by From Lars Syll Again and again, Oxford professor Simon Wren-Lewis rides out to defend orthodox macroeconomic theory against attacks from ‘heterodox’ critics like yours truly. A couple of years ago, it was the rational expectations hypothesis (REH) he wanted to save: 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 now it is the concept of non-accelerating inflationary rate of unemployment (NAIRU) he tries to save. A couple of weeks ago he wrote: 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.
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from Lars Syll
Again and again, Oxford professor Simon Wren-Lewis rides out to defend orthodox macroeconomic theory against attacks from ‘heterodox’ critics like yours truly.
A couple of years ago, it was the rational expectations hypothesis (REH) he wanted to save:
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 now it is the concept of non-accelerating inflationary rate of unemployment (NAIRU) he tries to save. A couple of weeks ago he wrote:
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.
And he followed this 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 …
Q: So rather than live with variability, write a formula in stone!
A: What led to rational expectations was a fear of the uncertainty and, worse, the lack of understanding of how modern economies work. The rational expectationists wanted to bottle all that up and replace it with deterministic models of prices, wages, even share prices, so that the math looked like the math in rocket science. The rocket’s course can be modeled while a living modern economy’s course cannot be modeled to such an extreme. It yields up a formula for expectations that looks scientific because it has all our incomplete and not altogether correct understanding of how economies work inside of it, but it cannot have the incorrect and incomplete understanding of economies that the speculators and would-be innovators have …
Q: The economics profession, including Federal Reserve policy makers, appears to have been hijacked by Robert Lucas.
A: You’re right that people are grossly uninformed, which is a far cry from what the rational expectations models suppose. Why are they misinformed? I think they don’t pay much attention to the vast information out there because they wouldn’t know what to do what to do with it if they had it. The fundamental fallacy on which rational expectations models are based is that everyone knows how to process the information they receive according to the one and only right theory of the world. The problem is that we don’t have a “right” model that could be certified as such by the National Academy of Sciences. And as long as we operate in a modern economy, there can never be such a model.
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 correctnes of the hypothesis has 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 is 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 equlibrium 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 refering 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 modeling 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.
The conventional wisdom, codified in the theory of the non-accelerating-inflation rate of unemployment (NAIRU) … holds that in the longer run, an economy’s potential growth depends on – what Milton Friedman called – the “natural rate of unemployment”: the structural unemployment rate at which inflation is constant …
We argue in our book Macroeconomics Beyond the NAIRU that the NAIRU doctrine is wrong because it is a partial, not a general, theory. Specifically, wages are treated as mere costs to producers. In NAIRU, higher real-wage claims necessarily reduce firms’ profitability and hence, if firms want to protect profits (needed for investment and growth), higher wages must lead to higher prices and ultimately run-away inflation. The only way to stop this process is to have an increase in “natural unemployment”, which curbs workers’ wage claims.
What is missing from this NAIRU thinking is that wages provide macroeconomic benefits in terms of higher labor productivity growth and more rapid technological progress …
NAIRU wisdom holds that a rise in the (real) interest rate will only affect inflation, not structural unemployment. We argue instead that higher interest rates slow down technological progress – directly by depressing demand growth and indirectly by creating additional unemployment and depressing wage growth.
As a result, productivity growth will fall, and the NAIRU must increase. In other words, macroeconomic policy has permanent effects on structural unemployment and growth – the NAIRU as a constant “natural” rate of unemployment does not exist.
This means we cannot absolve central bankers from charges that their anti-inflation policies contribute to higher unemployment. They have already done so. Our estimates suggest that overly restrictive macro policies in the OECD countries have actually and unnecessarily thrown millions of workers into unemployment by a policy-induced decline in productivity and output growth. This self-inflicted damage must rest on the conscience of the economics profession.
