Yesterday, Paul Krugman had a post in which he pontificated on the Stock Flow Consistent (SFC) models of the economy used by Wynne Godley (and generally by post-Keynesians). These models focus on simple flows of funds between sectors, use endogenous money mechanics and are consistent with accounting identities, making them highly suitable for modelling financial crises. Krugman, however, is not impressed. He seems to see these simple mechanics – with relationships between sectors determined by coefficients – as not quite ‘rigorous’ in the same way as the type of optimising, equilibrium model he favours. He believes that “Hydraulic” approaches like Godley’s have been supplanted by superior models, and so it would be a step backward to take another look at them.
It is worth noting that Krugman’s dismissal of these “hydraulic” models is strange given his zealous promotion of IS/LM, which is surely a hydraulic model if there ever was one: variables are simply determined by coefficients and left largely unexplained in terms of typical ‘optimising’ behaviour. More importantly, though, I think Krugman has quite an ignorant conception of how economic theory has developed. He tries to paint picture of economics as continually discovering new and interesting insights, but the reality is far more complex. In fact, many of the ‘insights’ mainstream economics claims to have discovered were already known; what’s more, their solutions to the purported problems with “hydraulic” models leave a lot to be desired. Often the only problems with a theory resulted from misinterpretations of particular thinkers, and, properly interpreted, the model offered a credible alternative to the neoclassical approach. Overall the history of economic thought is not really a clear cut story of scientific progression.
Yet Krugman sees things through a ‘Whig‘ perception of the history (of thought), where everything has progressed over time and culminated naturally in what we have now. He thinks that macroeconomics in the 1950s and 60s was similar to Godley’s work, but that it was abandoned for good reasons:
What you might not realize from this passage is that Godley’s notion that we should represent behavior by rules of thumb isn’t something new — it’s something old, which got driven out of macroeconomics. The “hydraulic Keynesianism” of the 1950s was all about viewing the economy as a kind of mechanism in which consumer behavior could be represented by an ad hoc consumption function, investment behavior by an ad hoc investment function, and so on. This produced a more or less mechanistic view of the economy, and AW Phillips famously represented hydraulic macro with a literal hydraulic mechanism.
I’m glad Krugman knows about Phillips’ wonderful MONIAC model. However, economists really misinterpreted Phillips, as this is clear in Krugman’s discussion of his work. His ‘curve‘ – which Krugman goes on to reference – was supposed to be a dynamic model of how unemployment and inflation change over the business cycle, not a static trade off between the two. Furthermore, Phillips’ models also included expectations, one of the supposed strengths of the models that displaced his. What’s more, Phillips was well aware of the problem of how the economy may evolve and change over time or with policy – as he put it:
In my view it cannot be too strongly stated that in attempting to control economic fluctuations we do not have two separate problems of estimating the system and controlling it, we have a single problem of jointly controlling and learning about the system, that is, a problem of learning control or adaptive control.
Krugman doesn’t reference this point – known by the mainstream as the Lucas Critique – explicitly, but this is the major reason “hydraulic” models were abandoned in favour of the ‘microfounded’ models Krugman endorses: it was thought that the latter would not be as susceptible to change with policy. However, this insight had been stated by many long before Lucas – not only Phillips above, but also Keynes – and it is a continual problem, so we cannot ‘immunise’ ourselves from it with microfoundations or anything else. The heterodox economists Krugman dismisses so blithely were actually more alert to the problem than he was, because they didn’t think they had – or could – supersede it.
Krugman now discusses why his favoured ‘optimising’ approach took centre stage in the 1970s and 80s:
So why did hydraulic macro get driven out? Partly because economists like to think of agents as maximizers — it’s at the core of what we’re supposed to know — so that other things equal, an analysis in terms of rational behavior always trumps rules of thumb.
I’m not sure this even counts as a defense of economist’s approach, because it is hopelessly question-begging. Economists shouldn’t model a certain way “because [they] like to”; they should do it because it is more consistent with observed phenomenon. Rational behaviour doesn’t really “trump” anything, as it is largely unobserved in the real world, whether on the part of firms, consumers, governments or what have you. All this point actually demonstrates is how economists can be predisposed toward a certain framework, regardless of predictive success or failure.
However, Krugman thinks that the neoclassical approach has been largely a predictive success when compared with its “hydraulic” counterpart, and puts forward two major points to show this:
First involved consumption spending. Conventional Keynesian consumption functions suggested that the savings rate would rise as incomes rose — and this wasn’t just the Keynesian interpreters, Keynes himself made the same claim….In fact, however, savings rates don’t seem to follow the naive consumption function at all; they rise in booms, and are higher for the wealthy, but exhibit no secular trend. And Milton Friedman appeared to explain this paradox by arguing that people are more less rational: they base consumption on “permanent income”, a reasonable estimate of long-run income, and save temporary fluctuations in income.
First, as Ramanan quickly noted, Wynne Godley’s model did not suggest the savings rate would rise as incomes rose; in fact, it was the opposite. So his model was perfectly consistent with observed behaviour, and there was no need to invoke optimising agents to ‘explain’ anything.
Second, if we were looking for a model of consumption based on human behaviour, Friedman’s permanent income hypothesis – where people spent money as a function of their total lifetime, rather than current income – was not the first or best theory for the job. In fact, it actually displaced a better theory, the relative income hypothesis. This suggested that people’s expenditure was a function of what people around them were spending, or the norms in a society. Poor people’s consumption would be a higher percentage of their income because they were trying to “keep up with the Joneses”; however, as incomes as a whole rose, so would the socially acceptable level of income, so savings rates would not rise with total income. This kind of airy-fairy explanation is like nails on a blackboard for many mainstream economists, but it is more consistent with both the statistical evidence and observed human behaviour.
Krugman’s second point in favour of neoclassical economics is the role of the 1970s stagflation as a vindication of the ‘rational agent’ approach:
In came Friedman and Phelps to argue that rational price-setters would build expected inflation into their choices, so that sustained low unemployment would produce accelerating inflation. And the stagflation of the 70s seemed to vindicate their argument.
Friedman and Phelps’ model may “seem” consistent with stagflation, but there are alternative explanations for stagflation, too, and the question is which one is most closely consistent with the mechanics of the phenomenon. In fact, Friedman and Phelps’ NAIRU theory’s major prediction – that past a certain level of unemployment, inflation will start to increase dramatically – actually has little evidence behind it. On the other hand, Andrew Lainton has pointed out that in Wynne Godley’s Magnum Opus, Monetary Economics, he developed a full model of stagflation that dealt with the 1970s quite competently. On top this this, Godley’s model, as well as similar ones like Steve Keen’s, are also well equipped to explain the recent financial crisis. As Noah Smith once argued, the best theories are those which can explain all phenomena within their domain, and models like Godley’s simply fit this description more closely. But Krugman doesn’t realise this, because he knows very little about the work of Godley and people like him – after all, why bother when they’ve been relegated to the dustbin of progress?
The only problems with economist’s 1950s view of inflation and unemployment stemmed from the ‘bastard Keynesianism’ of the 1950s and 60s, which resulted from misinterpreting Keynes and Phillips and trying to shoehorn them into the neoclassical approach. However, even if we accept ‘bastard Keynesianism’, Krugman’s point is questionable, as the prominent post-war economists Robert Solow and Paul Samuleson were also aware of the potential for the relationship between inflation and unemployment to become unstable. Therefore, claiming that Friedman and Phelps swept in with new, largely successful insights is a stretch to say the least.
Essentially, Krugman believes in a Whiggish conception of the history of thought, where good ideas have driven out the bad, and economics has slowly made better and better predictions. But like all Whig history, Krugman’s opinion rests on arbitrarily placing current theory as the inevitable goal of complex and fractured processes, ignorance of things that don’t seem immediately relevant to these theories, and above all, a good old bit of self-aggrandisation. While I don’t want to tar too many with this brush, judging from the way I was taught, and what I’ve seen elsewhere, it seems that a large part of the discipline thinks this way. But the development of economics has been far more complex, and alternative theories are far more credible, than such a narrative would have you believe.