Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 3 July 2012

Ideology and Falsification in Macroeconomics

                This is a response to two posts, one by Stephen Williamson and another two by Noah Smith. Both are linked to a Paul Krugman post, which commented on, and had the same broad message, as one of my own. See also Mark Thoma here.
                Both Paul Krugman and I argued that the reason for the apparent disputative nature of macro lay in politics and ideology. To paraphrase my own take, the antagonism to a Keynesian reading of events since to financial crisis has ideological roots, based on a distrust of government intervention. This distrust is most apparent in the austerity versus stimulus debate on fiscal policy.
                Underneath Stephen Williamson’s obvious personal dislike for what Krugman is doing, there is a serious challenge to this view.  He writes
“Modern macroeconomics has been much more concerned with science than with politics. Robert Solow, David Cass, Tjalling Koopmans, Len Mirman, and Buzz Brock were not thinking about politics when they developed the theory that Kydland and Prescott used in their early work. I don't think Kydland and Prescott had politics on their mind in 1982, nor was Mike Woodford thinking about politics when he adapted Kydland and Prescott's work to come up with New Keynesian theory.”
Details aside, I think this will strike a chord with many academic macroeconomists. They are just trying to advance the discipline, and are certainly not trying to defend some ideological viewpoint. There are lots of interesting new ideas being explored in modern macro, producing high quality work with important implications. Most importantly, this work can be appreciated by most mainstream fellow researchers. Unlike the days of old, where members of different schools of thought talked across each other, we now have a shared language as a result of the microfoundation of macro.
I agree with everything in the previous paragraph, which is perhaps where I differ from some other Keynesians.[1] But I also obviously agree with what I wrote on ideology and macro. So how can I square this circle? The first, and probably critical, point to make is that when I and most others talk about antagonistic macroeconomic debates, we are referring to debates over current macroeconomic policy rather than the details of some macroeconomic research. The second point is that New Keynesian theory builds on Real Business Cycle foundations, and is therefore in theoretical terms not an alternative to it.
So, for example, I have no problem appreciating a seminar where the presenter explores a flex price DSGE model where fluctuations are only caused by productivity shocks, but where some relevant feature of the real world (some ‘friction’) is being added to earlier models. I might learn something about how to model this new feature, and what its macroeconomic implications might be. It could be the case that these techniques and results are completely negated once you added sticky prices into the model, but normally this is not the case. However, when it comes to looking at the impact of contractionary fiscal policy on the macroeconomy today, I will select a quite different model: sticky prices are essential, because we need to work in a world where we have demand deficiency.
The current reversion of macro back into schools of thought relates to policy advice. It’s about which models we select, and which we reject, when telling governments what to do. So the interesting question that arises is how this selection process takes place. Why do I insist we need to focus on aggregate demand to understand what is happening today, while others take a different view?
In the idealised Popperian description of scientific progress, it is evidence that provides this selection process. The moment that a piece of evidence is found that contradicts a theory or model, that theory will be rejected, and a new theory will emerge that is consistent with all known evidence. What is missing in macro, says Noah Smith, is this falsification process. I think the late and great Mark Blaug would wholeheartedly agree.
Now I could at this stage talk about the limits to falsificationism, and how it particularly fails to apply to economics. But I think Noah is essentially right. For a number of reasons I’ve talked about elsewhere, the microfoundation of macro and DSGE modelling downplays the role of evidence. More specifically, it allows modellers to be selective about which evidence they focus on (the ‘puzzle’). This may be fine for writing papers, but when it comes to model selection to tackle policy problems it is weak. And this weakness lets in the ideological factors I talked about.
So that is how I can be both supportive of current academic macro, and believe that macroeconomic policy advice is contaminated by ideology. I want to add one additional thought. Noah talked about this problem as one involving broken institutions, and I found that strange at first. But let’s go back to my fictional seminar involving a model where cycles are generated by productivity shocks. Even though the model is missing what I believe causes most business cycles, I can still learn something from the seminar, so it would be quite inappropriate for me to denounce the paper and storm out in disgust. Equally, academics should be free to choose what they think are interesting avenues to explore. The problem comes when the policy maker has to choose between models. But how and where exactly should evidence be exerting a greater influence? Is the problem in the selection processes of journals? Should there be more econometric analysis of structural macro relationships in journals, or do VARs tell us all we need to know? If nothing is missing from the academic journals, should policy making institutions employ more staff to do this kind of work? If you think that ideology plays too large a role in macro policy, but refuse to believe that this must always be so, these are interesting questions.        

[1] This is a different question about whether modern macro has advanced our understanding of the current crisis. Here I agree that old fashioned tools (be they 1970s macro – see Robert Gordon for example - or the General Theory itself) have proved their worth, but I also suspect that in time a more complete understanding will include more modern (and as yet undeveloped) elements. 


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  2. This is a sensible view, and one it would be nice to see it shared and acknowledged by more economists, especially freshwater ones.
    But I can't keep from feeling there are some imbalances in this view. Neoclassical theories lead to conclusions where markets are efficient, money is neutral and demand is not depressed. All of this calls for no government intervention, which can be (wrongly) perceived as non-political.
    On the other side, Keynesian theories routinely lead to recommendations for strong and counter-intuitive government intervention. And this looks highly political.
    In political terms, an advice of non-action does not weight the same as an advice of action. And thus, it is the non-partisan economists who look politically biased (something not entirely different happens in the US media, as Paul Krugman often mentions in his blog).

    Also, it is not enough that some economists demonstrate non-partisanship for refuting that "the disputative nature of macro lays in ideology and politics". For that, most economists should demonstrate non-partisanship. And the more I think about it, the more I believe that believing that inflation is a worse evil than unemployment is highly partisan.

  3. The key fact is that freshwater economics HAS been failing empirical tests for decades, most especially in the last 5 years. They refuse to change their minds because they're ideologically pre-disposed to despise government spending, and worship markets. That post by Stephen Williamson is frankly delusional.

    Krugman calls them out on this simple truth. Politeness in a situation like this is entirelly self-defeating.

  4. On the one hand, there is a model that is easy to use (relatively) for building models.
    However, the assumptions that simplify the model, the "microfoundations, are simply wrong.
    These assumptions replaced assumptions that are far more predictive in these economic conditions.
    Garbage In. Garbage out.

    It is flawed to treat Government spending in a way that is any different from any other spending. Spending is spending irrespective of the manner that the spending is conducted. This is a fatal flaw that needs desperately to be corrected.

    The other fatal flaw is not including wealth distribution in the models. Changes in distribution can and do effect spending and most particularly demand and velocity (which is not constant). Since the root of economic policy addresses how wealth is distributed, models that fail to address wealth inequality have nothing to contribute to policy in this area. To simply assume that redistribution (actually, it is part of distribution) is bad without examining the assumption is problematic.

    jonny bakho

    1. Yes, the fatal flaw was not to enter the variables that matter. Wealth distribution is certainly one, bankers' remuneration is another.
      Not taking them into account was either political-ideological or a mistake.
      Now, some economists admit their mistake, and other don't. Not difficult to tell who's biased.

  5. "The moment that a piece of evidence is found that contradicts a theory or model, that theory will be rejected, and a new theory will emerge that is consistent with all known evidence."

    I always say, a model is only as good as its interpretation. All models can be falsified; they're not reality, they’re for isolation of factors and insight. The better question is, is your interpretation falsifiable? And in an important way. Are your implications from the model to reality falsifiable, and in important ways?

    I'll give you a good example with Williamson:

    Williamson says some amazing things

    "No, in a liquidity trap, if the Fed purchases gold, it does not change the price of gold, just as it will not change the prices of Treasury bonds if it purchases them."


    "The Fed can buy all the government debt it wants right now, and that will be irrelevant, for inflation or anything else."


    And he seems to base this on Wallace, 1981 AER (or very largely on this paper).

    This intrigued and frustrated me so much that I've recently spent over 40 concentrated, uninterrupted, serious study hours on that paper. And it's extremely hard for me to make that kind of time. I'm still working on it, but what I see so far is that Williamson is interpreting this paper very literally, and that appears to be wrong:

    1) It depends on complete markets

    2) It assumes all investors are clones with identical information, analysis (perfectly forward looking), utility functions, even birth and death dates. I'd like to add to this model, if I can find the time, investor heterogeneity, perhaps by adding an error term for each investor h to the state return vector and/or state probability vector. I'm quite sure, then, the irrelevance proposition proof will no longer hold (at least if you add some incompleteness), and we may see interestingly how and why.

    3) It depends on the strong requirement (b) on page 270.

    But this is not Williamson's interpretation. His is very literal. I fault the interpretation, not the model. In the model, the clone investors all determine assets are worth the same exact prices. If the price goes even one cent higher, they all sell. But in the real world we have investors with heterogeneous information, analysis, and beliefs. If the price goes up by one cent, or much more, some will hold on in the belief that the asset is still underpriced.

    1. I agree with your point about interpretation.
      All mathematics have the following steps:

      1. Define a question.
      2. Translate the question into mathematical language.
      3. Perform Calculations
      4. Translate the results back into an answer to the question.

      The best model in the world will fail if Steps 1 and 4 fail.
      There are many assumptions that enter in steps 1 and 2.
      In step 1, the wrong question can be defined. The assumptions used to translate 1 into 2 may be incorrect or not relevant to the question asked.

      If economists focus on steps 2 and 3 and lose sight of the assumptions of step 1, then the answer, Step 4 (interpretation) may or may not be relevant.

      The mistake made by many economists is that many critical assumptions made based on conditions during the Great Moderation no longer apply to the current economic conditions. Thus, they over generalize their results to claim support for policy when their model is not addressing the question asked. Even worse are economists who assert that their model works under all economic conditions. The resurrection of Classical Keynsian analysis and policy is not based on a claim that this applies to all economic conditions. Rather, the set of assumptions used more closely model current conditions than alternative models that have assumptions invalidated by current conditions.

      Thus we have economists who promote policies that are based on flawed assumptions. These policies are the preferred policies of wealthy elites who care about inflation, bank bailouts, low taxes and cheap labor, but do not care one whit about unemployment, wealth inequality and the associated social costs that can drag on the future economy. The ones who own the biggest megaphone promoted by those seriously flawed policies that benefit them personally, and shout down policy that is far more credible and addresses the good of society.

      We have the bulk of the population who need policy to address the high unemployment. They are opposed by a tiny minority of wealthy special interests looking for any and all arguments to promote their self interest in austerity. It matters not to the wealthy special interests that the policies they promote are flawed or based on flawed assumptions. The flawed policies are recommended by credentialed "economists" and the credentials are used to confuse the public and news reporters who cannot understand the details nor have the time and patience to get down into the weeds of the flawed assumptions. Thus we have an argument over policy based on seriously flawed models using invalid assumptions and proponents who refuse to admit (too proud? too lazy) that their assumptions don’t meet current conditions. We have wealthy special interests who promote these flawed policies over more reasoned policy. The argument needs to focus on the flawed assumptions and why flawed assumptions produce bad policy prescription. The wealthy special interest who promote flawed policy for their own greedy selfish reasons must be attacked by the vast majority who are harmed by their misdeeds.

      jonny bakho

  6. Something that could benefit the future of macro-economics is to notionally separate it into "Science" and "Engineering" departments and journals etc.

    I make the analogy between "Material Science" and "Mechanical Engineering." The science guys are out there to create new materials. And they'd hope that they create new materials that do certain useful things. But their focus and their journals are not full of usefulness analysis. It's about new and exciting techniques to create materials. It' the engineering departments and journals that work on "usefulness" and applications.

    Wandering around DGSE or RBC models can teach you something in "science" side and be worth publishing in "macroeconomic science." But on the "Engineering" side there could be an emphasis on how various models perform for analysing real situations.

    1. I'm half way through writing a post that talks about this, based on Mankiw's classic article on that theme. I think what you say should be taken seriously.

  7. No professor, it is not about a "distrust of government intervention" it is about being against using public money to save private shareholdrs.

    Any public help should require shareholders losing their holdings of their failed organizations (failed the moment they go to the govt). This is more not less govt participation, until they can stabilize and privatize.

    Shareholders should not win when things go well and have public money save them when not, while keeping their holdings.


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