Home > Uncategorized > Phlogiston, the identification problem, and the state of macroeconomics

Phlogiston, the identification problem, and the state of macroeconomics

from David Ruccio

The other day, I argued (as I have many times over the years) that contemporary mainstream macroeconomics is in a sorry state.

Mainstream macroeconomists didn’t predict the crash. They didn’t even include the possibility of such a crash within their theory or models. And they certainly didn’t know what to do once the crash occurred.

I’m certainly not the only one who is critical of the basic theory and models of contemporary mainstream macroeconomics. And, at least recently (and, one might say, finally), many of the other critics are themselves mainstream economists—such as MIT emeritus professor and former IMF chief economist Olivier Blanchard (pdf), who has noted that the models that are central to mainstream economic research—so-called dynamic stochastic general equilibrium models—are “seriously flawed.”

Now, one of the most mainstream of the mainstream, Paul Romer (pdf), soon to be chief economist at the World Bank, has taken aim at mainstream macroeconomics.* You can get a taste of the severity of his criticisms from the abstract: 

For more than three decades, macroeconomics has gone backwards. The treatment of identification now is no more credible than in the early 1970s but escapes challenge because it is so much more opaque. Macroeconomic theorists dismiss mere facts by feigning an obtuse ignorance about such simple assertions as “tight monetary policy can cause a recession.” Their models attribute fluctuations in aggregate variables to imaginary causal forces that are not influenced by the action that any person takes. A parallel with string theory from physics hints at a general failure mode of science that is triggered when respect for highly regarded leaders evolves into a deference to authority that displaces objective fact from its position as the ultimate determinant of scientific truth.

That’s right: in Romer’s view, macroeconomics (by which he means mainstream macroeconomics) “has gone backwards” for more than three decades.

Romer’s particular concern is with the “identification problem,” which in econometrics has to do with being able to solve for unique values of the parameters of a model (the so-called structural model, usually of simultaneous equations) from the values of the parameters of the reduced form of the model (i.e., the model in which the endogenous variables are expressed as functions of the exogenous variables). A supply-and-demand model of a market is a good example: it is not enough, in attempting to identify the two different supply and demand equations, to solely use observations of different quantities and prices. In particular, it’s impossible to estimate a downward slope (of the demand curve) and an upward slope (of the supply curve) with one linear regression line involving only two variables. That’s because both supply and demand curves can be shifting at the same time, and it can be difficult to disentangle the two effects. That, in a nutshell, is the “identification problem.”

The problem is similar in macroeconomic models, and Romer finds that many mainstream economists rely on models that require and presume exogenous shocks—imaginary shocks, which “occur at just the right time and by just the right amount” (hence phlogiston)—to generate the desired results. Thus, in his view, “the real business cycle model explains recessions as exogenous decreases in phlogiston.”

The issue with phlogiston is that it can’t be directly measured. Nor, as it turns out, can many of the other effects invoked by mainstream economists. Here’s how Romer summarizes these imaginary effects:

  • A general type of phlogiston that increases the quantity of consumption goods produced by given inputs
  • An “investment-specific” type of phlogiston that increases the quantity of capital goods produced by given inputs
  • A troll who makes random changes to the wages paid to all workers
  • A gremlin who makes random changes to the price of output
  • Aether, which increases the risk preference of investors
  • Caloric, which makes people want less leisure

So, there you have it: in Romer’s view, contemporary mainstream economists rely on various types of phlogiston, a troll, a gremlin, aether, and caloric. That’s how they attempt to solve the identification problem in their models.

But, for Romer, there’s a second identification problem: mainstream economists continue to build and apply these phlogiston-identified dynamic stochastic general equilibrium models because they have “a sense of identification with the group akin to identification with a religious faith or political platform.”

The conditions for failure are present when a few talented researchers come to be respected for genuine contributions on the cutting edge of mathematical modeling. Admiration evolves into deference to these leaders. Deference leads to effort along the specific lines that the leaders recommend. Because guidance from authority can align the efforts of many researchers, conformity to the facts is no longer needed as a coordinating device. As a result, if facts disconfirm the officially sanctioned theoretical vision, they are subordinated. Eventually, evidence stops being relevant. Progress in the field is judged by the purity of its mathematical theories, as determined by the authorities.

I, for one, have no problem with group identification (I often identify with Marxists and many of the other strangers in the strange land of economics). But when it’s identification with a few leaders, and when it’s an issue of the purity of the mathematics—and not shedding light on what is actually going on out there—well, then, there’s a serious problem.

As it turns out, modern mainstream economics has two identification problems—one in the imaginary solution of the models, the other with the imagined purity of the mathematics. Together, the two identification problems mean that what is often taken to be the cutting edge of modern macroeconomics is in fact seriously flawed—and has become increasingly flawed for more than three decades.

But let me leave the last word to Daniel Drezner, who has lost all patience with mainstream economists’ self-satisfaction with their theories, models, and standing in the world:

this is a complete and total crock.

 

*Other mainstream economists, such as Narayana Kocherlakota and Noah Smith, have expressed their substantial agreement with Romer.

  1. September 22, 2016 at 3:28 pm

    See my Bogs # 12 and # 32

    http://www.InquiryAbraham.com

  2. originalsandwichman
    September 22, 2016 at 4:23 pm

    “Three decades” takes us back to the halcyon daze of the mid-1980s. Already in the Cambridge capital critique was pointing out the gelatinous fantasy of neo-Walrasian capital — or “leets” in Joan Robinson’s sarcastic terminology. The paradigm shifted from merely unreal to even more unreal. Romer’s complaint sounds like nostalgia for the merely unreal.

  3. September 22, 2016 at 7:43 pm

    The identification problem and the dumping of the old guard
    Comment on David Ruccio on ‘Phlogiston, the identification problem, and the state of macroeconomics’

    There is political economics and theoretical economics. The founding fathers were straightforward people and called themselves political economists, that is, they left no doubt that their main business was agenda pushing. Economists never got out of political economics. In other words, theoretical economics (= science) ultimately could not emancipate itself from political economics (= agenda pushing). And this is how economics became one of the most embarrassing failures in the history of scientific thought.

    Now, Paul Romer argues: “A parallel with string theory from physics hints at a general failure mode of science that is triggered when respect for highly regarded leaders evolves into a deference to authority that displaces objective fact from its position as the ultimate determinant of scientific truth.” (See intro)

    The key word is scientific truth. Why is scientific truth suddenly the uppermost value? Actually, it is not! Since the founding fathers, theoretical economics is dominated by political economics. What Romer is communicating with his critique of DSGE/RBC/mathiness is nothing less than a change of policy which means that theoretical economics has now speedily adapt to a new agenda. To wrap the new task for the economics community in a critique of the identification problem, which is a old as Econometrica (1933), proves a strong sense of humor.

    There is a policy change in the offing which requires a redecoration of the scientific fig leaf. The severe critique of the old authority makes it clear that there is a new authority and NOT that scientists should no longer accept political authority.

    With regard to the scientific status of economics (= material and formal consistency) the situation is UNCHANGED since half an eternity. Methodologically, the maximization-and-equilibrium approach has always been axiomatically unacceptable but economists swallowed it hook, line and sinker from Jevons/Walras/Menger onward to DSGE. The microfoundations approach is not a degenerated research program but has already been dead in the cradle.*

    This is the current state of economics: Walrasian microfoundations are false since 140 years and the Keynesian macrofoundations are false since 85 years.** As a consequence, all models that contain maximization-and-equilibrium or I=S/IS-LM are a priori false and together this is roughly 90 percent of the content of peer-reviewed economic quality journals and 100 percent of textbooks.

    Because they either do not fully realize that their research program has already been dead in the cradle or because they have not the slightest idea about what a progressive alternative could look like, the present generation of economists has not made and cannot make a significant contribution to the discussion about how the actual economy works.*** These folks are not part of the solution they ARE the defunct research program.****

    Egmont Kakarot-Handtke

    * See post ‘No future for axiomatically false economics’
    http://axecorg.blogspot.de/2016/09/no-future-for-axiomatically-false.html

    ** See post ‘Marshall and the Cambridge school of plain economic gibberish’
    http://axecorg.blogspot.de/2016/09/marshall-and-cambridge-school-of-plain.html

    *** See post ‘The trouble with economics prizes’
    http://axecorg.blogspot.de/2016/09/the-trouble-with-economics-prizes.html

    **** For the paradigm shift see cross-references
    http://axecorg.blogspot.de/2015/02/essentials-cross-references.html

  4. September 24, 2016 at 12:40 pm

    Take a look at the cartoon.

    An old joke in mathematics that’s not a joke, and every mathematician knows it.

  5. September 24, 2016 at 6:51 pm

    Out of science
    Comment on David Ruccio on ‘Phlogiston, the identification problem, and the state of macroeconomics’

    In his recent paper ‘The Trouble With Macroeconomics’* Paul Romer puts DSGE and its main proponents (Lucas, Sargent, Prescott) to rest. In the final section ‘The Trouble Ahead For All of Economics’ he appeals to emotions: “It is sad to recognize that economists who made such important scientific contributions in the early stages of their careers followed a trajectory that took them away from science. It is painful to say this so when they are people I know and like and when so many other people that I know and like idolize these leaders.”

    While it is true that DSGE and its proponents are out of science it is NOT correct to give the impression that an accident happened at some point on the way from science to non-science. The fact of the matter is that DSGE has always been out of science because economics has always been out of science. The leaders of the DSGE/RBC program have done exactly what they were supposed to do: “It is a touchstone of accepted economics that all explanations must run in terms of the actions and reactions of individuals. Our behavior in judging economic research, in peer review of papers and research, and in promotions, includes the criterion that in principle the behavior we explain and the policies we propose are explicable in terms of individuals, not of other social categories.” (Arrow, 1994, p. 1)

    This definition of the subject matter translates into this set of hard core propositions/axioms: “HC1 economic agents have preferences over outcomes; HC2 agents individually optimize subject to constraints; HC3 agent choice is manifest in interrelated markets; HC4 agents have full relevant knowledge; HC5 observable outcomes are coordinated, and must be discussed with reference to equilibrium states.” (Weintraub, 1985, p. 147)

    The critical axioms are HC2 and HC5. Krugman put it nicely: “… most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point.”

    It is obvious to anyone with a modicum of scientific instinct that the axiomatic starting point of orthodox economics is methodologically forever unacceptable. The axiom set consists of blatant nonentities but each student generation has swallowed it without turning an eyelid. Lucas, Sargent, Prescott certainly did. This is scientifically disqualifying.

    In order to be applicable HC3, which translates formally into calculus, requires a lot of auxiliary assumptions, most prominently a well-behaved production function.*** Taken together, all axioms and auxiliary assumptions crystallize to SS-DD-equilibrium or what Leijonhufvud famously called the Totem of Micro/Macro.

    Needless to stress that ALL THREE elements of the standard tool (SS-function, DD-function, equilibrium) are nonentities. The usual concept of a function is NOT applicable in economics. It was the heterodox economist Georgescu-Roegen who raised some methodological doubts long ago: “But why should economic laws … be expressed by analytical functions?” (1966, p. 123)

    The fact that neither SS/DD functions nor equilibrium exist leads with inescapable consequence to the identification problem in Econometrics (see Romer Sec. 4).** Romer takes this insurmountable technical difficulty as methodological silver bullet in order to finish off DSGE/RBC. It should be noted, though, that the identification problem has its roots in the Walrasian axiom set HC1/HC5 which is the accepted common ground of orthodox economics.

    The real and ultimate scientific error/mistake of Lucas, Sargent, Prescott et al. consists in accepting the very definition of economics. The failure of DSGE therefore calls (i) for a paradigm shift, i.e. a new definition of the subject matter, and (ii), the replacement of the silly supply-demand-equilibrium totem of economics (2013; 2014).

    To throw DSGE/RBC unceremoniously out of science is a bit ironic because textbook supply-demand-equilibrium, which is built upon the same maximization-and-equilibrium axioms, is rubbish since Jevons/Walras/Menger. By sticking to the post-real microfoundations HC1/HC5 economists are since 140 years out of science.

    Egmont Kakarot-Handtke

    References
    Arrow, K. J. (1994). Methodological Individualism and Social Knowledge. American Economic Review, Papers and Proceedings, 84(2): 1–9. URL
    http://www.jstor.org/stable/2117792.
    Georgescu-Roegen, N. (1966). Analytical Economics, chapter General Conclusions for the Economist, pages 92–129. Cambridge, MA: Harvard University Press.
    Kakarot-Handtke, E. (2013). How to Get Rid of Supply-Demand-Equilibrium. SSRN Working Paper Series, 2263172: 1–24. URL
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2263172
    Kakarot-Handtke, E. (2014). The Law of Supply and Demand: Here it is Finally. SSRN Working Paper Series, 2481840: 1–17. URL
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2481840
    Weintraub, E. R. (1985). Joan Robinson’s Critique of Equilibrium: An Appraisal. American Economic Review, Papers and Proceedings, 75(2): 146–149. URL
    http://www.jstor.org/stable/1805586.

    * Paper of Sep 14, 2016 https://paulromer.net/wp-content/uploads/2016/09/
    WP-Trouble.pdf
    ** See also Wikipedia https://en.wikipedia.org/wiki/Parameter_identification_
    problem
    *** See post ‘Putting the production function back on its feet’
    http://axecorg.blogspot.de/2016/09/putting-production-function-back-on-its.html

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