by The real flimflam man As yours truly noted the other day, Oxford professor Simon Wren-Lewis has been relentless in his efforts to defend orthodox macroeconomic theory against attacks from pluralist rethinking economics students and ‘heterodox’ critics like yours truly. Answering to this critique, Wren-Lewis now says he finds my view that he “obviously shares the view that there is nothing basically wrong with ‘standard’ theory” nothing but rather ‘pathetic’ flimflam. Well — why not look into some of the stuff Wren-Lewis has written and then decide who is a ‘pathetic’ flimflammer here. A couple of years ago, it was the rational expectations hypothesis (REH) he wanted to defend: It is not a debate about rational expectations in the abstract, but about a
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The real flimflam man
As yours truly noted the other day, Oxford professor Simon Wren-Lewis has been relentless in his efforts to defend orthodox macroeconomic theory against attacks from pluralist rethinking economics students and ‘heterodox’ critics like yours truly.
Answering to this critique, Wren-Lewis now says he finds my view that he “obviously shares the view that there is nothing basically wrong with ‘standard’ theory” nothing but rather ‘pathetic’ flimflam.
Well — why not look into some of the stuff Wren-Lewis has written and then decide who is a ‘pathetic’ flimflammer here.
A couple of years ago, it was the rational expectations hypothesis (REH) he wanted to defend:
It is not a debate about rational expectations in the abstract, but about a choice between different ways of modelling expectations, none of which will be ideal. This choice has to involve feasible alternatives, by which I mean theories of expectations that can be practically implemented in usable macroeconomic models …
However for the foreseeable future, rational expectations will remain the starting point for macro analysis, because it is better than the only practical alternative.
And a couple of months later it was the concept of non-accelerating inflationary rate of unemployment (NAIRU) he tried to defend:
If we really think there is no relationship between unemployment and inflation, why on earth are we not trying to get unemployment below 4%? We know that the government could, by spending more, raise demand and reduce unemployment. And why would we ever raise interest rates above their lower bound? …
There is a relationship between inflation and unemployment, but it is just very difficult to pin down. For most macroeconomists, the concept of the NAIRU really just stands for that basic macroeconomic truth.
This was followed up a couple of days later with another post:
The second [reflection] relates to the sharp reactions to my original post I noted at the start, and the hostility displayed by some heterodox economists (I stress some) to the concept. I have been trying to decide what annoys me about this so much. I think it is this. The concept of the NAIRU, or equivalently the Phillips curve, is very basic to macroeconomics. It is hard to teach about inflation, unemployment and demand management without it. Those trying to set interest rates in independent central banks are, for the most part, doing what they can to find the optimal balance between inflation and unemployment.
Well, Wren-Lewis is — sad to say, but still — totally wrong on both issues.
REH
Wren-Lewis doesn’t appreciate heterodox critiques of the rational expectations hypothesis. And he seems to be especially annoyed with yours truly, who “does write very eloquently,” but only “appeal to the occasional young economist, who is inclined to believe that only the radical overthrow of orthodoxy will suffice.”
If at some time my skeleton should come to be used by a teacher of osteology to illustrate his lectures, will his students seek to infer my capacities for thinking, feeling, and deciding from a study of my bones? If they do, and any report of their proceedings should reach the Elysian Fields, I shall be much distressed, for they will be using a model which entirely ignores the greater number of relevant variables, and all of the important ones. Yet this is what ‘rational expectations’ does to economics.
G. L. S. Shackle
Since I have already put forward a rather detailed theoretical-methodological critique of the rational expectations hypothesis elsewhere — Rational expectations – a fallacious foundation for macroeconomics in a non-ergodic world — I’m not going to recapitulate the arguments here, but rather limit myself to elaborate on a couple of the rather unwarranted allegations Wren-Lewis has put forward in his repeated attempts at rescuing the rational expectations hypothesis from the critique.
In macroeconomic rational expectations models the world evolves in accordance with fully predetermined models where uncertainty has been reduced to stochastic risk describable by some probabilistic distribution.
The tiny little problem that there is no hard empirical evidence that verifies these models doesn’t usually bother its protagonists too much. Rational expectations überpriest Thomas Sargent — often favourably mentioned by Wren-Lewis — has the following to say on the epistemological status of the rational expectations hypothesis (emphasis added):
Partly because it focuses on outcomes and does not pretend to have behavioral content, the hypothesis of rational epectations has proved to be a powerful tool for making precise statements about complicarted dynamic economic systems.
Precise, yes, but relevant and realistic? I’ll be dipped!
In his attempted rescue operations Wren-Lewis tries to give the picture that only heterodox economists like yours truly are critical of the rational expectations hypothesis. But, on this, he is, simply, eh, wrong. Let’s listen to Nobel laureate Edmund Phelps — hardly a heterodox economist — and what he has to say (emphasis added):
Q: So how did adaptive expectations morph into rational expectations?
A: The “scientists” from Chicago and MIT came along to say, we have a well-established theory of how prices and wages work … The [rational expectations] approach is to suppose that the people in the market form their expectations in the very same way that the economist studying their behavior forms her expectations: on the basis of her theoretical model.
Q: And what’s the consequence of this putsch?
A: Craziness for one thing. You’re not supposed to ask what to do if one economist has one model of the market and another economist a different model. The people in the market cannot follow both economists at the same time. One, if not both, of the economists must be wrong …
Just as when it comes to NAIRU, Wren-Lewis doesn’t want to take a theoretical discussion about rational expectations as a modelling tool. So let’s see how it fares as an empirical assumption. Empirical efforts at testing the correctness of the hypothesis have resulted in a series of empirical studies that have more or less concluded that it is not consistent with the facts. In one of the more well-known and highly respected evaluation reviews made, Michael Lovell (1986) concluded:
it seems to me that the weight of empirical evidence is sufficiently strong to compel us to suspend belief in the hypothesis of rational expectations, pending the accumulation of additional empirical evidence.
The rational expectations hypothesis presumes consistent behaviour, where expectations do not display any persistent errors. In the world of rational expectations, we are always, on average, hitting the bull’s eye. In the more realistic, open systems view, there is always the possibility (danger) of making mistakes that may turn out to be systematic. It is because of this, presumably, that we put so much emphasis on learning in our modern knowledge society.
NAIRU
Wren-Lewis is not the only economist that subscribes to the NAIRU story and its policy implication that attempts to promote full employment are doomed to fail since governments and central banks can’t push unemployment below the critical NAIRU threshold without causing harmful runaway inflation.
But one of the main problems with NAIRU is that it essentially is a timeless long-run equilibrium attractor to which actual unemployment (allegedly) has to adjust. But if that equilibrium is itself changing — and in ways that depend on the process of getting to the equilibrium — well, then we can’t really be sure what that equilibrium will be without contextualizing unemployment in real historical time. And when we do, we will see how seriously wrong we go if we omit demand from the analysis. Demand policy has long-run effects and matters also for structural unemployment — and governments and central banks can’t just look the other way and legitimize their passivity re unemployment by referring to NAIRU.
Wren-Lewis tries to escape this important problem by trivialising the NAIRU concept into the platitude “there is a relationship between inflation and unemployment.” But that is just looking the other way, instead of trying to heed the theoretically central question: if (the mythical) NAIRU is continually moving, how can it be consistently conceptualised as an attractor?
The existence of a long-run equilibrium is a very handy modelling assumption to use. But that does not make it easily applicable to real-world economies. Why? Because it is basically a timeless concept utterly incompatible with real historical events. In the real world, it is the second law of thermodynamics and historical — not logical — time that rules.
This importantly means that long-run equilibrium is an awfully bad guide for macroeconomic policies. In a world full of genuine uncertainty, multiple equilibria, asymmetric information and market failures, the long run equilibrium — including NAIRU — is simply a non-existent unicorn.
In celestial mechanics, we have a gravitational constant. In economics there is none. NAIRU does not hold water simply because it does not exist — and to base economic policies on such a weak theoretical and empirical construct is nothing short of writing out a prescription for self-inflicted economic havoc.
NAIRU is — whatever Wren-Lewis tries to make us think — a useless concept, and the sooner we bury it, the better.
ROMER
As if this wasn’t enough, Wren-Lews — of course — felt the urge to ride out and defend mainstream economics against the critique put forward by Paul Romer a couple of years ago. In a highly emotional blog post Wren-Lewis argued that Romer’s critique was
unfair and wide of the mark in places … Paul’s discussion of real effects from monetary policy, and the insistence on productivity shocks as business cycle drivers, is pretty dated … Yet it took a long time for RBC models to be replaced by New Keynesian models, and you will still see RBC models around. Elements of the New Classical counter revolution of the 1980s still persist in some places … The impression Paul Romer’s article gives, might just have been true in a few years in the 1980s before New Keynesian theory arrived. Since the 1990s New Keynesian theory is now the orthodoxy, and is used by central banks around the world.
Now this rather unsuccessful attempt to disarm the real force of Romer’s critique should come as no surprise to us.
In his paper Unravelling the New Classical Counter Revolution Wren-Lewis writes approvingly about all the ‘impressive’ theoretical insights New Classical economics has brought to macroeconomics:
The theoretical insights that New Classical economists brought to the table were impressive: besides rational expectations, there was a rationalisation of permanent income and the life-cycle models using intertemporal optimisation, time inconsistency and more …
A new revolution, that replaces current methods with older ways of doing macroeconomics, seems unlikely and I would argue is also undesirable. The discipline does not need to advance one revolution at a time …
To understand modern academic macroeconomics, it is no longer essential that you start with The General Theory. It is far more important that you read Lucas and Sargent (1979), which is a central text in what is generally known as the New Classical Counter Revolution (NCCR). That gave birth to DSGE models and the microfoundations programme, which are central to mainstream macroeconomics today …
There’s something that just does not sit very well with this picture of modern macroeconomics.
‘Read Lucas and Sargent (1979)’. Yes, why not. That is exactly what Romer did!
To Wren-Lewis is seems as though the ‘New Keynesian’ acceptance of rational expectations, representative agents and microfounded DSGE models is something more or less self-evidently good. Not all economists (yours truly included) share that view:
Given the fundamental philosophical problems presented for the use of DSGE models for policy simulation, namely the fact that a number of parameters used have completely implausible magnitudes and that the degree of freedom for different parameters is so large that DSGE models with fundamentally different parametrization (and therefore different policy conclusions) equally well produce time series which fit the real-world data, it is also very hard to understand why DSGE models have reached such a prominence in economic science in general.
Neither New Classical nor ‘New Keynesian’ microfounded DSGE macro models have helped us foresee, understand or craft solutions to the problems of today’s economies.
Wren-Lewis ultimately falls back on the same kind of models that he criticize, and it would sure be interesting to once hear him explain how silly assumptions like ‘hyperrationality’ and ‘representative agents’ help him work out the fundamentals of a truly relevant macroeconomic analysis.
These are some of my arguments for why I think that Simon Wren-Lewis ought to be critical of the present state of macroeconomics — including ‘New Keynesian’ macroeconomics. If macroeconomic models – no matter of what ilk – build on microfoundational assumptions of representative actors, rational expectations, market clearing and equilibrium, and we know that real people and markets cannot be expected to obey these assumptions, the warrants for supposing that conclusions or hypothesis of causally relevant mechanisms or regularities can be bridged, are obviously non-justifiable. Trying to represent real-world target systems with models flagrantly at odds with reality is futile. And if those models are New Classical or ‘New Keynesian’ makes very little difference.
Given what Wren-Lewis has been writing over the last couple of years I can’t see anything unfair — or ‘pathetic’ — in portraying his position as someone who “obviously shares the view that there is nothing basically wrong with ‘standard’ theory.”