Presentation on theme: "Economics Education “After” the Crisis"— Presentation transcript:
1 Economics Education “After” the Crisis Steve KeenUniversity of Western SydneyDebunking Economics
2 Before the Crisis Oliver Blanchard, founding editor of AER Macro “The state of macro is good…”“Dynamic Stochastic General Equilibrium” model is…“simple, analytically convenient, and has largely replaced the IS-LM model as the basic model of fluctuations in graduate courses…”“Unlike the IS-LM model, it is formally, rather than informally, derived from optimization by firms and consumers.” (Blanchard 2009, pp )
3 “After” the crisis…“The great moderation lulled macroeconomists and policymakers alike in the belief that we knew how to conduct macroeconomic policy.The crisis clearly forces us to question that assessment…It is important to start by stating the obvious, namely, that the baby should not be thrown out with the bathwater…” (Blanchard Dell'Ariccia et al. 2010; emphasis added)Wrong: this baby should never have been conceivedDSGE models logically flawedDeep neoclassical research proved cannot reduce macro to applied micro before DSGE models developedWhy don’t neoclassical economists know this?
4 A paradoxical but transcendental truth… Learn theory from textbooks: Mankiw, Varian, Mas-ColellIgnore fundamental research in good faithShould be able to trust textbooks to truthfully summarize fundamental researchBut textbooks teach sanitized “as if” version of theoryMacro “as if” can model whole economy as one agentFundamental research: “as if” conditions falseConsequently:Neoclassical economists don’t understand neoclassical economics; andNeoclassical models violate neoclassical theoryIllustration: DSGE models, SMD conditions, & Solow
5 Solow rejects DSGE Solow (2001 p. 19; emphases added) “The prototypical real-business-cycle model goes like this. There is a single, immortal household—a representative consumer—that earns wages from supplying labor. It also owns the single price-taking firm…This is nothing but the neoclassical growth model…[When I built it] … It was clear … what I thought it did not apply to, namely short-run fluctuations ... the business cycle...Now ... an article today [on the] 'business cycle' … will be ... a slightly dressed up version of the neoclassical growth model.The question I want to circle around is: how did that happen?”
6 Solow: SMD conditions invalidate DSGE “Suppose you wanted to defend the use of the Ramsey model as the basis for a descriptive macroeconomics. What could you say? ...You could claim that … there is no other tractable way to meet the claims of economic theory.I think this claim is a delusion.We know from the Sonnenschein-Mantel-Debreu theorems that the only universal empirical aggregative implications of general equilibrium theory are that excess demand functions should be continuous and homogeneous of degree zero in prices, and should satisfy Walras' Law.Anyone is free to impose further restrictions on a macro model, but they have to be justified for their own sweet sake, not as being required by the principles of economic theory.…” (Solow 2008, p. 244; emphasis added)
7 Sonnenschein-Mantel-Debreu Conditions “Law of Demand” applies to individual Hicksian-compensated demand curveReduce price, demand necessarily risesDoes it apply to a market demand curve? No!:“we prove that every polynomial … is an excess demand function for a specified commodity in some n commodity economy… (Sonnenschein 1972 , pp )That is, a demand curve for a single market can have any (polynomial) shape at allEven study of a single market demand curve can’t be reduced to study of a demand curve derived from a single utility-maximizing agentYet Neoclassical DSGE macro models the whole economy as a single utility/profit-maximizing agent
8 SMD: “Anything goes” for market demand curves SMD Conditions (Sonnenschein 1973; Shafer & Sonnenschein 1993;):Market demand curves do not obey the "Law of Demand"Even if summing "well behaved" individual demand curvesqPCrusoeFriday+=MarketQAn accidental "Proof by contradiction":Assume market demand curves do obey Law of DemandDerive conditions under which this is trueThese contradict initial assumptionsTherefore market demand curves don‘t obey the "Law" of Demand
9 Logic: Price changes alter income distribution “Law of Demand” derived from Hicksian compensated demand curve procedureTake individual with well-behaved utility functionVary price of one commodity while keeping others constant and consumer income constant(1) Can vary Price without altering incomePivot point does not moveBananasCoconutsWYXZBq1q2q3Price of Bananasp1p2p3IIIIIIKey assumptions:
10 Individual demand curve derivation (2) Can change income and perfectly compensate for income effect of lower price (Hicksian-compensation)BananasCoconutsXq1q2q3Price of Bananasp1p2p3Outcome: Hicksian-compensated individual demand curve necessarily slopes down: the “Law of Demand”Motivation behind SMD research: Does this result survive aggregation to market demand?Answer: No!
11 With more than one consumer… Logic: “individual demand curve” model ignores impact of price changes on incomeBut price changes will change income distributionIn 2 (or more) consumer model, each must haveDifferent income sources; andDifferent tastesOtherwise, there’s only one consumerTastes must change with incomeOtherwise, there’s only one commodityConsider 2-consumer, 2 commodity worldCrusoe and Friday; Coconuts and BananasCrusoe the Banana owner, Friday Coconut ownerCoconuts necessity, Bananas luxuryFriday higher preference for coconuts than Crusoe
12 Change in relative price alters incomes Start with arbitrary price ratio;Keep aggregate income constant;Consider lower price for bananasCrusoe’s (banana owner) income falls; Friday’s risesCrusoeFridayBananasCoconutsBananasCoconutsMarket demand for bananas falls because of lower priceCrusoe’s income fellFriday’s income roseBut his preferences for bananas less than Crusoe’s
13 Income growth alters distribution if tastes differ Hicksian procedureKeep relative prices constantIncrease income equallyBanana demand (luxury) rises more than CoconutCrusoe’s income rises more than Friday’sCrusoeFridayBananasCoconutsBananasCoconutsCannot “compensate” for income effect of price change:“Uniform” increase in income alters income distribution, because varying consumption as income rises favours luxury-producing agent over the other
14 Market demand curve any polynomial at all Outcome: market demand curve can have any (polynomial) shape at allNeed not obey “Law of Demand”Only way to avoid this:Assume all consumers have identical tastesSo there is only one consumer!And assume that tastes don’t change with incomeSo there is only one commodity!Contradicts starting assumption:Two consumers with different tastesTwo different commoditiesProof by contradiction that “Law of Demand” does not apply to market demand curveHow is this communicated to students?
15 Textbooks hide SMD results Samuelson and Nordhaus 2010 (p. 48)“The market demand curve is found by adding together the quantities demanded by all individuals at each price.Does the market demand curve obey the law of downward-sloping demand? It certainly does…”A provably false statement misleading undergraduatesVarian 1984 (p. 268)“it is sometimes convenient to think of the aggregate demand as the demand of some ‘representative consumer’…The conditions under which this can be done are rather stringent, but a discussion of this issue is beyond the scope of this book…”A vague statement reassuring PhD students
16 Macro an “emergent property” Real meaning of SMD conditionsMacroeconomic behavior an “emergent property” of interaction of agents in a complex systemCannot deduce behavior of macroeconomy from behavior of utility-maximizing individualsCannot reduce macroeconomics to “applied microeconomics”But that is what DSGE models do!Believe “macroeconomics is applied microeconomics”But SMD conditions prove otherwise“macroeconomics cannot be applied microeconomics”Neoclassical theory commits the fallacy of “Strong Reductionism”…
17 Fallacy of Strong Reductionism Common knowledge in real sciencesPhysics Nobel Laureate Anderson in “More is Different”, Science (1972, Vol. 177, p. 393)“The behavior of large and complex aggregates of elementary particles, it turns out, is not to be understood in terms of a simple extrapolation of the properties of a few particles.Instead, at each level of complexity entirely new properties appear, and the understanding of the new behaviors requires research which I think is as fundamental in its nature as any other.”
18 Fallacy of Strong Reductionism “one may array the sciences roughly linearly in a hierarchy, according to the idea: “The elementary entities of science X obey the laws of science Y”XYSolid state or many-body physicsElementary particle physicsChemistryMany-body physicsMolecular biologyCell biology…PsychologyPhysiologySocial sciencesBut this hierarchy does not imply that science X is “just applied Y”. At each stage entirely new laws, concepts, and generalizations are necessary, requiring inspiration and creativity to just as great a degree as in the previous one. Psychology is not applied biology, nor is biology applied chemistry.”
19 Neoclassical macro didn’t see “It” coming Strong reductionism blinded neoclassical macroeconomists:“The preferred model has a single representative consumer optimizing over infinite time with perfect foresight or rational expectations, in an environment that realizes the resulting plans more or less flawlessly through perfectly competitive forward-looking markets for goods and labor, and perfectly flexible prices and wages.How could anyone expect a sensible short-to-medium-run macroeconomics to come out of that set-up? …we want macroeconomics to account for the occasional aggregative pathologies that beset modern capitalist economies, like recessions, intervals of stagnation, inflation, “stagflation”…A model that rules out pathologies by definition is unlikely to help.” (Solow 2003, p. 1; emphases added)
20 Many other flaws in neoclassical doctrine Money is not neutral in a credit economy:“nothing is so unimportant as the [nominal] quantity of money … let the number of dollars in existence be multiplied by 100; that … will have no other essential effect provided that all other nominal magnitudes (prices of goods and services, and quantities of other assets and liabilities that are expressed in nominal terms) are also multiplied by 100.” Friedman 1969 (p. 1)Debts aren’t increased when prices risehence money is not neutral in a credit economyRational expectations = “capable of accurate prophesy”Lucas 1972 (p. 54) “one is led simply to adding the assumption that [the gap between actual and expected inflation] is zero as an additional axiom… or to assume that expectations are rational in the sense of Muth.”No wonder neoclassical macro couldn’t explain the crisis!
21 Neoclassical macro can’t explain “It” continuing… US Unemployment rising again after brief fall:“We don't have a precise read on why this slower pace of growth is persisting” (Bernanke, June )The Economist: “His admission of ignorance reflects genuine puzzlement with the economy’s failure to reach what he likes to call escape velocity.”Non-neoclassical macro can explain “It” and why “It” is continuing…
22 Private debt crisis, just like the Great Depression Debt-focused analysis is why “Bezemer 12” did see the crisis coming:Bezemer 2010, 2011R2=-0.96
23 Dilemma for economics educators What do you do when all you know is that you don’t know?Continue teaching neoclassical economicsBut from the originals, not the textbooksLearn/teach your own school of thought properlyTeach the theory “warts and all”Hire economists who know non-neoclassical economicsTeach parallel classes in the real Classical EconomistsAttend those classes & learn some different questionsEngage with part of the discipline you have ignored for 40 years
24 It ain’t Walras, Babe…Neoclassical macro direct descendant of Bentham, Say, Walras, MarshallEquilibrium, methodological individualism, strong reductionism, linearityUnrelated to Classical Economists Smith, Ricardo, Marx, Keynes, Schumpeter, Fisher, Minsky, GoodwinDynamics, social classes, emergent phenomena, complexity & evolutionNon-neoclassical economics underdeveloped compared to neoclassicalDoesn’t have all the answers…Many wrong ones—e.g., Labor Theory of Value in MarxSome correct—e.g., Financial Instability Hypothesis
25 It might be Marx, Schumpeter, Minsky… But many correct questionsFocus on instabilityUncertaintyCrucial role of moneyDisequilibrium dynamicsBetter to ask the right questions than give accurate answers to the wrong onesEquilibrium fetishRisk as proxy for uncertaintyBarter model of monetary economyEquilibrium Dynamicsan oxymoron in any real scienceGiven manifest failure of neoclassical macro, students must be exposed to non-neoclassical ideas
26 Some resourcesDebunking Economics II: almost all the economics you didn’t learn from the textbooks…Available September 2011My blogMinskian explanation of the crisisFree software program “Minsky”“Monetary Macro-dynamics for dummies”Recently received INET grantMathematica version in development (Mike HoneychurchPrototype available on my blog:Lectures on history of economic thought, non-neoclassical monetary macroeconomics:
27 ReferencesAnderson, P. W. (1972). "More Is Different." Science 177(4047):Bezemer, D. J. (2009). ““No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models.” Groningen, The Netherlands, Faculty of Economics University of Groningen.Blatt, J. M. (1983). Dynamic economic systems : a post-Keynesian approach. Armonk, N.Y, M.E. Sharpe.Bezemer, D. J. (2009). “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models. Groningen, The Netherlands, Faculty of Economics University of Groningen.Bezemer, D. J. (2011). "The Credit Crisis and Recession as a Paradigm Test." Journal of Economic Issues 45: 1-18.Bezemer, D. J. (2010). "Understanding financial crisis through accounting models." Accounting, Organizations and Society 35(7):Clark, J. B. (1898). "The Future of Economic Theory." The Quarterly Journal of Economics 13(1): 1-14.Friedman, M. (1969). The Optimum Quantity of Money. The Optimum Quantity of Money and Other Essays. Chicago, MacMillan: 1-50.Goodwin, R. (1967). A growth cycle. Socialism, Capitalism and Economic Growth. C. H. Feinstein. Cambridge, Cambridge University Press:Keen, S. (1995). "Finance and Economic Breakdown: Modeling Minsky's 'Financial Instability Hypothesis.'." Journal of Post Keynesian Economics 17(4):Keen, S. (2011). "A monetary Minsky model of the Great Moderation and the Great Recession." Journal of Economic Behavior & Organization In Press, Corrected Proof.Kirman, A. (1989). "The Intrinsic Limits of Modern Economic Theory: The Emperor Has No Clothes." Economic Journal 99 (395):Lucas, R. E., Jr. (1972). Econometric Testing of the Natural Rate Hypothesis. The Econometrics of Price Determination Conference, October O. Eckstein. Washington, D.C., Board of Governors of the Federal Reserve System and Social Science Research Council:
28 ReferencesLucas, R. E., Jr. (2004). "Keynote Address to the 2003 HOPE Conference: My Keynesian Education." History of Political Economy 36:Kydland, F. E. and E. C. Prescott (1990). "Business Cycles: Real Facts and a Monetary Myth." Federal Reserve Bank of Minneapolis Quarterly Review 14(2): 3-18.Marx, K. and F. Engels (1885). Capital II. Moscow, Progress Publishers.Mas-Colell, A., M. D. Whinston, et al. (1995). Microeconomic theory. New York :, Oxford University Press.Minsky, H. P. (1982). Can "it" happen again? : essays on instability and finance. Armonk, N.Y., M.E. Sharpe.Solow, R. M. (2001). From Neoclassical Growth Theory to New Classical Macroeconomics. Advances in Macroeconomic Theory. J. H. Drèze. New York, Palgrave.Solow, R. M. (2003). Dumb and Dumber in Macroeconomics. Festschrift for Joe Stiglitz. Columbia University.Solow, R. (2008). "The State of Macroeconomics." The Journal of Economic Perspectives 22(1):Samuelson, P. A. and W. D. Nordhaus (2010). Microeconomics. New York, McGraw- Hill Irwin.Schumpeter, J. A. (1934). The theory of economic development : an inquiry into profits, capital, credit, interest and the business cycle. Cambridge, Massachusetts, Harvard University Press.Shafer, W. and H. Sonnenschein (1993). “Market demand and excess demand functions”. Handbook of Mathematical Economics. K. J. Arrow and M. D. Intriligator, Elsevier. 2:Sonnenschein, H. (1973). "Do Walras' Identity and Continuity Characterize the Class of Community Excess Demand Functions?" Journal of Economic Theory 6(4):Varian, H. R. (1984, 1992). Microeconomic analysis. New York, W.W. Norton.