Heterodox economists and mainstream eclecticism

I knew when I wrote this post some economists would not like it. These are economists who locate themselves outside the mainstream: heterodox economists. They often claim that mainstream economics is this narrow discipline wedded to particular assumptions that are both implausible and ideological. So when I argue that in principle and practice it is not, they will not like it. Simply saying (as I do) that economists are often too reluctant (sometimes for good reason in terms of the sociology of economists) to explore this freedom is not enough for them. Some of them require mainstream economics to be beyond redemption.

Sure enough, Lars Syll attacks my post. He writes 

“And just as his colleagues, when it really counts, Wren-Lewis shows what he is — a mainstream neoclassical economist fanatically defending the insistence of using an axiomatic-deductive economic modeling strategy.” 

I can only think that reading my post got him so angry he temporarily lost his critical faculties. Because what he writes is completely false. I wrote a comment on his blog but it has not appeared, although fortunately Bruce Wilder makes my point in very gentle terms. As I have been here before with Syll (see the footnote to this post), I will be less gentle.

My post ended with the following sentence:

“Mainstream academic macro is very eclectic in the range of policy questions it can address, and conclusions it can arrive at, but in terms of methodology it is quite the opposite.”

I argue in the post that “this non-eclecticism in terms of excluding non-microfounded work is deeply problematic.” I then link to my many earlier posts where I have expanded on this theme. So how I can be a fanatic defender of insisting that this modelling strategy be used escapes me. Unless I have misunderstood what an ‘axiomatic-deductive’ strategy is. Perhaps for Syll not following this strategy means being able to completely (180 degrees completely) misrepresent what someone else says.

That out of the way, I wanted to say something more substantive. In macro, the insistence on using microfounded models also works as an exclusion device. (I am suggesting this as a fact, not a deliberate strategy.) You cannot just write down an aggregate macro model, based on other people’s work or empirical findings or whatever. You have to microfound it, and that requires a lot of skill and practice, as many a PhD student has found out.

If it also turns out when doing this that the issue you want to address or the innovation you want to make is ‘difficult’ in terms of finding an acceptable microfoundation, there are many wise supervisors who will suggest that the student tries something else. It is hardly surprising that this might put some people off mainstream macro.

I think some knowledge of these things is essential - the kind of knowledge to be able to read and understand a journal article. But the depth of knowledge required to be able to create your own microfounded model, if your own interests are more empirical but you nevertheless want to explore the implications of your empirical work for the economy as a whole? Here I think what Lars Syll says has validity. But his wish to tar even the critics of this aspect of mainstream macro with this brush is just bizarre. More generally heterodox economists misdirect their fire when they accuse mainstream macro of being inescapably narrow in its subject matter or assumptions, when their criticism should be directed at the limitations implied by microfoundations formalism.

Conditional and Unconditional Forecasting

Sometimes I wonder how others manage to write short posts. In my earlier post about forecasting, I used an analogy with medicine to make the point that an inability to predict the future does not invalidate a science. This was not the focus of the post, so it was a single sentence, but some comments suggest I should have said more. So here is an extended version.

The level of output depends on a huge number of things: demand in the rest of the world, fiscal policy, oil prices etc. It also depends on interest rates. We can distinguish between a conditional and an unconditional forecast. An unconditional forecast says what output will be at some date. A conditional forecast says what will happen to output if interest rates, and only interest rates, change. An unconditional forecast is clearly much more difficult, because you need to get a whole host of things right. A conditional forecast is easier to get right.

Paul Krugman is rightly fond of saying that Keynesian economists got a number of things right following the recession: additional debt did not lead to higher interest rates, Quantitative Easing did not lead to hyperinflation, and austerity did reduce output. These are all conditional forecasts. If X changes, how will Y change? An unconditional forecast says what Y will be, which depends on forecasts of all the X variables that can influence Y.

We can immediately see why the failure of unconditional forecasts tells us very little about how good a model is at conditional forecasting. A macroeconomic model may be reasonably good at saying how a change in interest rates will influence output, but it can still be pretty poor at predicting what output growth will be next year because it is bad at predicting oil prices, technological progress or whatever.

This is why I use the analogy with medicine. Medicine can tell us that if we eat our 5 (or 7) a day our health will tend to be better, just as macroeconomists now believe explicit inflation targets (or something similar) help stabilise the economy. Medicine can in many cases tell us what we can do to recover more quickly from illness, just as macroeconomics can tell us we need to cut interest rates in a recession. Medicine is not a precise enough science to tell each of us how our health will change year to year, yet no one says that because it cannot make these unconditional predictions it is not a science.

This tells us why central banks will use macroeconomic models even if they did not forecast, because they want to know what impact their policy changes will have, and models give them a reasonable idea about this. This is just one reason why Lars Syll, in a post inevitably disagreeing with me, is talking nonsense when he says: “These forecasting models and the organization and persons around them do cost society billions of pounds, euros and dollars every year.” If central banks would have models anyway, then the cost of using them to forecast is probably no more than half a dozen economists at most, maybe less. Even if you double that to allow for the part time involvement of others, and also allow for the fact that economists in central banks are much better paid than most academics, you cannot get to billions!   

This also helps tell us why policymakers like to use macroeconomic models to do unconditional forecasting, even if they are no better than intelligent guesswork, but I’ll elaborate on that in a later post.

Defending rational expectations

Whenever I post anything which suggests that the idea of rational expectations was a useful innovation in macroeconomics, Lars Syll writes something to the effect that I am (and therefore most mainstream macroeconomists are) “so wrong, so wrong”. Now why does this bother me? Well, to be honest, it does not bother me very much. As Bob Dylan sang: ‘Yes, I received your letter yesterday (About the time the doorknob broke)’.

But it does bother me a bit. Professor Syll does write very eloquently, and this kind of eloquent prose can appeal to the occasional young economist, who is inclined to believe that only the radical overthrow of orthodoxy will suffice. I meet one or two each year I teach. I remember the feeling: been there, done that. It also appeals to people like Aditya Chakrabortty who are understandably unhappy by the current state of things economic. (See this nice recent post by Diane Coyle on both this particular article but also heterodox critiques more generally.) There is plenty to legitimately criticise about mainstream economics (and its textbooks), so it is a shame Professor Syll wastes his talents on one of its major achievements, which is rational expectations. On this he is, well, so wrong.

This discussion can easily get populated with straw (super)men, so let's be clear about some things. It is not a debate about rational expectations in the abstract, but about a choice between different ways of modelling expectations, none of which will be ideal. This choice has to involve feasible alternatives, by which I mean theories of expectations that can be practically implemented in usable macroeconomic models. In the past, I have attempted to try and start a dialog with heterodox economists on the level of practical macroeconomics, to get beyond the fine words and phrases. It did not seem to work. I tried again in that recent post, asking for practical alternatives to rational expectations. Professor Syll referred me to behavioural economics, or Frydman and Goldberg’s ‘Imperfect Knowledge Economics’. But perhaps I did not make it clear what I meant by practical.

If I really wanted to focus in detail on how expectations were formed and adjusted, I would look to the large mainstream literature on learning, to which Professor Syll does not refer. (Key figures in developing this literature included Tom Sargent, Albert Marcet, George Evans and Seppo Honkapohja: here is a nice interview involving three of them.) Macroeconomic ideas derived from rational expectations models should always be re-examined within realistic learning environments, as in this paper by Benhabib, Evans and Honkapohja for example. No doubt that literature may benefit from additional insights that behavioural economics and others can bring. However it is worth noting that a key organising device for much of the learning literature is the extent to which learning converges towards rational expectations.

However most of the time macroeconomists want to focus on something else, and so we need a simpler framework. In practice that seems to me to involve a binary choice. Either we assume that agents are very naive, and adopt something very simple like adaptive expectations (inflation tomorrow will be based on current and past inflation), or we assume rational expectations. My suspicion is that heterodox economists, when they do practical macroeconomics, adopt the assumption that expectations are naive, if they exist at all (e.g. here). So I want to explain why, most of the time, this is the wrong choice. My argument here is similar but complementary to a recent piece by Mark Thoma on rational expectations.

Suppose we have an equation determining wage or price inflation (a Phillips curve), where inflation expectations appear on the right hand side of the equation. We need some way of determining those expectations. Lots of nice words like ‘non-ergodic’ will not do: we need something simple that can be used to solve the model. To assume, as mainstream macroeconomists once did, that these expectations just depend on past observations about inflation seems to assume that agents are stupid. These agents ignore everything that economists and the media say about inflation: they ignore monetary policy, and whether the economy is in a boom or recession. Now if getting expectations right did not matter too much to these agents, then maybe such naivety would be understandable. But in this case making expectations errors can mean getting real wages or profits wrong, so it matters.

Perhaps you think the alternative is equally unbelievable. Rational expectations, often called model consistent expectations, implies that agents know the model that the modeller has constructed, and use it to generate expectations. This is where the elegant prose comes in - you can make this sound incredible. Of course it will not be literally true, but I think it is a lot nearer the truth than the adaptive expectations alternative. The reason why mainstream economics replaced adaptive expectations with rational expectations in the 1970s was because the new approach was consistent with what economists did elsewhere. Firms may not know the true demand curve for their product and work out the price that maximises profits each period, but that is a better approximation to how they choose prices than a model where they have a fixed mark-up on costs. So it just seemed consistent to also assume that agents used relevant and available information to generate expectations when those expectations mattered. The closest we can get to that, without assuming an elaborate learning model, is to assume rational expectations.

This is an empirical claim. But how else do you make sense of a whole forecasting industry, and the newsworthy character of macro forecasts. Rational expectations at least acknowledges that endeavour, while adaptive expectations pretends it does not exist. And how else do you make sense of the response of Japanese inflation expectations to little more than a policy change: see Carola Binder’s discussion. How can you make sense of all the discussion of forward guidance without the concept of rational expectations?

Most of the references I make to rational expectations in posts are in the context of the history of macroeconomic thought. I suspect the problem some people have is that they associate rational expectations with the New Classical critique of Keynesian economics, and therefore think rational expectations must be anti-Keynesian. This confuses who fought wars with the weapons they used. I see it quite differently. Before rational expectations, mainstream Keynesian theory that incorporated the Phillips curve depended on a rather fragile story of why economic booms (downturns) could occur, which was that workers kept under (over) estimating inflation. New Keynesian theories based on rational expectations are more compelling, and can include the fact that information is both costly and incomplete.

So I just do not get this obsession that some heterodox economists have with rational expectations. I think its fine to criticise mainstream theory (particularly macro theory) for being too wedded to rationality in general: I seem to remember some remarks of my own along those lines. But mainstream macro does take learning, and the problem of costly and limited information, seriously. However for the foreseeable future, rational expectations will remain the starting point for macro analysis, because it is better than the only practical alternative. 

The choice really matters. An economy where agents form their expectations in a naive adaptive way is like an elaborate machine which takes no account of what policymakers are doing. In reality the economy appears more intelligent than this: policy is difficult because people in the economy take actions which anticipate what policymakers might do. This makes designing good policy difficult, but the concept of rational expectations has allowed macroeconomists to tackle this problem. To throw all that away by abandoning rational expectations would not improve macroeconomics, it would impoverish it.  

Heterodox and mainstream macroeconomics: a great divide

                In the blogs I write, I try  - when describing what most macroeconomists do and think - to add somewhere the qualification ‘mainstream’ or something similar. This is because I’m well aware of a strong and longstanding minority who are generally described as heterodox macroeconomists.

                One of the notable things I find about the mainstream/heterodox divide is how strong it is. I think it’s fair to say that most mainstream macroeconomists care little about what goes on in the heterodox world. That was clearly a big mistake when it came to Minsky and financial crises. However, my impression is that sometimes this feeling is mutual. When I have heard or read heterodox economists, what often strikes me is the wholesale rejection of the mainstream.

                Take, for example, a recent post from Lars P Syll which caught my attention for obvious reasons.[1] He writes: “People like Hyman Minsky, Michal Kalecki, Sidney Weintraub, Johan Åkerman, Gunnar Myrdal, Paul Davidson, Fred Lee, Axel Leijonhufvud, Steve Keen – and yours truly - do not share any theory or models with Real Business Cycle theorists or “New Keynesians”". Any theory? Is everything in what has been called the new neoclassical synthesis a waste of time?

                I think this is a bit of an exaggeration. To pick just one example I read recently, Steve Keen in his Minsky model forthcoming in JEBO uses a Phillips curve, which I would say was the defining relationship in New Keynesian theory. His and the New Keynes Phillips Curve are not identical, and of course Keen’s is not microfounded, and they do somewhat different jobs, but still there seems to be some overlap between mainstream and heterodox there. This is hardly surprising. The Phillips curve started life as an empirical discovery. It is neither the invention of New Classical or New Keynesian thought, nor the fruit of heterodox ideas, and so can quite happily be shared.

                What interests me is why the need for such wholesale rejection of the mainstream? I learnt one possible answer when young, which is the appeal of revolution rather than evolution. In Cambridge (UK) in the early 1970s, a significant group of the faculty called themselves Neo-Ricardians, and they too rejected neo-classical theory. Joan Robinson was an inspirational figure for this group, although the key influence was Piero Sraffa. They were strongly attracted to the ideas of the philosopher Thomas Kuhn, who talked about paradigm shifts in science. The mainstream was not going to evolve into something better: it was fundamentally flawed, and therefore had to be overthrown. Attractive stuff for undergraduates – too attractive in my case – but that particular paradigm shift never came.

                A rejectionist strategy is of course unlikely to win friends within the mainstream. Even those quite critical of aspects of mainstream thought and teaching can be exasperated by the rejectionist attitude.  My own view is very similar to that expressed by Diane Coyle in her review of Steve Keen’s ‘Debunking Economics: The Naked Emperor Dethroned’: “I have a lot of sympathy with the details of Professor Keen’s project, but not its ultimate ambition. For in the end I think the Naked Emperor needs to be reclothed rather than dethroned.”

                However, within macro the mainstream is hardly more accommodating. It may advertise that it is open to new ideas, but in practice, to get into good journals, these ideas need to be cast in a rather simplistic microeconomic framework that in all other respects is uncontroversial from a mainstream point of view. In effect this excludes those who have problems with much of that simple micro theory.

                Now many mainstream and heterodox macroeconomists may be quite comfortable with this state of affairs, but in practice it means any radical (but not wholesale) challenge to the mainstream is severely diminished. This is another reason why I would advocate that more macro analysis should start at the aggregate level, rather than be forced to always establish its microeconomic credentials in a formal way. (See here in particular.) The mainstream does need constant challenge, but not just on an ‘all or nothing’ basis.   

                               

                 

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[1] I don’t like having what I write described as “pure drivel” (who does), and for that reason I have never used that phrase about someone else’s writing. What seems to have upset Syll is a belief that I thought all macroeconomists signed up to neoclassical theory. It is true that I used the qualifier ‘mainstream’ only once in the post Syll attacks, but to imagine from it or my writing more generally that I believe all macroeconomists sign up to microfoundations (see here), that I am self-congratulatory about mainstream macro today (see here), or that the only debates are about policy (see here), requires a very selective reading. OK, rant over.