‘DSGE’macro models criticism: a limited round up. Part 2: market fundamentalism.
Look here for part 1 of this series, about money. Today: market fundamentalism. The posts are supposed to be succinct, to look at the issues from the angle of the economic statistician.
Today: market fundamentalism.
There are, in my view, three main strands of market fundamentalism in DSGE-macro models:
1) The idea that market prices are ‘optimal’, especially when we’re in equilibrium (whatever that is)
2) The idea that non market production, especially government production like lots of education or health care, is essentially worthless
3) The idea that markets are not just very dynamic and creative (which surprisingly does not seem to be very interesting to the DSGE economists) but that a market system leads to some kind of optimal general equilibrium or (taking the models at face value) is at least not totally inconsistent with such a situation.
Ad 1) We use purchased capital goods and durable consumer goods plus ‘intermediate inputs’ plus unpaid labour plus market exchange plus public goods to achieve our aims. Think of using you car to buy groceries. In this case, only the groceries and the gasoline used have ‘market prices’ and are included in the model. Aside: I define market prices as monetary prices which are set before a transaction takes place. ‘Shadow prices’, like the assumed monetary value of the time it takes to buy groceries, are not market prices, as no exchange between two parties takes place and as the price used to calculate the monetary value of this time might by set by an economist studying this behaviour – but it is not set ex ante by the person buying groceries. Which makes it a far cry from a real life monetary market price. The same hold for depreciation of (in this case) the car, which (though purchased as a market article) is used in a non-market, non-monetary surrounding. The costs can be calculated – but many people do not really do this, while, more important in this case, these costs are not (part of) the market price of buying groceries, as this price simply does not exist as a market price (yes, I know, the internet is changing this but the internet is also leading to the demarketing of many services). Long story short: the assumption that society is one big market and only transactions based upon market prices add to ‘social utility’ is silly and wrong (even when we could define social utility, which we can’t). Monetary market prices which, by definition, are set ex ante do guide our behaviour – but only part of it. Wonkish: ironically, it was Gary Becker (“the man who put a shadow price upon everything”) who showed that even in the case of markets and market prices you don’t have to assume rationality to derive downward sloping demand curves, which means that even if our society only consisted of markets and we were in equilibrium-la-la-land there is no deductive reason to assume that these prices are in any way optimal.
How do statisticians treat this? The National Accounts only look at the flow of monetary spending and disregard the use of consumer durables and non-paid labour. A large exception to this: housing services of owner occupied houses are seen as production, using a shadow price: the capital aspect of household labour is to a large extent covered by these accounts. Statistics of hours and time use however do exist and are used by economic statisticians, look for one example at this Levy Institute publication about labour time, unpaid labour and household production in Turkey. There clearly is no statistical reason to restrict the definition of social utility (whatever that definition is, does anybody have a source?) to market purchases.
Ad 2) Introductory remark: a much more eloquent elaboration of the same point along a somewhat different line is made by the very sharp June Sekera. According to DSGE models, a nurse paid by a private hospital does add to social utility (whatever that is) but the money earned by a nurse paid by the UK National Health Service is ‘wasteful expenditure’. You don’t believe this? It’s indeed not a necessary part of DSGE models but despite this almost all DSGE models assume this. Look here and here. Assuming this makes comparison of different countries almost impossible for economists using DSGE models, as health care is largely nationalized in a country like the UK (and therewith by assumption considered to be wasteful expenditure) while this is not the case in the USA – you really are comparing inconsistent sets of data when you restrict consumption to household consumption expenditure. Fortunately, economists have developed the concept of AIC, Actual Individual Consumption, which corrects for such differences between countries (and shows that differences in the level of consumption when corrected for these differences as well as for differences in price levels are much smaller than indicated by consumer spending). The point: there is no need at all to restrict our concept of non wasteful expenditure to market purchases. But neoclassical economists still do this – government expenditure is wasteful by definition. Even the dikes, without which my country simply would not exist, are a total waste… (mind that after every major flood (1570,1717, 1825, 1953) not just the dikes themselves were improved but the way they were financed too – more taxation and monetization and less private and local ownership and responsibility. To be clear: I totally want to discuss if private education is more effective and/or efficient than public education. But that’s not the point – according to the market fundamentalist models, public education adds nothing. Update (21-04-2015): look here for a New Keynesian model modified by Kuehn, Muysken and Veen which allows for ‘useful government spending’. Look here for Linnemann and Schabert (2004) for a comparable model which allows people to actually profit from government spending.
Ad 3) Do market systems tend to equilibrium? No, says Roger Farmer, who looks at the development of USA GDP (1955-2014) and discovers that there are persistent differences between the very long-term growth rate and long term growth rates. This might, however be explained by supply side changes of the economy. No, say Hendry and Mizon, who look at UK unemployment in the long run (1860-2011): there are inexplicable and large differences in the short and medium term level of unemployment. No, says Knibbe, who looks at the rate of investment in present day rich countries in the long run (1820-2010). There are very large differences in short as well as long-term rates of investment – and there does not seem to be any way in wich a market economy on its own adapts to large declines. Neither exports nor private consumption nor government consumption seems to fill the demand gap left by a decline in the investment rate in market-response way (the pattern of investment seems to be related in some way the Hendry/Mizon unemployment data). Now, somebody might succeed in explaining these empirical patterns using a DSGE model. As far as I know, this has not happened yet. The whole DSGE endeavour lacks empirical discipline and is, contrary to the scientific idea, not based upon independent estimates of variables like social utility (whatever that may be, indeed).