Understanding Macro: The Great Depression (1/3)

from  Asad Zaman

Preliminary Remarks: “The trouble is not so much that macroeconomists say things that are inconsistent with the facts. The real trouble is that other economists do not care that the macroeconomists do not care about the facts. An indifferent tolerance of obvious error is even more corrosive to science than committed advocacy of error.” From The Trouble with Macroeconomics (Paul Romer)

Personally, I do not understand why indifference to error is worse than committed advocacy. For an illustration of committed advocacy of error, see postscript below on 70 years of economists’ commitment to a fallacious theory of supply and demand in the labor market. Furthermore, the problem is not confined to macro. Microeconomists are also dogmatically committed to utility maximization, when in fact this hypothesis about consumer behavior is solidly rejected by empirical evidence; see: The Empirical Evidence Against Neoclassical Utility Maximization: A Survey of the Literature

Understanding Macro: The Great Depression

Due to frequent headlines, there is a substantial public awareness of core macroeconomic issues like unemployment, trade agreements, exchange rates, deficit, taxes, interest rates, etc. However, even professionals are often ignorant of the intellectual battles which have shaped modern macroeconomics, since this is not taught in typical PhD programmes in economics. This article attempts to provide the history of ideas which led to the emergence of macroeconomics, since this is an essential background required for informed analysis of these issues.

Lord John Maynard Keynes invented the entire field of macroeconomics in response to the Great Depression in 1929, which could not be understood according to economic theories dominant until then. According to the classical economic theory, forces of supply and demand in the labour market would ensure full employment. Keynes starts his magnum opus, The General Theory of Employment, Interest, and Money, with the observation that the economic theory cannot explain the long, persistent and deep unemployment that was observed following the Great Depression. Keynes set himself the goal of creating a theory which could explain wide fluctuations in levels of employment that he observed. He discovered that creating such a theory involved rejecting deeply held convictions, central to economic theory.  read more

Keynes on the use of mathematics in economics

from Lars Syll

But I am unfamiliar with the methods involved and it may be that my impression that nothing emerges at the end which has not been introduced expressly or tacitly at the beginning is quite wrong … It seems to me essential in an article of this sort to put in the fullest and most explicit manner at the beginning the assumptions which are made and the methods by which the price indexes are derived; and then to state at the end what substantially novel conclusions has been arrived at …

I cannot persuade myself that this sort of treatment of economic theory has anything significant to contribute. I suspect it of being nothing better than a contraption proceeding from premises which are not stated with precision to conclusions which have no clear application … [This creates] a mass of symbolism which covers up all kinds of unstated special assumptions.

Letter from Keynes to Frisch 28 November 1935

 

 

 

Investors — people knowing almost nothing whatever about what they are doing

from Lars Syll

How far the motives which I have been attributing to the market are strictly rational, I leave it to others to judge. They are best regarded, I think, as an example of how sensitive – over-sensitive if you like – to the near future, about which we may think that we know a little, even the best-informed must be, because, in truth, we know almost nothing about the more remote future …

The ignorance of even the best-informed investor about the more remote future is much greater then his knowledge … But if this is true of the best-informed, the vast majority of those who are concerned with the buying and selling of securities know almost nothing whatever about what they are doing … This is one of the odd characteristics of the Capitalist System under which we live …

It may often profit the wisest to anticipate mob psychology rather than the real trend of events, and to ape unreason proleptically … (The object of speculators) is to re-sell to the mob after a few weeks or at most a few months. It is natural, therefore, that they should be influenced by the cost of borrowing, and still more by their expectations on the basis of past experience of the trend of mob psychology. Thus, so long as the crowd can be relied on to act in a certain way, even if it be misguided, it will be to the advantage of the better informed professional to act in the same way – a short period ahead.

 

 

Uncertainty & reflexivity — implications for economics

from Lars Syll

Almost a hundred years after John Maynard Keynes wrote his seminal A Treatise on Probability (1921), it is still very difficult to find mainstream economists that seriously try to incorporate his far-reaching and incisive analysis of induction and evidential weight into their theories and models.

The standard view in economics – and the axiomatic probability theory underlying it – is to a large extent based on the rather simplistic idea that “more is better.” But as Keynes argues – “more of the same” is not what is important when making inductive inferences. It’s rather a question of “more but different.”

Variation, not replication, is at the core of induction. Finding that p(x|y) = p(x|y & w) doesn’t make w “irrelevant.” Knowing that the probability is unchanged when w is present gives p(x|y & w) another evidential weight (“weight of argument”). Running 10 replicative experiments do not make you as “sure” of your inductions as when running 10 000 varied experiments – even if the probability values happen to be the same.

What is Post Keynesian Economics?

from Lars Syll

John Maynard Keynes’s 1936 book The General Theory of Employment, Interest, and Money attempted to overthrow classical theory and revolutionize how economists think about the economy. Economists who build upon Keynes’s General Theory to analyze the economic problems of the twenty-first-century global economy are called Post Keynesians. Keynes’s “principle of effective demand” (1936, chap. 2) declared that the axioms underlying classical theory were not applicable to a money-using, entrepreneurial economic system. Consequently, the mainstream theory’s “teaching is misleading and disastrous if we attempt to apply it to the facts of experience” (Keynes 1936, p. 3). To develop an economic theory applicable to a monetary economy, Keynes suggested rejecting three basic axioms of classical economics (1936, p. 16).

Economics textbooks – how to get away with scientific fraud

from Lars Syll

As is well-known, Keynes used to criticize the more traditional economics for making the fallacy of composition, which basically consists of the false belief that the whole is nothing but the sum of its parts. Keynes argued that in the society and in the economy this was not the case, and that a fortiori an adequate analysis of society and economy couldn’t proceed by just adding up the acts and decisions of individuals. The whole is more than a sum of parts. This fact shows up already when orthodox – neoclassical – economics tries to argue for the existence of The Law of Demand – when the price of a commodity falls, the demand for it will increase – on the aggregate. Although it may be said that one succeeds in establishing The Law for single individuals it soon turned out – in the Sonnenschein-Mantel-Debreu theorem firmly established already in 1976 – that it wasn’t possible to extend The Law of Demand to apply on the market level, unless one made ridiculously unrealistic assumptions such as individuals all having homothetic preferences – which actually implies that all individuals have identical preferences.

Gold gibberish

from Lars Syll

Eighty years ago Keynes could congratulate Great Britain on finally having got rid of the biggest ”barbarous relic” of his time – the gold standard. He lamented that

advocates of the ancient standard do not observe how remote it now is from the spirit and the requirement of the age … [T]he long age of Commodity Money has at last passed away before the age of Representative Money. Gold has ceased to be a coin, a hoard, a tangible claim to wealth … It has become a much more abstract thing – just a standard of value; and it only keeps this nominal status by being handed round from time to time in quite small quantities amongst a group of Central Banks.

Ending the use of fiat money guaranteed by promises for currencies once more backed by gold is not the way out of the present economic crisis. Far from being the sole prophylactic against the alleged problems of fiat money, as the “gold bugs” maintain, a return to gold would only make things far worse. So yours truly – just as Keynes did – most certainly reject any proposals for restoring the gold standard.

What has Keynes got to do with New Keynesian Macroeconomics? Nothing!

from Lars Syll

Paul Krugman has a post on his blog discussing “New Keynesian” macroeconomics and the definition of neoclassical economics:

So, what is neoclassical economics? … I think we mean in practice economics based on maximization-with-equilibrium. We imagine an economy consisting of rational, self-interested players, and suppose that economic outcomes reflect a situation in which each player is doing the best he, she, or it can given the actions of all the other players …

Some economists really really believe that life is like this — and they have a significant impact on our discourse. But the rest of us are well aware that this is nothing but a metaphor; nonetheless, most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point or baseline, which is then modified — but not too much — in the direction of realism.

This is, not to put too fine a point on it, very much true of Keynesian economics as practiced … New Keynesian models are intertemporal maximization modified with sticky prices and a few other deviations …

Why do things this way? Simplicity and clarity. In the real world, people are fairly rational and more or less self-interested; the qualifiers are complicated to model, so it makes sense to see what you can learn by dropping them. And dynamics are hard, whereas looking at the presumed end state of a dynamic process — an equilibrium — may tell you much of what you want to know.

Being myself sorta-kinda Keynesian I  find this analysis utterly unconvincing. Why? Let me try to explain.

Keynes on speculators taking advantage of mob psychology

from Lars Syll

How far the motives which I have been attributing to the market are strictly rational, I leave it to others to judge. They are best regarded, I think, as an example of how sensitive – over-sensitive if you like – to the near future, about which we may think that we know a little, even the best-informed must be, because, in truth, we know almost nothing about the more remote future …

The ignorance of even the best-informed investor about the more remote future is much greater then his knowledge … But if this is true of the best-informed, the vast majority of those who are concerned with the buying and selling of securities know almost nothing whatever about what they are doing … This is one of the odd characteristics of the Capitalist System under which we live … 

Rethinking Keynes’ non-Euclidian theory of the economy

from Fred Zaman

“In his General Theory, John Maynard Keynes stated that classical economists ‘resemble Euclidean Geometers in a non Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight—as the only remedy for the unfortunate collisions which are occurring. Yet in truth there is no remedy except to throw over the axiom of parallels and to work out a non Euclidean geometry. Something similar is required today in economics.’” (Paul Davidson, The Keynes Solution, Ch. 4)

In this Euclidean analogy with the classical analysis of free
markets, which is based on “efficient market theory,” Davidson explains that
full employment is the Euclidean equivalent of parallel lines which never meet.
He nonetheless notes, however, that in the real world these lines, although
parallel in an Euclidean analogy with economics, nevertheless unfortunately do
often meet, thereby significantly and persistently producing economic
“collisions” understood as unemployment; the blame for which collisions always
is placed on workers for not passively accepting lower wages, and consequently
also a lower standard of living. Keynes’s solution,

Keynes on mathematical economics

from Lars Syll

But I am unfamiliar with the methods involved and it may be that my impression that nothing emerges at the end which has not been introduced expressly or tacitly at the beginning is quite wrong … It seems to me essential in an article of this sort to put in the fullest and most explicit manner at the beginning the assumptions which are made and the methods by which the price indexes are derived; and then to state at the end what substantially novel conclusions has been arrived at … I cannot persuade myself that this sort of treatment of economic theory has anything significant to contribute. I suspect it of being nothing better than a contraption proceeding from premises which are not stated with precision to conclusions which have no clear application … [This creates] a mass of symbolism which covers up all kinds of unstated special assumptions.

Keynes to Frisch 28 November 1935

Robert Lucas on the slump

from Lars Syll

In a recent lecture on the US recession – Robert Lucas gave an outline of what the New Classical school of macroeconomics today thinks on the latest downturn in the US economy and its future prospects.

Lucas starts by showing that real US GDP has grown at an average yearly rate of 3 per cent since 1870, with one big dip during the Depression of the 1930s and a big – but smaller – dip in the recent recession.

After stating his view that the US recession that started in 2008 was basically caused by a run for liquidity, Lucas then goes on to discuss the prospect of recovery, maintaining that past experience would suggest an “automatic” recovery, if the free market system is left to repair itself to equilibrium unimpeded by social welfare activities of the government.

As could be expected there is no room for any Keynesian type considerations on eventual shortages of aggregate demand discouraging the recovery of the economy. No, as usual in the New Classical macroeconomic school’s explanations and prescriptions, the blame game points to the government and its lack of supply side policies.

Lucas is convinced that what might arrest the recovery are higher taxes on the rich,

On the non-equivalence of Keynesian and Knightian uncertainty (wonkish)

from Lars Syll

Last year Bank of England’s Andrew G Haldane and Benjamin Nelson  presented a paper with the title Tails of the unexpected. The main message of the paper was that we should no let us be fooled by randomness:

For almost a century, the world of economics and finance has been dominated by randomness. Much of modern economic theory describes behaviour by a random walk, whether financial behaviour such as asset prices (Cochrane (2001)) or economic behaviour such as consumption (Hall (1978)). Much of modern econometric theory is likewise underpinned by the assumption of randomness in variables and estimated error terms (Hayashi (2000)).

But as Nassim Taleb reminded us, it is possible to be Fooled by Randomness (Taleb (2001)). For Taleb, the origin of this mistake was the ubiquity in economics and finance of a particular way of describing the distribution of possible real world outcomes. For non-nerds, this distribution is often called the bell-curve. For nerds, it is the normal distribution. For nerds who like to show-off, the distribution is Gaussian.

New Keynesians, price stickiness and involuntary unemployment (wonkish)

from Lars Syll

There are unfortunately a lot of neoclassical economists out there who still think that price and wage rigidities are the prime movers behind unemployment. What is even worse – I’m totally gobsmacked every time I come across this utterly ridiculous misapprehension -is that some of them even think that these rigidities are the reason John Maynard Keynes gave for the high unemployment of the Great Depression. This is of course pure nonsense. For although Keynes in General Theory devoted substantial attention to the subject of wage and price rigidities, he certainly did not hold this view.

Since unions/workers, contrary to classical assumptions, make wage-bargains in nominal terms, they will – according to Keynes – accept lower real wages caused by higher prices, but resist lower real wages caused by lower nominal wages. However, Keynes held it incorrect to attribute “cyclical” unemployment to this diversified agent behaviour. During the depression money wages fell significantly and – as Keynes noted – unemployment still grew. Thus, even when nominal wages are lowered, they do not generally lower unemployment.  

The savings paradox

from Lars Syll

An act of individual saving means — so to speak — a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day’s dinner without stimulating the business of making ready for some future act of consumption. It is not a substitution of future consumption-demand for present consumption-demand, — it is a net diminution of such demand …  

Keynes on the psychology of finance

from Lars Syll

To-day, in many parts of the world, it is the serious embarrassment of the banks which is the cause of our gravest concern …

[The banks] stand between the real borrower and the real lender. They have given their guarantee to the real lender; and this guarantee is only good if the money value of the asset belonging to the real borrower is worth the money which has been advanced on it.

It is for this reason that a decline in money values so severe as that which we are now experiencing threatens the solidity of the whole financial structure. Banks and bankers are by nature blind. 

A Keynesian theory of hegemonic currencies – or why the world pays dollar tribute

from Thomas Palley

Several years ago (June 2006) I wrote an article advancing a new theory of why the dollar is the world’s dominant currency and why it is likely to remain so. The article was published in the midst of the last boom and sank like a stone. But now debate about the cause of the dollar’s hegemony has been revived in an interesting paper by Fields and Vernengo titled “Hegemonic currencies during the crisis: The dollar versus the euro in a Cartelist perspective” (also here). Their paper provides an opportunity to revive discussion, so I am posting the article again. Here it is (subject to a couple of word edits):

The U.S. dollar is much in the news these days and there is a sense that the world economy may have become excessively reliant on the dollar. This reliance smacks of dysfunctional co-dependence whereby the U.S. and the rest of the world both rely on the dollar’s strength, but neither is well served by it. 

The Euro as the SDR of Europe?

from Steve Keen

The Euro is the national currency of a country that does not exist. Though there is a continent of Europe, as there is of America, there has never been a country of the United States of Europe, and there probably never will be.

The Euro is therefore not a currency as is the American dollar, and yet it is forced to masquerade as one—badly—by the Maastricht Treaty, in which the countries of Europe abandoned the right to produce their own genuine national currencies.

With the volume of the Euro being controlled by a supra-national authority (the ECB), and member states punished for breaching rules on government spending (the 3% maximum deficit and 60% accumulated deficit rules), the Euro is closer in function not to a currency, but to Special Drawing Rights as they were conceived of by Keynes at Bretton Woods. In his plan for a post-WWII international monetary system, Keynes proposed that common supranational currency be used for international trade (the “Bancor“), while domestic currencies should used for internal trade. The exchange rates between national currencies and the Bancor were to be fixed, with persistent trade deficit countries being forced to impose austerity and devalue, while persistent surplus countries were taxed Bancors, and required to stimulate their economies to increase imports.

The ergodic axiom: Davidson versus Stiglitz and Lucas

Contemporary neoclassical economists proceed under the assumption that as concerns the economy there exists a predetermined reality that can be fully described by “unchanging objective conditional probability functions”.  This is called the ”ergodic axiom”, and its current supporters include Joseph . Stiglitz and Robert Lucas.  In the anti-scientism spirit of Keynes, Paul Davidson has long campaigned against the use of the ergodic axiom, but never so tellingly as in his most recent paper, Is economics a science? Should economics be rigorous? It appears in the current issue of the Real-World Economics.  Here is one section from this paper.

The ergodic axiom 

First, let us take up the ergodic – nonergodic stochastic process distinction.  Paul Samuelson [1969] has written that if economists hope to move economics from “the realm of history” into “the realm of science” they must impose the “ergodic hypothesis” on their theory^[1].  In other words Nobel Prize Winner Paul Samuelson has made the ergodic axiom the sine qua non for the scientific method in economics. Lucas and Sargent [1981] have also claimed the principle behind the ergodic axiom is the only scientific method of doing economics. 

Following Samuelson’s lead, most economists (e.g., Cochrane, Stiglitz, Mankiw, M. Friedman, Scholes, etc) and economic textbook writers either implicitly or explicitly have assumed that observable economic events are generated by an ergodic stochastic process.  

David K. Levine is totally wrong on the rational expectations hypothesis

from Lars Pålsson Syll

In the wake of the latest financial crisis many people have come to wonder why economists never have been able to predict these manias, panics and crashes that haunt our economies.

In responding to these warranted wonderings, some economists – like renowned theoretical economist David K Levine in the article Why Economists Are Right: Rational Expectations and the Uncertainty Principle in Economics in the Huffington Post – have maintained that

it is a fundamental principle that there can be no reliable way of predicting a crisis.

To me this is a totally inadequate answer. And even trying to make an honour out of the inability of one’s own science to give answers to just questions, is indeed proof of a rather arrogant and insulting attitude.

The main reason Levine gives for his view is what he calls “the uncertainty principle in economics” and the “theory of rational expectations”: