Posts Tagged DSGE
This is the second part of my response to criticisms of Keen’s Debunking Economics. In my previous post* I covered some of the fundamental objections Keen had to neoclassical theory. Here, I will cover Keen’s exploration of alternatives: first, a brief note on dynamics and chaos theory; then a discussion of Keen’s own models; finally, his dismissal of the Marxist Labour Theory of Value (LTV).
Dynamics and Equilibrium
Many economists have argued that Keen’s contention that economists do not study dynamics is false. I agree. Keen does not really address the DSGE conception of equilibrium, which is highly different to the typical conception of a steady state. An equilibrium in an economic model occurs when all agents have specific preferences, endowments etc. and take the course of action which suits them best based on this. This can be subject to incomplete information, risk aversion or various other ‘frictions.’ These agents intermittently interact in market exchanges, during which all markets clear. Basically, ‘solving for equilibrium’ means you specify the actions and characteristics of economic agents, then see what happens when markets clear. It’s entirely possible that the subsequent model could exhibit chaotic behaviour.**
Now, there are obviously many problems here. The fact is that the overwhelming majority of people who learn economics will not touch this. They will instead be faced with static-style equilibrium models, which they have been told are unrealistic but ‘elucidate certain principals.’ This is nonsense – they elucidate nothing, and simply need to be thrown out. Nevertheless, many policymakers, regulators and business economists are working under this framework. Furthermore, even those economists who have gone beyond this level seem to have the concepts deeply ingrained into their minds, and regard them as useful.
However, even the more advanced ‘dynamic’ equilibrium clearly has problems. First, the presence of irreducible uncertainty – which, as far as I can see, is a concept entirely misused by economists – means that it is virtually certain not all expectations will be fulfilled, while equilibrium assumes they will be. Second, ‘fulfilled expectations’ is far stronger than economists seem to think – for example, it eliminates the possibility of default! Third, the assumption that all markets clear is obviously false, otherwise supermarkets wouldn’t throw out old food. Anyway, I digress: Keen could easily address all of these criticisms, but for some reason he doesn’t. This is indeed a shortcoming of his book.
First, a brief note on Keen’s model of firm behaviour: it seems to make the error of maximising the growth rate of profits, rather than profits themselves. I am not sure if this has been fixed. Nevertheless, I regard it as subsidiary to Keen’s main criticisms. His most important model is the Minsky Model of banking and the macroeconomy.
Keen recently had a debate over his Minsky Model with the Cambridge economist Pontus Rendahl. Andrew Lainton has a post on this, along with a contentious discussion with Rendahl, over on his blog. In my opinion, Rendahl – though overly dismissive in tone, and not causing as many problems for Keen as he seemed to think – highlighted a number of issues with Keen’s model in its current form:
(1) Say’s Law holds. In Keen’s model, income is simply a function of the capital stock, and there is no role for demand.
(2) In what was generally a model set in continuous time, which used ODEs, there is an equation which uses discrete time intervals. Such equations cannot be solved in the same way, so Keen’s methodology is inconsistent.
(3) There is, as of yet, no role for expectations in Keen’s model.
(4) Rendahl argues that DSGE models are also Stock Flow Consistent (SFC). I think he is correct – see, for example, his own paper, which has agents accumulating stocks of money from previous periods. The major differences between SFC and DSGE appear to be: a lack of micro foundations; continuous functions; use of classes; market clearing; fulfilled expectations; and, of course, with Keen’s, the role of banks and private debt.
In terms of assumptions, I’d say Keen’s model is in the ‘heuristic’ stage – it’s not completely right and needs development. The criticisms are essentially things that have not yet been added to the model, rather than conceptual or logical problems (save the inconsistent equation). This means they can be added as it develops. However, if the model makes good predictions, it may prove to be useful, even though that should never serve as a barrier to making it more realistic and comprehensive.
Labour Theory of Value
If neoclassical economists want a lesson in how to respond to a critique you strongly disagree with without being vitriolic and dismissive, then they need look no further than the marxist responses to Keen’s critique of the LTV. This is all the more ironic given said economist’s willingness to dismiss marxists as illogical and dogmatic.
Keen’s critique is threefold, so I will discuss it briefly, followed by the marxist responses.
The first critique is Bose’s commodity residue. The idea is that no matter how far you go back in time, disaggregating a commodity into what was required to produce it, there will always be a commodity residue left over. Hence, no commodity can be reduced to merely labour-power. The problem here is the projection of capitalism into all of history. For Marx, a commodity only resulted from capitalist production. However, if you go back in time you will find non-capitalist production, and eventually you will be able to reduce everything into land/natural resources and labour, which Marx never defined as commodities. Having said this, one question remains: can the natural resources or land not be a source of surplus value? Could this surplus value not have been transferred into capitalist commodities?
Second is Ian Steedman’s Sraffian interpretation of Marx. Simply put, it seems Steedman had his interpretation wrong – Marx’s is not a physical, equilibrium system based on determining factor prices. This is something that actually struck me on the first read of Keen’s LTV chapter: Steedman simply converts Marx into Sraffian form without much justification. If Marx did not intend this to be the case, the criticism is defunct from the outset.Hence, it follows that Steedman’s model is simply a misinterpretation of Marx, and it is not even necessary to go into the maths. There is, of course, a possibility that this is an overly superficial interpretation and I am mistaken.
The third criticism is that Marx’s treatment of use-value and exchange-value is inconsistent: properly applied, it implies that a commodity’s use-value can exceed its exchange value, and hence be a source of surplus value. Now, I remain unsure of this area so I might be wrong in my exposition, but here is my attempt to explain the Marxist response: (warning: the following paragraph will contain a vast overuse of the word ‘value’ in what is already a necessarily convoluted explanation).
Marxists contend that Keen’s is a misinterpretation of use-value, which is simply a binary concept and not quantifiable. Something may have any number of uses which give it a use-value, which is a necessary condition for it to have an exchange-value. However, the exchange-value cannot ‘exceed’ the use-value, because the use-value cannot be measured. It is in this sense that labour is unique in Marx’s conception of capitalism: its specific use-value is the production of surplus for capitalists. It is the only ‘factor of production’ that can do this – after all, capital ultimately reduces to past labour value. If production could take place without labour, prices would fall to zero and, while Marx would be refuted, nobody would care because the problem of economic scarcity would vanish. Hence, surplus production and profits depend on labour producing more than it is rewarded.
I remain neither convinced of the LTV, nor of its critics.*** For me, most discussion of the LTV appears to rest on the LTV as a premise. The debate is split into people who accept the LTV and people who not only reject it, but see no need for it. For this reason, critics seem to misrepresent and misinterpret it continually – a common theme is to try and abstract from historical circumstance, when it’s clear Marx emphasised that his analysis only applied under capitalism, which he saw as a particular social relation. For me, the main issue remains the same as it is for other theories: what is the falsification criteria for the LTV?
Overall, a couple of points stand out for post-Keynesians for their own theories, both of value and economic systems. The first is that DSGE models are probably not that different to some heterodox models, and identifying the actual differences is crucial to opening up a dialogue between mainstream and heterodox economists.
The second is that I would caution left-leaning economists not to be too hasty to dismiss Marxism as dogmatic (in my experience marxists are anything but), or avoid it simply out of fear of being dismissed themselves. In my opinion, the LTV – while not entirely convincing – is a cut above the neoclassical ‘utility’ conception of value, and I’d sooner be equipped with Marxist explanations of a crisis when trying to understand capitalism. This isn’t to say post-Keynesians haven’t thought about Marx; moreso that the issue is often approached with a degree of bias. At the very least, the distinction between use-value and exchange-value is something that befits post-Keynesian analysis well.
So, as far as theory goes, this is the last post on Keen’s book. I will, however, do some closing notes from a more general perspective. As I said before, if there are any other criticisms of Keen that I have not covered, feel free to discuss them in the comments.
*It is worth noting that in my previous post I was somewhat – thought not totally – off the mark with my discussion of Keen on demand curves. The Gorman conditions for the existence of a representative agent do indeed have many similarities to the SMD theorem and conceptually they are dealing with the same issue: aggregation of preferences. Nevertheless, Keen weaves between the two, when it would have been more accurate to note economists have used two (main) different methods to get around the problem, and critiqued them separately. Similarly, though Keen’s quote from MWG was incorrect, it is true that economists such as Samuelson have used the assumption of a dictator to aggregate preferences. However, the specific one Keen presented was not right.
**However, that does not make it the same as chaos theory.
***For me, claims that worker ownership of production would be desirable don’t really rest on the LTV; instead, the simple point is that workers could employ capital themselves.
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.
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 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.
As it happens, an essay by Christian Arnsperger & Yanis Varoufakis may provide us with the answer. In this essay, Arnsperger and Varoufakis attempt to define neoclassical methodology, hoping to nullify its lizard-like ability to dispose of certain parts in order to evade criticism. Personally, I think they hit the nail on the head.
They provide three axioms which define neoclassical methodology:
(1) Methodological individualism – the economy is modeled on the basis of the behaviour of individual agents.
(2) Methodological instrumentalism – individuals act in accordance with certain preferences rankings, to attain some end goal that they deem desirable.
(3) Methodological equilibration – given the above two, macroeconomics asks what will happen if we assume equilibrium. Note that this doesn’t necessarily posit that the system will end up in equilibrium (although that is often the case), but rather seeks to find out what will happen if we use equilibrium as an epistemological starting point.
I will not criticise the axioms here, but suffice to say that this gets to the crux of what the arguments have been about. This methodological core underlies everything from demand-supply to game theory to DSGE.
Much like the assumption of circular orbit, the methodological core of neoclassicism is at all times protected as it develops. Most neoclassical economists don’t think twice about the axioms, and this helps them deny that they are, in fact, ‘neoclassical’, seeing it only as a buzz word used by their enemies.
In fact, neoclassical economics has a habit of preserving not only these three axioms, but also many other assumptions it introduces. For example, take the case of Krugman and Eggertson versus Keen. Keen models the banks as explicit agents and creators of purchasing power, whilst Krugman and Eggertson preserve the ‘banks as intermediaries between savers and borrowers’ line, abstracting them out the economy, and ad-hocing a role for private debt.
You can also see these axioms in criticisms of Keen’s models. Krugman says that there is ‘a lot of implicit theorising’ going on in Keen’s paper. Perhaps this is true and maybe Keen needs to clarify his epistemology, but what Krugman really means - unknowingly, perhaps – is that Keen doesn’t start from the three axioms: he isn’t looking at individual behaviour, instead at the flow of money between agents; nobody is acting in accordance with attaining certain preferences; equilibrium is not used as a starting point. From my experience, I strongly suspect that most mainstream economists feel a similar skepticism when reading Keen’s paper.
I believe that in order for the debate to move forward, these 3 axioms – and others that are protected by the ad hoc style of DSGE – must be focused on and criticised. Otherwise critics will never land a convincing blow, and will be forever accused of straw manning.
* As a note, Austrians, this is why I link you with neoclassicism. The first two certainly define all of Austrian economics, and, at least in the case of Hayek, you also use equilibrium as an epistemological starting point.