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Economic modelling

from Lars Syll

A couple of years ago, Paul Krugman had a piece up on his blog arguing that the ‘discipline of modeling’ is a sine qua non for tackling politically and emotionally charged economic issues:

economist-nakedIn my experience, modeling is a helpful tool (among others) in avoiding that trap, in being self-aware when you’re starting to let your desired conclusions dictate your analysis. Why? Because when you try to write down a model, it often seems to lead some place you weren’t expecting or wanting to go. And if you catch yourself fiddling with the model to get something else out of it, that should set off a little alarm in your brain.

So when ‘modern’ mainstream economists use their models — standardly assuming rational expectations, Walrasian market clearing, unique equilibria, time invariance, linear separability and homogeneity of both inputs/outputs and technology, infinitely lived intertemporally optimizing representative agents with homothetic and identical preferences, etc. — and standardly ignoring complexity, diversity, uncertainty, coordination problems, non-market clearing prices, real aggregation problems, emergence, expectations formation, etc. — we are supposed to believe that this somehow helps them ‘to avoid motivated reasoning that validates what you want to hear.’

Yours truly is, to say the least, far from convinced. The alarm that sets off in my brain is that this, rather than being helpful for understanding real-world economic issues, is more of an ill-advised plaidoyer for voluntarily taking on a methodological straight-jacket of unsubstantiated and known to be false assumptions.

Let me just give two examples to illustrate my point

In 1817 David Ricardo presented — in Principles — a theory that was meant to explain why countries trade and, based on the concept of opportunity cost, how the pattern of export and import is ruled by countries exporting goods in which they have a comparative advantage and importing goods in which they have a comparative disadvantage.

Ricardo’s theory of comparative advantage, however, didn’t explain why the comparative advantage was the way it was. At the beginning of the 20th century, two Swedish economists — Eli Heckscher and Bertil Ohlin — presented a theory/model/theorem according to which the comparative advantages arose from differences in factor endowments between countries. Countries have comparative advantages in producing goods that use up production factors that are most abundant in the different countries. Countries would a fortiori mostly export goods that used the abundant factors of production and import goods that mostly used factors of productions that were scarce.

The Heckscher-Ohlin theorem –as do the elaborations on in it by e.g. Vanek, Stolper and Samuelson — builds on a series of restrictive and unrealistic assumptions. The most critically important — besides the standard market-clearing equilibrium assumptions — are

(1) Countries use identical production technologies.

(2) Production takes place with constant returns to scale technology.

(3) Within countries the factor substitutability is more or less infinite.

(4) Factor prices are equalised (the Stolper-Samuelson extension of the theorem).

These assumptions are, as almost all empirical testing of the theorem has shown, totally unrealistic. That is, they are empirically false. 

That said, one could indeed wonder why on earth anyone should be interested in applying this theorem to real-world situations. Like so many other mainstream mathematical models taught to economics students today, this theorem has very little to do with the real world.

From a methodological point of view, one can, of course, also wonder, how we are supposed to evaluate tests of a theorem building on known to be false assumptions. What is the point of such tests? What can those tests possibly teach us? From falsehoods, anything logically follows.

Modern (expected) utility theory is a good example of this. Leaving the specification of preferences without almost any restrictions whatsoever, every imaginable evidence is safely made compatible with the all-embracing ‘theory’ — and a theory without informational content never risks being empirically tested and found falsified. Used in mainstream economics ‘thought experimental’ activities, it may of course be very ‘handy’, but totally void of any empirical value.

Utility theory has like so many other economic theories morphed into an empty theory of everything. And a theory of everything explains nothing — just as Gary Becker’s ‘economics of everything’ it only makes nonsense out of economic science.

Some people have trouble with the fact that by allowing false assumptions mainstream economists can generate whatever conclusions they want in their models. But that’s really nothing very deep or controversial. What I’m referring to is the well-known ‘principle of explosion,’ according to which if both a statement and its negation are considered true, any statement whatsoever can be inferred.

poppWhilst tautologies, purely existential statements and other nonfalsifiable statements assert, as it were, too little about the class of possible basic statements, self-contradictory statements assert too much. From a self-contradictory statement, any statement whatsoever can be validly deduced. Consequently, the class of its potential falsifiers is identical with that of all possible basic statements: it is falsified by any statement whatsoever.

On the question of tautology, I think it is only fair to say that the way axioms and theorems are formulated in mainstream (neoclassical) economics, they are often made tautological and informationally totally empty.

Using false assumptions, mainstream modellers can derive whatever conclusions they want. Wanting to show that ‘all economists consider austerity to be the right policy,’ just e.g. assume ‘all economists are from Chicago’ and ‘all economists from Chicago consider austerity to be the right policy.’  The conclusions follow by deduction — but is of course factually totally wrong. Models and theories building on that kind of reasoning are nothing but a pointless waste of time.

  1. Dave Raithel
    May 5, 2022 at 12:45 pm

    Not exactly the point of your post, but why do countries trade?

    • Meta Capitalism
      May 6, 2022 at 1:36 am

      New constitutionalism, market civilization and disciplinary neo-liberalism
      .
      In Stephen Gill’s analysis of the ‘new constitutionalism’, globalization has involved the establishment of a globalized ‘market civilization’; the latest phase of an expanding capitalist system rooted in the nascent liberal state that emerged in Britain in the seventeenth century and the subsequent internationalization of liberalism in the nineteenth century (1998b: 27–9, 2003: 118; see also his Chapter 2 in this volume). Drawing on Foucault, Gill sees the increasing marketization of social relations as driven by a set of ‘disciplinary practices’ (2003: 130) centred on the use of legal institutions to structure and shape political forms of regulation and governance. This leads Gill to define ‘new constitutionalism’ as: (Gill, Stephen. New Constitutionalism and World Order (p. 67). Cambridge University Press. Kindle Edition.)
      .
      A macro-political dimension of the process whereby the nature and purpose of the public sphere in the OECD has been redefined in a more globalized and abstract frame of reference … [It is] the political project of attempting to make transnational liberalism, and if possible liberal democracy, the sole model for future development. (2003: 131–2) It mandates a particular set of state policies geared to maintaining business confidence through the delivery of a consistent and credible climate for investment and thus for the accumulation of capital … It stresses the rule of law … [and expands] state activity to provide greater legal and other protections for business. (1998b: 38)
      .
      [It] involves pre-commitment mechanisms to lock in not only present governments and citizens into the reforms, but more fundamentally to prevent future governments from undoing the reforms. In this way its central purpose is to reconstruct the political and legal terms through which governance and accountability operate not only in the near term, but also in the longer run. (Bakker and Gill 2003: 30, emphasis in original) (Gill, Stephen. New Constitutionalism and World Order (p. 67). Cambridge University Press. Kindle Edition.)
      .
      Emphasizing ‘market efficiency; discipline and confidence; economic policy credibility and consistency; and limitation[s] on democratic decision-making processes’ this new discipline establishes ‘binding constraints’ on fiscal, monetary and wider economic policy (Gill 2003: 132). Crucially, this ‘new constitutionalism’ seeks to confer privileged rights of citizenship on global corporate capital, and establish mechanisms by which the commitment to these values is embedded in current and future political practice. (Gill, Stephen. New Constitutionalism and World Order (pp. 67-68). Cambridge University Press. Kindle Edition.)
      .
      As Gill notes, ‘traditional notions of constitutionalism are associated with political rights, obligations and freedoms, and procedures that give an institutional form to the state’ (2003: 132). Although this ‘new constitutionalism’ proceeds at the global level, rather than focusing on the rights and obligations of the global citizenry relating to a globalized governing body (or bodies), it is concerned with a much smaller group: global capital and its operating agents, corporations (both national and multinational). It holds separate the political and economic to ensure that the economic remains uncontaminated by the political, and the rule of law stands between them: markets are facilitated by the legal structures of property, contract and other laws. Politics can add to these laws but their basic components represent the rule of law not of politics; the latter of which is limited to dealing with the effects of these rules (e.g. problems of market failure). In this sense, the pre-commitment to the rule of law limits and shapes any subsequent reformist dynamic. (Gill, Stephen. New Constitutionalism and World Order (p. 68). Cambridge University Press. Kindle Edition.)
      .
      (Gill, Stephen. New Constitutionalism and World Order. Kindle ed. New York: Cambridge University Press; 2014; pp. 67-68.)

  2. yoshinorishiozawa
    May 5, 2022 at 5:12 pm

    Does Lars Syll believe that only one mathematically formulation for a subject is possible? Of course, not. There are many theories formulated in mathematical forms, the content, the significance, and the reality of which are very different. So, it is useless to oppose all mathematical formulations as a group.

    Take the case of trade theory, which Lars has picked up. I have constructed a trade theory named new theory of international values. Among four standard assumptions that Lars listed above, the new theory explicitly denies assumptions (1), (3), and (4). As for (2), the theory assumes constant returns to scale as a simpler formulation. However, all production techniques are conditioned by the scale of demand. The firms prepare their production capacity. The constant returns to scale is assumed within the capacity limit. In this sense, the theory admits increasing returns to scale, because profit (and the profit rate over the fixed capital) increases as the scale of production increases withing the capacity limit.

    See my chapter: The new theory of international values: an overview. Chapter 1 (pp.3-73) in Shiozawa, Oka and Tabuchi (eds.) (2017) A new construction of Ricardian theory of international values / Analytical and historical approach, Springer, Tokyo.

    My theory is free from many inconveniences or defects in generations of neoclassical trade theories (international micro). There are four generations of them: (1) textbook Ricardian theory, (2) Heckscher-Ohlin-Samuelson theory (HO theory or HOS theory), (3) New trade theory à la Krugman, (4) New new trade theory à la Melitz. The last theory is the trade theory of a small open economy (implying real interactions between countries are absent). First three theories assume that trade of input goods (often called intermediate goods) is excluded. In the age of Global Value Chains (GVCs), all these theories are defective, because a GVC is a worldwide network of productions connected by input trade. Even in old times of Smith and Ricardo, they were defective. As Lionel McKenzie, one of founders of modern Ricardian theory of trade, put it,

    A moment’s consideration will convince one that Lancashire would be unlikely to produce cotton cloth if the cotton had to be grown in England. (Cited form page 179 in Review of Economic Studies 21(3) (1953-54): 165-180.)

    The importation of raw cotton was a sine qua non for the British industrial revolution.

    Dave Raithel, countries trade because there are gains from trade. But, we should keep in mind that there are also losses from trade (See Section 4 of my paper). For example, if the exchange rates are not good, countries suffer from unemployment. This is the main reason why we observe so often trade conflicts The mainstream trade theories ignore this possibility (i.e. losses from trade), because they assume that economy is in equilibrium. The new theory does adopt equilibrium framework. This is 0-th assumption I reject. It is the most important difference between mainstream trade theories and the new theory.

  3. Charlie Thomas aKa Cacciato
    May 5, 2022 at 9:20 pm

    Cotton is a good example of externalized and hence uncounted cost of raw material. And in the cotton obtained from slave labour in the Southern US an abomination. Trade has ever had a component of exploitation. How about the opium trade with China? Enforced by military domination and destruction by greedy britain (GB), Economics has always been about rationalizing profit by wars. Western powers’ wealth of nations. Is it possible to develop a science of economics that reaches the success of ecological modeling Odum et Btw no one here ever addresses the missing input (independent) variable effect on models.

    • Meta Capitalism
      May 6, 2022 at 1:39 am

      Far from representing a response to food riots and the need to grow food for hungry people, this land rush signals land speculation based on anticipated price increases due to increasing populations – a practice known as ‘land banking’. Also, many developing countries are ‘under pressure from the IMF, the World Bank and other regional banks to put farmland on the international market to increase economic development and improve the balance of payments’ (Vidal 2011). In Africa, most of the land deals have been to grow crops for export and these ‘unrestricted export clauses in contracts, together with small-scale food producers losing their key productive asset, may well worsen rather than improve food security’ (ibid.). Saskia Sassen has recently documented how the expulsing of people and the destruction of traditional livelihoods are intended ‘to feed the needs of high finance and the needs of natural resources’ (Sassen 2010). She links her analysis to the debt burdens of the global South from the 1980s that have favoured debt repayment over basic health, education and welfare needs. She points to how financial adjustment crises lead to ‘a savage sorting of winners and losers’ that heighten people’s expulsion from jobs and livelihoods. (Gill, Stephen. New Constitutionalism and World Order (p. 226). Cambridge University Press. Kindle Edition.)

      Oh how much is hidden behind that simple word “externalized”.

    • yoshinorishiozawa
      May 6, 2022 at 2:18 am

      Dear Charlie,
      history is full of abominable facts. Before the cotton plantation began, there was the slave trade. There was a triangle between Great Britain, West Africa and North America (including Caribbean islands in this case). GB exported industrial goods to West Africa. West Africa provided slaves to North America, and North America provided raw cotton to GB. With this triangle behind, Lancashire became the factory of the world. The first industrial revolution is based thus on toil of workers in factories and blood and sweat of slaves in plantations.

      However, it is necessary to distinguish theory and facts. You can condemn this and that facts, but you should estimate a theory if it explains better than other theories.

      Explanation does not necessary mean that a theory or model can give an accurate prediction. Many models in mainstream economics boast its predictive power, although in reality its accuracy and constancy (in time) are both quite low. Even if a theory cannot give a prediction, but if it makes observers understand better what is happening behind the surface of phenomena, it is a good theory.

      In the case of trade theories, it is quite clear that the new theory is better than other four generations of mainstream trade theories or international microeconomics, because it is only the new theory that can treat input trade in a general form. Mainstream trade theories cannot explain why Lancashire became the world center of cotton industry. They cannot explain why Global Value Chains (GVCs) grew rapidly in recent times, because mainstream trade theories do not have no general theory of input trade. Consequently, mainstream economics was very slow to discuss GVCs, although the importance of GVCs became evident more than two decades ago.

      A good understanding of GVCs is crucial for a good making of development policies. It is well known that import-substitution strategy for industrialization did not worked well. Then, people recommended export-oriented strategy. However, if one does not understand well how the catching-up process takes place, we have a risk of falling in the so-called middle income traps.

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