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What’s the use of economic models?

September 27, 2020 5 comments

from Lars Syll

chameleonOne can generally develop a theoretical model to produce any result within a wide range. Do you want a model that produces the result that banks should be 100% funded by deposits? Here is a set of assumptions and an argument that will give you that result. That such a model exists tells us very little …

Being logically correct may earn a place for a theoretical model on the bookshelf, but when a theoretical model is taken off the shelf and applied to the real world, it is important to question whether the model’s assumptions are in accord with what we know about the world. To be taken seriously models should pass through the real world filter.

Chameleons are models that are offered up as saying something significant about the real world even though they do not pass through the filter. When the assumptions of a chameleon are challenged, various defenses are made … In many cases the chameleon will change colors as necessary, taking on the colors of a bookshelf model when challenged, but reverting back to the colors of a model that claims to apply the real world when not challenged.

Paul Pfleiderer

Pfleiderer’s absolute gem of an article reminds me of what H. L. Mencken once famously said: Read more…

Evidence-based policies

September 23, 2020 1 comment

from Lars Syll

Evidence-based theories and policies are highly valued nowadays. Randomization is supposed to control for bias from unknown confounders. The received opinion is that evidence based on randomized experiments, therefore, is the best.

More and more economists have also lately come to advocate randomization as the principal method for ensuring being able to make valid causal inferences.

rowsonYours truly would, however, rather argue that randomization, just as econometrics, promises more than it can deliver, basically because it requires assumptions that in practice are not possible to maintain. Just as econometrics, randomization is basically a deductive method. Given the assumptions (such as manipulability, transitivity, separability, additivity, linearity, etc.) these methods deliver deductive inferences. The problem, of course, is that we will never completely know when the assumptions are right. And although randomization may contribute to controlling for confounding, it does not guarantee it, since genuine randomness presupposes infinite experimentation and we know all real experimentation is finite. And even if randomization may help to establish average causal effects, it says nothing of individual effects unless homogeneity is added to the list of assumptions. Real target systems are seldom epistemically isomorphic to our axiomatic-deductive models/systems, and even if they were, we still have to argue for the external validity of the conclusions reached from within these epistemically convenient models/systems. Causal evidence generated by randomization procedures may be valid in ‘closed’ models, but what we usually are interested in, is causal evidence in the real target system we happen to live in. Read more…

Expected utility theory — an ex-parrot

September 20, 2020 4 comments

from Lars Syll

If a friend of yours offered you a gamble on the toss of a coin where you could lose €100 or win €200, would you accept it? Many of us probably wouldn’t. But if you were offered to make one hundred such bets, you would probably be willing to accept it, since most of us see that the aggregated gamble of one hundred 50–50 lose €100/gain €200 bets has an expected return of €5000 (and making our probabilistic calculations we find out that there is only a 0.04% ‘risk’ of losing any money).

Unfortunately – at least if you want to adhere to the standard mainstream expected utility theory – you are then considered irrational! A mainstream utility maximizer that rejects the single gamble should also reject the aggregate offer.

Expected utility theory does not explain actual behaviour and choices. But still — although the theory is obviously descriptively inadequate — economists and microeconomics textbook writers gladly continue to use it, as though its deficiencies were unknown or unheard of.

That cannot be the right attitude when facing scientific anomalies! Read more…

The value of economics — a cost-benefit analysis

September 18, 2020 7 comments

from Lars Syll

Screenshot 2020-09-16 at 09.06.35Economists cannot simply dismiss as “absurd” or “impossible” the possibility that our profession has imposed total costs that exceed total benefits. And no, building a model which shows that it is logically possible for economists to make a positive net contribution is not going to make questions about our actual effect go away. Why don’t we just stipulate that economists are now so clever at building models that they can use a model to show that almost anything is logically possible. Then we could move on to making estimates and doing the math.

In the 19th century, when it became clear that the net effect of having a doctor assist a woman in child-birth was to increase the probability that she would die, western society faced a choice:

– Get rid of doctors; or
– Insist that they wash their hands.

I do not want western society to get rid of economists. But to remain viable, our profession needs to be open to the possibility that in a few cases, a few of its members are doing enormous harm; then it must take on a collective responsibility for making sure that everyone keeps their hands clean.

Paul Romer

Mainstream economic theory today is still in the story-telling business whereby economic theorists create mathematical make-believe analogue models of our real-world economic system. Read more…

Friedman-Savage and Keynesian uncertainty

September 16, 2020 42 comments

from Lars Syll

0

An objection to the hypothesis just
presented that is likely to be raised by
many … is that it conflicts with the way human beings actually behave and choose. … Is it not patently unrealistic to suppose that individuals … base their decision on the size of the
expected utility?

While entirely natural and under-
standable, this objection is not strictly relevant … The hypothesis asserts rather that, in making a particular class of decisions, individuals behave as if they calculated and compared expected utility and as if they knew the odds. The validity of this assertion … depend  solely on whether it yields sufficiently accurate predictions about the class of decisions
with which the hypothesis deals.

M Friedman & L J Savage

‘Modern’ macroeconomics — Dynamic Stochastic General Equilibrium, New Synthesis, New Classical and New ‘Keynesian’ — still follows the Friedman-Savage ‘as if’ logic of denying the existence of genuine uncertainty and treat variables as if drawn from a known ‘data-generating process’ with known probability distribution that unfolds over time and on which we therefore have access to heaps of historical time-series. If we do not assume that we know the ‘data-generating process’ – if we do not have the ‘true’ model – the whole edifice collapses. And of course, it has to. Who really honestly believes that we have access to this mythical Holy Grail, the data-generating process? Read more…

Does it — really — take a model to beat a model? No!

September 13, 2020 14 comments

from Lars Syll

Many economists respond to criticism by saying that ‘all models are wrong’ … But the observation that ‘all models are wrong’ requires qualification by the second part of George Box’s famous aphorism — ‘but some are useful’ … The relevant  criticism of models in macroeconomics and finance is not that they are ‘wrong’ but that they have not proved useful in macroeconomics and have proved misleading in finance.

kaykingWhen we provide such a critique, we often hear another mantra to which many economists subscribe: ‘It takes a model to beat a model.’ On the contrary, we believe that it takes facts and observations to beat a model … If a model fails to answer the problem to which it is addressed, it should be put back in the toolbox … It is not necessary to have an alternative tool available to know that the plumber who arrives armed only with a screwdriver is not the tradesman we need.

A similar critique yours truly sometimes encounters is that as long as I cannot come up with some own alternative model to the failing mainstream models, I shouldn’t expect people to pay attention.

This is, however, not only wrong for the reasons given by Kay and King, but is also to utterly misunderstand the role of philosophy and methodology of economics!

As John Locke wrote in An Essay Concerning Human Understanding: Read more…

Michael Woodford on models

September 10, 2020 18 comments

from Lars Syll

woodfordBut I do not believe that the route to sounder economic reasoning will involve an abandonment of economists’ penchant for reasoning with the use of models. Models allow the internal consistency of a proposed argument to be checked with greater precision; they allow more finely-grained differentiation among alternative hypotheses, and they allow longer and more subtle chains of reasoning to be deployed without both author and reader becoming hopelessly tangled in them. Nor do I believe it is true that economists who are more given to the use of formal mathematical analysis are generally more dogmatic in their conclusions than those who customarily rely upon more informal styles of argument. Often, reasoning from formal models makes it easier to see how strong are the assumptions required for an argument to be valid, and how different one’s conclusions may be depending on modest changes in specific assumptions. And whether or not any given practitioner of economic modeling is inclined to honestly assess the fragility of his conclusions, the use of a model to justify those conclusions makes it easy for others to see what assumptions have been relied upon, and hence to challenge them. As a result, the resort to argumentation based on models facilitates the general project of critical inquiry that represents, in my view, our best hope for some eventual approach toward truth.

Michael Woodford

This is — sad to say — a rather typical view among mainstream economists today. Read more…

Do ‘small-world’ models help us understand ‘large-world’ problems?

September 8, 2020 6 comments

from Lars Syll

In L. J. Savage’s seminal The Foundations of Satistics the reader is invited to tackle the problem of an uncertain future using the concept of ‘lottery tickets’ and the principle of ‘look before you leap.’

Savage_2Carried to its logical extreme, the ‘Look before you leap’ principle demands that one envisage every conceivable policy for the government of his whole life (at least from now on) in its most minute details, in the light of the vast number of unknown states of the world, and decide here and now on one policy. This is utterly ridiculous … because the task implied in making such a decision is not even remotely resembled by human possibility. It is even utterly beyond our power to plan a picnic or to play a game of chess in accordance with the principle, even when the world of states and the set of available acts to be envisaged are artificially reduced to the narrowest reasonable limits.

Savage was very explicit on the restrictions one had to put on decision analysis based on subjective (‘personal’) probabilities. Outside  ‘small worlds’ it would be “utterly ridiculous” to claim applicability for a theory based on its restricted assumptions.

In The World in the Model Mary Morgan characterizes the modelling tradition of economics as one concerned with “thin men acting in small worlds”‘ and writes: Read more…

The pseudo-scientific use of small-world models in a large world

September 5, 2020 17 comments

from Lars Syll

Radical uncertainty arises when we know something, but not enough to enable us to act with confidence. And that is a situation we all too frequently encounter …

aaLLWORLD_largeThe language and mathematics of probability is a compelling way of analysing games of chance. And similar models have proved useful in some branches of physics. Probabilities can also be used to describe overall mortality risk just as they also form the basis of short-term weather forecasting and expectations about the likely incidence of motor accidents. But these uses of probability are possible because they are in the domain of stationary processes. The determinants of the motion of particles in liquids, or overall (as distinct from pandemic-driven) human mortality, do not change over time, or do so only slowly.

But most of the problems we face in politics, business (including finance) and society are not like that. We do not have, and never will have, the kind of understanding of human behaviour which emulates the understanding of physical behaviour which yields equations of planetary motion. Worse, human behaviour changes over time in a way that the equations of planetary motion do not … Read more…

The capital controversy

September 3, 2020 17 comments

from Lars Syll

As every mainstream textbook on growth theory, most mainstream economists choose to turn a blind eye to the concept of capital and the Cambridge controversy over it and pretend it’s much fuss about nothing. But they are wrong!

12

The 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

As Edwin Burmeister admitted already twenty years ago: Read more…

Rethinking public debt

August 30, 2020 9 comments

from Lars Syll

wrong-focusPublic debt is normally — as emphasized again and again by MMT economists — nothing to fear, especially if it is financed within the country itself (but even foreign loans can be beneficent for the economy if invested in the right way). Some members of society hold bonds and earn interest on them, while others pay taxes that ultimately pay the interest on the debt. The debt is not a net burden for society as a whole since the debt ‘cancels’ itself out between the two groups. If the state issues bonds at a low-interest rate, unemployment can be reduced without necessarily resulting in strong inflationary pressure. And the inter-generational burden is also not a real burden since — if used in a suitable way — the debt, through its effects on investments and employment, actually makes future generations net winners. There can, of course, be unwanted negative distributional side effects for the future generation, but that is mostly a minor problem since when our children and grandchildren ‘repay’ the public debt these payments will be made to our children and grandchildren. Read more…

Uncertainty, learning, and rational expectations

August 27, 2020 6 comments

from Lars Syll

The rational expectations hypothesis presupposes — basically for reasons of consistency — that agents have complete knowledge of all of the relevant probability distribution functions. And when trying to incorporate learning in these models — trying to take the heat of some off the criticism launched against it up to date — it is always a very restricted kind of learning that is considered. A learning where truly unanticipated, surprising, new things never take place, but only rather mechanical updatings — increasing the precision of already existing information sets – of existing probability functions.

Nothing really new happens in these ergodic models, where the statistical representation of learning and information is nothing more than a caricature of what takes place in the real world target system. This follows from taking for granted that people’s decisions can be portrayed as based on an existing probability distribution, which by definition implies the knowledge of every possible event (otherwise it is in a strict mathematical-statistically sense not really a probability distribution) that can be thought of taking place. Read more…

MMT’s inflationary bias

August 26, 2020 6 comments

from Lars Syll

A view yours truly often encounters when debating MMT is that there is an inflationary bias in MMT and that its framework ignores expectations.

Hmm …

It is extremely difficult to recognize that description. Given its roots in the writings of Keynes, Lerner, and Minsky, it is, to say the least, rather amazing to attribute those views to MMT. Let me just quote one source to show how ill-founded the critique is on this issue:

defMMT recommends a different approach to the federal budgeting process, one that integrates inflation risk into the decision-making process so that lawmakers are forced to stop and think about whether they have taken the necessary steps to guard against inflation risk before approving any new spending. MMT would make us safer in this respect because it recognizes that the best defense against inflation is a good offense. We don’t want to allow excessive spending to cause inflation and then fight inflation after it happens. We want agencies like CBO helping to evaluate new legislation for potential inflation risk before Congress commits to funding new programs so that the risks can be mitigated preemptively. At its core, MMT is about replacing an artificial (revenue) constraint with a real (inflation) constraint.

MMT — debunking the deficit myth

August 22, 2020 16 comments

from Lars Syll

defWe have already shown that deficit spending increases our collective savings. But what happens if Uncle Sam borrows when he runs a deficit? Is that wht eats up savings and forces interest rates higher? The answer is no.

The financial crowding-out story asks us to imagine that there’s a fixed supply of savings from which anyone can attempt to borrow …

MMT rejects the loanable funds story, which is rooted in the idea that borrowing is limited by access to scarce financial resources …

Government deficits always lead to a dollar-for-dollar increase in the supply of net financial assets held in the nongovernment bucket. That’s not a theory. That’s not an opinion. It’s just the cold hard reality of stock-flow consistent accounting.

So fiscal deficits — even with government borrowing — can’t leave behind a smaller supply of dollar savings. And if that can’t happen, then a shrinking pool of dollar savings can’t be responsible for driving borrowing costs higher. Clearly, this presents a problem for the conventional crowding-out theory, which claims that government spending and private investment compete for a finite pool of savings.

The 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 credit, determined by supply and demand in the same way as the price of bread and butter on a village market. 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. Read more…

How to use models in economics

August 21, 2020 3 comments

from Lars Syll

The reason you study an issue at all is usually that you care about it, that there’s something you want to achieve or see happen. Motivation is always there; the trick is to do all you can to avoid motivated reasoning that validates what you want to hear.

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.

Paul Krugman 

Hmm … Read more…

Macroeconomics and reality

August 18, 2020 4 comments

from Lars Syll

crottyWhy would an academic profession sanction the use of theories based on crassly unrealistic assumptions? It is not an intuitively attractive idea. One suspects that the underlying reason is: economists are, in the main, committed to the defense of propositions that cannot be generated by models based on realistic assumptions. For example, a long string of unrealistic assumptions are necessary to generate the desired conclusion that unregulated financial markets perform optimally …

Milton Friedman was not only an economist; he was an energetic conservative political activist as well. His positivist methodology made it possible for conservative economists to use an absurd set of assumptions that no one would accept as a reasonable description of real- world capitalism to generate wide-spread acceptance of the proposition that unregulated capitalism is an ideal system.

Economics may be an informative tool for research. But if its practitioners do not investigate and make an effort of providing a justification for the credibility of the assumptions on which they erect their building, it will not fulfill its task. There is a gap between its aspirations and its accomplishments, and without more supportive evidence to substantiate its claims, critics like James Crotty — and yours truly — will continue to consider its ultimate arguments as a mixture of rather unhelpful metaphors and metaphysics. Read more…

Epistemic humility — an intellectual virtue

August 10, 2020 5 comments

from Lars Syll

Being a true expert involves not only knowing stuff about the world but also knowing the limits of your knowledge and expertise. It requires, as psychologists say, both cognitive and metacognitive skills. The point is not that true experts should withhold their beliefs or that they should never speak with conviction. Some beliefs are better supported by the evidence than others, after all, and we should not hesitate to say so. The point is that true experts express themselves with the proper degree of confidence—meaning with a degree of confidence that’s justified given the evidence …

t-shirt-daily-nous-design-4dcropEpistemic humility is an intellectual virtue. It is grounded in the realization that our knowledge is always provisional and incomplete—and that it might require revision in light of new evidence. A lack of epistemic humility is a vice—and it can cause massive damage both in our private lives and in public policy …

It’s never been more important to learn to separate the wheat from the chaff—the experts who offer well-sourced information from the charlatans who offer little but misdirection. The latter are sadly common, in part because they are in greater demand on TV and in politics. It can be hard to tell who’s who. But paying attention to their confidence offers a clue. People who express themselves with extreme confidence without having access to relevant information and the experience and training required to process it can safely be classified among the charlatans until further notice.

Eric Angner

Why economics is an impossible science

July 28, 2020 14 comments

from Lars Syll

In a word, Economics is an Impossible Science because by its own definition the determining conditions of the economy are not economic: they are “exogenous.” Supposedly a science of things, it is by definition without substance, being rather a mode of behavior: the application of scarce means to alternative ends so as to achieve the greatest possible satisfaction—neither means, ends, nor satisfaction substantially specified.stun Exogenous, however, is the culture, all those meanings, values, institutions, and structures, from gender roles, race relations, food preferences, and ethnicities, to technical inventions, legal regulations, political parties, etc., etc. The effect is a never-ending series of new theoretical breakthroughs, each an Economics du jour worthy of a Nobel prize, consisting of the discovery that some relevant little bit of the culture has something to do with it. Only to be soon superseded and forgotten since the continuous development and transformation of the culture, hence of the economy, leaves the Science in its wake. An impossible Science, by its own premises.

Marshall Sahlins

The increasing mathematization of economics has made mainstream economists more or less obsessed with formal, deductive-axiomatic models. Confronted with the critique that they do not solve real problems, they often react as Saint-Exupéry’s Great Geographer, who, in response to the questions posed by The Little Prince, says that he is too occupied with his scientific work to be able to say anything about reality. Read more…

Radical uncertainty

July 26, 2020 10 comments

from Lars Syll

61jCsB2gyQLIn Radical Uncertainty, John Kay and Mervyn King, two well-known British economists, state that rather than trying to understand the ever-changing, uncertain and ambiguous environment by trying to understand “what’s going on here”, the economics profession has become dominated by an approach to uncertainty that requires a comprehensive list of possible outcomes with well-defined numerical probabilities attached to them. Drawing widely on philosophy, anthropology, economics, cognitive science, and strategic management and organisation scholarship, the authors present an argument that probabilistic thinking gives us a false understanding of our power to make predictions and a false illusion of utility-maximising behaviour. Instead of trying to produce probability calculations to fill the unknown gaps in our knowledge, we should embrace uncertainty by adopting robust and resilient strategies and narratives to consider alternative futures and deal with unpredictable events …

The authors’ “radical uncertainty” is not about “long tails” (for example, imaginable and well-defined events whose low probability can be estimated). The authors emphasise the vast range of possibilities that lie in between the world of unlikely events which can nevertheless be described with the aid of probability distributions, and the world of the unimaginable. This is the world of uncertain futures and unpredictable consequences, about which there is necessary speculation and inevitable disagreement which often will never be resolved. In real life this is the world which we mostly encounter, and it extends to individual and collective decisions, as well as financial, economic and political ones.

Kay and King’s book is a thoughtful and welcome call for economists and policymakers to accept “radical uncertainty” and start rethinking their models.

IEA

The financial crisis of 2007-2008 hit most laymen and economists with surprise. What was it that went wrong with our macroeconomic models, since they obviously did not foresee the collapse or even made it conceivable?

Read more…

MMT = Keynes 2.0

July 24, 2020 16 comments

from Lars Syll

As time goes on, and 2020 turns into 2021, the long-held idea that governments are like households and businesses that have to repay their debts, or even that government deficits must be financed by debt at all, will increasingly be exposed as a mistake.

20It will be more or less a return to Keynes, except with the twist that the Keynesian aim of balancing the budget over the course of the cycle – deficits in bad times, surpluses in good times – doesn’t matter, not that anybody has actually achieved that lately anyway.

In future 2020 will be seen as the year when Keynes 2.0 got underway – when monetary and fiscal policy merged and a more sophisticated theory of government took hold, in which spending has no limit apart from the capacity of the economy.

As debt continues to be monetised, it will become obvious that without economic bottlenecks, spending and deficits can increase with no negative inflationary and welfare impacts.

Alan Kohler / The Austral