Is Economics A Gun That Only Fires Left?

Sometimes it seems like economist’s pet principles are applied selectively, in such a way that they attack ideas generally endorsed by the left end of the political spectrum. This isn’t to say economists themselves are ideologically inclined toward any opinion; merely, that key aspects of their own framework, and the way they present these aspects, lends itself to a more ‘right-friendly’ way of thinking.

In part, the issue is merely one of a disparity between how economists present issues to the public and how they speak to others in academia. Dani Rodrik noted this issue in his book The Globalisation Paradox. Here he describes a situation where a reporter asks an economist whether free trade is beneficial:

We can be fairly certain about the kind of response [the reporter] will get: “Oh yes, free trade is a great idea,” the economist will immediately say, possibly adding: “And those who are opposed to it either do not understand the principle of comparative advantage, or they represent the selfish interests of certain lobbies (such as labor unions).”

Rodrik then contrasts this with how such a question would be answered in the classroom:

Let [the student] pose the same question to the instructor: Is free trade good? I doubt that the question will be answered as quickly and succinctly this time around. The professor is in fact likely to be stymied and confused by the question. “What do you mean by ‘good’?” she may ask. “Good for whom?… As we will see later in this course, in most of our models free trade makes some groups better off and others worse off… But under certain conditions, and assuming we can tax the beneficiaries and compensate the losers, freer trade has the potential to increase everyone’s well-being…”

This adherence to basic, market-friendly principles over nuance can be found often in ‘pop’ economics: for example, economist Paul Krugman does it in his book Peddling Prosperity. The book is intended as an survey of nonsensical ideas from both the left and the right, remedying them both with a cold hard dose of facts, plus some basic economics. However, Krugman treats the left and right somewhat asymmetrically: with the right, he primarily opts for facts, whereas with the left, he uses economic principles

This is quite possibly because the right’s arguments, though they are taken to an extreme, have economic principles on their side, while the left’s do not. The ‘supply side’ economics that Krugman takes issue with is really just an extreme statement of the well known principle of deadweight loss, which suggests that taxes decrease output. If taxes reduce output by enough, then it logically follows that not only output, but overall revenues might fall if we raise taxes. Krugman would not question the principle, so he spends several chapters documenting evidence against the idea*.

Krugman then follows this up with a section berating the ‘strategic traders’, endorsed by Bill Clinton and others on the centre-left. Strategic trade suggested a role for government policy in promoting industry, because various clustering effects, economies of scale and positive feedback loops could mean that the initial wave of government investment could kick start an industry. As Krugman himself notes, such dynamic effects and ‘historical path dependence’ could render comparative advantage obsolete, since comparative advantage posits a more fundamental, innate reason a country produces a particular good, one that cannot be changed with policy (one that may be more applicable to agriculture).

Yet, in contrast with his section aimed at refuting the right, Krugman offers scant evidence suggesting government intervention doesn’t work. Instead, he effectively restates the theory of comparative advantage, coupled with a typical story to illustrate it. This is despite explicitly suggesting it might not be applicable in the previous chapter. When pushed, Krugman is prepared to fall back on his pro-market principles, even in areas where he knows they may not apply.

William Easterly does something similar in his book The Elusive Quest for Growth. The book is a survey of various policies than have purported to be panaceas for development, such as education, investment and population control. (As you can see, economists really love writing their “I’m an economist, here’s how it is” manifestos). Easterly finds every supposed development panacea wanting based on the available evidence, which is fine. However, occasionally he supplements his arguments with an excruciating example of ‘economic logic’ that always looks out of place.

For example, in the section on increasing availability of condoms, Easterly essentially makes the argument ‘how could people be lacking condoms? If they were, the free market would provide them!’ I am reminded of the joke about the economist who does not pick up a £10 note from the ground, because, if it were really there, somebody would already have picked it up. Easterly is a smart guy with a lot of concern for the poor, and I have a hard time believing he wouldn’t agree that a country might lack the institutions to deliver condoms, that people might lack the education to know why they’d need them, that it might conflict with their beliefs, etc. But the ease with which he can apply a pet economic principle is just too tempting, so he ignores these factors.

Another example is where Easterly asserts that population growth cannot be a problem, because “an additional person is a potential profit opportunity for a person that hires him or her” and as a result “the real wage will adjust until the demand for workers equals the supply.” It’s quite clear things don’t function this smoothly in labour markets even in developed countries; for theoretical reasons as to why, Easterly need look no further than John Maynard Keynes; failing that, modern work on labour market frictions might prove sufficient. Again we see a neat but overly simplistic principle applied when even the economist themselves surely knows better.

So it is not uncommon for economists to prefer their more ‘free market’ principles over nuance when writing for a popular audience**. But is this problem only limited to popular economics? Economists seem to think so; to them, the issue is primarily one of communication, and knowing the limits of your models. This is fine as it goes. However, there are reasons to believe this bias extends into the murky depths of academia.

In my opinion, there is one major culprit of selective application in economics, and it is one that cannot be explained by economists simplifying their work for public consumption: the Lucas Critique. The Lucas Critique suggests that adjusting policy based on observed empirical relationships from the past will alter the conditions under which these observations were generated, hence rendering the relationship obsolete.

Unfortunately, in practice, Lucas’ version of the critique seems to have been used to beat ‘Keynesians’ over the head, rather than being universally applied as a tool to further understanding. To illustrate this, here are some areas I think Lucas critique-style thinking could be applied, but hasn’t:

• Milton Friedman’s methodology. If a ‘black box’ theory corroborates well with past evidence but we aren’t entirely sure the internal mechanics are accurate, there’s no reason to believe the corroboration will hold, or to know how the mechanics of the system will change, if we change policy.
• Nominal GDP Targeting (NGDPT). This hasn’t caught on much on the left (in my opinion, for primarily ideological reasons: it’s anti-Keynesian, it partly absolves the private sector of responsibility for recessions). But it doesn’t seem to have occurred to proponents of NGDPT that we must ask if the relationship between inflation, RGDP and NGDP will break down if we try to exploit it for policy purposes. This is despite the fact that we are talking about precisely the same variables as  the Phillips Curve, the primary theory to which the Lucas Critique was initially applied.
• The supposed “deep parameters” of human behaviour on which Lucas suggests we construct economic models, such as technology and preferences. For a neoclassical economist, you are born with a set of preferences and you die with them, while in many models technology is a vaguely defined exogenous parameter. Yet a single example can show that both of these things can change with policy: government investment, which is at the root of a large number of technological break throughs. These break throughs have often resulted in new products, creating preferences that otherwise wouldn’t have existed. A model with fixed, exogenous parameters for technology and preferences is therefore hugely fallible to policy changes.

The fact that the critique hasn’t been applied to these examples leads me to believe it’s often only used to preserve existing economic theory.  In fact, the critique itself is really just a narrow version of the more general principle of reflexivity, noted by many before. Reflexivity is an ever-present problem that suggests an evolving relationship between policy and theory, not a principle that means we can fall back on economist’s preferred methods.

Is the Lucas Critique the only culprit? Well, I’ve found economists are generally critical of the assumptions and mechanics of heterodox models, despite appealing to Friedmanite arguments when questioned about their own. I’ve also found economists (okay, one) appeal to how businessmen really behave when defending their theories despite not paying much credence to alternative theories based on the same principle, such as cost-plus pricing. So maybe economists need to air out their theories and principles a bit, rather than simply applying them where it suits them.

Economist’s simple stories often capture some truths, which is why they will defend them to the death. But too often this becomes a matter of protecting a core set of beliefs, and being unwilling to apply them in new ways or even abandon them altogether. So economists end up deferring to their framework when it isn’t appropriate, or only interpreting it in their preferred way, particularly when they communicate their ideas to the public. The result can be that misleading conclusions about the economy remain prominent, even when economist’s own frameworks, interpreted completely, don’t necessarily imply them. Perhaps if economists were more willing to open up their theories, which can sometimes feel like something of a black box, these misinterpretations would be exposed.

*I won’t delve into the evidence here because it’s not the point, but you can easily find Krugman making the same arguments on his blog if you’re curious.

**In fairness to Krugman and Easterly, these books were written a while ago, and I’m sure they have updated their positions since then. I only wish to show that economists use this tactic, not that any one economist endorses any particular position.

The Dangers of Thinking Like an Economist

“Thinking like an economist” is one of those things you’ll see on the pages of every book released during the initial attack wave of pop economics books starting around 2006. In fact, the authors of such books set out with the explicit aim to educate the average person about the basics of economics: demand and supply, comparative advantage, opportunity cost, cost-benefit analysis, externalities, and of course the most beloved mantras: ‘people respond to incentives‘ and ‘there’s no such thing as a free lunch‘.

The typical economist’s mindset is a logical, dispassionate (though not necessarily uncaring) analyst who weighs up situations and policies using basic principles, bearing in mind there are always trade offs and no perfect solutions. Economists usually weigh things up with efficiency in mind, thinking of equitability as an important but often opposed goal to efficiency, and one that should probably be considered separately (this stems from Kaldor-Hicks efficiency, which suggests that pareto optimal policies can be combined with redistribution policies to produce the best possible outcome in terms of both efficiency and equity. Sadly, in practice this means economists sometimes just advocate the former, with the proviso that the latter could happen, but don’t worry as much as they should about whether the redistribution actually does happen).

There are obviously areas where economist’s toolkit applies. Cost-benefit analyses are appropriate for business plans and plans in other organisations. Opportunity cost is relevant when keeping the weekly shop within a budget: if we buy the biscuits, we won’t have enough for the cereal bars, etc. The economic way of thinking also has unexpected applications: for example, economists have done commendable work in the field of organ donation.

However, problems with the ‘economic way of thinking’ arise under certain circumstances. This is commonly when actions have outcomes that are fundamentally unknown, or are incommensurable. What is the opportunity cost of me writing this blog post? Well, I could be writing a different blog post, but I have no idea which one my readers would prefer. That’s assuming I evaluate blogging solely in terms of one metric, like page views, which obviously isn’t true. Alternatively, I could be reading a book; perhaps I’d get an idea for a better post for that, so over the long term reading would be more fruitful. I could also be sleeping, cooking, at the pub, or any number of things, but weighing up the various trade offs and benefits of these actions ‘like an economist’ is simply not possible.

I believe there are ample examples of economists extending their economist’s toolkit beyond where it is appropriate. I will note that good economists realise the limits of their approach, and would probably not endorse the (sometimes absurd) instances of ‘economic imperialism’ I am about to present:

Politicial science. Economists extended their toolkit to political science with public choice theory, which supposes that politicians and voters are rational self-maximisers who act to further their own interests, be they power, prestige, financial gain or what have you. This found its reductio in Bryan Caplan, who suggested that voters are rationally ignorant of politics because the costs outweigh the benefits, and so economists (who are obviously right about everything) should dictate public policy. You know, like in Chile.

Fortunately, this theory is wrong. Research, the best coming from Leif Lewin, has found that politicians and voters act in what they perceive to be the general interest, not narrow self interest. People vote and act out of a sense of obligation and citizenship, not because of any cost benefit analysis they partake in. Public servants are generally public spirited and less motivated by money than those in the private sector. While special interest groups are a problem, economists are better off turning to political scientists if they want to analyse this further, who have known what I outlined above for a long time.

The environment. Some of economist’s basic tools are easily shown to be absurd when applied to environmental analysis. It is not possible to place a monetary value – economist’s go to unit – on most environment variables. How do we compare the ‘value’ of a lake with the economic costs of a carbon tax? Is there some level of carbon tax at which we would forego every lake on earth rather than apply it? How do we compare, say, the depletion of coal with a rise in the sea level? These things have many different metrics by which they can be judged. The financial metrics used by economists are surely among them, but they are only a small part of the picture.

Another problem arises when looking at possible future environmental outcomes, as probabilities are fundamentally unknowable. Some try to approach the issue of global warming and environmental catastrophe by weighing up probabilities and doing cost-benefit analyses. But how do we propose to calculate the probability of environmental disaster? We don’t have a set of earths we can ‘run’ to evaluate how often catastrophe occurs; climate models display chaotic behaviour that is highly dependent on the accuracy of initial conditions. The fact is that we simply don’t know how likely disaster is, what its impacts will be, and framing it in such a way is deeply misleading. Furthermore, even if the probabilities were known, what matters is not just the weighted relative costs and benefits, but the potential for absolute disaster. If there is a 1% chance the world will end unless we do x, we shouldn’t do a cost-benefit analysis. Instead, assuming x is feasible, we should simply do it.

The law. As Yves Smith details in ECONNED (pp. 124-126), Chicago School economists managed to persuade first legal theorists, and then those involved in the legal system itself, of the efficacy of their way of thinking, eventually forming the ‘law and economics’ school. Since this was Chicago, it will not surprise you to learn that this approach largely consisted of a focus on efficiency over, say, due process, promoted deregulation, and rejected notions of corporate social responsibility. Nor should it surprise you that the movement had a large degree of – ahem – ‘support’ from various moneyed interests.

Theoretically, I find the corporate social responsibility position to be incoherent. Empirically, it’s obvious that the framework economists had a substantial part in setting up has failed. Fraud has risen; the changes in anti-trust have not had the benefits that economists predicted; we had a financial crisis in 2008 as a result of the regulatory framework put in place. Note that this isn’t an ideological point: you can think that the regulation was too loose, too tight, or simply wrongly formulated. But in general, defending the exact thinking and framework that led to the crisis is absurd.

Economists take pride in the seeming versatility and simplicity of their framework, and they are eager to apply it to other social sciences. That economists conclusions are, to quote Keynes, “austere and often unpalatable, len[d them] virtue”, especially when contrasted with less mathematically certain social sciences, such as sociology. But oftentimes economists act to displace existing theories without really considering the existing viewpoint. And oftentimes that existing viewpoint has more to it than economists, trained as they are to see things a certain way, might perceive. Hence, economists should always careful when venturing onto new intellectual turf, as otherwise they risk missing vital insights long known to others, insights to which their framework blinds them.

Sorry, Economists: The Crisis is a Huge Problem for Your Discipline

I recently stumbled upon a reddit post called ‘A collection of links every critic of economics should read.‘ One of the weaker links is a defence of economists post-crisis by Gilles Saint-Paul. It doesn’t argue that economists actually did a good job foreseeing the crisis; nor does it argue they have made substantial changes since the crisis. It argues that the crisis is irrelevant. It is, frankly, an exercise in confirmation bias and special pleading, and must be fisked in the name of all that is good and holy.

Saint-Paul starts by exploring the purpose of economists:

If they are academics, they are supposed to move the frontier of research by providing new theories, methodologies, and empirical findings.

Yes, all in the name of explaining what is happening in the real world! If economists claim their discipline is anything more than collective mathematical navel gazing, then their models must have real world corroboration. If this is not yet the case, then progress should be in that direction. Saint-Paul is apparently happy with a situation where economists devise new theories and all nod and stroke their beards, in complete isolation from the real world.

He continues:

If [economists] work for a public administration, they will quite often evaluate policies.

Hopefully ones that prevent or cushion financial crises, surely? Wait – apparently this is not a major consideration:

One might think that since economists did not forecast the crisis, they are useless. It would be equally ridiculous to say that doctors were useless since they did not forecast AIDS or mad cow disease.

Yet again, an economist insists on analogies to hard sciences that make no sense.

AIDs and mad cow disease were random mutations of existing diseases and so could not have been foreseen. Financial crises are repeated and have occurred throughout history. They demonstrate clear, repeated patterns: debt build ups; asset inflation; slow recoveries. Yet despite this, doctors have made more progress on AIDs and MCD in a few decades than economists have on financial crises in a few centuries. It was worrying enough that DSGE models were unable to model the Great Depression, but given that ‘it’ has now happened again, under very similar circumstances, you’d think that alarm bells might be going off inside the discipline.

Saint-Paul now starts to defend economics at its most absurd:

One example of a consistent theory is the Black-Scholes option pricing model. Upon its introduction, the theory was adopted by market participants to price options, and thus became a correct model of pricing precisely because people knew it.

This is the same model whose use has consistently been associated with financial collapse, right? Anyway…

Similarly, any macroeconomic theory that, in the midst of the housing bubble, would have predicted a financial crisis two years ahead with certainty would have triggered, by virtue of speculation, an immediate stock market crash and a spiral of de-leveraging and de-intermediation which would have depressed investment and consumption. In other words, the crisis would have happened immediately, not in two years, thus invalidating the theory.

‘A crisis will happen if these steps are not taken to prevent it’ is not the same as ‘Lehman Brothers will collapse for certain on September 15th, 2008.’  Saint-Paul confuses different levels, and types of, prediction. Nobody is suggesting economists should give us a precise date. What people are suggesting is that, by now, economists should know the key causal factors of financial crises and give advice on how to prevent them.

Saint-Paul charges critics with:

…[ignoring] that economics is a science that interacts with the object it is studying.

How he thinks this is beyond me, seeing as the whole criticism is that policies designed by economists had a hand in causing the crash. Predictably, he goes on to state a ‘hard’ version of the Lucas Critique, the go-to argument for economists defending their microfoundations:

Economic knowledge is diffused throughout society and eventually affects the behaviour of economic agents. This in turn alters the working of the economy. Therefore, a model can only be correct if it is consistent with its own feedback effect on how the economy works. An economic theory that does not pass this test may work for a while, but it will turn out to be incorrect as soon as it is widely believed and implemented in the actual plans of firms and consumers. Paradoxically, the only chance for such a theory to be correct is for most people to ignore it.

It is reasonable to suggest policy will have some impact on the behaviour of economic agents. It is absurd to suggest this will always have the effect of rendering the policy (model) useless (irrelevant). It is even more absurd to suggest that we can ever design a model that sidesteps this problem completely. What we have is a continually changing relationship between policy and economic behaviour, and this must be taken into account when designing policy. This doesn’t imply we should fall back on economist’s preferred methods, despite a clear empirical failure.

Saint-Paul moves on – now, apparently, the problem is not that economist’s theories don’t behave like reality, but that reality doesn’t behave like economist’s theories:

In other words, if market participants had been more literate in, or more trustful of economics, the asset bubbles and the crisis might have been avoided.

If only everyone believed, then everything would be fine! Obviously, the simple counterpart to this is that many investors and banks did believe in the EMH or some variant of it, yet, as always, reality had the final say, as happened with the aforementioned Black-Scholes equation.

Saint-Paul now attempts to play the ‘get out of reality completely’ card:

While it is valuable to understand how the economy actually works, it is also valuable to understand how it would behave in an equilibrium situation where the agents’ knowledge of the right model of the economy is consistent with that model, which is what we call a “rational expectations equilibrium”. Just because such equilibria do not describe past data well does not mean they are useless abstraction. Their descriptive failure tells us something about the economy being in an unstable regime, and their predictions tell is something about what a stable regime looks like.

Basically, Saint-Paul is arguing that economic models should be unfalsifiable. Since we can hazard a guess that he isn’t too bothered about unrealistic assumptions, given the models he is defending, and since he clearly doesn’t care about predictions either, he has successfully jumped the shark. Economists want to be left alone to build their models which posit conditions which are never fulfilled in the real world, and that’s final!

As if this wasn’t enough, he proceeds to castigate the idea that economists should even attempt to expand their horizons:

The problem with the “broad picture” approach, regardless of the intellectual quality of those contributions, is that it mostly rests on unproven claims and mechanisms. And in many cases, one is merely speculating that this or that could happen, without even offering a detailed causal chain of events that would rigorously convince the reader that this is an actual possibility.

Note what Saint-Paul means by “detailed causal chain of events.” He means microfoundations. But he is not concerned about whether these microfoundations actually resemble real world mechanics, only that whether they are a “possibility.” To him, the mere validity of an economic argument means that it has been ‘proven,’ regardless of its soundness. In other words: economists shouldn’t be approximately right, but precisely wrong.

Saint-Paul concludes by rejecting the idea that financial crises can be modeled and foreseen:

This presumption may be proven wrong, but to my knowledge proponents of alternative approaches have not yet succeeded in offering us an operational framework with a stronger predictive power.

It has indeed been proven wrong, as alternative models do exist.

I hope – and actually believe – that most economists don’t believe that the crisis is irrelevant for their discipline. I’m sure few would endorse the caricature of a view presented here by Saint-Paul. Nevertheless, it is common for economists to suggest that the crisis was unforeseeable: a rare event that cannot be modeled because the economy is too ‘complex.’ This must be combated. Financial crises are actually (unfortunately)  relatively frequent occurrences with clear, discernible patterns drawing them together. To paraphrase Hyman Minsky: a macroeconomic model must necessarily be able to find itself in financial crisis, otherwise it is not a model of the real world.

Economists Versus Physics

I’m not sure what it is about economics that makes both its adherents and its detractors feel the need to make constant analogies to other sciences, particularly physics, to try to justify their preferred approach. Unfortunately, this isn’t just a blogosphere phenomenon; the type of throwaway suggestion you get in internet debates. This problem appears in every area of the field, from blogs to articles to widely read economics textbooks.

Not too infrequently I will see a comment on heterodox work along the lines of “Newton’s theories were debunked by Einstein but they are still taught!!!!” Being untrained in physics (past high school) myself, I am grateful to have commenters who know their stuff, and can sweep aside such silly statements. As far as this particular argument – which is actually quite common – goes, the fact is that when studying everyday objects, the difference between Newton’s laws, quantum mechanics and general relativity is so demonstrably, empirically tiny that they effectively give the same results.

Even though quantum mechanics teaches us that in order to measure the position of a particle you must change its momentum, and that in order to measure its momentum you must change its position, the size of these ‘changes’ on every day objects is practically immeasurable. Similarly, even though relativity teaches us that the relative speed of objects is ‘constrained’ by the universal constant, the effect on everyday velocities is too small to matter. Economists are simply unable to claim anything close to this level of precision or empirical corroboration, and perhaps they never will be, due the fact that they cannot engage in controlled experiments.

Another, more worrying example, is Greg Mankiw’s widely read Macroeconomics textbook (7th ed, p. 395), when discussing estimates of the NAIRU:

If you ask an astronomer how far a particular star is from our sun, he’ll give you a number, but it won’t be accurate. Man’s ability to measure astronomical distances is still limited. An astronomer might well take better measurements and conclude that a star is really twice or half as far away as he previously thought.

Mankiw’s suggestion astronomers have this little clue what they are doing is misleading. We are talking about people who can calculate the existence of a planet close to a distant star, based on the (relatively) tiny ‘wobble’ of said star. Astronomers have many different methods for calculating stellar distances: parallax, red shift, luminosity; and these methods can be used and cross-checked against one another. As you will see from the parallax link, there are also in-built, estimable errors in their calculations, which can help them straying too far off the mark.

While it is true that at large distances, luminosity can be hard to interpret (a star may be close and dim, or bright and far away) Mankiw is mostly wrong. Astronomers still make many, largely accurate predictions, while economist’s predictions are at best contested and uncertain, or worse, incorrect. The very worst models are unfalsifiable, such as the NAIRU Mankiw is defending, which seems to move around so much that it is meaningless.

Another example is a classic case of economists misunderstanding the use of assumptions. This is from Jehle and Reny’s textbook, Advanced Microeconomics (3rd ed, preface XVI):

In the physical world, there is ‘no such thing’ as a frictionless plane or a perfect vacuum.

Perhaps not, but all these assumptions do is eliminate a known mathematical variable. This is not the same as positing an imaginary substance (utility) just so that mathematics can be used; or assuming that decision makers obey axioms which have been shown to be false time and time again; or basing everything on the impossible fantasy of perfect competition, which the authors go on to do all at once. These assumptions cannot be said to eliminate a variable or collection of variables; neither can it be said that, despite their unrealism, they display a remarkable consistency with the available evidence.

Even if we accept the premise that these assumptions are merely ‘simplifying,’ the fact remains that engineers or physicists would not be sent into the real world without friction in their models, because such models would be useless - in fact, in my own experience, friction is introduced in the first semester. Jehle and Reny do go on to suggest that one should always adopt a critical eye toward their theories, but this is simply not enough for a textbook that calls itself ‘advanced.’ At this level  such blatant unrealism should be a thing of the past, or just never have been used at all.

Economics is a young science, so it is natural that, in search of sure footing, people draw from the well respected, well grounded discipline of physics. However, not only do such analogies typically demonstrate a largely superficial understanding of physics, but since the subjects are different, analogies are often stretched so far that they fail. Analogies to other sciences can be useful to check one’s logic, or as illuminating parables. However, misguided appeals to and applications of other models are not sufficient to justify economist’s own approach, which, like other sciences (!), should stand or fall on its own merits.

‘Free Market’ Double Standards 6.0

It’s been a while since I did my last free market double standards post, which received some flak. To be honest, I think some of the criticisms were fair. Having said that, I don’t search for these contradictions just to wind up libertarians (though that can be a desirable side effect); generally they are quite obvious once you look past the way the right frame the debate.

I think the nature of many right wing arguments lends itself to contradiction: the shape shifting free market, which seems to mean something different to everyone; the nature of reactionary arguments, which causes people to make bizarre claims about proposed policies (see 5). Many right wingers also, despite themselves, end up supporting Republican candidates, which of course lends itself to all manner of contradiction (18).

I’ve also got some more economic theory ones in here. In particular, I’ve noticed economists ask some tough questions about new models, seemingly forgetting the various responses they have to the same criticisms of their own models (or if they don’t have responses, forgetting to apply these apparently pertinent criticisms to their own models). There are no links when I consider a point to be well established.

Anyway, enough preamble – let’s commence:

1. Libertarians emphasise that people didn’t consent to the state. They do not ask questions about whether people consented to the existing property distribution.

2. Mises and other libertarians thought socialism is about supposedly superior men running the world, which is wrong. Mises also said:

You have the courage to tell the masses what no politician told them: you are inferior and all the improvements in your conditions which you simply take for granted you owe to the effort of men who are better than you.

in a letter to Ayn Rand (p. 996).

3. NGDP targeting proponents will generally reference the Lucas Critique during discussions of modern macro. However, I have yet to see one apply the critique to NGDP targeting, when it is actually incredibly pertinent.

4. NGDP targeters defend supposed incidences of Central Bank’s inability to control NGDP (like 2008) by arguing that the CB must announce a policy rule for it to work, but simultaneously hold up Israel and Australia – where the CB has done no such thing – as examples of NGDP targeting working.

5. Stephen Williamson – and I’m sure he is not the only one – has at different times claimed QE will have no effect, and that it will produce runaway inflation.

6. Austrians generally present businesses as smart and forward looking, but their business cycle theory effectively asserts business decisions will be wildly thrown off by temporary short term interest rates changes.

7. Milton Friedman emphasised that regulatory capture would create a lot of problems, but also suggested looking at the amount of regulations, rather than their actual enforcement, as a guide to the ‘level’ of regulation. So he simultaneously endorsed the bizarre idea that regulation is a dial we can turn up and down, and the idea that it’s really more complicated than that.

8. Milton Friedman argued that businesses have no social responsibility, but should not engage in fraudulent behaviour, and “stay within the rules of the game.” Which is a form of social responsibility.

9. Milton Friedman endorsed both the Friedman Rule and the K-Percent Rule. They are contradictory.

10. Anarcho-capitalists are against the state, preferring insurance companies to provide what are commonly known as ‘public goods.’ They also have no trouble with monopolies. So if an insurance company that uses force is the only game in town (and owns all the land), how is that different from a state?

11. According to libertarians, if you can possibly leave a job, your freedom cannot be impinged during the job. Of course, many of us are free to leave our countries but libertarians still complain about coercive legislation.*

12. Libertarians are often resistant to the applicability of behavioural economics. Yet companies use behavioural insights in advertising and marketing to expand profits, something that’s usually a sign of efficacy in a libertarian world.

13. Libertarians generally oppose fraud in abstract, but many have the same knee-jerk reactions against prosecuting any specific instance as they have to most questioning of business practice.

14. David Smith (and other austerity defenders) tried to pin the decline in UK output on bank holidays. But this implies a day contributes a significant amount to output, so during every working day the economy must have boomed!

15. Again, austerians such as David Smith can’t decide whether to defend austerity by insisting it’s working (see 14) or whether it isn’t happening at all.

16. Economists complain a lot about sticky wages causing unemployment. But as of yet, I have yet to see one volunteer for a pay cut!

17. Economists love ceteris paribus. But apparently if preferences are held constant in a model, it must be worthless.

18. Greg Mankiw’s textbook analysis of the financial sector implies asset bubbles do not have a major effect on the real economy. But he also attributes Clinton’s boom to the internet stock bubble, implying the exact opposite.

19. Generally economists argue they shouldn’t be expected to make accurate predictions about the future. But when one of Steve Keen’s specific predictions did not come true, they took it as grounds to dismiss him (btw, bonus points for reading that entire thread and staying sane).

20. Economists, though few endorse a ‘hard’ version of Friedman’s methodology, will generally reference a derivative of it when pushed. However, when criticising alternative models, they raise questions about their internal mechanics.

21.

What is original in the book is not true; and what is true is not original.

- Henry Hazlitt on Keynes’ General Theory, a quote originally attributed to Samuel Johnson.

Neither true nor original, then.

*Note also that Hayek roughly endorsed my position on this, but AFAIK he never drew attention to the workplace.

Links and Stuff

This (semi-)post will meander.

The website mindful money followed up on its recent post about ‘New Economics’ sites, in which I was happy to be mentioned, with interviews with some of the bloggers, including Steve Keen and me. Here is the interview ‘home page,’ and here is my interview. A brief excerpt, sure to be hated by economists:

In economics, the elephant in the room is, and always has been, assumptions…many economic models are invalid before we even begin, simply because the assumptions don’t resemble the real world at all.

Vaguely related, I recently claimed on twitter that Bob Solow was the most quotable economist of all time. My above point about assumptions reminds me of another of his – on why he doesn’t engage neoclassical economists:

Suppose someone sits down where you are sitting right now and announces to me that he is Napoleon Bonaparte. The last thing I want to do with him is to get involved in a technical discussion of cavalry tactics at the Battle of Austerlitz. If I do that, I’m getting tacitly drawn into the game that he is Napoleon Bonaparte.

To this end, Miles Kimball – a guy who is so nice and open minded I feel like I am kicking a puppy by daring to disagree with him – has a post on economic models that I would surely be excoriated for (‘straw man’) if I were to post it as a parody:

The closest we can come to treating consumption, leisure and the public good in this model as ordinary goods is if we imagine a social planner…in other words, the social planner I am talking about is not a fallible human, but the Invisible Hand.

I’m sure Gavin Kennedy would take issue with the use of the Invisible Hand metaphor, but seriously? There is an obvious chicken and egg problem if we are to invoke the ‘free market’ as a mechanism before trade takes place. I mean, I also object to the idea that there is some sort of magical omnipotent force making everything perfect in a market economy.

In other news, OWS have a video in which Raghuram Rajan repeats various crap and John Cassidy is unable to escape the governments versus markets mentality. Nonetheless, I am glad to see it. Anyway, I could ramble on for a while but I’ll stop here.

The Fundamental Difference Between Mainstream and Heterodox Economics

Simon Wren-Lewis discusses the large gap between mainstream and heterodox economics, and asks why the heterodox economists are so willing to throw out almost every aspect of neoclassical theory. Allow me to offer an explanation.

The reason heterodox economists remain dissatisfied with mainstream economics, no matter how many modifications the latter adds to its core framework, is that there is always an implication that, in the absence of various real world ‘frictions’, the economy would function like a smoothly oiled machine. That is: assuming perfect information, mobility, ‘small’ firms, no unions, flexible prices/wages and so forth, the economy would achieve full employment, with near perfect utilisation of resources, and stay there, perhaps buffeted by mild external shocks.

New Keynesians and New Classicals sometimes act like bitter rivals, but mainly they only differ on which ‘frictions’ should be present or not (this is an oversimplification of the disagreement, of course). The original New Classical models started with economies that are always in equilibrium, preferences are constant, and competition is perfect. New Keynesian models add imperfect competition, sticky prices, transaction costs and so forth. The newest papers go further and add heterogeneous agents (which generally means two), changing preferences, and other ‘frictions.’ However, it is assumed that if the economy were rid some specific features/characteristics, it would function similarly to one of the core Walrasian or Arrow-Debreu style formulations.

So is it not true that real world mechanics prevent things from going as smoothly as they might do in absence of those mechanics? Well, partially. But according to heterodox economists, capitalism has inherent tendencies to crisis, unemployment and misallocation anyway.

A key example of where this is evident is finance. Generally the mainstream analyses of why finance is unstable focus on irrationality, imperfect information, externalities and other such modifications. If only everyone had access to information, if transactions were cost less, and if people were rational self maximisers, then finance would be stable.

Minskyites, on the other hand, argue that this isn’t the real problem. Even if the economy starts stable, the resultant strong returns on investments will cause capitalists/investors to take more risk. This process will continue and the economy will endogenously destabilise itself as higher returns are sought and more risk is taken on, until eventually the capacity to make a return on these risks is outrun and we face a collapse. There is no need to invoke a specific ‘friction’ for this process to occur.*

Another prominent example is the labour market. Generally, economists presume that without ‘search costs’, oversized firms/unions and sticky wages, the economy would achieve full employment. But heterodox economists disagree on a number of counts: the Marginal Value Product Theory is faulty, so higher wages will not necessarily cause unemployment to rise; wages are also an essential component of aggregate demand, so reducing them may well be counterproductive. In fact, Keynes argued that sticky wages were far from a barrier to full employment; they actually stabilised aggregate demand. Steve Keen’s model also produces less severe business cycles when sticky wages and prices are added.

So the reason heterodox economists want to throw the proverbial baby out with the bath water (and also redecorate the bathroom and possibly even move house, or something), is that they think the core of mainstream economics has dug itself too deep into a ditch. The inevitable ad hoc modifications of ‘perfect’ models sometimes have so many ‘frictions’ introduced that the supposed ‘deep’ mechanics that underlie them become questionable. But they are still never abandoned. Heterodox economics is not just about adding a few real world mechanics here and there; it’s about throwing out the entire core and starting over.

*It could be said that this might not occur if Knightian uncertainty were not a factor in the real world, but I think calling this a ‘friction’ jumps the gap between friction and fundamental reality.

The ‘Sumner Critique’, or Why Not to Ignore Keynes

I thought I’d offer a brief note on Scott Sumner’s latest offering to the field of economics – the ‘Sumner Critique.’ Sumner offers an apt example of why macroeconomists who ignore TGT are basically wasting their time – virtually every macroeconomic insight is already in The General Theory. Sumner says he has ‘never been able to take the book seriously.’ Maybe he just needs to read it properly.

The ‘Sumner Critique’ states that if the path of NGDP is stable, all macroeconomic effects become classical in nature. Sumner and others appear to think this is new and original, but, unfortunately for them, it was stated 76 years ago by Keynes:

Our criticism of the accepted classical theory of economics has consisted not so much in finding logical flaws in its analysis as in pointing out that its tacit assumptions are seldom or never satisfied, with the result that it cannot solve the economic problems of the actual world. But if our central controls succeed in establishing an aggregate volume of output corresponding to full employment as nearly as is practicable, the classical theory comes into its own again from this point onwards. If we suppose the volume of output to be given, i.e. to be determined by forces outside the classical scheme of thought, then there is no objection to be raised against the classical analysis of the manner in which private self-interest will determine what in particular is produced, in what proportions the factors of production will be combined to produce it, and how the value of the final product will be distributed between them. Again, if we have dealt otherwise with the problem of thrift, there is no objection to be raised against the modern classical theory as to the degree of consilience between private and public advantage in conditions of perfect and imperfect competition respectively. Thus, apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest, there is no more reason to socialise economic life than there was before.

There you go. Replace ‘NGDP’ with full employment, and Keynes said it a long time ago. Keynes’ primary policy prescription of long term interest rates also has the benefit of being tried, and of working, after WW2. Conversely, NGDP targeting relies on expectations fairies and continually pumping up the value of asset prices. In other words: Keynes said it, but better.

Addendum: The riposte the NGDP and full employment are sufficiently different to make my criticism void does not hold. As Jonathan Catalan points out, for Keynes, ‘full employment’ was synonymous with ‘maximum effective demand, given potential output constraints.’ It’s hard to deny that Sumner uses something very similar.

Economists & ‘New Economic Thinking’

The doublethink with which mainstream economists are able to ’embrace’ new economic thinking and simultaneously shout down any attempt at, well, new economic thinking, is quite incredible. For example, see the infamous Krugman/Keen debate, where Krugman behaved startlingly similarly to his usual opponents on the right, even despite his own essay readily acknowledging the failure of economics in the crisis. Mark Thoma also had a similar reaction to Keen, but he then went on to write an essay praising new economic thinking.

In fairness to Thoma, his essay appears to acknowledge that economists like him are set in their ways and cannot embrace change on the scale required, but of course this in itself isn’t encouraging. Why can’t they change their ways? Why carry on if you strongly suspect your paradigm is flawed? I am reminded of a Richard Dawkin’s documentary, where he spoke of a scientist who had been working on a theory for the best part of his career. A new scientist arrived at his place of work, and falsified the theory – the older scientist, however, thanked him. This type of attitude would be helpful in economics.

Watching economists react to Keen’s work, and the work of others, I feel there are a few major barriers to economists accepting new economic thinking; once these are addressed they, hopefully, will find it easier.

Identifying Neoclassical Economics

Neoclassicism is seen by some economists as either a non-existent school of thought; a swear word used by their opponents, or as a long outdated paradigm which has been abandoned in favour of sticky wage/price models and other developments in the DSGE framework. So the first step towards engaging sympathetic neoclassicals is convincing them that their school exists.

I have commented on this briefly before, but I think that Christian Arnsperger & Yanis Varoufakis’ essay on this subject is excellent. It identifies neoclassicism as a methodology, rather than as the ‘rational self maximising, perfectly informed’ agent criticism that economists are so able to brush off with appeals to higher level work. That neoclassical economics uses methodological core of individualism, instrumentalism (preference satisfaction) and equilibration is hard to dispute, and so is an important starting point different schools to engage each other in both directions.

The Lucas Critique

Robert Lucas’ 1976 paper contains some valuable insights, but it also contains several flaws, at least in the way it has been intepreted:

(1) It has given grounds for economists to revert to their old mantra of ‘that’s OK in practice, but does it work in theory?‘ Krugman’s first post on Keen mentions that there is ‘a lot of implicit theorising’ in his paper – in other words, there are no microfoundations. Krugman uses this as grounds to dismiss the overwhelming empirical relationship between private debt and other economic variables.

(2) In practice, application of the Lucas Critique has basically amounted to the use of rational expectations and representative agents, rather than any deep change in economic modelling. There is a great discussion of the flaws in these approaches here, but that’s not necessarily relevant – what matters is that the LC is only applied sparingly.

(3) There is no empirical evidence to support it’s application – that is, it doesn’t appear to be useful when developing new theories or policies.

(4) The most important criticism of Lucas’ paper is that he suggests we model based on the ‘deep parameters’ of human behaviour. As anyone with even a passing familiarity with anthropology and history should know, these parameters simply don’t exist. You can find people throughout history behaving in any number of ways, both as societies and as individuals – even the most basic instincts, such as the need for sustenance and reproduction, have been overcome by environment (abstinent monks, lent, self sacrifice). The fact is that, for economists, ‘deep parameters of human behaviour’ seems to mean nothing more than the individualist, instrumentalist core outlined by Arsnperger & Varoufakis. This is as vulnerable to the Lucas Critique as any other theory or methodology.

So what are we left with? In essence, a suggestion that using a model for policy might have unintended consequences. This is true, and unfortunate, but it’s the reality of the social sciences, and has been known for a long time.

The ‘It Doesn’t Matter’ Mentality

Economists sometimes acknowledge that a model is flawed, but assert that the real world still behaves as if it corroborates with their models. This mentality can be found in one of my textbooks:

…[the student] rightly assumes that few firms can have any detailed knowledge of marginal revenue or marginal cost. However, it should be remembered that marginal analysis does not pretend to describe how firms maximise profits or revenue. It simply tells us what the output and price must be if they do succeed in maximising these items, whether by luck or judgement.

And also in Nick Rowe, defending exogenous money on the grounds that:

So the central bank must stop them creating loans and deposits out of thin air. The central bank will raise its rate of interest by whatever it takes to stop banks creating loans and deposits out of thin air. It is exactly as if the banks were reserve-constrained and couldn’t create money out of thin air.

This is one of those positions that I find it hard to articulate a response to. Of course it matters that we get the mechanics of a system right, otherwise we simply don’t have a model of the system – we’ve got something else! This is what I’ve been trying to get at with useful assumptions – useful ones simply eliminate a complication, whereas ones that are essentially hypotheses about how agents behave can be falsified in their own right. Economists seem to enjoy clinging to the ‘hypothesis’ variety of assumption, and this needs to stop.

There are some other important traps economists fall into – three of which I mentioned in my post on how to unlearn economics. From the perspective of accepting new economic theories, however, these three (and maybe the third one in the aforementioned post) are the most important – if they are not addressed, heterodox and mainstream economists will continue to talk past each other.

The Keen/Krugman Debate: A Summary

Paul Krugman and Steve Keen have been debating endogenous versus exogenous money – as well as some other issues – for the past few days. The debate appears to have drawn to close, so here I offer a summary for those who can’t see the wood for the trees.

1. Krugman reads Steve Keen’s paper and rejects it; specifically, he rejects endogenous money, asserting that banks need deposits before they can lend.

2. Keen responds, noting that banks do not require savings before they make a loan, as they can create loans and deposits simultaneously through double entry bookkeeping. The CB has to provide the reserves required for whichever loans they do make in the short term, else the economy will grind to a halt.

3. Nick Rowe weighs in, with a comment thread well worth reading. He sides with Krugman overall but appears to agree with at least some of what endogenous money proponents are claiming, including the the double entry accounting view of money creation.

4. Krugman, however, continues to deny this, claiming that CBs have monetary control, and citing a paper by James Tobin to support his point of view. He fails to note that, not only did nobody ever assert that the CB has no control whatsoever over monetary activity, but Tobin also wrote a paper called ‘Commercial Banks as Creators of ‘Money’‘, in which he agrees with the view that Krugman opposes.

5. Scott Fullwiler schools Krugman on how banking actually works in the real world.

6. Krugman makes a post where, through a sleight of hand, he seems to acknowledge that banks can create money, but goes on to straw man endogenous money proponents by saying that they claim there is no limit to this process. Of course, that’s not true – the only claim is that reserves are not the limit, the actual limitations being capital, risk and interest rates.

7. Krugman, unfortunately, goes on to make another post, one in which he effectively asserts that the Central Bank has complete control of the money supply, something completely contradictory to what he said before and blatantly falsified by the failure of monetarism in the 80s.

8. Krugman and Rowe both parade their ignorance by making it clear they have not read Keen’s latest post properly, and fall straight into his characterisation of DSGE. Keen responds. Krugman says the debate is over.

Looking over the debate, I’d score it to Keen – you might expect that, but I genuinely went through periods where I thought he might be wrong. Sadly, Krugman quite clearly moved the goalposts a couple of times, and Rowe didn’t make it exactly clear where he stands, even after I asked him. Neither of them engaged properly with Keen’s or anyone else’s arguments.

I can’t help but feel that the orthodox economists were deliberately obfuscating the debate – making it unclear exactly what they advocate, but simultaneously clinging to a core theory and asserting that its critics are attacking a straw man, ignorant of what is ‘added’ at a higher level. I’m forced to wonder if their theories are simply immune to falsification.

NB: A couple of others provide some constructive comments on Keen’s slack definitions in his most recent paper, particular with respect to units, that are worth reading in their entirety. Having said that, Keen’s accounting appears to be correct, even if it’s not the clearest.