Yanis Varoufakis on the irrelevance of mainstream economics

from Lars Syll

Varoufakis is undoubtedly right — there is indeed something about the way mainstream economists construct their models that obviously doesn’t sit right.

One might have hoped that humbled by the manifest failure of its theoretical pretences during the latest economic-financial crises, the one-sided, almost religious, insistence on axiomatic-deductivist modelling as the only scientific activity worthy of pursuing in economics would give way to methodological pluralism based on ontological considerations rather than formalistic tractability. But

Frank Ramsey — a portrait and a critique

from Lars Syll

Mainstream economics nowadays usually assumes that agents that have to make choices under conditions of uncertainty behave according to Bayesian rules, axiomatized by Ramsey (1931) and Savage (1954) — that is, they maximize expected utility with respect to some subjective probability measure that is continually updated according to Bayes theorem. If not, they are supposed to be irrational, and ultimately — via some “Dutch book” or “money pump” argument — susceptible to being ruined by some clever “bookie”.

Bayesianism reduces questions of rationality to questions of internal consistency (coherence) of beliefs, but – even granted this questionable reductionism – do rational agents really have to be Bayesian? As I have been arguing elsewhere (e. g. here, here and here) there is no strong warrant for believing so.

In many of the situations that are relevant to economics, one could argue that there is simply not enough adequate and relevant information to ground beliefs of a probabilistic kind and that in those situations it is not really possible, in any relevant way, to represent an individual’s beliefs in a single probability measure.

Say you have come to learn (based on your own experience and tons of data) that the probability of you becoming unemployed in Sweden is 10 %. Having moved to another country (where you have no own experience and no data) you have no information on unemployment and a fortiori nothing to help you construct any probability estimate. A Bayesian would, however, argue that you would have to assign probabilities to the mutually exclusive alternative outcomes and that these have to add up to 1 if you are rational. That is, in this case – and based on symmetry – a rational individual would have to assign a probability of 10% of becoming unemployed and 90% of becoming employed.

That feels intuitively wrong though, and I guess most people would agree. Bayesianism cannot distinguish between symmetry-based probabilities from information and symmetry-based probabilities from an absence of information. In these kinds of situations, most of us would rather say that it is simply irrational to be a Bayesian and better instead to admit that we “simply do not know” or that we feel ambiguous and undecided. Arbitrary and ungrounded probability claims are more irrational than being undecided in face of genuine uncertainty, so if there is not sufficient information to ground a probability distribution it is better to acknowledge that simpliciter, rather than pretending to possess a certitude that we simply do not possess. 

Economics and the law of the hammer

from Lars Syll

As yours truly has reported repeatedly during the last couple of years, university students all over the world are increasingly beginning to question if the kind of economics they are taught — mainstream economics — really is of any value. Some have even started to question if economics is a science.

My own take on the issue is that economics

On statistics and causality

from Lars Syll

Ironically, the need for a theory of causation began to surface at the same time that statistics came into being … This was a critical moment in the history of science. The opportunity to equip causal questions with a language of their own came very close to being realized but was squandered. In the following years, these questions were declared unscientific and went underground. Despite heroic efforts by the geneticist Sewall Wright (1889-1988), causal vocabulary was virtually prohibited for more than half a century. And when you prohibit speech, you prohibit thought and stifle principles, methods, and tools.

Readers do not have to be scientists to witness this prohibition. In Statistics 101, every student learns to chant, “Correlation is not causation.” With good reason! The rooster’s crow is highly correlated with the sunrise; yet it does not cause the sunrise.

Unfortunately, statistics has fetishized this commonsense observation. It tells us that correlation is not causation, but it does not tell us what causation is. In vain will you search the index of a statistics textbook for an entry on “cause.” Students are not allowed to say that X is the cause of Y — only that X and Y are “related” or “associated.”

Statistical reasoning certainly seems paradoxical to most people.

Take for example the well-known Simpson’s paradox.

Heckman on where causality resides

from Lars Syll

I make two main points that are firmly anchored in the econometric tradition. The first is that causality is a property of a model of hypotheticals. A fully articulated model of the phenomena being studied precisely defines hypothetical or counterfactual states. A definition of causality drops out of a fully articulated model as an automatic by-product. A model is a set of possible counterfactual worlds constructed under some rules. The rules may be the laws of physics, the consequences of utility maximization, or the rules governing social interactions, to take only three of many possible examples. A model is in the mind. As a consequence, causality is in the mind.

James Heckman

So, according to this ‘Nobel prize’ winning econometrician, “causality is in the mind.” But is that a tenable view? Yours truly thinks not. If one as an economist or social scientist would subscribe to that view there would be pretty little reason to be interested in questions of causality at all.  And it sure doesn’t suffice just to say that all science is predicated on assumptions. To most of us, models are seen as ‘vehicles’ or ‘instruments’ by which we represent causal processes and structures that exist and operate in the real world. As we all know, models often do not succeed in representing or explaining these processes and structures, but if we didn’t consider them as anything but figments of our minds, well then maybe we ought to reconsider why we should be in the science business at all …

Mainstream economics — the triumph of ideology over science

from Lars Syll

Research shows not only that individuals sometimes act differently than standard economic theories predict, but that they do so regularly, systematically, and in ways that can be understood and interpreted through alternative hypotheses, competing with those utilised by orthodox economists.

To most market participants — and, indeed, ordinary observers — this does not seem like big news … In fact, this irrationality is no news to the economics profession either. John Maynard Keynes long ago described the stock market as based not on rational individuals struggling to uncover market fundamentals, but as a beauty contest in which the winner is the one who guesses best what the judges will say …

Adam Smith’s invisible hand — the idea that free markets lead to efficiency as if guided by unseen forces — is invisible, at least in part, because it is not there …

For more than 20 years, economists were enthralled by so-called “rational expectations” models which assumed that all participants have the same (if not perfect) information and act perfectly rationally, that markets are perfectly efficient, that unemployment never exists (except when caused by greedy unions or government minimum wages), and where there is never any credit rationing.

That such models prevailed, especially in America’s graduate schools, despite evidence to the contrary, bears testimony to a triumph of ideology over science. Unfortunately, students of these graduate programmes now act as policymakers in many countries, and are trying to implement programmes based on the ideas that have come to be called market fundamentalism … Good science recognises its limitations, but the prophets of rational expectations have usually shown no such modesty.

Joseph Stiglitz

The rational expectations hypothesis — one of the cornerstones of mainstream economics — presupposes, basically for reasons of consistency, that agents have complete knowledge of all relevant probability distribution functions. And

The ’empirical revolution’ in economics — some critical perspectives

from Lars Syll

Most research in economics nowadays involves empirical work … It is therefore odd to find a great deal of economic reasoning still starting from “standard theory”. Whilst it does generate predictions that can be tested empirically, it does not have an empirical foundation, but rather is based on a story about universal human nature … It remains true that the traditional models retain a central place, and accumulating evidence does not tend to lead to the abandonment of a conventional starting point, even when the two are in conflict …

The link from evidence into theory is similarly not always pursued in behavioural and experimental economics. One approach is to study human behaviour as a departure from homo economicus, explicitly to retain traditional theory as the starting point, and then to modify the analysis by incorporating important biases that deviate from this ideal … This involves two stages: the traditional assumptions of rationality, perfect information, etc., and then a correction. In terms of causal mechanism, neither of these represents an actually occurring process: the first stage is derived from axioms not observed behaviour and the second is a correction of the resulting error.

Michael Joffe

Although discounting empirical evidence cannot be the right way to solve economic issues, there are still, in my opinion, a couple of weighty reasons why we perhaps shouldn’t be too excited about the so-called ’empirical revolution’ in economics.

Threats to substantive relevance of natural experiments

from Lars Syll

External validity poses a challenge for most kinds of research designs, of course. In true experiments in the social sciences, the study group is not usually a random sample from some underlying population. Often, the study group consists instead of a convenience sample, that is, a group of units that have been “drawn” through some nonrandom process from an underlying population. In other studies, one cannot even readily claim that the study group has been drawn from any well-defined population. In either case, one cannot confidently project estimated causal effects to a broader population, or attach estimates of sampling error to those projections. In most true experiments, in other words, causal inferences are drawn conditional on the study group—the particular set of units assigned to treatment and control groups. While randomization to treatment and control groups generally ensures that estimators of effects for the study group are unbiased (barring differential attrition or other threats to internal validity), whether these effects generalize to other populations is often an open question.

Thad Dunning

Yours truly’s view is that nowadays many social scientists maintain that ‘imaginative empirical methods’ — such as natural experiments, field experiments, lab experiments, RCTs — can help us to answer questions concerning the external validity of models used in social sciences. In their view, they are more or less tests of ‘an underlying model’ that enable them to make the right selection from the ever-expanding ‘collection of potentially applicable models.’ When looked at carefully, however, there are in fact not that many convincing reasons to share this optimism.

Economics as ideology

from Lars Syll

Although I never believed it when I was young and held scholars in great respect, it does seem to be the case that ideology plays a large role in economics. How else to explain Chicago’s acceptance of not only general equilibrium but a particularly simplified version of it as ‘true’ or as a good enough approximation to the truth? Or how to explain the belief that the only correct models are linear and that the von Neuman prices are those to which actual prices converge pretty smartly? This belief unites Chicago and the Classicals; both think that the ‘long-run’ is the appropriate period in which to carry out analysis. There is no empirical or theoretical proof of the correctness of this. But both camps want to make an ideological point. To my mind that is a pity since clearly it reduces the credibility of the subject and its practitioners.                   Frank Hahn

The Law of Demand

from Lars Syll

Mainstream economics is usually considered to be very ‘rigorous’ and ‘precise.’ And yes, indeed, it’s certainly full of ‘rigorous’ and ‘precise’ statements like “the state of the economy will remain the same as long as it doesn’t change.” Although ‘true,’ this is, however — like most other analytical statements — neither particularly interesting nor informative.

As is well known, the law of demand is usually tagged with a clause that entails numerous interpretation problems: the ceteris paribus clause. In the strict sense this must thus at least be formulated as follows to be acceptable to the majority of theoreticians: ceteris paribus – that is, all things being equal – the demanded quantity of a consumer good is a monotone-decreasing function of its price …

If the factors that are to be left constant remain undetermined, as not so rarely happens, then the law of demand under question is fully immunized to facts, because every case which initially appears contrary must, in the final analysis, be shown to be compatible with this law. The clause here produces something of an absolute alibi, since, for every apparently deviating behavior, some altered factors can be made responsible. This makes the statement untestable, and its informational content decreases to zero.

One might think that it is in any case possible to avert this situation by specifying the factors that are relevant for the clause. However, this is not the case. In an appropriate interpretation of the clause, the law of demand that comes about will become, for example, an analytic proposition, which is, in fact, ​true for logical reasons, but which is thus precisely for this reason not informative …

Various widespread formulations of the law of demand contain an interpretation of the clause that does not result in a tautology, but that has another weakness. The list of the factors to be held constant includes, among other things, the structure of the needs of the purchasing group in question. This leads to a difficulty connected with the identification of needs. As long as there is no independent test for the constancy of the structures of needs, any law that is formulated in this way has an absolute ‘alibi’. Any apparent counter case can be traced back to a change in the needs, and thus be discounted. Thus, in this form, the law is also immunized against empirical facts. To counter this situation, it is in fact necessary to dig deeper into the problem of needs and preferences; in many cases, however, this is held to be unacceptable, because it would entail crossing the boundaries into social psychology.

Hans Albert

In mainstream economics there’s — still — a lot of talk about ‘economic laws.’

Mainstream economics — the art of building fantasy worlds

from Lars Syll

Mainstream macroeconomic models standardly assume things like rational expectations, Walrasian market clearing, unique equilibria, time invariance, linear separability and homogeneity of both inputs/outputs and technology, infinitely lived intertemporally optimizing representative household/ consumer/producer agents with homothetic and identical preferences, etc., etc. At the same time, the models standardly ignore complexity, diversity, uncertainty, coordination problems, non-market clearing prices, real aggregation problems, emergence, expectations formation, etc., etc.

Behavioural and experimental economics — not to speak of psychology — show beyond doubt that “deep parameters” — peoples’ preferences, choices and forecasts — are regularly influenced by those of other economic participants. And how about the homogeneity assumption? And if all actors are the same — why and with whom do they transact? And why does economics have to be exclusively teleological (concerned with intentional states of individuals)? Where are the arguments for that ontological reductionism? And what about collective intentionality and constitutive background rules?

Free trade

from Lars Syll

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 mostly export goods that used the abundant factors of production and import goods that mostly used factors of production 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

— Countries use identical production technologies.

— Production takes place with constant returns to scale technology.

— Within countries, the factor substitutability is more or less infinite.

— 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.

Abduction — beyond deduction and induction

from Lars Syll

Science is made possible by the fact that there are structures that are durable and independent of our knowledge or beliefs about them. There exists a reality beyond our theories and concepts of it. Contrary to positivism, yours truly would as a critical realist argue that the main task of science is not to detect event-regularities between observed facts, but rather to identify and explain the underlying structures/forces/powers/ mechanisms that produce the observed events.

Given that what we are looking for is to be able to explain what is going on in the world we live in, it would — instead of building models based on logic-axiomatic, topic-neutral, context-insensitive, and non-ampliative deductive reasoning, as in mainstream economic theory — be so much more fruitful and relevant to apply inference to the best explanation.

Mainstream economics — sacrificing realism at the altar of mathematical purity

from Lars Syll

This critique goes beyond the narrowly technical — that the workhorse neoclassical model of the economy was found to be lame when it came to running a real crisis race. The deeper critique is that these models, and the technical language that accompanies them, have played a role in policy and in society that has been disproportionate in two senses. First, disproportionate relative to our state of knowledge. Existing economic frameworks have shouldered a policy weight that is simply too great for them to bear, given the degree of uncertainty and fragility that surrounds them. Second, disproportionate because these frameworks placed an excessive degree of policy power in the hands of the technocrats wielding them …

Causal mediation

from Lars Syll

In the real world, it’s my impression that almost all the mediation analyses that people actually fit in the social and medical sciences are misguided: lots of examples where the assumptions aren’t clear and where, in any case, coefficient estimates are hopelessly noisy and where confused people will over-interpret statistical significance …

So how to do it? I don’t think traditional path analysis or other multivariate methods of the throw-all-the-data-in-the-blender-and-let-God-sort-em-out variety will do the job. Instead we need some structure and some prior information.

Andrew Gelman

Most facts have many different, possible, alternative explanations, but we usually want to find — since all real explanation takes place relative to a set of alternatives — the best of all contrastive explanations.

So which is the best explanation?

Axel Leijonhufvud (1933-2022)

from Lars Syll

The orthodox Keynesianism of the time did have a theoretical explanation for recessions and depressions. Proponents saw the economy as a self-regulating machine in which individual decisions typically lead to a situation of full employment and healthy growth. The primary reason for periods of recession and depression was because wages did not fall quickly enough. If wages could fall rapidly and extensively enough, then the economy would absorb the unemployed. Orthodox Keynesians also took Keynes’ approach to monetary economics to be similar to the classical economists.

Leijonhufvud got something entirely different from reading the General Theory. The more he looked at his footnotes, originally written in puzzlement at the disparity between what he took to be the Keynesian message and the orthodox Keynesianism of his time, the confident he felt. The implications were amazing. Had the whole discipline catastrophically misunderstood Keynes’ deeply revolutionary ideas? Was the dominant economics paradigm deeply flawed and a fatally wrong turn in macroeconomic thinking? And if this was the case, what was Keynes actually proposing?

Leijonhufvud’s “Keynesian Economics and the Economics of Keynes” exploded onto the academic stage the following year; no mean feat for an economics book that did not contain a single equation. The book took no prisoners and aimed squarely at the prevailing metaphor about the self-regulating economy and the economics of the orthodoxy. He forcefully argued that the free movement of wages and prices can sometimes be destabilizing and could move the economy away from full employment.

Arjun Jayadev

Fortunately, when you’ve got tired of the kind of macroeconomic apologetics produced by ‘New Keynesian’ macroeconomics, there are still some real Keynesian macroeconomists to read. One of them will always be Axel Leijonhufvud.

Formalizing economic theory

from Lars Syll

What guarantee is there … that economic concepts can be mapped unambiguously into mathematical concepts? The belief in the power and necessity of formalizing economic theory mathematically has thus obliterated the distinction between cognitively perceiving and understanding concepts from different domains and mapping them into each other. Whether the age-old problem of the equality between supply and demand should be mathematically formalized as a system of inequalities or equalities is not something that should be decided by mathematical knowledge or convenience. Surely it would be considered absurd, bordering on the insane, if a surgical procedure was implemented because a tool for its implementation was devised by a medical doctor who knew and believed in topological fixed-point theorems? Yet, weighty propositions about policy are decided on the basis of formalizations based on ignorance and belief in the veracity of one kind of one-dimensional mathematics

K. Vela Velupillai

Gödel and the limits of mathematics

from Lars Syll

irrelevant model abstractions
with no bridges to real-world economies

 

Gödel’s incompleteness theorems raise important questions about the foundations of mathematics.

The most important concern is the question of how to select the specific systems of axioms that mathematics is supposed to be founded on. Gödel’s theorems irrevocably show that no matter what system is chosen, there will always have to be other axioms to prove previously unproven truths.

This, of course, ought to be of paramount interest for those mainstream economists who still adhere to the dream of constructing deductive-axiomatic economics with analytic truths that do not require empirical verification. Since Gödel showed that any complex axiomatic system is undecidable and incomplete, any such deductive-axiomatic economics will always consist of some undecidable statements. When not even being able to fulfil the dream of a complete and consistent axiomatic foundation for mathematics, it’s totally incomprehensible that some people still think that could be achieved for economics.

Economics phrasebook

from Lars Syll

In 1990, two economics PhD students at the University of Chicago, Jeffrey Smith and Kermit Daniel … composed “Economics to Sociology Phrase Book” in order, as they put it, “to help economists adjust their way of speaking in a manner that will make it comprehensible to Sociologists” … Concerning economics terminology, by the way, one can see that not much has changed since then.

Oleg Komlik

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:

In 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