Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 24 September 2014

Where macroeconomics went wrong

In my view, the answer is in the 1970/80s with the New Classical revolution (NCR). However I also think the new ideas that came with that revolution were progressive. I have defended rational expectations, I think intertemporal theory is the right place to start in thinking about consumption, and exploring the implications of time inconsistency is very important to macro policy, as well as many other areas of economics. I also think, along with nearly all macroeconomists, that the microfoundations approach to macro (DSGE models) is a progressive research strategy.

That is why discussion about these issues can become so confused. New Classical economics made academic macroeconomics take a number of big steps forward, but a couple of big steps backward at the same time. The clue to the backward steps comes from the name NCR. The research programme was anti-Keynesian (hence New Classical), and it did not want microfounded macro to be an alternative to the then dominant existing methodology, it wanted to replace it (hence revolution). Because the revolution succeeded (although the victory over Keynesian ideas was temporary), generations of students were taught that Keynesian economics was out of date. They were not taught about the pros and cons of the old and new methodologies, but were taught that the old methodology was simply wrong. And that teaching was/is a problem because it itself is wrong.

There had always been opposition to Keynesian ideas, and much (though not all) was ideological, such as attempts to remove Keynesian textbooks from US universities. However the NCR gave what should more precisely be called ‘aggregate demand denial’ an intellectual respectability that it never deserved. The reasons for believing that shifts in demand move output and employment in the short run and prices are sticky are overwhelming, so to deny both was a seemingly impossible task. It was achieved by adopting a methodological position which could ignore inconvenient evidence.

I do not think it had to be like this. Mainstream macroeconomics did not need a revolution in the 1970s and 1980s. Ideas like rational expectations could have been assimilated into the mainstream methodology, and microfounded models could have been developed alongside more eclectic econometric models (SEMs, not VARs), or aggregate theoretical models that Blanchard and Fischer rightly called ‘useful models’. Microfounded models could have shown the kind of errors that can arise in more empirically based models when theory is ignored or only applied piecemeal, and these empirical models could have highlighted the key areas where additional microfoundations were needed.

I think if this had happened, macroeconomics would have been better prepared when the financial crisis hit. Take just one issue: the role of credit conditions in influencing consumption. This is clearly crucial in understanding how consumption might respond to a credit crunch, yet any mechanism of this kind was absent from most DSGE models in 2008. However a more empirically based model of consumption would have had to address this issue well before 2008, as I argue here. If these types of models had continued to be developed within academia, rather than confined to the dustbin by the microfoundations revolution, then at least policymakers would have had something to work with. If there had been interaction between empirical and microfounded models some of the financial frictions literature that has flourished since 2008 might have appeared earlier.

So why didn’t this happen? Why did we have a revolution which overturned an existing methodology and temporarily banished Keynesian theory, rather than an adaptation and augmentation of what was then mainstream? Was the attraction of overturning orthodoxy too strong, as it is for a minority of heterodox economists today? Did an ideological imperative of dismissing Keynesian ideas play a role? To what extent was the hostile reaction of many in the macroeconomic establishment to eminently sensible ideas like rational expectations responsible? Was the attraction of a methodology where at least you could be sure you were consistent too enticing, perhaps encouraged by increasing segmentation between theoretical and empirical macro? I would love to know the answer to these questions. 

  

58 comments:

  1. You don't mention the decision to model the source of recessions as exogenous shocks. To my mind this gets at the heart of many criticisms of mainstream macro, which aren't so much focussed on the "what to do after a recession happens" question, but more on a failure to recognise vulnerabilities or unsustainable trends that lead to crises.

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  2. The profession fell in thrall to maths and gadgets. Out went careful historical and philosophical study and the expertise that goes with it. -the expertise to handle contradictions and inconsistencies. I do not think it was even ideological driven all though it acted to serve the Reagan/Thatcher administrations and the neo-liberal positions of the Blair/Clinton governments by default, in addition to the World Bank and IMF, especially pre Asia crisis.

    Another big factor in the UK. The research exercise. This suits econometric and other "formal" model based analysis that gets articles into major US journals. Big books with meticulously documented case studies do not suit such exercises. Remember most economists opposed Thatcher's policies in the early 1980s in UK universities. Remember the signatures? This was when a significant number of post-Keynesians remained in UK universities. They have now virtually disappeared.

    However if there were more historians and post-Keynesians in the discipline there would have been much more healthy scepticism about micro-founded and ahistorical approaches.

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    1. For the UK, I think there was initially the kind of assimilation/adaptation that I imagined, rather than the revolution that occurred in the US. The macromodels developed both in policymaking institutions and academia did adapt to include rational expectations etc. A critical point in the UK came at the end of the 1990s, when the ESRC decided to end support for its Macromodelling Bureau. Perhaps that was inevitable, as the criteria for success in economics in the UK has always been publication in top US journals.

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    2. The ESRC has sometimes put a lot of emphasis on "policy relevance" for its funding criteria. Unfortunately policy-makers know what is policy relevant for their agenda and hard up economics departments have to catch on.

      Even still I think meeting the criteria asked for by major US journals and how this helps things like the RAE is the penultimate problem. I still think this problem is going to be the major barrier for people wishing to reform economics teaching and introduce more methodological diversity and influences from outside the discipline, especially at the post-graduate level, in UK universities.

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    3. What I actually want to know is why microeconomics remains so sick. It's a broken field full of orthodoxies which are just not true.

      The most dramatic example is the "supply curve" -- in the fantasy world of microeconomics, firms set production based on price. Which is not true in the short run, not true in the medium run, and only true very indirectly in the long run.

      It's not clear to me why micro is rotten.

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  3. Thatcher spending cuts to UK universities which were seen as bastions of Marxism greatly weakened the institutions, their intellectual independence, and their ability to withstand the onslaught from Chicago/MIT.

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    1. This is about right. Meanwhile in the US the Koch Brothers and Olin were actually paying to insert ideologues into professorial positions.

      You want to know why an econ department pushes a particular idea? Look at who's paying for it. About 90% reliable.

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  4. the same thing happened in the early '80 happened to OECD, with the removal of Stephen Marris, and the U-turn from keynesian to neoclassical recommended policies to their members, free flow of capital, privatizations and liberalizations, disinflation with fancy "flexicurity" as fig leaf..

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  5. I have to agree with this well-reasoned essay but only up until the part that an adaptation would have been better than a revolution.
    The development of micro founded/RE models within the Keynesian paradigm would have likely not worked out. So a revolution was necessary.
    Still, 40 years later macroeconomists should know both Keynesian and modern macro and be a little bit more pragmatic and less ideological (theory-wise).

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    1. I do not understand why you say 'The development ...' New Keynesian models are now everywhere, so we know that works. Equally we know we can incorporate rational expectations, intertemporal consumption etc in more econometrically based SEMs. You need to have some other good reason for saying a revolution was necessary.

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    2. New Keynesian aspects were not incorporated into DSGEs until the 1990s. But rational expectations and the intertemporal micro-based approach came to light in the early 1970s. Lucas, Sargent et al. and their approach were ridiculed by the academic Keynesian status quo. A revolution was needed to be heard over the dissenting establishment.

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    3. That is certainly one of my list of options. But there is a chicken and egg problem here: were they 'ridiculed' because they were trying to overturn everything, which was indeed something to react against. What I have reread recently has that flavour: interesting ideas but criticism of existing practice over the top. Would be useful to have some concrete evidence here.

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  6. Some points about DSGE models which could have been different but which were *chosen* to be part of their core (at least the core of a lot of them):

    (1) As a rule they ignore 'government consumption', i.e. things like pirmary education paid for by the government. It's not included in the utility function, not directly and not in an Edgeworth compelemntarity way. Teaching children is, i.e., just a waste.

    (2) Involuntary unemployment is defined away. The representative consumer decides (!) to work a little less or a little more and as there is only one person nobody is ever totally out of work... If you think this is daft ranting, consider the ideas of Cole and Ohanian about the Great Depression: unemployment during this period did not exist as the decline in hours worked was a voluntary choice about the *average* number of hours worked per person.
    (3) About the European Union: the New Area Wide model als well as a lot of other models assume that all European countries use the same technology while prices of non-labour inputs are the same for everybody, which leaves wages as the only competitivety influencing factor... *Nothing* about ideas about international chains of supply and the like!
    (4) The housing bubble clearly shows that money is endogenous. Hundreds, trillions of Euro's were creating based upon mortgage lending and the (of course: rising) value of houses as collateral. Which means that 'loanable funds' does not apply but it's still used in the models... That's not 'progressive', that's retarded.
    (5) Which of course also means that the banks reap the seigniorage profits, not the government! According to the definition of seigniorage profits the interest on newly created mortage loans is the seigniorage profits - the models should include this. See also a score of recent Voxeu posts about this.
    (6) And which of course also means that the risk of financial crises increases as debt to GDP ratios increase.

    Aside of this, the idea of the representative consumer and his (her? its?) 'national utility' is bonkers. About the interemporal consumption constraint - if we restrict consumption today (i.e. don't go for a vacation at the beach or don't care for our elderly) we can't store that vacation for a later period or care for our buried. Bygones are bygones.

    So, please, let's be rational and skip the idea of intertemporal optimization in the framework of an economy where future oriented activities like teaching the children are considered wastefull. Remember that such ideas did lead to economic policy advices for countries like Greece and the Baltic countries: don't bother about unemployment, restrict wages of teachers and fire them and do not provide for the elderly. That's DSGE. And that's what it was designed to be.

    Merijn Knibbe

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    1. Thanks for a list of additional boneheaded things in the phony DSGE models, on top of the very basic errors which I mention below (basically, the entire microeconomics underlying it is nonsense).

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  7. "The development of micro founded/RE models within the Keynesian paradigm would have likely not worked out. So a revolution was necessary."

    @Anonymous 04:08 Is that because a national economy is not an aggregation of individuals and markets?

    Or is it do you think more to do with uncertainty in Keynesian economics?

    "[Ricardian theory], being based on so flimsy a foundation, it is subject to sudden and violent changes. The practice of calmness and immobility, of certainty and security, suddenly breaks down. New fears and hopes will, without warning, take charge of human conduct. The forces of disillusion may suddenly impose a new conventional basis of valuation. All these pretty, polite techniques, made for a well-panelled Board Room and a nicely regulated market, are liable to collapse. At all times the vague panic fears and equally vague and unreasoned hopes are not really lulled, and lie but a little way below the surface (Keynes 1937: 215).

    Arguably the problems predated the New Classical Revolution:

    "And even to this day, people still reject Keynes’s overall philosophical claims, or at least continue to follow those who made this mistake. For example Paul Samuelson automatically rejected this philosophical issue on the basis of the assumption of the ergodic axiom and did much work under this assumption, see for example, Samuelson’s “Optimality of Sluggish Predictors under Ergodic Probabilities” (1976) or “What Classical and Neoclassical Monetary Theory Really was” (1968). It is worth to note that his answer for using the ergodic assumption, thus rejecting Keynes’s philosophical emphasis, was on the grounds that if one rejected the ergodic principle, one rejected calling economics a science (1969: 12)

    ...Economics is in the category in trying to explain the ‘irrational’ subjective human."

    http://radicalsubjectivist.wordpress.com/2012/09/18/keynesian-uncertainty/

    In many ways trying to reconcile Keynesian approaches with Classical ones, let alone New Classical ones, is a non-starter. People should look at these as separate frameworks.

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    1. As I say in my post, by Keynesian I mean the absence of 'demand denial', not other views that Keynes might have had.

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  8. "Follow the money" seems strange in a discussion on Economics but politics is where the money, and hence the direction comes from. Right wing parties make sure when they are in power that they appoint those favourable to their views and ideologies to positions of influence eg Heads of Universities, the US Supreme Court, the BBC and so on. Some time later the effects of having appointed these ideologically led officials is seen through an insufficiently wide world view, and hence shocks like 2008 hit 'without warning'.

    In the case of the 1970s/80s Margaret Thatcher trained first as a Chemist before she studied Law. Chemistry is one of the sciences that believes in absolutes; it is hardly surprising that her subsequent views on other subjects were similarly absolute - 'twas the nature of the beast.

    In the US of course University funding is hugely influenced by private donations from Billionaires who are mostly right wing and want their views to be taught. Keynesianism is considered by these people to be 'socialist' and anathema to their world view, and it seems to me that over a few decades the removal of those Keynesians still teaching created today's situation.

    In Ecology, the fully evolved state of an ecosystem is to favour a monoculture; in economics I was taught that unbridled competition creates an eventual monopoly; is it any wonder that politics and ideologies follow similar paths? All three UK parties are now following the current Tory-originated meme that the deficit is why the UK has a problem, rather than the UK has a deficit because the UK economy has a problem. And nobody is going to stand up and say "That's our fault, we did that" because ultimately it's a game of power.

    Not that I'm a cynic or anything...

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    1. currently, the right wing in america is anti-science. Palo Alto, Ca. used to be a moderately conservative place given that it is gushing with money. It is probably still a moderately conservative place that believes in science and so now has twice as many democratic voters as republicans.

      our right wing party is not science friendly.

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    2. How much of that is due to Home Schooling do you think? Education since the early 80s has become very political. Even the World Bank insisted Third World governments charge their children for their education in order to give them development funds. Ignorance breeds contempt, and there is a lot of ignorance going around these days.

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    3. Here is just one recent example. A Denver, US school board, recently taken over by Conservatives, is setting up a Committee to to make sure materials for the History syllabus “promote citizenship, patriotism, essentials and benefits of the free-market system, respect for authority and respect for individual rights” and don’t “encourage or condone civil disorder, social strike or disregard of the law.”
      http://www.salon.com/2014/09/23/denver_area_students_walk_out_of_school_in_protest/?utm_source=facebook&utm_medium=socialflow

      That kind of censorship is happening at all levels of education. Conservatives have recognised they can't win the argument, so have decided to remove the argument from the school books.

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    4. the problem is more pervasive; there are not that many home schoolers though they certainly tend to be anti-science.

      Right-wing religious groups think that cutting taxes for the rich and benefits for the poor is just what Jesus would have wanted. Literally.

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    5. Sad but true. The more extreme the religious zeal, the more they believe it too.

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  9. Of course, DSGE was progressive and, because of this, very attractive for economists: DSGE wants to explain the whole economy from the single person to a whole country. If it worked, it would be a triumph, and I guess it's possible that it's going to work in the future. But at the moment, it's probably still too much of an abstraction from reality. The structural parameters probably change over time. I would also say that budget constraints don't always hold - people buy homes they can't afford, if they are offered them. Government budget constraints also don't always hold. In DSGE-models, there is no way to have a collapse, which I would define in this context as a moment when some constraints do not hold anymore, and economic development is being defined by other, more universal constraints (like, say, you can circumvent the budget constraint of the government with the printing press, and while there might be an expansionary effect of more money, at some point that's going to stop because the relation between the money stock and the real economy is being torn apart and you just have more inflation).
    There needs to be some kind of recognition that producers are not "honest dealers", but that they want to seduce consumers. These producers include banks and real estate and what I really want to say is that Keynes' animal spirits need to be in there.
    By the way, I think a lot of confusion within economics could be solved if there was a clearer distinction between normative and positive economics. An equilibrium is not per se good. A pareto optimum is not always perfect, you've written so yourself. The neo-classical revolution was very attractive for capital, Big Business and the finance industry, because it abstracted away many uncomfortable questions, material equality, the responsibility of financial services, money and political economics (lobbying and vote buying). Rational expectations is very tidy, but it forgets that there are organisations out there to change the consumer's idea of what is rational. The fake accuracy of DSGE hides that there are more levels to the economy than just the individual consumer and the economy as a whole.

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    1. Nice post.
      "The neo-classical revolution was very attractive for capital, Big Business and the finance industry, because it abstracted away many uncomfortable questions, material equality, the responsibility of financial services, money and political economics (lobbying and vote buying)"
      Applying the same geometric growth rate to those on low and on high incomes not only increases each, but also increases the difference. So long as everyone is getting richer and feeling richer you can have as much inequality as you want; people only start noticing when they are getting poorer while the ruling classes are getting richer, such as is happening now.

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    2. As I've said below, the problem with DSGE is not so much the idea of DSGE, but the microeconomic model underlying it, which is complete and utter irredemable garbage.

      If you started with economic actors who work on rough heuristics such as people actually use, corresponding to the behavior found in economic experiments, and tried to build up a macroeconomic model from *that*, you might get somewhere.

      Starting with completely phony microeconomics gets you completely phony macroeconomics. Of course, this phony macroeconomics was popular *because* it could be used as propaganda by rich, crooked businessmen. It has no intellectual value whatsoever.

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  10. "Was the attraction of a methodology where at least you could be sure you were consistent too enticing, perhaps encouraged by increasing segmentation between theoretical and empirical macro?"

    Mostly that. But also, the really neat thing about revolutions, if you are a young grad student, is that it gives you an excuse not to have to read all that old stuff. And if your undergrad was in math, or physics, it gave you an excuse not to have to read all that undergrad economics stuff too.

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    1. And in that respect, the Keynesian revolutionaries were just as bad, in their heyday.

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    2. "And if your undergrad was in math, or physics, it gave you an excuse not to have to read all that undergrad economics stuff too."

      It gives you an excuse not to read anything.

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    3. "And if your undergrad was in math, or physics, it gave you an excuse not to have to read all that undergrad economics stuff too."

      I remember having to do problem sets in Romer's textbook. Myself and a friend, both BA (Econ) had to go to a mathematician to solve them. He could do all of them immediately without ever studying any economics in his life.

      I am really sceptical of how much the real world informs modern macro-economic theory and what its value is to the real world.

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    4. "And in that respect, the Keynesian revolutionaries were just as bad, in their heyday."

      I was going to make that point. A lot of good stuff got forgotten in the mainstream due to the New Classical Revolution. Similarly, a lot of the so-called "Classical Economists" were dismissed on the grounds that they were either silly old duffers like Pigou (or rather Keynes's misinterpretation of Pigou) or "on the right track but too ad-hoc to be real economics" (Irving Fisher).

      One of the respects in which economics often UNFORTUNATELY resembles the physical sciences is in ignorance of the full depth and richness of its history.

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  11. @ Anonymous 24 September 2014 04:49
    "(4) The housing bubble clearly shows that money is endogenous. Hundreds, trillions of Euro's were creating based upon mortgage lending and the (of course: rising) value of houses as collateral."

    Are you sure about that? In my experience, the country that is most applicable to is the UK in which home ownership for 'profit' (in reality debt deflation) is the main goal of most people. Only the UK sees such regular double digit increases in house prices; some European countries' house prices hardy inflate at all, but maybe you can show statistics that support your point of view?

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  12. With the housing bubble I mean tthe period 1995-2008. In the Netherlands alone, about 450 billion in additional money was created by the banks to lend to people buying houses (with up to 120% loan to value ratios - and the central bank approved because these mortgages were securitized). By the way - these securitized mortgages were 'off balance sheet', which for too long fooled the monetary statisticians which consequently underestimated money growth (they used balance sheets of banks to do this).Add this money to the money created in Ireland (which saw up to 30% a year increases in thes tock of money...), Spain etcetera and you will arrive at the magnitudes mentioned. Mind that I'm not monetarist here as I use quadruple entry accountng ideas instead of the single entry accounting of the monetarist 'economists'.

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    1. You have to answer the (current) ultimate question of life, the universe and everything. Are you broadly categorised as ”exogenous”, where deposits create loans; OR, are you "endogenous” "Post-Keynsian" (with a capital P as in MMT), where loans create deposits?

      Jacky M thinks the question "... in a recursively defined system to debate whether loans create deposits or deposits create loans is quintessentially tautologous." I think it is fundamental to understanding the system. Anyway, her fourth revision of the following, at least mentions MMT; has jettisoned previous mention of taxation funding government interest payments. (Remember, taxation doesn't fund anything, it is just a brake pedal for the economy.)

      arxiv.org/pdf/0904.1426v4 .

      ATB Acorn

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    2. True, Ireland is much like the UK, but with only 3 million population is hardly going to make a dent in the overall EU picture; similarly The Netherlands. Spain might have some effect, but there the money wasn't created so much as introduced by Russian interests and it was the sudden removal of this money that created their particular problem. I'll accept the point that many of the commercial loans taken out to build the condos the Russians were expected to buy should not have been given, but I am not sure house prices themselves created a boom in consumer spending as you suggest. That is the UK way of thinking.

      Germany, twice as big economically as all those three put together had a different experience altogether. Most of Europe has a much smaller proportion of home owners than does the UK so using the UK way of thinking and applying it to Europe simply doesn't work in the same way when it comes to housing or even personal debt.

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    3. This chart from the Deutche Bundesbank clearly shows the German property situation. As a percentage of GDP, outstanding mortgage lending has been falling since 1999, and over your 1995 to 2008 period only went up a couple of percent (but the trend is down).
      http://www.globalpropertyguide.com/template/assets/img/Germany-outstanding-housing-loans-1.gif

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    4. "...Most of Europe has a much smaller proportion of home owners than does the UK...". Nope (using the EU as a proxy for Europe...):
      http://epp.eurostat.ec.europa.eu/statistics_explained/index.php/File:Population_by_tenure_status,_2012_%281%29_%28%25_of_population%29_YB14_II.png

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  13. "There had always been opposition to Keynesian ideas, and much (though not all) was ideological, such as attempts to remove Keynesian textbooks from US universities."

    I've said this before, but I think perverse incentives play a role here. Politicians and think tanks make up a significant portion of the demand for economic research. The career prospects of macroeconomists is enhanced by serving this demand, which creates an incentive for researches in the field to join one of two camps, one providing research that support the conservative view and the other supporting the liberal side. Barbara Bergmann made this argument here:

    http://www.jstor.org/discover/10.2307/25046110?uid=3739256&uid=2&uid=4&sid=21104735817283

    It goes beyond government appointment of economists to prominent positions such as Treasury Secretary and Chair of the Federal Reserve. An economist's career aspirations and influence are enhanced more by a politician citing their research than their model's forecasting accuracy.

    My graduate macro course was at a very math-light institution, and so was more of a history of macro thought course, and what I learned supports this interpretation (which I didn't read until after my degree). On the conservative side, arguing for less government intervention in markets, you have Classical, New Classical, Supply-Side, and Austrian. On the liberal side, arguing for more government intervention, you have Keynesian, New Keynesian, Post Keynesian, Behavioral, Institutionalist.

    The New Classical and New Keynesian divide is particularly interesting, as it had a geographical freshwater/saltwater divide. Additionally, they had a methodological disagreement won by the New Classical school, and yet the two schools still persisted over the same divide with New Keynesians using sticky prices in DSGE models to continue their same argument.

    In other sciences, you would expect to see a resolution of such a disagreement to result in the two schools merging and a new disagreement creating a fresh divide with former opponents now on the same side.

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    1. Did Keynes argue for more Government spending? Or did he say debt was a bad thing to be repaid when times were good, and taken on if needed to smooth out the economy in bad times?

      The problem comes when the necessary surplus in place to protect against future bad times is spent by Conservatives on tax breaks for their supporters ("it's not the Government's money, it's the people's money!") leaving no surplus to protect against lower output in bad times, meaning the only way to get by is to borrow more and cut spending. Cutting spending reduces output and tax revenues more, while increasing the ratio of debt to GDP.

      Seems to me like Keynes' common sense idea is rather like how the springs on a car need shock absorbers to give a smooth ride. You might not need the shock absorbers on a smooth road, but they will help you go faster around unseen curves and you'll notice they aren't there when things get bumpy.

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    2. I'm not sure what you are addressing. I say that Keynesians argue for more government intervention in the economy, while Classical and New Classical argue for less. I say that both sides face incentives to argue this due to political and ideologically driven demand for economic research.

      Government debt is due to Keynesianism combined with what is politically palatable (and Keynesian dominance in the political debate is because it's distillable into sound bytes -- the same reason suppy-side was influential -- and this is not true of a DSGE model).

      Liberals argued for expansionary fiscal policy via increased government spending while conservatives argued for tax cuts. Voters don't like higher taxes or the effects of less government spending (Republicans talk about shrinking government but don't actually enact it when they have control over the government -- public choice could point out that they have no incentive to reduce the scope of their own influence, but I don't think they say it that much because Republicans tend to be their political allies).

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    3. "Did Keynes argue for more Government spending? Or did he say debt was a bad thing to be repaid when times were good, and taken on if needed to smooth out the economy in bad times?"

      Neither. The latter is functional finance and was best articulated by Abba Lerner, nearly 10 years after the General Theory.

      As for the former, Keynes wrote in correspondence with Colin Clarke that "25 percent taxation is about the limit of what is easily borne", i.e. 25% of national income. That's not a Scandinavian-sized state, that's a Chile/Hong Kong/Australia sized state. (The USA is above that level.) Would Keynes have compromised in favour of going above the limit? Well, he said in the class war that he was on the side of the "educated bourgeoisie" (at that time in the UK a very elite sect) and he believed that economic prosperity was dependent on the ease of businessmen (quote to follow).

      He was associated with the inter-war Liberal party (well to the right of almost every modern party on most economic issues) not the socialist Labour party. And one can see Keynes's economics in the context of his metaphor about his house and Adam Smith's house: a good macroeconomic regime makes the pro-market of Adam Smith always true, because there isn't a macroeconomic disequilibrium that makes nonsense of notions of scarcity. (George Orwell's critique of the idea of scarcity is worth reading; it's hard to make equilibrium arguments about scarce resources when unemployment is over 15%.)

      Keynes said of the Labour party that its programme was "anti-capitalist rubbish". (It was.)

      Keynes said in 1926 that "The political problem of mankind is to combine three things: Economic Efficiency, Social Justice, and Individual Liberty. …….The second ingredient is the best possession of the great party of the Proletariat. But the first and third require the qualities of the party which, by its traditions and ancient sympathies, has been the home of Economic Individualism and Social Liberty."

      However, you might say, this must all be from the EARLY Keynes, before Joan Robinson et al helped poor John Maynard to understand his own theories. Ok, here's a line from the General Theory- "Economic prosperity is dependent on a political and social atmosphere which is congenial to the average businessmen." That doesn't sound like someone keen on a lot of government spending to me. (And no, "socialisation of investment" doesn't necessarily mean a lot of government spending.)

      Sticking with the later Keynes, "How to Pay for the War" includes some wonderful critiques of many of the incorrect ideas that left-wing economists had (and some sadly still have) regarding how to deal with inflation.

      Keynes was generally a social liberal and generally a fiscal conservative, in modern jargon, which is perfectly compatible with having a General Theory view of the macroeconomy. I could see him supporting today's Conservative party, although he might regard their spending and trade policies as having a bit too much "big government" for his tastes, and might be puzzled at their ignorance of the great science of eugenics. Anyway, we're certainly far FAR away from having a tax/national income ratio of 25% in the UK!

      (I don't think I'm interpreting Keynes as agreeing with me, which is a great temptation, since I know that (a) I'm not a Keynesian, (b) I don't mind disagreeing with Keynes on probability theory, although I think he was on the right track, and (c) I'm very happy to disagree with Keynes fundamentally on eugenics.)

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  14. I wonder what your thoughts are on this article by Jayadev and Mason: "Strange Defeat: How Austerity Economics Lost All the Intellectual Battles but Won the War"
    http://slackwire.blogspot.com/2014/07/strange-defeat.html

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    1. I only had a quick look, but it seems to be an argument that I have heard before and I think it is misguided. It correctly says that the intellectual basis for austerity is very weak. But it then turns this around to say that somehow using New Keynesian models made arguments for austerity more credible. I do not think this makes sense.

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  15. "New Classical economics made academic macroeconomics take a number of big steps forward, but a couple of big steps backward at the same time."

    Not how I see it at all. Looking at the long sweep of economic thought there have been "five crises" since the time of Ricardo -- roughly the 1820s, 1870s, 1930s, 1970 and now. The second and third crises were resolved by accommodating and assimilating the heretical views. The first and fourth were resolved by counter-revolutions that banished the heretics and imposed a rigid, reactionary orthodoxy. No doubt "steps forward" can still take place under a dogmatic and reactionary regime just as doctrinal degeneration happens in the progressive periods. Even clouds have silver linings.

    But calling a spade a spade the "New Classical Revolution" was a counter-revolution. It will not be surpassed by reverting to the spent political Keynesianism of the 1950s and 60s. If a counter-revolution is to have any progressive legacy at all, it can only be in demonstrating the inadequacy of the revolution it overturned.

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    1. (You could call it the Kondratieff wave theory of the history of economic thought. ;-)

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    2. Oh, VERY wise, thanks, Sandwichman. I'd like to see an essay on the 1820s "rigid orthodoxy" counter-revolution. I know all about the disastrous theo-economic orthodoxy counter-revolution of the 1970s, but I know nothing about the 1820s one.

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  16. Here I am again more certain than ever that this comment serves no useful purpose. You support an eclectic approach and not the utter rejection of all of the past 40 years of theoretical macroeconomics. I guess this must seem obviously reasonable to you and to basically everyone. However, while you have very often stated this view, I don't recall much in the way of argument, evidence or even examples.

    "Microfounded models could have shown the kind of errors that can arise in more empirically based models when theory is ignored or only applied piecemeal, "

    for example ? To be sure such errors can arise, one should point to examples of such errors arising. The classic example is the 1960s era Keynesian ad hoc assumption that the Phillips curve is a structural relationship. This error never happened. It may well be that going to the data armed only with common sense and verbal arguments leads to errors which would have been avoided if one used formal theory. But to claim that such errors occured, one should cite them with authors, dates, titles, Journal titles volume and page numbers.

    "However I also think the new ideas that came with that revolution were progressive. I have defended rational expectations, I think intertemporal theory is the right place to start in thinking about consumption, and exploring the implications of time inconsistency is very important to macro policy, as well as many other areas of economics. I also think, along with nearly all macroeconomists, that the microfoundations approach to macro (DSGE models) is a progressive research strategy."

    I note that the word "progressive" appears twice. I think it is very useful, too useful. To argue that something is progressive, one need not point to achievements. The word is consistent with the claim that the approach will in the future yield valuable fruits. I recall reading in 1982 Sargent expressing the hope that realistic micro founded models which could be taken seriously and confronted with the data would be developed in the following 30 years. I say time is up.

    I also note "to start". Now the claim that something is the right place to start can't be disproven. The claim is that something good will happen. I know of no evidence against the view "(6) Changes in expectations of the relation between the present and the future level of income. — We must catalogue this factor for the sake of formal completeness. But, whilst it may affect considerably a particular individual’s propensity to consume, it is likely to average out for the community as a whole. Moreover, it is a matter about which there is, as a rule, too much uncertainty for it to exert much influence." Keynes 1936 chapter 8 section II.

    I have 2 final questions.
    1. What evidence could possibly convince you that intertemporal theory is not the right place to start in thinking about consumption ?
    2. What evidence could possibly convince you that DSGE isn't a prgressive research program ?

    What could the data do which they have failed to do in the past 40 years ?

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  17. I will write a second comment. I will try to respond to your questions. I wasn't an economist in the 70s so (as usual) I don't know what I am talking about.

    "So why didn’t this happen? Why did we have a revolution which overturned an existing methodology and temporarily banished Keynesian theory, rather than an adaptation and augmentation of what was then mainstream?"

    "Was the attraction of overturning orthodoxy too strong, as it is for a minority of heterodox economists today? "

    I think this attraction was very strong. There is something else. A couple of Economists from U Minnesota mentioned Harvard for no clear reason -- I think there was and is an element of Midwestern pride (neither of the economists is originally from the USA). In particular a distasteful aspect of appeals to common sense or judgment is that they are and must be assertions of intellectual authority. Math has the appealing feature that a proof is a proof and does not rely on the authority of the person stating it.

    " Did an ideological imperative of dismissing Keynesian ideas play a role?" I think it definitely did. Friedman, Lucas, Prescott and Barro are very ideological. The models change but the policy proposals remain the same. Views on methodology change (Sargent asserted that Lucas and Prescott were all in favor of testing models as null hypothesis until he rejected their favored models).


    "To what extent was the hostile reaction of many in the macroeconomic establishment to eminently sensible ideas like rational expectations responsible? "

    I think the extremely hostile reaction played an important role (of course, I don't think that rational expectations is a sensible idea).


    "Was the attraction of a methodology where at least you could be sure you were consistent too enticing, ? "

    Here I would say that mathematics was enticing. Writing papers that look like Physics except the variables have different meanings is enticing.


    "perhaps encouraged by increasing segmentation between theoretical and empirical macro? "

    I'm quite sure this came later. In the 70s and early 80s new Classicals developed new empirical tools and did a lot of empirical work. I think theoretical macro separated from empirical macro when the data kept saying that new Classical models were not good approximations to reality.

    So far, I have made no progress towards understanding how a few departments were so influential. Here I think that hard work and the passion due to fanaticism were important. The general rightward political shift also must have mattered. I think that the loony left managed to cast discredit on Republican Keynesians somehow. But I really don't understand how and why it happened.

    I have another thought.

    If macro theory (or non theory or ad hoc models or whatever) were about as good as it is would ever be in 1973, PhD candidates and junior faculty would still have to present something new. In fields which aren't progressing a new and crazy original contribution is preferable to an unoriginal contribution. Here I think the trouble is that some questions in macro are too simple and have for decades been answered well enough to serve. I think it is very easy to fit consumption and investment without theory -- 1960s equations fit well out of sample.




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  18. "Here I think the trouble is that some questions in macro are too simple and have for decades been answered well enough to serve."

    Especially be for applied mathematicians and physicians who want an excuse to use maths (even when most of the time what they do does not impress mathematicians and physicians working in real maths and physics departments).

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  19. Sargent associates mathematics with progress. Whether it helps understand or solve real world problems (or makes them more complicated, abstract or irrelevant) is a an afterthought.

    The New Classical Revolution was really just an excuse to use mathematical techniques.

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  20. I suppose you would need to assess the impact Jimmie Savage and Thomas Kuhn have had on criticising Popper's rationalism in economics as a putative science.

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    1. If we had the Habermas/Popper debates in economics teaching as it is in other social sciences- that would really shake it up. It would probably finish it!

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  21. I'll just add one part, very overliteral interpretation of models to reality, what Krugman calls considering them "The Truth" as opposed to "intuition pumps". And as I always say, a model is only as good as its interpretation. Lots of this freshwater stuff can be very useful if interpreted well to reality.

    Right now I just got drawn back into Wallace '81 AER, and that model is so literally interpreted by so many, so many who really make our crucial monetary policy! -- in part because it's really hard to understand; people see the conclusions at the end, know there are mathematical proofs, but can't understand the process in the model and why, and so what interferes with it in the real world, so they're like Wallace proved it!

    In any case, I just had some new insights with Wallace, and now am really thinking of doing a paper, a Wallace based model with some important reality added which will show that irrelevance, Wallace neutrality, doesn't hold, and how, and with mathematical proof, and maybe even some calibration and quantification (I have freaky little free time for this, but I think now I will start the first stages of trying).

    Also, if you're interested, I had this Wallace paper puzzle from my first look at the paper in 2012:

    http://richardhserlin.blogspot.com/2012/08/wallace-1981-aer-puzzle.html

    I now know the answer, which I think is kind of interesting. I'll do a post on it in the near future, but if anyone wants to know sooner, just email me.

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  22. All economists should think about the influence that bubble cause to the balance sheet of every economic unit.
    Their balance sheet swell under bubble, with the banks making loans to economic units, by high speed (That is velocity of money. Money is created between corporations and banks).
    And one day the bubble burst and the value disappear from the balance sheet suddenly, and debt remain.
    Because every economic unit acts on its balance sheet and income statement (both actual and future), all economists should take this effect into account and establish a theory.
    In my opinion, this is a defect naturally of capitalism or market economy.
    Capitalism or market economy have naturally other kinds of defects, for example, which we must cope with by anti-monopoly committee or by Securities Exchange Commission.
    The bubble burst has the characteristic of such kind, which every economist must think of the remedy.
    One way to solve the problem is to write-off the national bond which the central bank holds. The rest national bond (which the central bank doesn’t hold) will be paid duly. The national bond held by central bank is, to the extreme, originally was the debt of economic entities, which economic entities couldn’t cope with.
    Though formerly I presented Yamada Model as follows, this model works at the early stage of bubble burst.
    After quite a time has passed, the central bank needs to write-off of the national bond which the central bank holds, in order to put the economy into orbit.

    https://sites.google.com/site/newmonetarypolicy/

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  23. " It was achieved by adopting a methodological position which could ignore inconvenient evidence." ...

    Was this not also ideological positioning? It seems to me that this period could also be considered the Lliberatarian revolution.

    Since then much of the work of Friedman and other Libertarian Apologists seems to have shown many flaws which are glossed over for ideology over facts and advancement of the science.

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  24. "I have defended rational expectations, I think intertemporal theory is the right place to start in thinking about consumption, and exploring the implications of time inconsistency is very important to macro policy, as well as many other areas of economics. I also think, along with nearly all macroeconomists, that the microfoundations approach to macro (DSGE models) is a progressive research strategy."

    You're simply wrong about nearly all of this. Let me go through it point by point; you probably won't be convinced but you should be.
    (1) rational expectations is known to be extremely false, based on mountains of neuroscience, psych, anthro, and sociology research (experiments and studies), not to mention the economic game experiments. Go visit your colleagues in those departments and learn the *foundations* which you need to know. There are only very, very, limited arenas in which rational expectations exist.
    (2) while the "microfoundations" approach to macroeconomics *would* be extremely valuable *if you had any microfoundations*, classical microeconomics is a rotten pile of shit. It is far more false than macroconomics! Supply curves don't even exist in most industries, and this is well known; pricing is done on a cost-plus basis in reality. Advertising/marketing/"demand creation", which is the dominant term in most industries, is omitted from standard theories. And I can list a dozen other things like this. Classical microeconomics is BULLSHIT.

    You need to use foundations which aren't bullshit. It's like attempting to build your theory on the "microfoundations" of alchemy or phrenology. Garbage in garbage out. As a result, DSGE is worthless; because the microfoundations it's built on are simply WRONG. You might be able to make a DSGE model based on real microfoundations, but you'd have to have some real microfoundations first.

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  25. “Economics graduate programs may be turning out a generation with too many idiot savants skilled in technique but innocent of real economic issues.”- This was one of the conclusions of the American Economic Association’s Commission on Graduate Education in Economics, formed in 1991, chaired by Anne Krueger and included Kenneth Arrow, Robert Lucas, Joseph Stiglitz, Lawrence Summers and Edward Leamer.
    See more here in this interesting post:
    http://economicsociology.org/2014/09/28/economics-graduate-programs-may-be-turning-out-a-generation-with-too-many-idiot-savants-skilled-in-technique-but-innocent-of-real-economic-issues/

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  26. You say: " I also think, along with nearly all macroeconomists, that the microfoundations approach to macro (DSGE models) is a progressive research strategy."

    I do not exactly understand what "progressive" means here, and whether a progressive theory is better than a non-progressive one, but I find the microfoundations program was really a big step backwards because it assumed that the aggregation problem is solved. It isn't, and this was seriously discussed in pre-revolution times, rather than assumed away. We know at least since Hicks' "Revision of Demand Theory" (1956) that rationality does not carry over from individuals to groups.

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  27. “Economics graduate programs may be turning out a generation with too many idiot savants skilled in technique but innocent of real economic issues.”

    I would go further and say the techniques themselves are dubious.

    A good idea of what reformists such as the movement for Post-Autistic Economics are up against is seen by looking at Tony Yate's blog who says that anything but the use of mathematical reasoning based on micro-foundations is "pub talk"

    http://longandvariable.wordpress.com/

    A classic case of someone who confuses maths with intellectual rigour (and by the way is that the end game even if it is?). Goodness knows what he reads. Aren't we supposed to be trying to understand how the real world works so we can get answers to unemployment? Don't we need to consult other expertise from other areas to understand that real world? Isn't being open to knew approaches more likely to open avenues and increase the chances of finding those solutions, especially even given the profession's spectacular progress in doing so over the last 40 years? Why hasn't the big methodological debates (Popper, Habermas) infiltrated economics as it has other disciplines? Isn't it instructive that some of the major critics of the methods of economics are not only from the humanities, but from the sciences themselves?

    He says it has been a hard slog. Well, I guess if it has been with such a large sunk cost and big associations with this and your identity, you don't want to find out you've being going up the wrong alley.

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