Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 3 February 2016

Whatever happened to the General Theory

My paper in the Review of Keynesian Economics is out. It is a special issue on the relevance of the General Theory 80 years after its publication. My paper is about the New Classical Counter Revolution (NCCR). At first this may seem an odd fit, but I think quite the opposite. If we go back 40 years, macroeconomics as it was then practiced could be justifiably described as being a development of that great work. In contrast students today would not see the General Theory as the foundation of macroeconomics. The change in view is the result of the NCCR.

I also think that many heterodox economists, who tend to read this journal, have failed to come to terms with the NCCR. They are critical of course, but often they fail to address the obvious question: why was the NCCR so successful? Revolutions may be plotted by a small number of individuals to whom you can ascribe (fairly or unfairly) ideological motives, but you also need to account for why the revolution succeeds. Do heterodox economists think that generations of PhD students who continue to ignore their arguments are being forced to do so against their will?

My paper is in part an attempt to begin to answer this question. It argues that the success of the NCCR had little to do with external events (stagflation), or with policy, or indeed with the specific innovations the revolution brought. Instead it was about being seduced by a methodology: the methodology of microfounded models. Where I probably depart from most heterodox economists is that I think macroeconomists were right to be attracted to the methodology, which is a progressive research programme, but the problem was the same as with all seductions: to see only the good and not the bad in their new love.

But my paper is not primarily directed at heterodox economists. I make two claims that should worry mainstream economists. The first is that what masters students are taught, which is that pre-NCCR methods are fatally flawed, is simply wrong. Microfoundations simply replaces one set of flaws with others. The mistake of the NCCR was not in developing DSGE models, but in believing that only these models can provide macroeconomic insight. The pre-NCCR methodology was also progressive, and as developments in UK macro in the 1990s showed, the two methodologies could help each other.

My second claim is that the exclusive focus on a microfoundations methodology seriously compromised the ability of the science to understand the Great Recession. Here I am very specific: mainstream macroeconomics ignored a clear property of the time series for aggregate consumption in the UK and US in a way that pre-NCCR methods would not have done. As a direct result, the importance of the financial sector was largely ignored before the global financial crisis. If pre-NCCR methods had not been trashed by mainstream macroeconomics, the discipline would have been in a far better shape to understand what happened during the Great Recession.

I cannot do justice to the arguments in this short post, so please read the paper.

29 comments:

  1. Yours is an interesting paper. The paper by Zinn is also interesting.

    I am one of those people that is of the opinion that the NCCR found its motivation in a burgeoning (well, it probably never had to "burgeon", it was always there)neoliberal milieu in the US, its natural harbour. (Maybe all this was a reaction to the free-wheeling, anti-Vietnam war and hippy strewn 1960s.)

    There was also another factor and that was the mathematization and scientification of economics. For some reason or other we are compelled to pretend that economics is a science and the lingua franca of science is mathematics. Look also at the number of economists that began/begin academic life as physicists and pure mathematicians - following undergraduate degrees in science and mathematics with PhDs in economics. There is more career money in economics/finance than science.

    Henry

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    1. OK, but a similar point can be made in a less politically loaded way. The 1960s wasn't only the era of the hippy and the student rebel, it was also the golden age of operational research and cost-benefit analysis. And re those neoliberals, Chicago wasn't only Milton Friedman, it was also the home of Arnold Harberger and the beginnings of what is now called applied micro. It really did look as if microeconomics, aided by some quantitative techniques, had at last become a useful subject, and it's not surprising that some of that spirit found its way from micro to macro. Whether any good resulted is of course another matter.

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    2. Yes, I agree. The mathematicians that cut their operations research teeth during WWII left a legacy and culture of micro problem solving. You can't beat good ol' American "can do".

      Henry

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    3. I agree. The reasons are as mundane as that. Formalisation became an objective in itself. It merely reflects what the type of people that do the discipline like - to the exclusion of others and the knowledge that would go with it. You have to really ask what has been the benefits. Has it delivered better understanding and policy? No, if anything the reverse because it requires a lot of silly stuff (ridiculous stories to get an equation) to use it. Meanwhile what we really need to know probably lies further away than ever.

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    4. "(Maybe all this was a reaction to the free-wheeling, anti-Vietnam war and hippy strewn 1960s.)"

      The other social sciences became subject to radical attack, rather than anything like Sargent and Lucas. In the late 1960s there was a big debate about the role formalism in the social sciences. In most social sciences positivism lost. Economics, on the other hand, went the other way. It was also the discipline that started aligning with the conservatives in the 1970s. Sargent and Lucas in particular. (Friedman was conservative, but actually he was an empiricist first, and said in an important article about Keynes that his methodology was the right one, even if his conclusions weren't; Coase was someone else not happy with the excesses of formalism in economics). Formalism and conservatism went together, as did ripping out Keynesian ideas and thinking - the representative agent for example is fundamentally un-Keynesian. British economists opposed Thatcher in the 1980s, but these economists were more in the tradition of Keynes, Kaldor and Robinson than Lucas and Sargent.

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  2. What is the value of a progressive research programme when the object of research changes (at times faster than possible research progress), partly/largely in response to research results (and to the development of the conceptual framework used in research and in communicating its results/claims to society/politics)?
    I would be very interested if you could take into account the concept of 'performative economics'.

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  3. I am curious as to what exactly is so valuable in DSGE models per your opinion. What, specifically is so nice about it? You said it a few times, but I do not recall you being specific and going into details. I know other people probably wonder about this too, although I'd be looking for something a little more meaningful than a few general claims since I myself study economics.

    Another point, it is extremely curious to me why macroeconomics lived its most extended theoretical transformation right after the Sonnenschein Mantel Debreu result (and the subsequent demonstration made by Mas-Colell about reverse enggineering GE out of pretty much any price vector). The whole of microeconomics only became more empirical, turned away from GE and loads of theoretical solutions to problems such as multiple equilibria in game theory are often inspired by empirical regularities... Yet, while this happens, macroeconomics somehow managed to be filled with some people whose main concerns have been formalism. I know neokeynesians weren't so odd in that context, especially considering how they motivate some of their hypotheses, but RBC models really come off as the black swan of the 1980s. Why was the macroeconomics of RBC in the 1980s almost a replica of the 1950s and 1960s microeconomics program?

    Maybe some mouvements require to attain some level of maturity to end, maybe the keynesian habits simply delayed the NCCR and, somehow, it needed to happen before economics could get down to business.

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    1. "I am curious as to what exactly is so valuable in DSGE models per your opinion."

      I hope the reason is it gives good forecasts. The reason often given though is silly - that it unites micro with macro. That should be not be an objective (a) because there is no compelling reason why it should in the first place and (b) even it was, micro theory itself is not insufficiently solid ground to justify it.

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    2. It certainly doesn't give good forecasts! You just need to look back over a sequence forecasts and compare with the actual to see that.

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    3. Do heterodox economists think that generations of PhD students who continue to ignore their arguments are being forced to do so against their will?"

      It would be an extremely brave PhD student from a mainstream University to present a heterodox thesis. To begin with, how would she get access to heterodox thought in the neoclassical monoculture? Where would she find a supervisor? And why would she bother, since most academic appointments would then be closed to her, and she would not be able to publish in the 'top' economic journals?

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    4. Dear Prof Wren-Lewis,
      It's very generous of you to make your paper freely available, I hope you don't get into trouble with your publishers. You make your case very convincingly, and I agree that the debate over microfoundations has dominated the macroeconomic discourse in recent decades. Interestingly, there was a recent special issue on microfoundations (perhaps from a more heterodox point of view) in the latest Review of Political Economy (vol.28, issue 1) and I wonder if your paper is in reply? Or coincidence, perhaps the microfoundations debate is resurfacing?

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  4. Wren-Lewis’s methodological double whammy
    Comment on ‘Whatever happened to the General Theory’

    Keynes’s lasting scientific contribution relates to methodology. He spoke it out loud, so that every fellow economist could hear it: Throw over the classical axioms and put theoretical economics on new foundations: “For if orthodox economics is at fault, the error is to be found not in the superstructure, which has been erected with great care for logical consistency, but in a lack of clearness and of generality in the premises.” (1973, p. xxi)

    With the revolutionary shift in mathematics and physics from Euclidean to non-Euclidean axiomatics (Hilbert, Einstein) before his eyes, Keynes called his fellow economists to arms: “Something similar is required to-day in economics.” (1973, p. 16)

    Consequently, Keynes formulated the foundational syllogism of the General Theory as follows: “Income = value of output = consumption + investment. Saving = income - consumption. Therefore saving = investment.” (1973, p. 63)

    This elementary two-liner is conceptually and logically defective because Keynes did not come to grips with profit and therefore “discarded the draft chapter dealing with it.” (Tómasson et al., 2010, p. 12) As a result, all I=S models including the Keynesian multiplier are false (2014).

    To see the enormity of intellectual failure one has to let this sink in: Keynes had no idea of the fundamental concepts of his discipline, viz. profit and income. This did not hinder him to push his economic policy agenda. As a matter of fact, Keynes’s policy proposals never had a sound theoretical foundation but were at best commonsensical.

    After-Keynesians, including Wren-Lewis, did not realize until this day that there is something fundamentally wrong with Keynes’s two-liner and I=S but still hallucinate about ex ante/ex post.*

    In the neoclassical synthesis of Samuelson, Keynes’s new non-Euclidean axioms and the old Euclidean axioms of marginalism were cobbled together. Textbooks consisted of two well-balanced halves: micro and macro. Needless to emphasize that both halves did not fit together.

    The inconsistency was never resolved but gradually all returned to the pre-Keynesian formal foundations of marginalism. As Krugman put it on his blog “most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point.” These two concepts “were already central to economic thought in the previous century.” (Woodford, 1999, p. 2)

    Now, it can be shown that the axiomatic foundations of the neoclassical paradigm are methodologically inadmissible.** Needless to emphasize that the promoters of NCCR, including Wren-Lewis, never got the point.

    So we have two indicators of the logical incapacity of present day economists: Keynesians are since more than 80 years in the dark. Sorta-kinda neoclassicals are since more than 140 years in the dark.

    Because they have disqualified themselves neither Keynesians nor neoclassicals can be taken seriously. Marginalism has been a dead research program from the very start and things have not improved until DSGE. Just the contrary.

    As Keynes said, the fault is in the premises.

    Egmont Kakarot-Handtke

    References see
    http://axecorg.blogspot.de/2016/02/wren-lewiss-methodological-double-whammy.html

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    1. As per usual, someone complaining about the whole of economics spouts general, vague accusations without any regard for nuance or even a hint of self-criticism and humility.

      Just in case you do bother to do something constructive, criticism is way more believable when specific and empirically grounded. At least people in the 1980s and 1990s had the decency to provide ground for proposed departures. It never caught on, except for behavioral economics and the use of experiments, and those critiques would sure fall flat today. It is 2016. Microeconomics is organized around loads of game theory, much of which does not limit itself to static, full information, full processing capabilities, etc. It is also the age of econometrics and laboratory experiments, both of which seldom shy away from borrowing intuitions from outside the usual set of concepts found in introduction textbooks.

      I'm not saying some pluralism in economic journals wouldn't be nice or refreshing. I'm saying nobody has enough information to send the whole of economics down the drain. This requires an act of faith -- and blind at that given its actual success in policy analysis.

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  5. "Microfoundations simply replaces one set of flaws with others."

    In other words there are trade-offs, not just in economics, but in economic methods too. So it normally makes sense to use a mix of methods, rather than choosing a corner solution.

    Sounds sensible to me.

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  6. Ideology also plays a part, a very large part. And context. For many, Keynesianism is just too collectivist, even more so for those having experienced the rise of extremist politics in Europe. Prejudice also plays a part, a very large part. Social welfare plans adopted in response to the Great Depression coincided with integration in the U.S., the former blamed for the difficulty of the latter, a convenient explanation in the context of massive resistance to the inclusion of an entire race in the economic and social mainstream. Ideology and prejudice, two powerful forces working together.

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  7. Don't forget the extent to which new classical economics swims with the current of money and power. There's always a market for telling wealthy people what they want to hear; that such ideas are popular needs no further explanation.

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    1. One only has to look at the financial supporters of academic chairs in the US. Whose values do you think will prevail or be promoted?

      Henry

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  8. From where I stand, which is outside of economics, this is a fantastic paper!

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  9. Some of the comments get close to the nub of the question - which I suspect cannot be admitted by a 'serious' academic economist.

    Microfoundations based on optimising individuals effectively enshrines Margaret Thatcher's dictum "There is no such thing as society". It is not feasible, so far as I know, to model a sense of sufficiency, of 'enough is enough'from microfoundations when the foundations are built on the sand of individual optimisation. It is probably possible, but certainly difficult, to model anything but the most superficial altruism or sense of community, of doing something not because you are paid to, or even because you enjoy doing it, but because someone else will benefit if the job is done better. So the economic imperative is to grind down any sense of wider purpose.

    Hence the move to forbid firms from following objectives other than profit-maximisation (or more honestly, executive compensation maximisation). Hence the insistence that no 'lower' individual should be paid more than his or her marginal value, leaving the surplus for those who know how to manage the system.

    To be honest, as I step back from active life as an economist I get more and more sick of the whole construct. This article is a brave attempt to patch up some of the most obvious failings but there is something rotten at the heart. Economics has become the kind of 'social work' found in Douglas Adams' Hitchhikers Guide to the Universe - the art of comforting the rich.

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    1. You are right. Micro and Macro should be as different as psychology and sociology. One is not the sum of the other. I moved out of economics when I started doing my post-doc. Economic theory does not help us understand the economy. It greatly constrains us. Funnily enough I have moved to another social science discipline - and found it has given me a better understanding of the economy!

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    2. Actually, you can do lots of things using this methodology. If you insist on incorporating aggregate factors that do not stem from individual decisions, you can impose them without technical problem. Most DSGE do exactly that with representative agents: they impose WARP conditions on the whole economy by doing this. A different question is: will you get published?

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  10. I have read your paper Simon and the fact that you are making Lucas & Sargent 1979, the new “macro” peg in the ground for New Classical Counter Revolution (NCCR). Alas, like all academic macro stuff that has appeared lately, it is looking backwards. Is it another post mortem codicil, to the last NK Will and DSGE Testament?

    Lucas & Sargent 1979, doesn’t separate monetary and fiscal policy, or explain the role of either. “Exogenous variables were those under governmental control like tax rates or the supply of “money”. No mention of the role of a currency issuer or a currency user. Surely, the last eight years of the slowest UK economic recovery in Christendom, has proved something to NK economic academia. It certainly has to some recent economics students, stacking up the student loans!

    Anyway, “According to James Tobin the Keynesian revolution has evoked three counter-revolutions since 1965.” http://www.economicsdiscussion.net/macroeconomics/contemporary-macroeconomics-new-classical-economics/8175

    Meanwhile, I will have a “rational expectation” that the BoE will put interest rates up, or down. Also, a rational expectation that all those economists that said QE would create hyper-inflation, will be universally ignored.

    Face it Simon, MMT deficit spending (fiscal stimulus in academic terms) is the only thing that has been proven in the last eight years; particularly in the USA with the TARP programme. It only needs a “sovereign fiat currency extension” to IFRS accounting rules to let the Accountants take over from the failed Economists.

    The UK has developed the Whole of Government Accounts system, based on International Financial Reporting System (IFRS). The WGA spells out loud and clear, where the fiat currency creation and destruction components fit into IFRS. It makes it simple enough for the average voter to understand, with a little application. Particularly for those of the 99%, who don’t know their Ricardian Equivalence from their Rational Expectations!

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  11. I remember reading that Keynes was quite dismissive of Tinbergen's attempts to turn his ideas into an estimated system of equations. I understand he was skeptical of econometrics, so not sure he'd have been a big fan of cowles comission econometrics. Anyways I think you're exaggerating the inflexibility of DSGE models in incorporating financing constraints. DSGE models with credit constraints appeared a few years after Kydland and Prescott's original RBC paper if you include models with OLG (e.g Williamson,1986, or Bernanke/Gertler 1989). By the mid 1990's you had more standard models with long-horizon agents and credit constraints like Kiyotaki and Moore model. I'm not sure that's so bad for the 1st 20 years of a research program (I suspect if I look carefully, I'd also find the original SEM's from the 1940's and 1950's to be underedevelopped and simplistic compared to 1970's vintage). Once you had rule of thumb households, it's not really difficult to add time varying credit constraints tied for example to housing (as in the Iacoviello model which became a de facto standard, or exogenous shocks to borrowing limits). Chari et al themselves promote what they call business cycle accounting in which the simple DSGE model is seen as a semi structural framework with representative agents whose decisions are affected by different correlated wedges that follow e.g a VAR and represent financial ,pricing or other distortions. e.g some of the wedges could be labeled external financ or risk premia and linked to a reduced form time series model of credit conditions. Or if you don't like the notion in business cycle accounting that agents have rational expectations on the reduced form model of the wedges, you can go with one of the hybrid DSGE+pure time series models approaches like DSGE-VAR or with model combination approaches (e.g Geweke and Amisano paper on combining a DSGE with a VAR and a DFM forecast). I've seen some of that research in AER or Journal of Econometrics, and I think it's quite a hot research topic in academic macroeconometrics right.

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  12. "Do heterodox economists think that generations of PhD students who continue to ignore their arguments are being forced to do so against their will?"

    Another example why you have to understand irrational behaviour. Herd behaviour, groupthink, power relations, identity etc etc. You could ask the same of the financial sector; how did they get so sold on those financial engineering products for so long? Ditto for a lot of economic and political decisions made by policy-makers.

    It is precisely because of these sorts of dangers you need real eclecticism and real critical thinking.

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    1. Actually, you can accomodate some of those ideas within neoclassical models, although, to be fair, you do need to question the hypotheses that go into building models, as well as be aware of those ideas and the relevant empirics. THAT thing is not done sufficiently often.

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    2. Of course you can. But that is not enough. You also have to justify the framework you are using. There is also a strong argument that hypothesis approaches and hypothesis testing is not the way you go about subjects like economics. There are also a lot of people who think being empirical means running huge amounts of numerical data through computers.

      These are the types of important philosophical debates (which are largely about methodology) which have long been overdue in economics.

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  13. The longer I think about microfoundations the more I have the feeling it is a cul de sac. In the 70s and 80s "microfoundations" meant modelling the "market making process" because the "auctioneer" was considered to be an abysmal construction. Leijonhufvud and Clower suggested to follow the microeconomics of Marshall instead of Walras. However, that was blown away by NCCR. The largest market for intellectual ideas determines the issues that are discussed and that's the US market. Take it or leave it.

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  14. I really do have to read the paper (and I am eager to read it). Unfortunately (especially for my students) I have to teach today.

    This comment is more than usually pointless (which is typing a lot) but I wonder if you would explain what you mean by "progressive research program".

    I don't think that economists using pre NCCR methodology have made noticeable progress in the past few decades. I also think that the NCCR approach is the epitome of a degenerative research program.

    I am always puzzled by your use of the word "progressive" and I notice that I have read it here many times but have never read your definition.

    Can you describe a way can a research program can fail to be progressive in which the DSGE program hasn't failed ?

    Also don't ask me, ask cshalizi@cmu.edu about how the Smets-Wouters model performs compared to 5039 randomly generated models (hints below average and below median).

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