Posts Tagged Paul Krugman

Whig Theories of the History of Thought

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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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.

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DSGE, Epicycles and Neoclassical Methodology

Daniel Kuehn asks me to define the difference between incorporating something into a model and ‘adding epicycles‘, as Keen and others so often put it.

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.

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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.

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