Economic models: worse than Whelan thinks.

Karl Whelan has an interesting longread on the state of (the teaching of) economics. I agree with many points. But not with everything. It’s worse than he thinks: (1) A large part of economics gives us, intentionally, less insights into the economy, for instance because it ‘abandons’ the idea that people use money (and no, that’s not just a convenient assumption to keep models simple for undergraduates – it is a core aspect of reputed policy models, see below). (2) Much of economics is ideologically framed. A shortread on (1) and (2) below. But first a Whelan quote:

I reckon nobody’s reading at this point, so I’ll just say what I think to keep myself happy.

The world economy is more complicated than any of us can understand and getting more so by the day. There are no magic formulae for understanding it and it takes many years of learning about it to even understand which kinds of approaches to thinking about the economy are useful versus which kinds are not. Undergraduate students are really not the best people to be designing a syllabus for a subject that is so bloody complicated.

But the truth is that many students are dissatisfied and a significant amount of their complaints are well-founded. With all the attractions of the information age available to them, students are more demanding than ever and can be turned off a subject more quickly in the past. We need to work harder to show students how economics connects with the real world and we need to explain to them how we think and why we think that way.

The point: economics, as taught to students and as used by economists and politicians, does not always connect with the real world.

An example:

The main economic model of the European Central Bank is the New Area Wide model (NAWM), arguably the most influential ‘DSGE’ economic model ever.

This model assumes, as stated on p. 9 of a working paper of model co-authors Christoffel, Coenen and Warne (2008) “the assumption that a fraction of households is limited in their ability to participate in asset markets has been abandoned, along with the usage of money as a means of facilitating transactions”.

A bank which uses a model which abandones the use of money… hey, why was the financial crisis called a financial crisis! Why didn’t the ECb see it coming! By the way – this abandonment of ‘money’ from economic thinking was a clear and total betrayal of traditional Bundesbank thinking!

Other flaws of the model:

* government consumption is, in the model, produced by private companies and used as ‘intermediate expenditure’ by the government. The government does in fact not produce anything useful at al, in this model. In reality, what is called ‘government consumption’ by real economists is stuff like primary education, produced by the government and consumed by households.

* Government consumption is, in the model, not a part of the ‘national utility’ (in fact: Eurozone utility) concept of the model. What is this ‘national utility’ anyway? It’s not defined at all (why does it, for instance, stop at the borders of the Eurozone).

* Unemployment? Assumed away.

* Differences in income? Assumed away by using what is basically one single representative consumer.

* Productivity differences between countries?

* Technological differences between countries? Nope, which means that competitivety is a function of the wage level and the wage level only. And this goes on, and on and on.

Which means that this is not a ‘neutral’ model. It is an anti labour, don’t look at inequality and don’t look at money and banks model, i.e. full blown right wing ranting model. And it was intended to be like that, as is shown by Look at the recently published letter from Trichet (at the time boss of the ECB) to Zapatero (at the time prime minister of Spain). This letter from 2011, with its disdain for democracy and govenrment and its totally anti-labour, pro-inquality and pro-financial markets content, was fully consistent with the NAWM.

Quote: “to restore the credibility of the sovereign’s signature in capital markets … We see a need for further significant measures to improve the functioning of the labour market with a view to making progress towards reducing the very high rate of unemployment”

Well, we now what happened. The measures taken by the Spanish and other European governments deepened the crisis, increased unemployment and did not lead to lower government deficits. While it was only when the ECB itself became credible, by living up to its classic role as lender of last resort, that government interest rates came down, a decline which by now – belatedly, belatedly – leads to somewhat lower interest rates for households and companies. But what the incredible Trichet-ECB in fact did, based on ultra right-wing economic models which did not even look at money, banks and capital markets, was increasing national interest rates during the gravest economic crisis since WW II while, based upon the ideas of these same models, at the same very time trying to put democracy on hold and push countries to decreasing government spending as well as wages (read the rest of the letter).

It’s indeed hard to explain such policies and models to students.

But it’s not hart to explain what happened in Spain.

Considering the size of the construction bubble, enabled and partly but surely not entirely caused by capital inflows, nothing could have avoided a very severe downturn in Spain. But high and in fact increasing interest rates, plummeting investments and wage cuts in combination with soaring unemployment and cuts in government spending and increases of VAT (which is what happened) did not lead to an economic recovery or a mitigation of the implosion – macro policies could have been aimed at trying to lower interest rates, write down bad debts, sustain net wage incomes and not increasing the consumer price level. We can expand this line of thinking by showing that the Spanish export industry was and is reasonably comeptitive and did not need wage cuts etcetera. But that’s a lot easier to explain to students when they are not taught DSGE models and their neoclassical foundations than when they have to misuse their time by mastering these flawed theorems and concepts.