neoclassical economics

Economics: science or politics? A reply to Kay and Romer

Romer’s article on ‘mathiness’ triggered a debate in the economics blogs last year. I didn’t pay a great deal of attention at the time; that economists were using relatively trivial yet abstruse mathematics to disguise their political leanings didn’t seem a particularly penetrating insight.

Later in the year, I read a comment piece by John Kay on the same subject in the Financial Times. Kay’s article, published under the headline ‘Economists should keep to the facts, not feelings’, was sufficiently cavalier with the facts that I felt compelled to respond. I was not the only one – Geoff Harcourt wrote a letter supporting my defence of Joan Robinson and correcting Kay’s inaccurate description of her as a Marxist.

After writing the letter, I found myself wondering why a serious writer like Kay would publish such carelessly inaccurate statements. Following a suggestion from Matteus Grasselli, I turned to Romer’s original paper:

Economists usually stick to science. Robert Solow was engaged in science when he developed his mathematical theory of growth. But they can get drawn into academic politics. Joan Robinson was engaged in academic politics when she waged her campaign against capital and the aggregate production function …

Solow’s mathematical theory of growth mapped the word ‘capital’ onto a variable in his mathematical equations, and onto both data from national income accounts and objects like machines or structures that someone could observe directly. The tight connection between the word and the equations gave the word a precise meaning that facilitated equally tight connections between theoretical and empirical claims. Gary Becker’s mathematical theory of wages gave the words ‘human capital’ the same precision …

Once again, the facts appear to have fallen by the wayside. The issue at the heart of the debates involving Joan Robinson, Robert Solow and others is whether it is valid to  represent a complex macroeconomic system (such as a country) with a single ‘aggregate’ production function. Solow had been working on the assumption that the macroeconomic system could be represented by the same microeconomic mathematical function used to model individual firms. In particular, Solow and his neoclassical colleagues assumed that a key property of the microeconomic version – that labour will be smoothly substituted for capital as the rate of interest rises – would also hold at the aggregate level. It would then be reasonable to produce simple macroeconomic models by assuming a single production function for the whole economy, as Solow did in his famous growth model.

Joan Robinson and her UK Cambridge colleagues showed this was not true. They demonstrated cases (capital reversing and reswitching) which contradicted the neoclassical conclusions about the relationship between the choice of technique and the rate of interest. One may accept the assumption that individual firms can be represented as neoclassical production functions, but concluding that the economy can then also be represented by such a function is a logical error.

One important reason is that the capital goods which enter production functions as inputs are not identical, but instead have specific properties. These differences make it all but impossible to find a way to measure the ‘size’ of any collection of capital goods. Further, in Solow’s model, the distinction between capital goods and consumption goods is entirely dissolved – the production function simply generates ‘output’ which may either be consumed or accumulated. What Robinson demonstrated was that it was impossible to accurately measure capital independently of prices and income distribution. But since, in an aggregate production function, income distribution is determined by marginal productivity – which in turn depends on quantities – it is impossible to avoid arguing in a circle . Romer’s assertion of a ‘tight connection between the word and the equations’ is a straightforward misrepresentation of the facts.

The assertion of ‘equally tight connections between theoretical and empirical claims’, is likewise misplaced. As Anwar Shaikh showed in 1974, is it straightforward to demonstrate that Solow’s ‘evidence’ for the aggregate production function is no such thing. In fact, what Solow and others were testing turned out to be national accounting identities. Shaikh demonstrated that, as long as labour and capital shares are roughly constant – the ‘Kaldor facts’ – then any structure of production will produce empirical results consistent with an aggregate Cobb-Douglas production function. The aggregate production function is therefore ‘not even wrong: it is not a behavioral relationship capable of being statistically refuted’.

As I noted in my letter to the FT, Robinson’s neoclassical opponents conceded the argument on capital reversing and reswitching: Kay’s assertion that Solow ‘won easily’ is inaccurate. In purely logical terms Robinson was the victor, as Samuelson acknowledged when he wrote, ‘If all this causes headaches for those nostalgic for the parables of neoclassical writing, we must remind ourselves that scholars are not born to live an easy existence. We must respect, and appraise, the facts of life.’

What matters, as Geoff Harcourt correctly points out, is that the conceptual implications of the debates remain unresolved. Neoclassical authors, such as Cohen and Harcourt’s co-editor, Christopher Bliss, argue that the logical results,  while correct in themselves, do not undermine marginalist theory to the extent claimed by (some) critics. In particular, he argues, the focus on capital aggregation is mistaken. One may instead, for example, drop Solow’s assumption that capital goods and consumer goods are interchangeable: ‘Allowing capital to be different from other output, particularly consumption, alters conclusions radically.’ (p. xviii). Developing models on the basis of disaggregated optimising agents will likewise produce very different, and less deterministic, results.

But Bliss also notes that this wasn’t the direction that macroeconomics chose. Instead, ‘Interest has shifted from general equilibrium style (high-dimension) models to simple, mainly one-good models … the representative agent is now usually the model’s driver.’ Solow himself characterised this trend as ‘dumb and dumber in macroeconomics’. As the great David Laidler – like Robinson, no Marxist –  observes, the now unquestioned use of representative agents and aggregate production functions means that ‘largely undiscussed problems of capital theory still plague much modern macroeconomics’.

It should by now be clear that the claim of ‘mathiness’ is a bizarre one to level against Joan Robinson: she won a theoretical debate at the level of pure logic, even if the broader implications remain controversial. Why then does Paul Romer single her out as the villain of the piece? – ‘Where would we be now if Solow’s math had been swamped by Joan Robinson’s mathiness?’

One can only speculate, but it may not be coincidence that Romer has spent his career constructing models based on aggregate production functions – the so called ‘neoclassical endogenous growth models’ that Ed Balls once claimed to be so enamoured with. Romer has repeatedly been tipped for the Nobel Prize, despite the fact that his work doesn’t appear to explain very much about the real world. In Krugman’s words ‘too much of it involved making assumptions about how unmeasurable things affected other unmeasurable things.’ So much for those tight connections between theoretical and empirical claims.

So where does this leave macroeconomics? Bliss is correct that the results of the Controversy do not undermine the standard toolkit of methodological individualism: marginalism, optimisation and equilibrium. Robinson and her colleagues demonstrated that one specific tool in the box – the aggregate production function – suffers from deep internal logical flaws. But the Controversy is only one example of the tensions generated when one insists on modelling social structures as the outcome of adversarial interactions between  individuals. Other examples include the Sonnenschein-Mantel-Debreu results and Arrow’s Impossibility Theorem.

As Ben Fine has pointed out, there are well-established results from the philosophy of mathematics and science that suggest deep problems for those who insist on methodological individualism as the only way to understand social structures. Trying to conceptualise a phenomenon such as money on the basis of aggregation over self-interested individuals is a dead end. But economists are not interested in philosophy or methodology. They no longer even enter into debates on the subject – instead, the laziest dismissals suffice.

But where does methodological individualism stop? What about language, for example? Can this be explained as a way for self-interested individuals to overcome transaction costs? The result of this myopia, Fine argues, is that economists ‘work with notions of mathematics and science that have been rejected by mathematicians and scientists themselves for a hundred years and more.’

This brings us back to ‘mathiness’. DeLong characterises this as ‘restricting your microfoundations in advance to guarantee a particular political result and hiding what you are doing in a blizzard of irrelevant and ungrounded algebra.’ What is very rarely discussed, however, is the insistence that microfounded models are the only acceptable form of economic theory. But the New Classical revolution in economics, which ushered in the era of microfounded macroeconomics was itself a political project. As its leading light, Nobel-prize winner Robert Lucas, put it, ‘If these developments succeed, the term “macroeconomic” will simply disappear from use and the modifier “micro” will become superfluous.’ The statement is not greatly different in intent and meaning from Thatcher’s famous claim that ‘there is no such thing as society’. Lucas never tried particularly hard to hide his political leanings: in 2004 he declared, ‘Of the tendencies that are harmful to sound economics, the most seductive, and in my opinion the most poisonous, is to focus on questions of distribution.’ (He also declared, five years before the crisis of 2008, that the ‘central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.’)

As a result of Lucas’ revolution, the academic economics profession purged those who dared to argue that some economic phenomena cannot be explained by competition between selfish individuals. Abstract microfounded theory replaced empirically-based macroeconomic models, despite generating results which are of little relevance for real-world policy-making. As Simon Wren-Lewis puts it, ‘students are taught that [non-microfounded] methods of analysing the economy are fatally flawed, and that simulating DSGE models is the only proper way of doing policy analysis. This is simply wrong.’

I leave the reader to decide where the line between science and politics should be drawn.

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Response to Tony Yates’ critique of Teaching Economics After the Crash

Tony Yates has written a critical rejoinder to Aditya Chakrabortty’s Radio 4 documentary on student demands for changes to university teaching of economics. Yates’ contribution is welcome as a rare example of a mainstream economist publicly engaging with the issues raised by dissatisfied students. For too long, the response of the mainstream has been to ignore criticism. Yates’ willingness to enter into dialogue – even if motivated by unhappiness with the content of the programme – is encouraging. Further, it clarifies the view of (some) mainstream economists on the teaching debate.

Yates’ first complaint is that the programme is an opinion piece rather than a report in which equal space is given to each side. It is true that the bulk of the programme focused on the grievances raised by the student movement – this was after all the subject of the piece – and provided only brief slots for dissenting voices. Criticising the programme on this basis ignores the bigger picture of total dominance by mainstream economics – not only in academia but also in the media and public debate. The number of critical economists who appear regularly on television and radio can be counted on one hand. Chakrabortty’s programme and the student movement that pushed it onto the agenda are welcome, yet remain a drop in the ocean.

Yates might reflect on the following question: Were a programme broadcast that defined economics in the terms he believes – a rigorous scientific discipline systematically discovering objective truths and discarding past mistakes – would he object to such an equally one-sided narrative?  For decades, this narrative has dominated to the extent that, until recently, there was no publicly audible debate. It is to the enormous credit of student groups that they have raised the volume of critical voices such that Chakrabortty’s programme could be made.

The more substantive criticisms made by Yates relate to what he regards as manifold factual inaccuracies peddled by interviewees and allowed to go unchallenged – in particular, inaccuracies about the assumptions of mainstream economics.

There are two important problems with Yates’ argument.  First, Chakrabortty’s programme was explicitly concerned with teaching economics – teaching economics at undergraduate level specifically.  Yates’ response is mainly concerned with academic and professional economics in general and, in particular, the higher reaches of contemporary research programmes. Second, and more importantly, Yates condenses students’ calls for increased methodological pluralism into a debate between rational choice theory and its (neoclassical) alternatives. One of the first students interviewed by Chakrabortty complains about a “lack of alternative perspectives, lack of history or context, that could include politics . . . lack of critical thinking, and lack of real world application” in undergraduate degrees. Yates’ response entirely fails to address this key issue.

The “caricatures” of mainstream economics to which Yates takes offence include rational choice, rational expectations, perfect markets, quantifiable risk, and an ignorance of money, banking and finance. Yates argues that this characterisation fails to take account of recent innovations such as bounded rationality, asymmetric information, monopolistic competition, learning effects, uncertainty, sticky prices, credit frictions, and so on. Moreover, Yates has previously argued that a course based on these types of models could adequately replace the course on Bubbles, Panics and Crashes which Manchester University cancelled.

Putting aside, for the moment, issues of methodological pluralism and historical context, does Yates really believe that Farmer’s multiple equilibrium models, internal rationality in intertemporal optimisation, or search models of money and credit should be taught in undergraduate degrees? One of us (Jump) took an MSc on which John Hardman Moore taught. Even there, the “collected works of the Kiyotaki-Moore collaboration” didn’t make it onto the syllabus. One can hardly criticise a programme about teaching economics – and, by extension, those involved with the various student movements – for ignoring papers that most PhD students find difficult to follow.  Regardless of the validity of the approach, “crunching exotic nonlinear ordinary differential equations” is unlikely to become part of the undergraduate economics syllabus any time soon.

A squabble over the exact models taught is not, however, the real issue.  While true that, since the heyday of real business cycle models, the mainstream has pulled back from the most egregious extremes of asserting a world of continuous full employment and total policy ineffectiveness, subsequent modifications to general equilibrium models – sticky prices for instant price adjustment, internal rationality for rational expectations, asymmetric information for full information – are always assumed to be “frictions” and “imperfections”; deviations from some socially optimal baseline.  Arguing about which specific unrealistic assumption has been dropped in this or that model misses the wood for the trees. The students want to be allowed to engage with different methodological approaches to economics – not to be told that if they study for another two years they can learn the Bernanke-Gertler financial accelerator model instead of the Woodford version with “perfect capital markets”.

The methodological approach of neoclassical economics – equilibria derived from optimisation problems couched in ever-more complicated mathematical settings – is highly restrictive, ideologically loaded, and universally imposed on undergraduates. The result of the complete elimination of any other approach from the curriculum is that students spend all their time learning how to manipulate abstract mathematical models which appear to hold little relevance for the real-world problems they are interested in addressing – as is made clear from the interviews conducted by Chakrabortty.

An important consequence of this methodological narrowing has been the (almost complete) eradication of economic history and the history of economic thought from the undergraduate curriculum.  This is a point conceded by Karl Whelan who argues, in his response to Chakrabortty’s programme, that mixing the formal neoclassical syllabus with “broader knowledge” would produce more rounded students – a conclusion also reached by the RES steering group on teaching economics.

Yates admits that he doesn’t believe that “any of the monetary policymakers I worked for or read believed much of [the workhorse NK model].  They worked off hunches, gut instinct, practical experiences.” (This is ironic given that Gali and Gertler – key architects and advocates of the models Yates claims policy-makers weren’t using – believe the models were introduced because previous versions were so inaccurate that “monetary policymakers turned to a combination of instinct, judgment, and raw hunches to assess the implications of different policy paths for the economy”.) What are such hunches and instincts based upon?  Aside from personal experience, one imagines that historical knowledge of previous crises played a part here (e.g., Ben Bernanke). Re-introducing this type of material into economics teaching would, as Whelan argues, produce more capable graduates.  Moreover, knowledge of the way that theory has evolved alongside economic events would provide valuable context for the “exotic non-linear equations” – but it would also cultivate an awareness of the dramatic methodological narrowing within the subject.

One of us (Michell) put this point to Yates on Twitter – admittedly not the ideal medium for careful debate. His response was approximately the following: economic history and history of economic thought are irrelevant – at best, a fun diversion for bath-time reading. This is because economics continually progresses so that the history of the discipline only reveals things “either discarded or whose husks were bettered and extracted”. As an example: “I don’t need to read Keynes to understand the liquidity trap … Wallace and Woodford suffices”.

At this point, one arrives at the inevitable argument that, whilst increasing methodological pluralism in undergraduate degrees may be a good thing, “heterodox economics” is best consigned to optional modules, or discarded altogether.  This misses a point of considerable importance: academic heterodoxy in economics is, more often than not, associated with methodological disagreement.  This is most clear in the further reaches of Post Keynesian and Austrian economics – e.g. Shackle, Lachmann – and in Marxian political economy where historical analysis is central.

If, for example, one wanted to teach the economics of financial crisis, surely the history of financial crises and inductive theory are the correct places to start?  Kindleberger and Minsky are the obvious candidates – after which more formal models could be considered.  This is not to say that the various heterodox approaches do not have their problems, but they are useful springboards to a deeper understanding of economic phenomena. Such empirically-based study would surely be a better starting point than learning Euler equations – despite the fact that the standard consumption Euler equation is known to fail miserably when taken to the data – or the standard model of a representative firm’s investment decision – despite the on-going failure of econometricians to find a robust relation between short run capital investment and the real interest rate.

Let us finish by returning to Yates’ Whig-historical view of the liquidity trap – a view which encapsulates much of the problem with mainstream economics. In modern neoclassical parlance, the liquidity trap refers to a situation in which nominal interest rates are equal to zero and quantitative easing is ineffective because changes in the quantity of (base) money have no effect on the (rational expectations) equilibrium future inflation path. As a result, the central bank is unable to reduce the real rate of interest and stimulate spending. All this matters because the economy fails to bring itself back to equilibrium in a timely fashion due to slow price adjustment.

This is unrecognisable to any serious scholar of Keynes. The liquidity trap refers to a situation in which fundamental uncertainty about the future leads people to hoard cash in preference to other financial assets, no matter how cheap those assets become. At the same time, uncertainty means firms may not commit to investment even if interest rates fall to a point that would previously have stimulated spending. The stickiness or otherwise of prices and wages is irrelevant because changes in output and employment provide the mechanism by which saving and investment are brought into equilibrium.

This brings other contentious topics to the fore, such as uncertainty, animal spirits and the neoclassical treatment of money. Each of these is highlighted by Yates as used in the programme to unfairly attack mainstream economics – he does concede that money as a veil over barter is a fair description for the most part.

Recall the definition of uncertainty emphasised by Knight and Keynes: a situation in which the future simply cannot be predicted, in contrast to a ‘risky’ situation in which all possible events are known, along with the probability of each.  This differentiation is fairly basic, and has been textbook material in game theory since (at least) Luce and Raiffa.  Now consider one example using Yates’ favoured approach to modelling uncertainty in macroeconomics: The central bank, unable to determine which of its three Phillips Curve models is correct, uses Bayesian inference to decide which model to use. This is almost beyond parody – simply a branding exercise which conceals the fact that the model has nothing whatsoever to do with the true meaning of the concept. Other “Keynesian” features of modern neoclassical economics highlighted by Yates are similarly grotesque caricatures of the original concepts.

By not studying Keynes in the original – or any other important economist from more than forty years ago – students are prevented from discovering such inconsistencies and are forced to take at face value the distortions and misrepresentations of mainstream economics. They are prevented from understanding how historical circumstance plays a role in the development and acceptance of economic theory: the Great Depression for Keynes and the stagflation of the 1970s for Friedman, for example. They also – crucially – fail to appreciate that economic and political power matters: mainstream economic theory is “history as written by those perceived to have been the intellectual victors of key debates”.

Yates describes Aditya Chakrabortty’s Radio 4 documentary as “a distorting dramatisation, on account of allowing multiple silly, uninformed critiques to go unchallenged in the program. Yet presented as a reasonable, impartial take on what is going on in economics.” This is unfair to the students involved in the reform movement and misses the main point of the programme. While we would not defend every claim made in the programme, we strongly support the call for a widening of the economics curriculum.

Given the role of the profession in contributing to the 2008 crisis, and in justifying the inexcusable policy packages imposed in response to the post-crisis expansion of sovereign debt, we might – at the very least – display some humility when addressing the inevitable public backlash. Beyond this, we must act on student demands and address past failings by implementing a fundamental overhaul of the economics curriculum.

 

Rob Jump
Jo Michell