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“The intrinsic limits of modern economic theory”

from Lars Syll

Almost a century and a half after Léon Walras founded neoclassical general equilibrium theory, economists still have not been able to show that markets move economies to equilibria.

We do know that – under very restrictive assumptions – equilibria do exist, are unique and are Pareto-efficient. After reading Franklin M. Fisher‘s masterly article The stability of general equilibrium – what do we know and why is it important? one, however, has to ask oneself – what good does that do?

As long as we cannot show, except under exceedingly special assumptions, that there are convincing reasons to suppose there are forces which lead economies to equilibria – the value of general equilibrium theory is nil. As long as we cannot really demonstrate that there are forces operating – under reasonable, relevant and at least mildly realistic conditions – at moving markets to equilibria, there cannot really be any sustainable reason for anyone to pay any interest or attention to this theory.

A stability that can only be proved by assuming “Santa Claus” conditions is of no avail. Most people do not believe in Santa Claus anymore. And for good reasons. Santa Claus is for kids, and general equilibrium economists ought to grow up, leaving their Santa Claus economics in the dustbin of history.

Continuing to model a world full of agents behaving as economists – “often wrong, but never uncertain” – and still not being able to show that the system under reasonable assumptions converges to equilibrium (or simply assume the problem away), is a gross misallocation of intellectual resources and time.

In case you think, even for a moment, that drawing this dismal conclusion is just an idiosyncracy of yours truly and other heterodox economists, you better think twice! Here is what one of the world’s greatest microeconomists – Alan Kirman – writes in his thought provoking paper The intrinsic limits of modern economic theory:

If one maintains the fundamentally individualistic approach to constructing economic models no amount of attention to the walls will prevent the citadel from becoming empty. Empty in the sense that one cannot expect it to house the elements of a scientific theory, one capable of producing empirically falsifiable propositions …
kirman
Starting from ‘badly behaved’ individuals, we arrive at a situation in which not only is aggregate demand a nice function but, by a result of Debreu, equilibrium will be ‘locally unique. Whilst this means that at least there is some hope for local stability, the real question is, can we hope to proceed and obtain global uniqueness and stability?

The unfortunate answer is a categorical no! [The results of Sonnenchein (1972), Debreu (1974), Mantel (1976) and Mas Collel (1985)] shows clearly why any hope for uniqueness or stability must be unfounded … There is no hope that making the distribution of preferences or income ‘not to dispersed’ or ‘single peaked’ will help us to avoid the fundamental problem …

The problem seems to be embodied in what is an essential feature of a centuries-long tradition in economics, that of treating individuals as acting independently of each other …

To argue in this way suggests … that once the appropriate signals are given, individuals behave in isolation and the result of their behaviour may simply be added together …

The idea that we should start at the level of the isolated individual is one which we may well have to abandon … we should be honest from the outset and assert simply that by assumption we postulate that each sector of the economy behaves as one individual and not claim any spurious microjustification …

Economists therefore should not continue to make strong assertions about this behaviour based on so-called general equilibrium models which are, in reality, no more than special examples with no basis in economic theory as it stands.

From a macroeconomic point of view, the arguments of Fisher and Kirman also show why New Classical, Real Business Cycles, Dynamic Stochastic General Equilibrium (DSGE) and “New Keynesian” microfounded macromodels are such bad substitutes for real macroeconomic analysis.

These models try to describe and analyze complex and heterogeneous real economies with a single rational-expectations-robot-imitation-representative-agent. That is, with something that has absolutely nothing to do with reality. And – worse still – something that is not even amenable to the kind of general equilibrium analysis that they are thought to give a foundation for, since the Sonnenschein-Mantel-Debreu theorem unequivocally showed that there did not exist any condition by which assumptions on individuals would guarantee either stability or uniqueness of the equlibrium solution.

Opting for cloned representative agents that are all identical is of course not a real solution to the fallacy of composition that the theorem points to. After all – as Nobel laureate Robert Solow noted in “The State of Macroeconomics” (Journal of Economic Perspectives 2008:243-249) – “a modern economy is populated by consumers, workers, pensioners, owners, managers, investors, entrepreneurs, bankers, and others, with different and sometimes conflicting desires, information, expectations, capacities, beliefs, and rules of behavior.” So, representative agent models are rather an evasion whereby issues of distribution, coordination, heterogeneity – everything that really defines macroeconomics – are swept under the rug.

Conclusion – don’t believe a single thing of what these microfounders tell you until they have told you how they have coped with – not evaded – Sonnenschein-Mantel-Debreu!

Of course, most neoclassical macroeconomists know that to use a representative agent is a flagrantly illegitimate method of ignoring real aggregation issues. They keep on with their business, nevertheless, just because it significantly simplifies what they are doing. It reminds – not so little – of the drunkard who has lost his keys in some dark place and deliberately chooses to look for them under a neighbouring street light just because it is easier to see there!

  1. john
    June 21, 2013 at 1:14 am

    Thanks Lars, such delightful comments turn my day into a pleasant equilibrium :)

  2. davetaylor1
    June 21, 2013 at 9:24 am

    “The problem seems to be embodied in what is an essential feature of a centuries-long tradition in economics, that of treating individuals as acting independently of each other …

    “To argue in this way suggests … that once the appropriate signals are given, individuals behave in isolation and the result of their behaviour may simply be added together … “.

    Exactly what I’ve objected to coming at this from the mathematics end. See the comparison of Grassman and Hamilton’s quaternion algebras in D E Littlewood’s “The Skeleton Key of Mathematics” ch. VIII (Hutchinson, 1949), wherein independent has become “nilpotent” and “the Grassman algebra is completely eliminated when the nilpotent invariable sub-algebra is removed”. [Littlewood, you may recall, was a colleague of the great physicist and monetary theorist Frederick Soddy]. My own framework is a quaternion structure using dynamic error correction.

    Good to see Kirman making the argument so much more simply!

  3. guest
    June 21, 2013 at 10:39 am

    “It reminds – not so little – of the drunkard who has lost his keys in some dark place…”

    A more appropriate image would be an astronomer, who, long after Kepler and Copernicus have invalidated the earth-centric view of the planetary system and just as Newton is publishing his law of universal attraction, continue to produce new fancy epicycles to “explain” the movement of celestial objects.

  4. Paul Schächterle
    June 21, 2013 at 10:55 am

    I think this critique of neoclassical micro falls even short. EVERYTHING in neoclassical micro is a mess! The problem of aggregation is just one of the many severe flaws of neoclassical micro.
    It has a flawed definition of rationality. It has a bad utility model which predicts behaviour no sane human being would ever display. Even from this flawed utility model it can NOT prove the individual consumer demand “curve” without such ludicrous assumptions as “income compensation” (Slutsky) or “utility compensation” (Hicks) – things that obviously do not exist in reality. Mind you, this is just the individual level and the consumer side of neoclassical theory.
    Give me a break and read Keen, Steve: Debunking Economics – the Naked Emperor of the Social Sciences. That is a must read starter for everyone genuinely interested in economics.
    The simple truth is: No useful economic model can be based on neoclassical theory.

  5. sergio
    June 21, 2013 at 3:20 pm

    Sorry for repeating but that what really neoclassical economics is “trees make wind blow”.
    Their models include only what can be observed, calculated and for what there is data.
    Any neoclassical model fit this “trees make wind blow”.
    The best example is Friedman’s “inflation is always and everywhere a monetary phenomenon”. (Always and everywhere (!). As if it is a God’s Law. And the God is Friedman, of course.)

    So, in order to fight with inflation it just recommended to cut money supply. And yes! It wrks The law is “true”! Cut money supply 100% and people start what ? Of course bartering! Can you observe inflation in barter? No! Look at statistics, NO inflation at all. Genius! He won inflation! But does he care that people a bartering as in primitive economy? No! Who cares. Statistical data is more important.
    That is why it is called “treesmakewindblownomics”

  6. Robert Locke
    June 21, 2013 at 3:34 pm

    I don’t think most economists realize what a swindle the discipline has turned out to be. I met the mother of a young man who is in the last year of his degree course in economics in a European university. The mother said he was in despair. Most people, if they study a subject, e.g, engineering, medicine, etc. acquire a body of knowledge that constitutes their “education.” The young man said he is acquiring no such body of knowledge, almost everything he is learning is questioned and questionable. He isn’t getting an education and will leave the university prepared to do exactly nothing. That’s the swindle. Young people can’t do it all over again. Considering the heavy indebtedness that people assume to be educated and considering the shift in education away from traditional humanities and arts into economics and management studies, our indebted students have been short-changed. I couldn’t think of anything very reassuring to say to that student’s mother.

  7. sergio
    June 21, 2013 at 4:31 pm

    Related paper “Still dead after all these years: interpreting the failure of general equilibrium theory” by Frank Ackerman

  8. sergio
    June 21, 2013 at 4:34 pm

    Paper: “Two Responses to the Failings of Modern Economics: the Instrumentalist and the Realist” by Tony LAWSON

  9. sergio
    June 21, 2013 at 4:41 pm

    “Mathematical Modelling and Ideology in the Economics Academy: competing explanations of the failings of the modern discipline?” by Tony Lawson

  10. June 25, 2013 at 9:22 pm

    Economics theory is fundamentally mistaken and befuddled because it ignores the true nature of money and banking.

    Here is my 4 minute cartoon that provides a very simple explanation:

    How to Create the Impossible Debt that is Swallowing the World

  11. Michael Handelman
    July 13, 2020 at 1:28 am

    I’m very confused as to the relationship between Rational Expectations and Representative Agent model. So Stiglitz seems to think one can have Rational Expectations without subscribing to Representative Agent assumptions. But isn’t the whole point of Rational Expectations, is that economist’ expectations are universal (i.e. market participants have the same expectations as economist’s expectation), which depends on economist is the only actor in the system.

    In contrast, you can have Representative Agent model, without subscribing to Rational Expectations. Namely, the “biblical Adam” refers to both individual human being and humanity, while remaining agnostic on the particular forms of rationality that people adopt.

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