumers will not spend money in one category until they have had their needs in a more ‘basic’ or ‘fundamental’ category satisfied, which creates a Maslow-esque hierarchy of spending – starting with necessities such as food & shelter and culminating in yachts & modern art. This means relative price changes do not have as much of an impact on the type of goods bought as implied by the utility maximising model; instead, the amount spent on different types of goods is primarily determined by the consumer’s level of income.
On first inspection, this might seem to imply a tirade against the efficacy of the price system for coordinating preferences and scarcity, as well as a comment on the ‘wastefulness’ of inequality (and perhaps it could be interpreted as such). However, this doesn’t necessarily make the theory generally ‘anti-libertarian’. In fact, one major implication is that placing high taxes on something low in someone’s hierarchy will not have much impact on their spending, and hence ‘sin taxes’ – which are a major expense for the poor – will not reduce their consumption of alcohol/smoking substantially; instead, these things will simply take up more and more of their income (which is pretty consistent with available evidence). This implies that paternalistic tax policies aimed at the poor will generally fail to achieve their aims.
The Market for Lemons (TML): George Akerlof’s famous paper explored information asymmetry, using used car markets as its primary example. Akerlof was trying to understand what buyers do when they face a product of unknown quality, and argued that since they are unsure, they will only be willing to bid the average expected value of a car in the market. However, if the seller is selling a ‘good’ car, its value will be above this average, so the seller will not sell it at the price the buyer offers. The result is that the best sellers drop out of the market, creating a cumulative process which results in the market unravelling completely.
Though theoretically neat and compelling, this ‘seminal’ example of market failure has always struck me as incredibly weak, for the simple reason that used car markets do not actually fall apart. Why? Maybe people aren’t rational maximisers etc etc (for example, in another nod to behavioural economics, it may be that buyers’ irrational overconfidence leads them to go ahead with a purchase, even if it’s statistically likely they’ll get a ‘lemon’). Ultimately, though, I’d argue the answer is that capitalism – or if you prefer, ‘the market’ – is a network of historically contingent institutions and social interactions, rather than abstract individuals trading in a vacuum where outcomes are mathematically knowable. The reason used car markets work ‘despite’ information asymmetry is due to hard-to-establish trust and norms between buyers and sellers, and due to intermediaries such as auto trader, who spring up to help both sides avoid being ripped off. I’ve not seen anyone provide an example of the process TML outlines actually occurring, so I don’t see why it adds to our understanding of markets.
To be fair to Austrians, they have been talking about ‘the market as a social process’ for a long time, and in places have disputed the Lemons Model on similar grounds to the above. Hence they have something in common with old institutionalists, Marxists (to a degree) and perhaps even hard-to-place heterodox economists like Tony Lawson, who argues economics should primarily be a historical, rather than mathematical subject. To put it another way, while heterodox economists typically advocate a move away from marginalist economics to understand why capitalism doesn’t work, such a move may also be necessarily to understand why it does.
Mark up Pricing: Post-Keynesian, Sraffian and Institutionalist economics typically subscribe to the cost-plus theory of prices, which states that businesses set prices at their average cost per unit, plus a mark up. Furthermore, they avoid price changes where possible, preferring to keep their prices stable for long periods of time to yield a target rate of profit, varying quantity rather than price, and keeping spare capacity and stocks so that they can do so. The problem libertarians might have with this is that it implies prices are somewhat arbitrary, do not usually ‘clear’ markets, and do not adjust to the preferences of consumers especially smoothly. However, while these things may be true, they do not mean mark up pricing comes with no benefits.
In my opinion, one such benefit is stability: I’m glad I can rely on prices only changing every so often, and that if there are a lot of people at the hairdressers he doesn’t raise the price to ‘clear’ the market. Furthermore, the fact that firms keep buffer stocks and can adjust quantity instead of price allows them to deal with uncertainty and unexpected demand more easily, making them more adaptable to real world conditions than if they always squeezed every drop out of their existing capacity. While I’m not going to pretend post-Keynesian pricing theory doesn’t imply some anti-libertarian policies (particularly with regards to price regulation), but it’s certainly not a one sided idea, and its policy implications are open to further interpretation.
I generally prefer to refrain from immediately linking everything to policy as I have done above, because, well, there are enough people doing that. However, the examples I’ve given actually help to demonstrate a point about the relationship between economic analysis and policy: theories with premises that seem to imply a certain policy may not once you’ve followed them through to their conclusions. What’s more, the same analysis can seem to imply different policies from different perspectives (at its most extreme, Austrian Business Cycle Theory seems to imply that even a teensy regulation will send capitalism off the rails, which could be interpreted as a damning criticism if you were a leftist). This means calls for pluralism in economics should be embraced by all, even if on the surface some ‘alternatives’ to mainstream economics seem to conflict with one’s world view.
I have new post on Pieria, following up on mainstream macro and secular stagnation. The beginning is a restatement of my critique of EM/a response to Simon Wren-Lewis, but the main nub of the post is (hopefully) a more constructive effort at macroeconomics, from a heterodox perspective:
There are two major heterodox theories which help to understand both the 2008 crisis and the so-called period of ‘secular stagnation’ before and after it happened: Karl Marx’s Tendency of the Rate of Profit to Fall (TRPF), and Hyman Minsky’s Financial Instability Hypothesis (FIH). I expect that neither of these would qualify as ‘precise’ or ‘rigorous’ enough for mainstream economists – and I’ve no doubt the mere mention of Marx will have some reaching for the Black Book of Communism – but the models are relatively simple, offer an understanding of key mechanisms and also make empirically testable predictions. What’s more, they do not merely isolate abstract mechanisms, but form a general explanation of the trends in the global economy over the past few decades (both individually, but even moreso when combined). Marx’s declining RoP serves as a material underpinning for why secular stagnation and financialisation get started, while Minsky’s FIH offers an excellent description of how they evolve.
I have two points that I wanted to add, but thought they would clog up the main post:
First, in my previous post, I referenced Stock-Flow Consistent models as one promising future avenue for fully-fledged macroeconomic modelling, a successor to DSGE. Other candidates might include Agent-Based Modelling, models in econophysics or Steve Keen’s systems dynamics approach. However, let me say that – as far as I’m aware – none of these approaches yet reach the kind of level I’m asking of them. I endorse them on the basis that they have more realistic foundations, and have had fewer intellectual resources poured into them than macroeconomic models, so they warrant further exploration. But for now, I believe macroeconomics should walk before it can run: clearly stated, falsifiable theories, which lean on maths where needed but do not insist on using it no matter what, are better than elaborate, precisely stated theories which are so abstract it’s hard to determine how they are relevant at all, let alone falsify them.
Second, these are just two examples, coloured no doubt by my affiliation with what you might call left-heterodox schools of thought. However, I’m sure Austrian economics is quite compatible with the idea of secular stagnation, since their theory centres around how credit expansion and/or low interest rates cause a misallocation of investment, resulting in unsustainable bubbles. I leave it to those more knowledgeable about Austrian economics than me to explore this in detail.
A frustrating recurrence for critics of ‘mainstream’ economics is the assertion that they are criticising the economics of bygone days: that those phenomena which they assert economists do not consider are, in fact, at the forefront of economics research, and that the critics’ ignorance demonstrates that they are out of touch with modern economics – and therefore not fit to criticise it at all.
Nowhere is this more apparent than with macroeconomics. Macroeconomists are commonly accused of failing to incorporate dynamics in the financial sector such as debt, bubbles and even banks themselves, but while this was true pre-crisis, many contemporary macroeconomic models do attempt to include such things. Reputed economist Thomas Sargent charged that such criticisms “reflect either woeful ignorance or intentional disregard for what much of modern macroeconomics is about and what it has accomplished.” So what has it accomplished? One attempt to model the ongoing crisis using modern macro is this recent paper by Gauti Eggertsson & Neil Mehrotra, which tries to understand secular stagnation within a typical ‘overlapping generations’ framework. It’s quite a simple model, deliberately so, but it helps to illustrate the troubles faced by contemporary macroeconomics.
The model has only 3 types of agents: young, middle-aged and old. The young borrow from the middle, who receive an income, some of which they save for old age. Predictably, the model employs all the standard techniques that heterodox economists love to hate, such as utility maximisation and perfect foresight. However, the interesting mechanics here are not in these; instead, what concerns me is the way ‘secular stagnation’ itself is introduced. In the model, the limit to how much young agents are allowed to borrow is exogenously imposed, and deleveraging/a financial crisis begins when this amount falls for unspecified reasons. In other words, in order to analyse deleveraging, Eggertson & Mehrotra simply assume that it happens, without asking why. As David Beckworth noted on twitter, this is simply assuming what you want to prove. (They go on to show similar effects can occur due to a fall in population growth or an increase in inequality, but again, these changes are modelled as exogenous).
It gets worse. Recall that the idea of secular stagnation is, at heart, a story about how over the last few decades we have not been able to create enough demand with ‘real’ investment, and have subsequently relied on speculative bubbles to push demand to an acceptable level. This was certainly the angle from which Larry Summers and subsequent commentators approached the issue. It’s therefore surprising – ridiculous, in fact – that this model of secular stagnation doesn’t include banks, and has only one financial instrument: a risk-less bond that agents use to transfer wealth between generations. What’s more, as the authors state, “no aggregate savings is possible (i.e. there is no capital)”. Yes, you read that right. How on earth can our model understand why there is not enough ‘traditional’ investment (i.e. capital formation), and why we need bubbles to fill that gap, if we can have neither investment nor bubbles?
Naturally, none of these shortcomings stop Eggertson & Mehrotra from proceeding, and ending the paper in economists’ favourite way…policy prescriptions! Yes, despite the fact that this model is not only unrealistic but quite clearly unfit for purpose on its own terms, and despite the fact that it has yielded no falsifiable predictions (?), the authors go on give policy advice about redistribution, monetary and fiscal policy. Considering this paper is incomprehensible to most of the public, one is forced to wonder to whom this policy advice is accountable. Note that I am not implying policymakers are puppets on the strings of macroeconomists, but things like this definitely contribute to debate – after all, secular stagnation was referenced by the Chancellor in UK parliament (though admittedly he did reject it). Furthermore, when you have economists with a platform like Paul Krugman endorsing the model, it’s hard to argue that it couldn’t have at least some degree of influence on policy-makers.
Now, I don’t want to make general comments solely on the basis of this paper: after all, the authors themselves admit it is only a starting point. However, some of the problems I’ve highlighted here are not uncommon in macro: a small number of agents on whom some rather arbitrary assumptions are imposed to create loosely realistic mechanics, an unexplained ‘shock’ used to create a crisis. This is true of the earlier, similar paper by Eggertson & Krugman, which tries to model debt-deflation using two types of agents: ‘patient’ agents, who save, and ‘impatient agents’, who borrow. Once more, deleveraging begins when the exogenously imposed constraint on the patient agent’s borrowing falls For Some Reason, and differences in the agents’ respective consumption levels reduce aggregate demand as the debt is paid back. Again, there are no banks, no investment and no real financial sector. Similarly, even the far more sophisticated Markus K. Brunnermeier & Yuliy Sannikov – which actually includes investment and a financial sector – still only has two agents, and relies on exogenous shocks to drive the economy away from its steady-state.
Why do so many models seem to share these characteristics? Well, perhaps thanks to the Lucas Critique, macroeconomic models must be built up from optimising agents. Since modelling human behaviour is inconceivably complex, mathematical tractability forces economists to make important parameters exogenous, and to limit the number (or number of types) of agents in the model, as well as these agents’ goals & motivations. Complicated utility functions which allow for fairly common properties like relative status effects, or different levels of risk aversion at different incomes, may be possible to explore in isolation, but they’re not generalisable to every case or the models become impossible to solve/indeterminate. The result is that a model which tries to explore something like secular stagnation can end up being highly stylised, to the point of missing the most important mechanics altogether. It will also be unable to incorporate other well-known developments from elsewhere in the field.
This is why I’d prefer something like Stock-Flow Consistent models, which focus on accounting relations and flows of funds, to be the norm in macroeconomics. As economists know all too well, all models abstract from some things, and when we are talking about big, systemic problems, it’s not particularly important whether Maria’s level of consumption is satisfying a utility function. What’s important is how money and resources move around: where they come from, and how they are split – on aggregate – between investment, consumption, financial speculation and so forth. This type of methodology can help understand how the financial sector might create bubbles; or why deficits grow and shrink; or how government expenditure impacts investment. What’s more, it will help us understand all of these aspects of the economy at the same time. We will not have an overwhelming number of models, each highlighting one particular mechanic, with no ex ante way of selecting between them, but one or a small number of generalisable models which can account for a large number of important phenomena.
Finally, to return to the opening paragraph, this paper may help to illustrate a lesson for both economists and their critics. The problem is not that economists are not aware of or never try to model issue x, y or z. Instead, it’s that when they do consider x, y or z, they do so in an inappropriate way, shoehorning problems into a reductionist, marginalist framework, and likely making some of the most important working parts exogenous. For example, while critics might charge that economists ignore mark-up pricing, the real problem is that when economists do include mark-up pricing, the mark-up is over marginal rather than average cost, which is not what firms actually do. While critics might charge that economists pay insufficient attention to institutions, a more accurate critique is that when economists include institutions, they are generally considered as exogenous costs or constraints, without any two-way interaction between agents and institutions. While it’s unfair to say economists have not done work that relaxes rational expectations, the way they do so still leaves agents pretty damn rational by most peoples’ standards. And so on.
However, the specific examples are not important. It seems increasingly clear that economists’ methodology, while it is at least superficially capable of including everything from behavioural economics to culture to finance, severely limits their ability to engage with certain types of questions. If you want to understand the impact of a small labour market reform, or how auctions work, or design a new market, existing economic theory (and econometrics) is the place to go. On the other hand, if you want to understand development, historical analysis has a lot more to offer than abstract theory. If you want to understand how firms work, you’re better off with survey evidence and case studies (in fairness, economists themselves have been moving some way in this direction with Industrial Organisation, although if you ask me oligopoly theory has many of the same problems as macro) than marginalism. And if you want to understand macroeconomics and finance, you have to abandon the obsession with individual agents and zoom out to look at the bigger picture. Otherwise you’ll just end up with an extremely narrow model that proves little except its own existence.
I’ve recently been re-reading John Maynard Keynes’ The General Theory (TGT), along with some other tweeps, and thought I’d collect up quotes which struck me as particularly insightful. Obviously, there many such quotes in TGT, some of them quite well-known, so I’ve opted for ones you don’t see reproduced as much, and which those have not fully read TGT may not have seen before.
As an aside: I don’t know why TGT has such a reputation for being difficult to read. There are surely some difficult sections: chapter 6, the list of points on Say’s Law, the fact that Keynes insists on describing diagrams instead of just bloody drawing them. But the rest is merely a mixture of: well-known economic theories, expressed verbally; passages of (wonderful) intuitive observatory prose that even someone with no economics training could understand; basic concepts and ideas which Keynes introduces (like liquidity preference), some of which may require mulling over but none of which are particularly taxing. My hunch is that those who complain that they can’t understand it simply set out not to understand it in the first place, and are all the poorer for it.
Anyway, onto the quotes. After inquiring on Twitter, I’ve decided to retain the length of the quotes, but I’ve bolded what I see as the absolutely crucial parts.
1. In Chapter 4, in a passage about how to measure depreciation, Keynes speaks about the aggregation of capital and seems to touch on some of the points raised much later on in the Cambridge Capital Controversies:
The difficulty is even greater when, in order to calculate net output, we try to measure the net addition to capital equipment; for we have to find some basis for a quantitative comparison between the new items of equipment produced during the period and the old items which have perished by wastage. In order to arrive at the net National Dividend, Professor Pigou deducts such obsolescence, etc., “as may fairly be called ‘normal’; and the practical test of normality is that the depletion is sufficiently regular to be foreseen, if not in detail, at least in the large.” But, since this deduction is not a deduction in terms of money, he is involved in assuming that there can be a change in physical quantity, although there has been no physical change; i.e. he is covertly introducing changes in value. Moreover, he is unable to devise any satisfactory formula to evaluate new equipment against old when, owing to changes in technique, the two are not identical. I believe that the concept at which Professor Pigou is aiming is the right and appropriate concept for economic analysis. But, until a satisfactory system of units has been adopted, its precise definition is an impossible task. The problem of comparing one real output with another and of then calculating net output by setting off new items of equipment against the wastage of old items presents conundrums which permit, one can confidently say, of no solution.
Clearly, these arguments about capital had been floating around for some time before they came to a head in the 1950s/60s – in Chapter 11, Keynes notes that even Alfred Marshall was aware of them. Then, in Chapter 14, Keynes explicitly states the point that you cannot measure the ‘productivity’ of capital independent of its price:
Nor are those theories more successful which attempt to make the rate of interest depend on “the marginal efficiency of capital”. It is true that in equilibrium the rate of interest will be equal to the marginal efficiency of capital, since it will be profitable to increase (or decrease) the current scale of investment until the point of equality has been reached. But to make this into a theory of the rate of interest or to derive the rate of interest from it involves a circular argument, as Marshall discovered after he had got half-way into giving an account of the rate of interest along these lines. For the “marginal efficiency of capital” partly depends on the scale of current investment, and we must already know the rate of interest before we can calculate what this scale will be. The significant conclusion is that the output of new investment will be pushed to the point at which the marginal efficiency of capital becomes equal to the rate of interest; and what the schedule of the marginal efficiency of capital tells us, is, not what the rate of interest is, but the point to which the output of new investment will be pushed, given the rate of interest.
Clearly, this was part of Keynes’ reason for formulating a theory of the rate of interest independent of considerations about productivity, time-preference and so forth.
The equivalence between the quantity of saving and the quantity of investment emerges from the bilateral character of the transactions between the producer on the one hand and, on the other hand, the consumer or the purchaser of capital equipment.Income is created by the value in excess of user cost which the producer obtains for the output he has sold; but the whole of this output must obviously have been sold either to a consumer or to another entrepreneur; and each entrepreneur’s current investment is equal to the excess of the equipment which he has purchased from other entrepreneurs over his own user cost. Hence, in the aggregate the excess of income over consumption, which we call saving, cannot differ from the addition to capital equipment which we call investment. And similarly with net saving and net investment. Saving, in fact, is a mere residual. The decisions to consume and the decisions to invest between them determine incomes. Assuming that the decisions to invest become effective, they must in doing so either curtail consumption or expand income. Thus the act of investment in itself cannot help causing the residual or margin, which we call saving, to increase by a corresponding amount.
3. In Chapter 7, Keynes offers an argument against the Hayekian Natural Rate of Interest. This is not a comprehensive critique, but it sums up my thoughts on ABCT quite adequately: the naturalistic fallacy, along with implicit appeals to neoclassical equilibrium concepts, lurk in the background and leave some crucial points vague or undefined:
Thus “forced saving” has no meaning until we have specified some standard rate of saving. If we select (as might be reasonable) the rate of saying which corresponds to an established state of full employment, the above definition would become: “Forced saving is the excess of actual saving over what would be saved if there were full employment in a position of long-period equilibrium”. This definition would make good sense, but a sense in which a forced excess of saving would be a very rare and a very unstable phenomenon, and a forced deficiency of saving the usual state of affairs.Professor Hayek’s interesting “Note on the Development of the Doctrine of Forced Saving” shows that this was in fact the original meaning of the term. “Forced saving” or “forced frugality” was, in the first instance, a conception of Bentham’s; and Bentham expressly stated that he had in mind the consequences of an increase in the quantity of money (relatively to the quantity of things vendible for money) in circumstances of “all hands being employed and employed in the most advantageous manner”. In such circumstances, Bentham points out, real income cannot be increased, and, consequently, additional investment, taking place as a result of the transition, involves forced frugality “at the expense of national comfort and national justice”. All the nineteenth-century writers who dealt with this matter had virtually the same idea in mind. But an attempt to extend this perfectly clear notion to conditions of less than full employment involves difficulties.
4. In the excellent Chapter 19, in which Keynes refutes the idea that sticky wages are responsible for recessions, he concludes a section by sarcastically noting that if sticky wages were the cause of recessions, we should want “monetary management by the trade unions”:
If, indeed, labour were always in a position to take action (and were to do so), whenever there was less than full employment, to reduce its money demands by concerted action to whatever point was required to make money so abundant relatively to the wage-unit that the rate of interest would fall to a level compatible with full employment, we should, in effect, have monetary management by the Trade Unions, aimed at full employment, instead of by the banking system.
What say you, libertarians?
5. At the very beginning of Chapter 21, Keynes notes the tension between monetarist reasoning based on the Quantity Theory of Money and conventional microeconomic theory. The former assumes a smooth, mechanistic relationship between the stock of money and the price level, but the latter teaches us that prices depend on microeconomic ‘fundamentals’ such as preferences and technology:
So long as economists are concerned with what is called the Theory of Value, they have been accustomed to teach that prices are governed by the conditions of supply and demand; and, in particular, changes in marginal cost and the elasticity of short-period supply have played a prominent part. But when they pass in volume II, or more often in a separate treatise, to the Theory of Money and Prices, we hear no more of these homely but intelligible concepts and move into a world where prices are governed by the quantity of money, by its income-velocity, by the velocity of circulation relatively to the volume of transactions, by hoarding, by forced saving, by inflation and deflation et hoc genus omne; and little or no attempt is made to relate these vaguer phrases to our former notions of the elasticities of supply and demand.
Keynes then goes on to anticipate Joan Robinson‘s simple but (IMO) rather damning critique of the QToM and the velocity of money as a concept:
But the “income-velocity of money” is, in itself, merely a name which explains nothing. There is no reason to expect that it will be constant. For it depends, as the foregoing discussion has shown, on many complex and variable factors. The use of this term obscures, I think, the real character of the causation, and has led to nothing but confusion.
So, there we have it: in a relatively small set of quotes, Keynes has forcefully critiqued neoclassical theories of capital and the rate of interest, the Quantity Theory of Money, the Natural Rate of Interest, the idea that sticky wages are responsible for recessions, and the idea that savings create investment. Then there’s the rest of the book, where he sort of invents macroeconomics (I know, I know – but he does bring it together far more effectively than anyone else before, and adds a lot along the way). There’s a reason books like this catch on.
I rarely (never) post based solely on a quick thought or quote, but this just struck me as too good not to highlight. It’s from a book called ‘Capital as Power’ by Jonathan Nitzan and Shimshon Bichler, which challenges both the neoclassical and Marxian conceptions of capital, and is freely available online. The passage in question pertains to the way neoclassical economics has dealt with the problems highlighted during the well documented Cambridge Capital Controversies:
The first and most common solution has been to gloss the problem over – or, better still, to ignore it altogether. And as Robinson (1971) predicted and Hodgson (1997) confirmed, so far this solution seems to be working. Most economics textbooks, including the endless editions of Samuelson, Inc., continue to ‘measure’ capital as if the Cambridge Controversy had never happened, helping keep the majority of economists – teachers and students – blissfully unaware of the whole debacle.
A second, more subtle method has been to argue that the problem of quantifying capital, although serious in principle, has limited practical importance (Ferguson 1969). However, given the excessively unrealistic if not impossible assumptions of neoclassical theory, resting its defence on real-world relevance seems somewhat audacious.
The second point is something I independently noticed: appealing to practicality when it suits the modeller, but insisting it doesn’t matter elsewhere. If there is solid evidence that reswitching isn’t important, that’s fine, but then we should also take on board that agents don’t optimise, markets don’t clear, expectations aren’t rational, etc. etc. If we do that, pretty soon the assumptions all fall away and not much is left.
However, it’s the authors’ third point that really hits home:
The third and probably most sophisticated response has been to embrace disaggregate general equilibrium models. The latter models try to describe – conceptually, that is – every aspect of the economic system, down to the smallest detail. The production function in such models separately specifies each individual input, however tiny, so the need to aggregate capital goods into capital does not arise in the first place.
General equilibrium models have serious theoretical and empirical weaknesses whose details have attracted much attention. Their most important problem, though, comes not from what they try to explain, but from what they ignore, namely capital. Their emphasis on disaggregation, regardless of its epistemological feasibility, is an ontological fallacy. The social process takes place not at the level of atoms or strings, but of social institutions and organizations. And so, although the ‘shell’ called capital may or may not consist of individual physical inputs, its existence and significance as the central social aggregate of capitalism is hardly in doubt. By ignoring this pivotal concept, general equilibrium theory turns itself into a hollow formality.
In essence, neoclassical economics dealt with its inability to model capital by…eschewing any analysis of capital. However, the theoretical importance of capital for understanding capitalism (duh) means that this has turned neoclassical ‘theory’ into a highly inadequate took for doing what theory is supposed to do, which is to further our understanding.
Apparently, if you keep evading logical, methodological and empirical problems, it catches up with you! Who knew?
How economics is taught has been the subject of a lot of debate recently. Although there have been a lot of good points made, in my opinion Andrew Lainton‘s recent blog post hits the nail on the head: we need to begin economics education with a discussion of key, contested ideas.
Starting with contested ideas has a few major benefits. First, it immediately shows students what economics is: a subject where there is a lot of disagreement, and where key ideas are often not well understood, even by the best. Second, it allows students to grapple with the kinds of critical questions that, in my experience, people generally have in mind when they think of ‘economics': where do growth, profits come from? How do things ‘work’? Third, it allows us to intertwine the teaching of these concepts with economic history and the history of thought.
Lainton’s key contested idea is savings: how naive national accounting might make you believe that saving instantly create investment; how Kalecki and Keynes showed that it’s closer to the other way around; and onto modern debates that add nuances to these simplified expositions. Naturally, this would also tie in with debates about the banking system, loanable funds and endogenous versus exogenous money. On top of ‘savings’, I can think of quite a few other important economic ideas that are not agreed upon, but are central to the discipline:
Decision making and expectations
How do people make decisions? This question is clearly central to economics, as any economic model that explicitly includes agents must make some assumption about what drives these agents’ decisions. In modern economics, an agent’s decision rule generally rests on seeking some form of ‘gain’, whether subjective satisfaction or simply units of money. Economists themselves have also, to their credit, pushed behavioural and even neurological investigations into decision making. However, much of this has yet to filter down to the main models/courses, even though it should really be at the forefront of economic modelling.
All too often, the most mathematically tractable models such as utility maximisation and rational expectations are simply assumed, perhaps with caveats, but not with any real discussion of whether they represent human behaviour. Well established psychological characteristics and behavioural heuristics/biases are ignored, even though they may alter the analysis of choice in fundamental ways. Public officials are often assumed to follow behaviour that creates their personally preferred outcome, despite important evidence to the contrary. It is assumed the public understands the fundamentals of the economy, even though a lot of evidence suggests this is way, way off. Decisions in the workplace that concern morale, hierarchy and norms are often disregarded, despite evidence that they are of utmost importance.
However, my point isn’t necessarily about which models are right or wrong. It’s that these debates about how people act, and based on which motives and expectations, are not only incredibly interesting but are incredibly important. Such debates could also tie in with a comprehensive discussion of the Lucas Critique – not as a binary phenomenon that can be solved with microfoundations, but as an ongoing problem that requires us to evaluate the way the parameters of the economy change over time and with policy, culture and so forth. This would allow students to see how the economy evolves, and how its behaviour depends on fundamental questions about human behaviour.
Theories of value underlie economic theories, whether economists like it or not – in fact, it’s pretty difficult (impossible?) to judge the “performance” of the economy without a theory of value. Classical economics was built on the Labour Theory of Value (LTV), and distinguished between the price of an object (exchange-value) and its value to whomever used it (use-value). Marginalist economics is built on the Subjective Theory of Value (STV), which tends to combine use and exchange value into mathematically ordered preferences. GDP calculations simply measure ‘value added’ as a monetary quantity. There are also other, albeit less popular, theories of value, such as those based on agriculture and energy.
A crucial point here is that the concept of ‘value’ is not necessarily well-defined, and each theory of value generally has something slightly different in mind when they use it. For the (Marxist) LTV,value refers to an objective quality: the total productive ‘value’ in the economy, which is expressed as an exchange relationship between commodities, and originates solely from labour. For the STV , value refers to the subjective ‘surplus’ gained from transactions, which neoclassical theory seeks to optimise to maximise social welfare. For theories of value based on the natural sciences, value refers to more physical qualities, such as how energy is transformed in production and the limits to this process. However, the common ground between theories is the question of how we create more than we had – and what to do about it.
I expect a lot of economists would regard the STV as largely obvious and not up for debate, but if it’s so obvious and important that’s even more reason to study it explicitly – after all, Newton’s Law’s are not tucked away underneath classical physics: they are explicit, and their empirical relevance is frequently demonstrated to students. Clearly, we can’t demonstrate the empirical relevance of a theory of value (hey, it’s almost as if economics is not a science!) but we can discuss it in depth and how it is a relevant and necessary backdrop to formulating theories about utility, surplus and profit.
What is economics?
It’s a testament to how contested the field of economics is that even the definition is not agreed upon. Open a ‘pop‘ economics book and you’ll find a definition such as “the study of how people respond to incentives”. Another popular mainstream definition is “the allocation of scarce resources” or even “satisfying unlimited wants with scarce resources“. Classical economics – and more recently, Sraffians – considers economics the study of how society reproduces itself. Austrians might give you a definition that says something about human action and the market system. The definition given by Wikipedia is “the study of production, distribution and consumption”. I’m sure there are many more out there.
Agreeing on a definition of economics would put the discipline on surer footing. Right now it occupies a space where it is simultaneously used as an all encompassing worldview, and as a very narrow toolkit that only investigates one or two things at a time (I expect many economists would basically consider themselves applied statisticians or econometricians). I sometimes even find that economists fall back on defining economics by “what economists do”, which is a rather weak (and circular) definition. Given that we are not even sure which problems economic theories are designed to understand and solve, is it any wonder people can’t agree on which ones to use?
This post is by no means exhaustive. Off the top of my head, some other relevant contested ideas might be: capital; money; how to measure the economy; different economic systems; institutions; policy and economists’ relationship with it. This kind of approach is surely better for furthering students’ understanding than simply teaching a set of abstract theories which are labelled ‘economics’, often with little critical engagement. It would open students’ minds to the kinds of difficult and relevant questions that are currently either shied away from, or only open to those who have completed an Economics PHD. I expect many would also leave with an understanding of economics closer to what students currently expect (and do not really get) from an economics education.
Since posts have been scant recently (I have things coming up, promise!) I thought I’d do a standard “most popular posts” post. I’ll look at the 5 most popular posts of 2013 on this blog, as well as the 5 posts I most enjoyed writing and the 5 other blogs I’ve enjoyed reading this year. The first list is ranked from highest page-views to lowest, but the others aren’t in any particular order.
Most Popular Posts on This Blog
18 Signs Economists Haven’t the Foggiest (12,857) An off-the-cuff polemic response to Chris Auld’s similar list, this attracted a lot of attention (and ire). I stand by all 18 points in one way or another, although I’ll grant that some (such as 10) are far less common than others (such as 1).
The Dangers of Thinking Like an Economist (10,333) Due largely to a link from Hacker News, this blog post was widely read (apparently by climate change deniers). I actually feel like I didn’t flesh out the analysis as fully as I could have, but the basic points about the ‘economic way of thinking’, and the subjects I highlighted are, in my opinion, important examples of how limiting an economics education can be when discussing social problems.
Yes, Libertarians Really Are Lazy Marxists (6,851). I’m not the first to refer to libertarians as lazy marxists, but I’ve never seen somebody actually write about it in depth. Apparently this struck a chord with a lot of marxists and so was linked to from various commie websites. This surprised me, as I’m not great at political philosophy, but clearly that’s not a necessary condition for being able to criticise libertarianism.*
Sorry, Economists: The Crisis is a Huge Problem for Your Discipline (4,676). Giles-Saint Paul’s exercise in special pleading, attempting to relieve economists from the burden of actually being able to describe the real economy, was one of the silliest things I’ve ever seen written by an economist, which is quite a feat, and it deserved fisking.
Mankiw to the Rescue (of the 1%) (3,545). Another fisking (and another one of the silliest things ever written by an economist), this post concerned Mankiw’s universally derided defence of the top 1% of earners, with its questionable grasp of the facts, 15 year old political philosophy and inconsistent use of economic theory. While it probably wasn’t necessary for me or anyone else to point out the stupidity in Mankiw’s paper explicitly, it was still a lot of a fun to do so.
NB: my FAQ actually got 4,799 views in 2013, but since it was written in 2012 I didn’t count it (and it has the unfair advantage of being linked to in my About section). I’ve also been posting on the website Pieria this year, and though I don’t have access to the views for those posts, a handful of my posts there were on their ‘top 20′ list.
Posts on This Blog I Enjoyed Writing
Economists Say The Funniest Things. ‘Economic Imperialism’ never fails to delight and amuse, and although this post required quite a lot of research, it was probably one of the most rewarding posts I’ve done. Admittedly I was a bit unfair to Irving Fisher in the first draft, but it’s still silly to suggest that workers become socialists largely because of changes in the money supply.
Reconsidering the Labour Theory of Value. The straw man of the LTV that many are willing to refer to as “discredited” may well be untenable. But the actual theory endorsed by Marx, along with its implications about capitalist crises, is far better for understanding the business cycle than any mainstream economic theory I’ve come across. This post was a thumbnail sketch of said theory.
Whig Theories of the History of Thought. As much as everybody hates Paul Krugman posts, as a blogger you unavoidably find yourself having to do one every so often. Here I tried to counter popular myths about naive Keynesianism and how its practitioners were unaware of the possibility of stagflation (as well as the Lucas Critique). Sadly, this caricature of events is often endorsed by both left and right economists.
In Praise of Econometrics. Since a lot of ‘economists’ are mostly asking specific, relatively boring empirical questions, I thought it would be worth clarifying that most of my criticisms are not directed at this kind of work, which is in my opinion of quite a different nature to the pure theoretical aspects of economics. It is true that problematic theoretical concepts (like production functions) are sometimes used in these empirical estimations, but I think that is a problem of application rather than something more fundamental.
Against Friedman: Why Assumptions Matter. Although it’s not news to anybody except the most dyed-in-the wool economist that the assumptions of a theory must be carefully scrutinised, it was good to compile a comprehensive argument for exactly why this is the case.
My Favourite Blogs of 2013
Matt Bruenig. While there aren’t necessarily any stand-out posts (although this recent smackdown of Ezra Klein is amusing), I never fail to delight in Bruenig’s effortless dismissals of libertarian theories of…well, everything. He also does some good policy analysis (including a basic income calculator), and blogs in a similar vein over at Demos.
Chris Dillow (Stumbling and Mumbling). There should probably be a rule against including Chris Dillow on lists like this – everyone can just agree that he’s a Really Good Blogger. His unique mixture of marxist, behavioural and mainstream economic reasoning makes him both endlessly interesting and frustratingly hard to disagree with, even when he is casually tearing your pet beliefs to pieces. Oh, and his sidebar ‘top blogging’ is always worth a look.
Noah Smith (Noahpinion). Despite the fact that Noah’s dismissive attitude toward heterodox economics irritates me, there’s no denying that he is an excellent and consistent blogger. Naturally, I enjoy his posts on macroeconomics, but he also writes interesting things about Japan, has good overviews of economics debates and makes a lot of interesting political/miscellaneous posts.
‘Lord Keynes’ (Social Democracy for the 21st Century: a Post-Keynesian Perspective). This blog has always been a great source of, among other things, post-Keynesian theories and criticisms of Austrian Business Cycle Theory. However, this year LK pushed the boat out with relentless attacks on both marginalist theories of pricing and Mises’ a priori philosophy. An excellent resource for heterodox economists.
David Glasner (Uneasy Money). I expect most people would agree with me that Glasner is one of the best economic bloggers around. Just a glance at the top right hand corner of his blog undoubtedly reveals a handful of must-read posts. He also wrote one of my favourite blog posts of 2013, That Oh So Elusive Natural Rate of Interest, and did an interesting series on the presumably underrated Ralph Hawtrey’s book ‘Good and Bad Trade‘.
Honorable mentions: Corey Robin, whose blogging and book are both excellent, if a little jargon-filled; Robert Vienneau, who posts consistently interesting stuff on economic theory; Left Outside, who is a great follow and whose series on Karl Polanyi and Beijing is a must-read (even if he does support NGDP targeting); Fuck Yeah, Piero Sraffa! who posts a lot of interesting material, although the blog does some to be a bit on and off.
Happy New Year!
I’m happy to say that I’ve had a few blog posts this year that were viewed as much as the top posts on much more popular blogs like naked capitalism, and also that I made the list of top 200 most influential economics blogs. I had 227,037 views in 2013, which was a massive improvement over 2012. I’m not entirely sure how all of this compares to other blogs overall, but in any case I’m glad to have had a continuous rise in readers/commenters relative to where I was before. Here’s hoping 2014 is just as successful.
What did you enjoy reading this year?
*I know, cheap shot. Sorry.