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Modern macroeconomics — totally messed up

August 23, 2017 1 comment

from Lars Syll

Until a few years ago, economists of all persuasions confidently proclaimed that the Great Depression would never recur. In a way, they were right. After the financial crisis of 2008 erupted, we got the Great Recession instead. Governments managed to limit the damage by pumping huge amounts of money into the global economy and slashing interest rates to near zero. But, having cut off the downward slide of 2008-2009, they ran out of intellectual and political ammunition.

EconomistsMessedUp2

Economic advisers assured their bosses that recovery would be rapid. And there was some revival; but then it stalled in 2010. Meanwhile, governments were running large deficits – a legacy of the economic downturn – which renewed growth was supposed to shrink. In the eurozone, countries like Greece faced sovereign-debt crises as bank bailouts turned private debt into public debt.

Attention switched to the problem of fiscal deficits and the relationship between deficits and economic growth. Should governments deliberately expand their deficits to offset the fall in household and investment demand? Or should they try to cut public spending in order to free up money for private spending?

Depending on which macroeconomic theory one held, both could be presented as pro-growth policies. The first might cause the economy to expand, because the government was increasing public spending; the second, because they were cutting it. Keynesian theory suggests the first; governments unanimously put their faith in the second.

The consequences of this choice are clear. It is now pretty much agreed that fiscal tightening has cost developed economies 5-10 percentage points of GDP growth since 2010. All of that output and income has been permanently lost. Moreover, because fiscal austerity stifled economic growth, it made the task of reducing budget deficits and national debt as a share of GDP much more difficult. Cutting public spending, it turned out, was not the same as cutting the deficit, because it cut the economy at the same time.

Robert Skidelsky 

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Economists — people being paid for telling stories justifying inequality

August 19, 2017 6 comments

from Lars Syll

If economics was an honest profession, economists would focus their efforts on documenting the waste associated with protectionist barriers for professionals. They devoted endless research studies to estimating the cost to consumers of tariffs on products like shoes and tires. It speaks to the incredible corruption of the economics profession that there are not hundreds of studies showing the loss to consumers from the barriers to trade in physicians’ services. If trade could bring down the wages of physicians in the United States just to European levels, it would save consumers close to $100 billion a year.

But economists are not rewarded for studying the economy. That is why almost everyone in the profession missed the $8 trillion housing bubble, the collapse of which stands to cost the country more than $7 trillion in lost output according to the Congressional Budget Office (that comes to around $60,000 per household).

Few if any economists lost their 6-figure paychecks for this disastrous mistake. But most economists are not paid for knowing about the economy. They are paid for telling stories that justify giving more money to rich people. Hence we can look forward to many more people telling us that all the money going to the rich was just the natural workings of the economy. When it comes to all the government rules and regulations that shifted income upward, they just don’t know what you’re talking about.

Dean Baker

In case you’re in doubt, you might better have a look at e. g. what Harvard economist and George Bush advisor Greg Mankiw writes on the rising inequality we have seen for the last 30 years in both the US and elsewhere in Western societies:

Read more…

Krugman and Mankiw on loanable funds — so wrong, so wrong

August 14, 2017 1 comment

from Lars Syll

slide_6A couple of years ago — in a debate with James Galbraith and Willem Buiter — Paul Krugman made it perfectly clear that he was a strong believer of the ‘loanable funds’ theory.

Unfortunately, this is not an exception among ‘New Keynesian’ economists.

Neglecting anything resembling a real-world finance system, Greg Mankiw — in his intermediate textbook Macroeconomics — more or less equates finance to the neoclassical thought-construction of a ‘market for loanable funds.’

On the subject of financial crises, he admits that

perhaps we should view speculative excess and its ramifications as an inherent feature of market economies … but preventing them entirely may be too much to ask given our current knowledge.

This is, of course, self-evident for all of us who understand that genuine uncertainty makes any such hopes totally unfounded. But it’s rather odd to read this in a book that bases its models on assumptions of rational expectations, representative actors and dynamically stochastic general equilibrium – assumptions that convey the view that markets – give or take a few rigidities and menu costs – are efficient! For being one of many neoclassical economists so proud of their consistent models, Mankiw here certainly is flagrantly inconsistent!  Read more…

The loanable funds hoax

August 12, 2017 22 comments

from Lars Syll

loanable_funds_curve-13FEC80C6110B93D6D9The loanable funds theory is in many regards nothing but an approach where the ruling rate of interest in society is — pure and simple — conceived as nothing else than the price of loans or credits set by banks and determined by supply and demand — as Bertil Ohlin put it — “in the same way as the price of eggs and strawberries on a village market.”

It’s a beautiful fairy tale, but the problem is that banks are not barter institutions that transfer pre-existing loanable funds from depositors to borrowers. Why? Because, in the real world, there simply are no pre-existing loanable funds. Banks create new funds — credit — only if someone has previously got into debt! Banks are monetary institutions, not barter vehicles.

In the traditional loanable funds theory — as presented in mainstream macroeconomics textbooks — the amount of loans and credit available for financing investment is constrained by how much saving is available. Saving is the supply of loanable funds, investment is the demand for loanable funds and assumed to be negatively related to the interest rate. Lowering households’ consumption means increasing savings that via a lower interest.

That view has been shown to have very little to do with reality. It’s nothing but an otherworldly neoclassical fantasy. But there are many other problems as well with the standard presentation and formalization of the loanable funds theory:  Read more…

The bonus puzzle

August 10, 2017 6 comments

from Lars Syll

If bonus or “incentive pay” schemes work so well for senior executives and bankers, why does everyone not get them?

The conventional answer is that a bonus scheme or incentive plan will indeed encourage the recipients to make more money for the shareholders or clients on whose behalf they act …

juggleA classic paper on the “principal-agent problem” … by Bengt Holmstrom and Paul Milgrom pointed out that the conventional answer makes the mistake of assuming that jobs are simple and consist only of one task. In reality, agents — such as executives acting on behalf of shareholders — have multiple tasks with many dimensions. Some of these will be easier to measure than others …

The more complex the job, the more dimensions involved — as in being a corporate chief executive, say — the less justification there is for an incentive reward scheme. This is reinforced in the specific context of shareholder principals and chief executives, when the latter are responsible for the value of the assets they are managing on behalf of the company’s owners. Incentives linked to whatever can easily be measured lead agents to turn their efforts away from maintaining and enhancing the value of the asset over time …

As the economy becomes increasingly complex and intangible, monitoring and measuring seem ever harder. The simplistic case for bonus and incentive pay schemes grows ever weaker.

Indeed, the best arrangement would seem to be the opposite of the pattern we observe now. Corporate executives and senior bankers doing complex jobs involving many impossible-to-monitor activities are the last people who ought to be paid via an incentive scheme; while bonuses for fast-food workers or shop-floor employees make more sense.

Diane Coyle

At a deeper level, this ‘puzzle’ confirms that the alleged close connection between productivity and remuneration postulated in mainstream income distribution theory simply does not exist.   Read more…

How rigged markets make the rich richer

August 8, 2017 3 comments

from Lars Syll

rigged_coverMarkets are never just given. Neither God nor nature hands us a worked-out set of rules determining the way property relations are defined, contracts are enforced, or macroeconomic policy is implemented. These matters are determined by policy choices. The elites have written these rules to redistribute income upward. Needless to say, they are not eager to have the rules rewritten — which means they also have no interest in even having them discussed.

But for progressive change to succeed, these rules must be addressed. While modest tweaks to tax and transfer policies can ameliorate the harm done by a regressive market structure, their effect will be limited. The complaint of conservatives — that tampering with market outcomes leads to inefficiencies and unintended outcomes — is largely correct, even if they may exaggerate the size of the distortions from policy interventions. Rather than tinker with badly designed rules, it is far more important to rewrite the rules so that markets lead to progressive and productive outcomes in which the benefits of economic growth and improving technology are broadly shared.

Dean Baker’s new book forcefully argues that mainstream textbook economics has pretty little in common with the real world in which we actually live. Especially when it comes to the mainstream neoclassical paradigm of income distribution, Baker convincingly shows how wide is the gap between mainstream economic theory and reality.   Read more…

The conundrum of unknown unknowns

August 6, 2017 18 comments

from Lars Syll

Short-term weather forecasting is possible because most of the factors that determine tomorrow’s weather are, in a sense, already there … But when you look further ahead you encounter the intractable problem that, in non-linear systems, small changes in initial conditions can lead to cumulatively larger and larger changes in outcomes over time. In these circumstances imperfect knowledge may be no more useful than no knowledge at all.

economic_forecastingMuch the same is true in economics and business. What gross domestic product will be tomorrow is, like tomorrow’s rain or the 1987 hurricane, more or less already there: tomorrow’s output is already in production, tomorrow’s sales are already on the shelves, tomorrow’s business appointments already made. Big data will help us analyse this. We will know more accurately and more quickly what GDP is, we will be more successful in predicting output in the next quarter, and our estimates will be subject to fewer revisions …

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Why should we care about Sonnenschein-Mantel-Debreu?

August 3, 2017 29 comments

from Lars Syll

Along with the Arrow-Debreu existence theorem and some results on regular economies, SMD (Sonnenschein-Mantel-Debreu) theory fills in many of the gaps we might have in our understanding of general equilibrium theory …

It is also a deeply negative result. SMD theory means that assumptions guaranteeing good behavior at the microeconomic level do not carry over to the aggregate level or to qualitative features of the equilibrium. It has been difficult to make progress on the elaborations of general equilibrium theory that were put forth in Arrow and Hahn 1971 …

24958274Given how sweeping the changes wrought by SMD theory seem to be, it is understand-able that some very broad statements about the character of general equilibrium theory were made. Fifteen years after General Competitive Analysis, Arrow (1986) stated that the hypothesis of rationality had few implications at the aggregate level. Kirman (1989) held that general equilibrium theory could not generate falsifiable propositions, given that almost any set of data seemed consistent with the theory. These views are widely shared. Bliss (1993, 227) wrote that the “near emptiness of general equilibrium theory is a theorem of the theory.” Mas-Colell, Michael Whinston, and Jerry Green (1995) titled a section of their graduate microeconomics textbook “Anything Goes: The Sonnenschein-Mantel-Debreu Theorem.” There was a realization of a similar gap in the foundations of empirical economics. General equilibrium theory “poses some arduous challenges” as a “paradigm for organizing and synthesizing economic data” so that “a widely accepted empirical counterpart to general equilibrium theory remains to be developed” (Hansen and Heckman 1996). This seems to be the now-accepted view thirty years after the advent of SMD theory …

S. Abu Turab Rizvi

And so what? Why should we care about Sonnenschein-Mantel-Debreu?

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When ignorance is bliss

July 30, 2017 7 comments

from Lars Syll

joanThe production function has been a powerful instrument of miseducation.
The student of economic theory is taught to write Q = f(L, K) where L is a quantity of labor, K a quantity of capital and Q a rate of output of commodities. He is instructed to assume all workers alike, and to measure L in man-hours of labor; he is told something about the index-number problem in choosing a unit of output; and then he is hurried on to the next question, in the hope that he will forget to ask in what units K is measured. Before he ever does ask, he has become a professor, and so sloppy habits of thought are handed on from one generation to the next.

Joan Robinson The Production Function and the Theory of Capital (1953)

What so many critiques of economics gets right

July 28, 2017 4 comments

from Lars Syll

Yours truly had a post up the other day on John Rapley’s Twilight of the Money Gods.

In the main I think Rapley is right in his attack on contemporary economics and its ‘priesthood,’ although he often seems to forget that there are — yes, it’s true — more than one approach in economics, and that his critique mainly pertains to mainstream neoclassical economics.

Noah Smith, however, is not too happy about the book:

strw manThere are certainly some grains of truth in this standard appraisal. I’ve certainly lobbed my fair share of criticism at the econ profession over the years. But the problem with critiques like Rapley’s is that they offer no real way forward for the discipline … Simply calling for humility and methodological diversity accomplishes little.

Instead, pundits should focus on what is going right in the economics discipline — because there are some very good things happening.

First, economists have developed some theories that really work. A good scientific theory makes testable predictions that apply to situations other than those that motivated the creation of the theory. Slowly, econ is building up a repertoire of these gems. One of them is auction theory … Another example is matching theory, which has made it a lot easier to get an organ transplant …

Second, economics is becoming a lot more empirical, focusing more on examining the data than on constructing yet more theories.

Noah Smith maintains that new imaginative empirical methods — such as natural experiments, field experiments, lab experiments, RCTs — help us to answer questions concerning the validity of economic theories and models.   Read more…

Ricardo’s trade paradigm — a formerly true theory

July 26, 2017 10 comments

from Lars Syll

Two hundred years ago, on 19 April 1817, David Ricardo’s Principles was published. In it he presented 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 comparative advantage and importing goods in which they have a comparative disadvantage.

Heckscher-Ohlin-HO-Modern-Theory-of-International-TradeAlthough a great accomplishment per se, Ricardo’s theory of comparative advantage, however, didn’t explain why the comparative advantage was the way it was. In 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 a comparative advantages in producing goods that use up production factors that are most abundant in the different countries. Countries would 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 — beside the standard market clearing equilibrium assumptions — are   Read more…

The balanced budget paradox

July 24, 2017 4 comments

from Lars Syll

The balanced budget paradox is probably one of the most devastating phenomena haunting our economies. The harder politicians — usually on the advise of establishment economists — try to achieve balanced budgets for the public sector, the less likely they are to succeed in their endeavour. And the more the citizens have to pay for the concomitant austerity policies these wrong-headed politicians and economists recommend as “the sole solution.”

national debt5One of the most effective ways of clearing up this most serious of all semantic confusions is to point out that private debt differs from national debt in being external. It is owed by one person to others. That is what makes it burdensome. Because it is interpersonal the proper analogy is not to national debt but to international debt…. But this does not hold for national debt which is owed by the nation to citizens of the same nation. There is no external creditor. We owe it to ourselves.

A variant of the false analogy is the declaration that national debt puts an unfair burden on our children, who are thereby made to pay for our extravagances. Very few economists need to be reminded that if our children or grandchildren repay some of the national debt these payments will be made to our children or grandchildren and to nobody else. Taking them altogether they will no more be impoverished by making the repayments than they will be enriched by receiving them.

Abba Lerner The Burden of the National Debt (1948)

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Why testing axioms is necessary in economics

July 21, 2017 8 comments

from Lars Syll

Of course the more immediate target of Davidson in his formulation of the argument in the early 1980s was not Samuelson, but Lucas and Sargent and their rational expectations hypothesis … This was indeed the period when new classical economics was riding at its highest point of prestige, with Lucas and Sargent and their rational expectations assumption apparently sweeping the boards of any sort of Keynesian theories. Curiously, they did not seem to care whether the assumption was actually true, because it was “an axiom,” something that is assumed and cannot be tested …

requirements-based-testing-13-728This matter of “testing axioms” is controversial. Davidson is right that Keynes was partly inspired by Einstein’s Theory of General Relativity that was based on a relaxation of the parallel axiom of Euclid. So, Davidson argued not unreasonably that he would also be inclined to wish to relax any ergodic axiom. However, of course, the rejection of the parallel postulate (or axiom) did come from empirical tests showing that it does not hold in space-time in general due to gravity curving it. So, the empirical testing of axioms is relevant, and the failure of the rational expectations axiom to hold empirically is certainly reasonable grounds for rejecting it.

J. Barkley Rosser Jr

On this Einstein and Keynes are of course absolutely right. Economics — in contradistinction to logic and mathematics — is an empirical science, and empirical testing of ‘axioms’ ought to be self-evidently relevant for such a discipline. For although the economist himself (implicitly) claims that his axiom is universally accepted as true and in now need of proof, that is in no way a justified reason for the rest of us to simpliciter accept the claim.   Read more…

Are methodological discussions risky?

July 20, 2017 10 comments

from Lars Syll

Most mainstream economists are reluctant to have a methodological discussion. They usually think it’s too ‘risky.’

Well, maybe it is. But on the other hand, if we’re not prepared to take that risk, economics can’t progress, as Tony Lawson forcefully argues in his Essays on the Nature and State of Modern Economics:

Twenty common myths and/or fallacies of modern economics

1. The widely observed crisis of the modern economics discipline turns on problems that originate at the level of economic theory and/or policy.

onedoesIt does not. The basic problems mostly originate at the level of methodology, and in particular with the current emphasis on methods of mathematical modelling.The latter emphasis is an error given the lack of match of the methods in question to the conditions in which they are applied. So long as the critical focus remains only, or even mainly, at the level of substantive economic theory and/or policy matters, then no amount of alternative text books, popular monographs, introductory pocketbooks, journal or magazine articles … or whatever, are going to get at the nub of the problems and so have the wherewithal to help make economics a sufficiently relevant discipline. It is the methods and manner of their use that are the basic problem.

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Economics as a religion

July 19, 2017 3 comments

from Lars Syll

rapleyContrary to the tenets of orthodox economists, contemporary research suggests that, rather than seeking always to maximise our personal gain, humans still remain reasonably altruistic and selfless. Nor is it clear that the endless accumulation of wealth always makes us happier. And when we do make decisions, especially those to do with matters of principle, we seem not to engage in the sort of rational “utility-maximizing” calculus that orthodox economic models take as a given. The truth is, in much of our daily life we don’t fit the model all that well.

For decades, neoliberal evangelists replied to such objections by saying it was incumbent on us all to adapt to the model, which was held to be immutable – one recalls Bill Clinton’s depiction of neoliberal globalisation, for instance, as a “force of nature”. And yet, in the wake of the 2008 financial crisis and the consequent recession, there has been a turn against globalisation across much of the west …

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Why not even Paul Krugman is a real Keynesian

July 18, 2017 5 comments

from Lars Syll

Keynes’s insights have enormous practical importance, according to Lance Taylor and Duncan Foley …

But isn’t Keynes now mainstream? No, say Foley and Taylor. The mainstream still sees economies as inherently moving to an optimal equilibrium … It still says demand causes short-run fluctuations, but only supply factors, such as the capital stock and technology, can affect long-run growth.

EVEN PAUL KRUGMAN, a self-described Keynesian, Nobel laureate, and New York Times columnist, writes in the 2012 edition of his textbook: “In the long run the economy is self-correcting: shocks to aggregate demand affect aggregate output in the short run but not in the long run” …

KeynesUpsidedownKrugman does point to one exception: If interest rates are nearly zero, as during the financial crisis, markets lose restorative force. But, Taylor asks, what’s the logic?

Keynes saw capitalism’s general state as allowing almost arbitrary unemployment: hence his “General Theory.” Full employment was a lucky exception.

To Taylor, calling full employment the general state and allowing one unlucky exception turns Keynes upside down.

Jonathan Schlefer

Iy is difficult not to agree with Taylor and Foley. To a large degree one does get the impression that Krugman thinks he is a Keynesian because he is a stout believer in John Hicks IS-LM interpretation of Keynes.  Read more…

A new perspective on microfoundations

July 16, 2017 1 comment

from Lars Syll

Defenders of microfoundations and its rational expectations equipped representative agent’s intertemporal optimization often argue as if sticking with simple representative agent macroeconomic models doesn’t impart a bias to the analysis. I unequivocally reject that unsubstantiated view, and have given the reasons why here.

These defenders often also maintain that there are no methodologically coherent alternatives to microfoundations modeling. That allegation is of course difficult to evaluate, substantially hinging on how coherence is defined. But one thing I do know, is that the kind of microfoundationalist macroeconomics that New Classical economists and “New Keynesian” economists are pursuing, are not methodologically coherent according to the standard coherence definition (see e. g. here). And that ought to be rather embarrassing for those ilks of macroeconomists to whom axiomatics and deductivity is the hallmark of science tout court.

ba7658c533d4de20cf77161b8910d903cab9cbe6_m

The fact that Lucas introduced rational expectations as a consistency axiom is not really an argument to why we should accept it as an acceptable assumption in a theory or model purporting to explain real macroeconomic processes (see e. g. here). And although virtually any macroeconomic empirical claim is contestable, so is any claim in micro (see e. g. here).

On this issue I think Paul Krugman comes closer to truth than his “New Keynesian” buddies with his remark that  Read more…

Krugman vs Syll on the IS-LM model

July 15, 2017 5 comments

from Lars Syll

islmSome time ago yours truly ventured to question Paul Krugman for his unadulterated devotion to the IS-LM model. For years self-proclaimed “proud neoclassicist” Paul Krugman had in endless harpings on the same IS-LM string told us about the splendour of the Hicksian invention.

Krugman’s response contained nothing new. In an earlier post on his blog, Krugman had argued that ‘Keynesian’ macroeconomics more than anything else “made economics the model-oriented field it has become.” In Krugman’s eyes, Keynes was a “pretty klutzy modeler,” and it was only thanks to Samuelson’s famous 45-degree diagram and Hicks’s IS-LM that things got into place. Although admitting that economists have a tendency to use ”excessive math” and “equate hard math with quality” he still vehemently defends — and always have — the mathematization of economics:

I’ve seen quite a lot of what economics without math and models looks like — and it’s not good.

Sure, ‘New Keynesian’ economists like Mankiw and Krugman — and their forerunners, ‘Keynesian’ economists like Paul Samuelson and (young) John Hicks — certainly have contributed to making economics more mathematical and “model-oriented.”   Read more…

Mainstream monetary theory — neat, plausible, and utterly wrong

June 24, 2017 31 comments

from Lars Syll

In modern times legal currencies are totally based on fiat. Currencies no longer have intrinsic value (as gold and silver). What gives them value is basically the legal status given to them by government and the simple fact that you have to pay your taxes with them. That also enables governments to run a kind of monopoly business where it never can run out of money. Hence spending becomes the prime mover and taxing and borrowing is degraded to following acts. If we have a depression, the solution, then, is not austerity. It is spending. Budget deficits are not the major problem, since fiat money means that governments can always make more of them.

Financing quantitative easing, fiscal expansion, and other similar operations, is made possible by simply crediting a bank account and thereby – by a single keystroke – actually creating money. One of the most important reasons why so many countries are still stuck in depression-like economic quagmires is that people in general – including most mainstream economists – simply don’t understand the workings of modern monetary systems. The result is totally and utterly wrong-headed austerity policies, emanating out of a groundless fear of creating inflation via central banks printing money, in a situation where we rather should fear deflation and inadequate effective demand.

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Do you want to get a Nobel prize? Eat chocolate and move to Chicago!

June 21, 2017 7 comments

from Lars Syll

chocolateSource

As we’ve noticed, again and again, correlation is not the same as causation …

If you want to get the prize in economics — and want to be on the sure side — yours truly would suggest you complement  your intake of chocolate with a move to Chicago.

Out of the 78 laureates that have been awarded “The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel,” 28 have been affiliated to The University of Chicago — that is 36%. The world is really a small place when it comes to economics …