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Demystifying economics

from Lars Syll

The first thing to understand about macroeconomic theory is that it is weirder than you think. The heart of it is the idea that the economy can be thought of as a single infinite-lived individual trading off leisure and consumption over all future time …

reality-header2This approach is formalized in something called the Euler equation … Some version of this equation is the basis of most articles on macroeconomic theory published in a mainstream journal in the past 30 years …

The models may abstract away from features of the world that non-economists might think are rather fundamental to “the economy” — like the existence of businesses, money, and government … But in today’s profession, if you don’t at least start from there, you’re not doing economics.

J W Mason

Yes indeed, mainstream macroeconomics sure is weird. Very weird. And among the weirdest things are those Euler equations Mason mentions in his article.  

In a post on his blog, sorta-kinda ‘New Keynesian’ Paul Krugman argues that the problem with the academic profession is that some macroeconomists aren’t “bothered to actually figure out” how the New Keynesian model with its Euler conditions —  “based on the assumption that people have perfect access to capital markets, so that they can borrow and lend at the same rate” — really works. According to Krugman, this shouldn’t  be hard at all — “at least it shouldn’t be for anyone with a graduate training in economics.”

If people (not the representative agent) at least sometimes can’t help being off their labour supply curve — as in the real world — then what are these hordes of Euler equations that you find ad nauseam in ‘New Keynesian’ macromodels gonna help us?

Yours truly’s doubts regarding the macroeconomics modellers’ obsession with Euler equations is basically that, as with so many other assumptions in ‘modern’ macroeconomics, the Euler equations don’t fit reality — and it seems as though I’m not alone holding that view:

fubar1This equation underlies every DSGE model you’ll ever see, and drives much of modern macro’s idea of how the economy works …

[T]he Euler Equation says that if interest rates are high, you put off consumption more. That makes sense, right? Money markets basically pay you not to consume today. The more they pay you, the more you should keep your money in the money market and wait to consume until tomorrow.

But what Canzoneri et al. show is that this is not how people behave. The times when interest rates are high are times when people tend to be consuming more, not less.  No matter what we assume that people want, their behavior is not consistent with the Euler Equation … The consumption Euler Equation is an important part of nearly any such model, and if it’s just wrong, it’s hard to see how those models will work.

Noah Smith

In the standard neoclassical consumption model — used in DSGE macroeconomic modeling — people are basically portrayed as treating time as a dichotomous phenomenon – today and the future — when contemplating making decisions and acting. How much should one consume today and how much in the future? Facing an intertemporal budget constraint of the form

ct + cf/(1+r) = ft + yt + yf/(1+r),

where ct is consumption today, cf is consumption in the future, ft is holdings of financial assets today, yt is labour incomes today, yf is labour incomes in the future, and r is the real interest rate, and having a lifetime utility function of the form

U = u(ct) + au(cf),

where a is the time discounting parameter, the representative agent (consumer) maximizes his utility when

u´(ct) = a(1+r)u´(cf).

This expression – the Euler equation – implies that the representative agent (consumer) is indifferent between consuming one more unit today or instead consuming it tomorrow. Typically using a logarithmic function form – u(c) = log c – which gives u´(c) = 1/c, the Euler equation can be rewritten as

1/ct = a(1+r)(1/cf),

or

cf/ct = a(1+r).

This importantly implies that according to the neoclassical consumption model that changes in the (real) interest rate and the ratio between future and present consumption move in the same direction.

So good, so far. But how about the real world? Is the neoclassical consumption as described in this kind of models in tune with the empirical facts? Hardly — the data and models are as a rule inconsistent!

In the Euler equation, we only have one interest rate,  equated to the money market rate as set by the central bank. The crux is that — given almost any specification of the utility function  – the two rates are actually often found to be strongly negatively correlated in the empirical literature.

Well, that more or less says it all, doesn’t it? Modern mainstream macroeconomics is indeed “weirder than you think.” If an economic model is found to be inappropriately used in research, then it is the model that has to be revised. Economic processes and structures are not about to change just to make the model relevant. Using scientific models is fine, but it has to be done within the limits set by the nature of the beast!

  1. Frank Salter
    November 30, 2018 at 12:05 pm

    The are many equations attributed to Euler. What these macro-economists are doing is simply to invent a differential equation all on their own. Then the failure of economists to falsify their hypotheses arises. I believe this is simply explained. If they did so it would become apparent to all, that conventional economic analysis has NO theories which are empirically validated. Where would that leave academic careers based on significant publication histories? There would appear to be a significant interest in NOT to draw attention to this fact.

    I disagree with the proposition of weirdness. Quantum mechanics is genuinely weird. Consumption theory is simply wrong.

    Please do NOT attribute the mere use of mathematics as “scientific”. There are infinitely more way of being wrong than being right. For real science it is necessary to be correct.

  2. Craig
    November 30, 2018 at 6:16 pm

    DSGE Macro-economics has not only become an obscuration of the monetary nature of the economy, it has also become a justification of private finance, its money creating powers and the paradigm of Debt Only.

    Until macro-economics’ realizes that it was born into the over 5000 year old domination of economics by the paradigm of Debt Only as the sole means and vehicle for the creation and distribution of credit/money it will either miss the entire point (Neo-liberal DSGE) or splash around on the surface of this paradigmatic insight with the palliative reforms of extremely erudite people like Steve Keen, Michael Hudson and the various advocates of MMT.

    Only the realization of the new paradigm of Direct and Reciprocal Monetary Gifting, its primacy over Debt Only, the significance of the triple power point of retail sale and monetary policies implemented at that point will actually resolve the problem and complete the theories and insights of the above individuals. The answer to the coalescence of the financialization of the economy is the re-retailization of it.

  3. December 2, 2018 at 12:43 am

    Dear colleagues, these formulations are getting even more weird than the weirdest Econometric or Statistical models have ever dared to attempt! This may be a repetition on my part, but the only “free” gifts — that is to say, the only non-monetary exchanges that have ever taken place throughout all human history are those based on friendship, respect, affinity, and a genuine devotion to all living creatures on this dying planet without the expectation of reciprocality. Clearly, this does not involve calculations of indebtedness irrespective of one’s own socio-economic standing. Isn’t it time that mainstream and other Economists made a U turn, particularly given the state of affairs that all economies are in and that worse is to come by the admission of all?

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