Home > Uncategorized > The state of ‘New Keynesian’ economics

The state of ‘New Keynesian’ economics

from Lars Syll

Tnkhe standard NK [New Keynesian] model, like most of its predecessors in the RBC literature, represents an economy inhabited by an infinitely-lived representative household. That assumption, while obviously unrealistic, may be justified by the belief that, like so many other aspects of reality, the finiteness of life and the observed heterogeneity of individuals along many dimensions … can be safely ignored for the purposes of explaining aggregate fluctuations and their interaction with monetary policy, with the consequent advantages in terms of tractability …

There is a sense in which none of the extensions of the NK model described above can capture an important aspect of most financial crises, namely, a gradual build-up of financial imbalances leading to an eventual “crash” characterized by defaults, sudden-stops of credit flows, asset price declines, and a large contraction in aggregate demand, output and employment. By contrast, most of the models considered above share with their predecessors a focus on equilibria that take the form of stationary fluctuations driven by exogenous shocks. This is also the case in variants of those models that allow for financial frictions of different kinds and which have become quite popular as a result of the financial crisis … The introduction of financial frictions in those models often leads to an amplification of the effects of non-financial shocks. It also makes room for additional sources of fluctuations related to the presence of financial frictions … or exogenous changes in the tightness of borrowing constraints​ … Most attempts to use a version of the NK models to explain the “financial crisis,” however, end up relying on a large exogenous shock that impinges on the economy unexpectedly, triggering a large recession, possibly amplified by a financial accelerator mechanism embedded in the model. It is not obvious what the empirical counterpart to such an exogenous shock is.

Jordi Gali

Gali’s presentation sure raises important questions that serious economists ought to ask themselves. Using ‘simplifying’ tractability assumptions such as “infinitely-lived representative household,” rational expectations, common knowledge, additivity, ergodicity, etc — because otherwise they cannot ‘manipulate’ their models or come up with ‘rigorous ‘ and ‘precise’ predictions and explanations, does not exempt — ‘New Keynesian’ or not — economists from having to justify their modelling choices. Being able to ‘manipulate’ things in models cannot per se be enough to warrant a methodological choice. If economists do not come up with any other arguments for their chosen modelling strategy than Gali’s “advantages in terms of tractability,” it is certainly a just question to ask for clarification of the ultimate goal of the whole modelling endeavour.

Gali’s article underlines that the essence of mainstream economic theory is its almost exclusive use of a deductivist methodology. A methodology that is more or less used without a smack of argument to justify its relevance.

The theories and models that mainstream economists construct describe imaginary worlds using a combination of formal sign systems such as mathematics and ordinary language. The descriptions made are extremely thin and to a large degree disconnected to the specific contexts of the targeted system than one (usually) wants to (partially) represent. This is not by chance. These closed formalistic-mathematical theories and models are constructed for the purpose of being able to deliver purportedly rigorous deductions that may somehow by be exportable to the target system. By analyzing a few causal factors in their “laboratories” they hope they can perform “thought experiments” and observe how these factors operate on their own and without impediments or confounders.

Unfortunately, this is not so. The reason for this is that economic causes never act in a socio-economic vacuum. Causes have to be set in a contextual structure to be able to operate. This structure has to take some form or other, but instead of incorporating structures that are true to the target system, the settings made in economic models are rather based on formalistic mathematical tractability. In the models they appear as unrealistic assumptions, usually playing a decisive role in getting the deductive machinery to deliver “precise” and “rigorous” results. This, of course, makes exporting to real-world target systems problematic, since these models – as part of a deductivist covering-law tradition in economics – are thought to deliver general and far-reaching conclusions that are externally valid. But how can we be sure the lessons learned in these theories and models have external validity when based on highly specific unrealistic assumptions? As a rule, the more specific and concrete the structures, the less generalizable the results. Admitting that we in principle can move from (partial) falsehoods in theories and models to truth in real-world target systems do not take us very far unless a thorough explication of the relation between theory, model and the real world target system is made. If models assume representative actors, rational expectations, market clearing and equilibrium, and we know that real people and markets cannot be expected to obey these assumptions, the warrants for supposing that conclusions or hypothesis of causally relevant mechanisms or regularities can be bridged, are obviously non-justifiable. To have a deductive warrant for things happening in a closed model is no guarantee for them being preserved when applied to an open real-world target system.

Henry Louis Mencken once wrote that “there is always an easy solution to every human problem – neat, plausible and wrong.” And mainstream economics has indeed been wrong. Very wrong. Its main result, so far, has been to demonstrate the futility of trying to build a satisfactory bridge between formalistic-axiomatic deductivist models and real-world d target systems. Assuming, for example, perfect knowledge, instant market clearing and approximating aggregate behaviour with unrealistically heroic assumptions of “infinitely-lived” representative actors, just will not do. The assumptions made, surreptitiously eliminate the very phenomena we want to study: uncertainty, disequilibrium, structural instability and problems of aggregation and coordination between different individuals and groups.

The punch line is that most of the problems that mainstream economics is wrestling with, issues from its attempts at formalistic modelling per se of social phenomena. If scientific progress in economics – as Robert Lucas and other latter days mainstream economists seem to think – lies in our ability to tell “better and better stories” without considering the realm of imagination and ideas a retreat from real-world target systems reality, one would, of course, think our economics journal being filled with articles supporting the stories with empirical evidence. However, I would argue that the journals still show a striking and embarrassing paucity of empirical studies that (try to) substantiate these theoretical claims. Equally amazing is how little one has to say about the relationship between the model and real-world target systems. It is as though thinking explicit discussion, argumentation and justification on the subject not required. Mainstream economic theory is obviously navigating in dire straits.

If the ultimate criterion for success of a deductivist system is to what extent it predicts and cohere with (parts of) reality, modern mainstream economics seems to be a hopeless misallocation of scientific resources. To focus scientific endeavours on proving things in models is a gross misapprehension of what an economic theory ought to be about. Deductivist models and methods disconnected from reality are not relevant to predict, explain or understand real-world economic target systems. These systems do not conform to the restricted closed-system structure the mainstream modelling strategy presupposes.

Mainstream economic theory still today consists mainly of investigating economic models. It has since long given up on the real world and contents itself with proving things about thought up worlds. Empirical evidence still only plays a minor role in mainstream economic theory, where models largely function as substitutes for empirical evidence.

What is wrong with mainstream economics is not that it employs models per se, but that it employs poor models. They are poor because they do not bridge to the real world target system in which we live. Hopefully humbled by the manifest failure of its theoretical pretences, the one-sided, almost religious, insistence on mathematical deductivist modelling as the only scientific activity worthy of pursuing in economics will give way to methodological pluralism based on ontological considerations rather than “consequent advantages in terms of tractability.”

 

  1. July 31, 2018 at 1:59 am

    Yes, the models are poor, and we can be much more concise. An equilibrium model cannot crash, therefore cannot be used to model a crash.

    On the other hand I constructed a quite ‘tractable’ model that can exhibit equilibrium, oscillations like a business cycle, or a crash, depending on one parameter. A simple model I grant, but it is capable of exhibiting the behaviour in question, so it may be worth pursuing. ANY equilibrium model is not worth pursuing. That’s really all that needs to be said.

    See
    https://rwer.wordpress.com/2014/03/10/a-science-of-economies/#more-15181

    • Frank Salter
      July 31, 2018 at 7:33 am

      Both the original and Geoff Davies’ comment are valid descriptions of the state of economic theory. Geoff’s reference is a thoughtful wide ranging analysis. His simple model demonstrates that inadequate control systems hunt.

      His most significant statements are:
      “My model uses much simpler mathematics (one first-order differential equation in time) but more sensible assumptions. A fundamental difference is that in my model time is allowed to flow, whereas in neoclassical models it is not.”

      Only by developing analyses in time will economics progress.

    • July 31, 2018 at 8:21 pm

      Greatly enjoying your comments here and here.

      Perhaps I can elaborate on some of them a little from my perspective as a scientist studying a rather messy object – the Earth. Earth is not as complicated as people and social phenomena, but it’s much messier than laboratory physics, so it has given me a broader appreciation of how to proceed scientifically. ~ Geoff Davies

      Having spent decades studying the history of the earth sciences I appreciate your comments and their pragmatic wisdom which seems missing in the minds of some economists. The question of how to proceed scientifically is best illuminated, in my view, by practicing scientists and frequently these lessons are only really revealed in frank and honest first person histories and “stories” of their own experience solving complex scientific questions and issues. The history of plate tectonics and the earth sciences are replete with just such lessons that belie the stereotyped idealization of the “scientific method” vs the totality of science as the very real human endeavor that it includes the fullness of what it means to be curious questioning human beings seeking to understand material reality.

      If one wants to see the way the sausage is made one must attend the seminars and such where the real questions are debated, sometimes with excruciating humanity (ad hominem personal attacks, unscientific dogmatic assertions, etc.) to know where the real knowns and unknowns lie buried behind polished papers.

    • August 1, 2018 at 3:00 am

      Thanks for your appreciative comments. I’m often unsure if anyone gets what I’m talking about here. :-)

      btw there will be a WEA book. Watch this space.

      MetaC – yes continental drift/plate tectonics is a great story. I cover some of it in the opening chapters of my text book Dynamic Earth http://www.cambridge.org/gb/academic/subjects/earth-and-environmental-science/solid-earth-geophysics/dynamic-earth-plates-plumes-and-mantle-convection?format=PB&isbn=9780521599337

      • August 6, 2018 at 5:17 pm

        I am looking forward to the WEA book Geoff. Thanks. Will checkout your book too. A while back I received Mott T. Greene’s biography/history “Alfred Wegener: Science,Exploration, and the Theory of Continental Drift (http://a.co/i1TGvl4) and have been enjoying it greatly. I hope the opening chapters on your book are readily available as my book budget has been blown!

        Rob Reno

  2. Prof Dr James Beckman, Germany
    July 31, 2018 at 9:04 am

    Looking at humans as biologic entities–we learn, procreate, raise our successors, fade from work & then disappear–there is nothing in the models that deals with the biggest economic issues of our lives, it seems to me. Our lives start with training to support families which we also help train, so that when we retire we have enough through our efforts & theirs to continue with dignity & some comfort. And then there are those unfortunates who either have psychological or sociological issues, the latter often connected to corruption & violence. During my dissertation research in West Africa I found it refreshing to watch the local witch doctor in operation, as he reminded me of many of the academic economists I had temporarily left behind.

  3. Helen Sakho
    July 31, 2018 at 5:45 pm

    The biology of the poor trains itself to be self-healing. It reaches perfect equilibrium on death. If the bodies can be identified, even vultures benefit as part of a legitimate ecological cycle. When buried in mass graves, dug up and traded decades later (and continuing) as a bargaining tool to determine the alpha male/female, things are slightly less accurate!
    The WUDU doctors in Africa and elsewhere have a profound physical and phycological function. In other parts of the world, curses, spells, coffee-tea fortune telling are prevalent and often work as the body and the soul are undoubtedly related.
    Economics lags behind and the time lagging is so prolonged that neither its models nor its magic seem to work. Magic is timeless, how does Economics explain its function in academia? A new formula explaining the last sentence can easily be developed as a first stepping stone by learned Econometricians, particularly those who have too much time on their hands. I suggest though that they whitewash their hands first.

  4. August 1, 2018 at 10:11 pm

    It’s an interesting article, but I was frustrated that it seems content to dwell on what is wrong with existing theory. I would be more impressed by an account of an alternative method that works. Even Geoff Davies’ impressive contribution is another model. My take on these issues is that the answer is evidence-based economics, rather than the rather vague throwaway line about “methodological pluralism based on ontological considerations”. You can see some of my articles on evidence-based economics at https://evidence-based-economics.org/.

  5. Robert Locke
    August 2, 2018 at 6:59 am

    I do not understand, as an historian, why one would turn to a science that is not evidence based, to learn about the economy. Historian rarely start with economic theory and that means academic economists, to confront economic issues. I never did. And those historians who were impressed with Neoclassical economics and econometrics have not faired well in historical investigations.)See D.McCloskey, “Rhetoric of Economics, 1982).
    I have always asked people experiencing the problems (businessmen, trade unionist, political investigation committees, etc.) to find out what were principal economic concerns. And have learned that these concerns are deeply rooted in nation state rivalries, culture, and politics. Economic theory is constantly being caught out because of its inability to deal with the real historical world, which is fraught with unpredictability. The last people to ask about the real economic world are economists. But this is the crowd this blog deals with, mainly negatively, to prove them wrong. First, try to deal with the problems that society sees as problems, don’t deal with a crowd of experts that ignore them.

  6. Edward K Ross
    August 3, 2018 at 12:23 am

    In reply to Robert Locke I am not an economist or academic but I am certainly in agreement with you. I am now in my eighties and my logic is based on my lived experience in the real world rather than theory constructed in an ivory tower isolated from the real world. To support the importance of history;
    “To understand the present we need to know the experience of the past which shaped and moulded Western thinking and action and produced the primary ideological presumptions which underpin interaction meaning and organisation in Western communities.” Bill Geddes (1995) cited in Anthropology Voices from the Margins p 66Tus I argue that ignoring history and real peoples real concerns in the real world reduces economics to irrelevant chatter. Ted

    • August 6, 2018 at 6:01 pm

      Thanks Edward, enjoy the quote. But I am unable to source it. Any help appreciated.

  7. Helen Sakho
    August 8, 2018 at 9:16 pm

    Thank you Ted, and MC, and all, I wish I knew how to help you source the quote, but appropriate to real life and my contribution above, let me just cite a short quote from another wonderful classic:
    “I entered the water as naked as when my mother bore me. When I first the cold water, I felt a shudder go through me, then the shudder was transformed into a sensation of wakefulness. The river was not in full spate as during the days of the flooding nor yet was it at its lowest level.”
    (Tayeb Salih – Seasons of Migration to the North, Page 166, Modern Classics, Penguin Books, 2003). But do please look up the original source of the book and what it came to symbolise.

    Should be part of the Essential Reading on a long list of books for most Economists (old and new ones) on colonialism, global warming, slavery, innovative analyses, and the meaning of life. Mathematics is easy, and cheap talk is free.

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