Bookblogging: What next for macroeconomics ?

It’s been slow going, but I’ve finally finished the draft chapter of my book-in-progress that looks forward to a new research program for macroeconomics, an absurdly ambitious task, but one that needs to be tackled. Of course, what I’ve written isn’t fundamentally new – it’s a distillation of points that Old Keynesians, post-Keynesians and some behavioral economists have been putting forward for a while. But I hope I’ve got some positive contribution to make. More than ever, comments are much appreciated.

Update In response to comments, mostly at Crooked Timber, I’ve fairly substantially revised the section on “avoiding stagflation”. While I don’t back away from the points I made previously, I took for granted some things that I’d mentioned in other places in the book. The result made for a fairly unbalanced treatment with an excessive focus on the role of labor militancy. I’ve now tried to put this into proper context. I don’t expect that will satisfy everybody, but this is closer to what I meant to say all along.End update

What next ?

The economics of the textbooks seeks to minimise as much as possible departures from pure economic motivation and from rationality. There is a good reason for doing so – and each of us has spent a good portion of his life writing in this tradition. The economics of Adam Smith is well understood. Explanations in terms of small deviations from Smith’s ideal system are thus clear, because they are posed within a framework that is already very well understood. But that does not mean that these small deviations from Smith’s system describe how the economy actually work. Our book marks a break with this tradition. In our view, economic theory should be derived not from the minimal deviations from the system of Adam Smith but rather from the deviations that actually do occur and can be observed. Animal Spirits, Akerlof and Shiller

It was reading this passage in Animal Spirits, and posting about its implications for macroeconomics in the Crooked Timber blog, that led to the writing of this book. A commenter suggest that this, and some earlier posts, would make a good book, Brad DeLong of UC Berkeley picked the idea up and the result is before you.

Animal Spirits was mostly written before, or in the early stages of, the Global Financial Crisis, but the Crisis has made its central point more important than ever. For many years economists have worked like the anecdotal drunk who searches for his dropped keys under a lamppost because the light is better there. In the future, and particularly in macroeconomics, economists need to start looking where the keys are, and try to build tools that will improve the chances of success.

This does not mean abandoning all the work of the past thirty years and returning to old-style Keynesianism. But it does mean starting from the traditional Keynesian perspective that a general macroeconomic theory must encompass the reality of booms and slumps, and, particularly of sustained periods of high unemployment that cannot be treated as marginal and temporary deviations from general equilibrium. We must model a world where people display multiple and substantial violations of the rationality assumptions of microeconomic theory and where markets depend not only on prices, preferences and profits but on complicated and poorly understood phenomena like trust and perceived fairness.

First, the program needs more realistic microfoundations. As Akerlof and Shiller observe, we need to look at how people actually behave, and how this behavior contributes to the performance of the economy as a whole.

Second, we need to reconsider the concept of equilibrium. The whole point of Keynes “General Theory” was that the market-clearing equilibrium analysed by the classical economists, and central to DSGE models, was not the only possible equilibrium. An economy can settle for long periods in a low-output, high-unemployment state that may not meet the neoclassical definition of equilibrium, but does match the original concept, borrowed from physics of a state in which the system tends to remain and to which it tends to return. More importantly, perhaps, we need a theory which encompasses crises, and rapid jumps between one kind of equilibrium and another. Ideally this will combine ‘old Keynesian’ analysis of economic imbalances with a Minsky-style focus on financial instability.

Between these two levels, we need to consider the fact that the economy is not a simple machine for aggregating consumer preferences, and allocating resources accordingly. The economy is embedded in a complex social structure, and there is a continuous interaction between the economic system and society as a whole. Phenomena like ‘trust’ and ‘confidence’ are primarily social, but they affect, and are affected by the performance of the economic system.

Finally, now that Keynesian macroeconomic policy has re-emerged as a practical tool, we need to reconsider the real and perceived failures of the past, and in particular the emergence of stagflation in the 1960s. If the revival of Keynesian policy is to be sustained, it must provide not only an emergency response to the present crisis but a set of tools that can deliver sustained non-inflationary growth.

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Better microfoundations ?

It is now generally accepted that people are not, and cannot be, the infinitely foresightful, unbounded rational utility maximizers described by the axioms of dynamic stochastic general equilibrium theory. On the contrary, economic behavior, even that of highly sophisticated actors like the ‘rocket scientists’ who design financial instruments for investment banks, is inevitably driven by a partial view of the world, with heuristics and unconsidered assumptions inevitably playing a crucial role. For finite beings in a world of boundless possibilities, nothing else is possible.

The problem for a new macroeconomics is not so much a failure of economists to understand this point as an embarrassment of riches. Several decades of research in behavioral economics, non-expected utility decision theory and other fields have demonstrated, to anyone willing to look, a wide variety of ways in which real economic behavior differs from the neoclassical ideal. The problem is to focus on behavioral foundations that are most relevant to the problems of macroeconomics.

An obvious place to start is with attitudes to risk and uncertainty. Keynes himself wrote extensively in this topic, and was highly sceptical of the ideas that led to the emergence of the now-dominant expected utility theory (the first formal exposition, von Neumann and Morgenstern’s classic Theory of Games and Economic Behavior was published in 1994 only two years before Keynes’ death. The starting point for expected utility was the idea that people can, and should, reason about uncertainty on the basis of their perceived probability of relevant events such as an increase in interest rates or a slump in exports.

“By `uncertain’ knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty…The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence…About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.” (J.M. Keynes, 1937)

Post-Keynesian economists like Davidson and Shackle argued, that this fundamental uncertainty was central to Keynes’ thought and that it had been ignored as part of the development of the Keynesian-neoclassical synthesis. But, as with so many ‘heterodox’ schools of economic thought, the post-Keynesians were much stronger on critique than on the development of a coherent and usable alternative. Shackle in particular ended up denying that we can know anything about probability, even in such simple cases as the toss of a coin, a nihilistic view that was never likely to convince many.

Davidson took the critique in more productive directions and did some valuable work on the way in which attitudes to uncertainty affect individuals demand to hold money, which play a crucial role in Keynes theory of the ‘liquidity trap’, a situation where even at interest rates of zero, investors and households would prefer to save rather than invest.

Mainstream Keynesians, such as James Tobin, had also developed the idea that liquidity preference could be seen as a reflection of risk attitudes. Tobin’s analysis, was developed using the standard financial portfolio analysis based on the idea that the investment involves trading off mean returns against measures of riskiness such as the variance, which depend on the assumption that we can always formulate sensible probabilities for events. Although Tobin himself was always highly critical of the irrational behavior of financial markets, his analysis was easily restated in terms of expected utility theory and absorbed into models based on the efficient financial markets hypothesis.

Over the past thirty years, however, a huge body of research has shown that people do not always make choices in line with the requirements of expected utility, and a great many models of choice under uncertainty have been developed over the past thirty years to produce more realistic representation of behavior. Probably the most famous is the prospect theory of Kahneman and Tversky, put forward in 1979, which earned Kahneman a Nobel prize in economics and Tversky a rare posthumous mention.

My own academic career got its start with a paper published a couple of years later, giving a tweak to the idea of probability weighting by showing that the model worked better if low-probability extreme events (large gains and large losses) were overweighted, while events leading to intermediate outcomes were overweighted. Kahneman and Tversky incorporated this idea in a revised version of their original model, called cumulative prospect theory.

What specific features of a more general and realistic model of choice under uncertainty might contribute usefully to a renewal of Keynesian macroeconomics? There are at least two obvious examples. First, there is the problem of unknown unknowns, which is also, and not coincidentally, a critical problem for the efficient markets hypothesis. An obvious feature of economic crises is that people are forced to consider contingencies they might previously have disregarded, such as the possibility that their employer, or their bank might fail, or that currency might rapidly lose its value. When such a contingency suddenly enters the minds of many people, large macroeconomic shocks may result.

Second, as I’ve already mentioned, although people fail to consider some low-probability extreme contingencies, they tend (perhaps in compensation) to overweight those they do consider. It is this fact that keeps the sellers of lottery tickets and air crash insurance in business. In the macroeconomic context, a ‘normal’ situation in which people disregard or at least do not account for the risk of a serious recession may suddenly be replaced by a far more pessimistic outlook in which the same people place a high weight on the possibility of total economic collapse. Unsurprisingly, such a change in ‘animal spirits’ may represent a self-fulfilling prophecy. If a lot of people expect a recession and try to increase savings and reduce investment, these defensive actions may bring about the recession against which they are designed to guard.

Of course, awareness of this fact will do nothing to moderate the potential impact; if anything the reverse. People who are suddenly worried about a recession will not, if they are looking to their own well-being, keep spending in the hope that others will do likewise and thereby keep the economy afloat. Rather they will reason that others are likely to think as they do, and that a recession is even more probable than the objective evidence would suggest.

Keynes talked about such phenomena in terms of ‘animal spirits’. Such notions seemed hopelessly old-fashioned in the light of the development of rigorous models of choice under uncertainty based on the elegant axioms of expected utility theory, the apparent success of the theory in explaining a wide range of economic behavior and the dominance of the efficient markets hypothesis. But as the evidence against these models has mounted, the pendulum has swung. The idea of animal spirits has been revived in by George Akerlof and Robert Shiller in a recent book of the same name.

Akerlof and Shiller consider five deviations from the standard model of rational maximization (confidence/trust, fairness, corruption, money illusion and stories) and argue that some combination of these can be used to explain a range of economic outcomes inconsistent with the standard model. Their discussion makes a compelling case that macroeconomics needs new, and more realistic foundations.

If the prospects for a macroeconomic analysis based on alternatives to expected utility theory are so promising, why has so little work been done along these lines? In part, perhaps, this simply reflects the effects of specialisation. Decision theorists focus on individual choices, and when they seek economic applications, this leads them naturally to look at microeconomic problems (that’s certainly true in my own case).

But there is a more fundamental problem. Individuals who satisfy the conditions of expected utility theory display a property called ‘dynamic consistency’ which, as the name suggests is of fundamental importance in dynamic stochastic general equilibrium models. Dynamically consistent economic agents never change their view of the world in any fundamental way. They respond to new information by changing their subjective probabilities for particular events, but they never change their underlying prior beliefs and preferences about the world. That means, in particular, that they can fully anticipate how they will respond to any possible future situation, and would never wish to change their mind about this, or to ‘lock themselves in’ to a course of action they might be unwilling to carry through when the time comes.

Such consistency is admirable (at least in the eyes of decision theorists) and makes it much easier to obtain well-defined solutions for dynamic stochastic general equilibrium models. But it is far from realistic. It turns out, however, that the decisions predicted by such models always display dynamic inconsistency under certain circumstances. This problem has been the subject of considerable controversy on the rare occasions when economists have sought to introduce non-expected utility preferences into macroeconomic theory (as with the robust control theory of Hansen and Sargent.

From the neoclassical viewpoint that dominates modern macroeconomics, the absence of a coherent dynamic equilibrium concept seems like a fatal objection. But from a Keynesian perspective, and on the basis of real world experience, this is a positive, indeed necessary, feature of a sensible macroeconomic model. The fundamental macroeconomic problem is precisely that an economy that seems to be enjoying an equilibrium path of steady growth can suddenly crash or veer off into an unsustainable boom.

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Aggregate models and equilibrium

If there is one thing that distinguished Keynes’ economic analysis from that of this predecessors it was the rejection of the idea of a unique full employment equilibrium to which a market economy will automatically return when it experiences a shock. Keynes argued that an economy could shift from a full-employment equilibrium to a persistent slump as the result of the interaction between objective macroeconomic variables and the subjective ‘animal spirits’ of investors and other decisionmakers. It is this perspective that has been lost in the absorption of New Keynesian macro into the DSGE framework.

The revival of notions like ‘animal spirits’ by leading economists such as Akerlof and Shiller offers the potential to revive these fundamental Keynesian insights. But this is not simply a matter of modifying the way we model individual behavior Phenomena like animal spirits, social trust and business confidence can’t be reduced to individual psychology. They arise from economic and social interactions between people.

It’s precisely for this reason that such social aspects of individual psychology are likely to be associated with multiple equilibria in the real economy. The aggregate level of trust and confidence in an economy cannot be derived by simply adding up individual values in the way in which DSGE models aggregate consumer preferences.

As long as particular assumptions are implicitly taken for granted in a given social group, such as the business community, few members of that group are likely to consider the possibility that these assumptions might fail. Evidence against those assumptions will be ignored or explained away. So, for example, the spectacular examples of market irrationality and business corruption exhibited during the dotcom boom and bust did almost nothing to shake the faith of business and political leaders in the efficiency and stability of financial markets. This faith remained strong even as the evidence of fundamental problems grew through 2007 and early 2008. Then, in the space of a few months this confidence collapsed to be replaced by a panic in which even the most reputably financial institutions would not lend to each other, and instead threw themselves on the protection of the national governments they had previously dismissed as obsolete relics.

A realistic macroeconomics requires the incorporation of variables like trust and confidence in explanatory models. Fluctuations between ‘irrational exuberance’ and equally irrational ‘panics’ (this old term for a financial crisis is in many ways more useful than the technical language of ‘recessions’) give rise to bubbles and busts, which in turn drive much of the macroeconomic cycle. The insights of behavioral economics provide good reasons to expect such fluctuations, but they do not, at least as yet, admit the kind of rigorous derivation of aggregate values from individual preferences that is referred to in the standard demand for ‘microfoundations’.

Expressed in the language of systems theory, the traditional Keynesian approach treated macroeconomic behavior as an emergent property of the economic system, to be analysed in their own terms rather than being derived from supposedly more ‘fundamental’ microeconomic explanations. [1] In a world of boundedly rational economic decisionmakers, and, for that matter, boundedly rational economists, we need to simplify and the simplifications that are appropriate for doing macroeconomics may not be the same as those that are appropriate in microeconomics.

Obviously, it’s much easier to announce a new program for macroeconomics than to actually implement it. To give some more concreteness to the general proposals presented here, it’s worth thinking about some specific problems, such as bubbles and the ‘Minsky moments’ in which they burst.

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Bubbles and Minsky moments

Macroeconomists working in the micro-economic foundations framework did not ignore bubbles. Far from it. Dozens of papers were written on the possibility or otherwise of self-sustaining bubbles in asset markets. But, characteristically, the central concern was to determine whether or not bubbles could arise in markets with market participants who were perfectly rational, or nearly so. This focus on microeconomic foundations diverted attention from the real issues.

There was a rather smaller policy oriented literature, concerned with the question of whether central banks should intervene to prevent the emergence of bubbles, or to burst them early, before they became too damaging. Most of this literature followed the lead of Alan Greenspan, who initially showed some sympathy for the idea of intervention, but eventually became the strongest advocate of the view that central banks should not second-guess markets. But even interventionist participants in the discussion took it for granted that an anti-bubble policy had to be implemented within a policy framework of inflation targeting using interest rates as the sole policy instrument. With these constraints, the conclusion that nothing could or should be done was largely inevitable.

A realistic theory of bubbles would start with the observation that every bubble has a story to explain why, in the words of …, ‘this time it’s different’. And, for particular assets and markets, sometimes it is different. Those who got in early with shares in Microsoft or Google, or with land in … in … multiplied their money many times over. And although the days of spectacular growth came to an end in each case, there was no bursting of the bubble ending in losses all around.

So a theory of bubbles designed to inform a policy of bubble-pricking must begin with an attempt to understand how ‘this time it’s different’ stories emerge and come to be believed and how to distinguish true, or at least plausible, stories from those that involve a collective abandonment of reality. The story-telling aspect of animal spirits discussed by Akerlof and Shiller is important here.

Given a better understanding of bubbles it may be possible to develop an analysis of the costs and benefits of pricking putative bubbles. Such a policy reduces the damage from spectacular busts such as the one we have just seen, but it would require a willingness on the part of central banks to explicitly over-ride the judgements of capital markets, rather than merely ‘leaning against the wind’ by raising interest rates.

An uncontrolled bubble must eventually burst, and the bursting of a bubble is a prime example of a ‘Minsky moment’, when euphoria suddenly turns to panic. In Minsky’s model there are three classes of financial enterprises – conservative ‘hedge’ financiers whose operations generate sufficient income to service their capital costs, speculative financiers who rely on rising asset prices to service debt and who drive the market further upwards, and ‘Ponzi financiers’ cover their costs in either the short term or the long term, but who can conceal their insolvency long enough to reap substantial gains. Ponzi operators fail from time to time, but, in periods of growth, these failures are seen as isolated events of no general significance. However, in the later stages of a bubble, when a large proportion of economic activity has been devoted to speculative finance, the failure of a Ponzi financier can bring about a sudden shift in sentiment, as investors fear that the associated corruption is widespread. The rush to withdraw extended credit brings about more failures, not only of Ponzi financiers but of the speculative finance firms that relied on continued growth.

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Avoiding stagflation

Avoiding stagflation

The last Keynesian golden age ended in stagflation. The causes of this breakdown are many and complex, but they must be addressed if we are to avoid repeating them. In particular, it is important to avoid relying on easy excuses, such as the 1973 oil shock and to face the fact that the stagflationary breakdown reflected serious failures in the dominant version of Keynesian macro theories, and in the political and industrial strategies of the social democratic, left and labour movements. These failures were amplified by the expansion, from very small beginnings, of a global financial system that broke down the institutional framework of the Bretton Woods agreement.

The discovery of the Phillips Curve around 1960, and the general success of Keynesian macroeconomic policies in the postwar period produced increasing support for policies of fiscal expansion aimed at reducing already low levels of unemployment even further, and an acceptance of higher rates of inflation and sustained budget deficits as a reasonable price to pay. This intellectual atmosphere fitted in neatly with the political needs of the Johnson Administration in the US, which sought to implement both an expensive (but initially quite successful) set of welfare programs dubbed the War on Poverty and an actual, if undeclared, war in Vietnam, while avoiding the political opprobrium of raising taxes. There were similar developments in other countries as pressure to expand the welfare state ran into the first elements of resistance that would later become the Tax Revolt of the 1970s.

In the short run at least, expansionary fiscal policies resolved these problems, and an expansionary fiscal stance became accepted as the norm. This contrasted with the older Keynesian approach where expansionary policies used to stimulate the economy out of recessions and depressions were balanced by contractionary policies aimed at controlling overheated booms.

From the late 1960s onwards, rates of wage and price inflation rose steadily. Throughout society, the combination of (seemingly permanent) full employment and economic growth with inflationary pressure led to the abandonment of attitudes of restraint that had, until then, been engendered by memories of the Great Depression and fears of a new one. Business leaders ceased to be the sober, socially-minded, technocrats described in works like JK Galbraith’s New Industrial State and started on the path that would lead to the lionization of figures like ‘Chainsaw Al’ Dunlap and Jack Welch.

Financial markets shook off the memories of the Great Crash and became, once again, places where vast fortunes could be made from abstruse transactions. Most attention was focused on stock markets, which went through their first real boom since the 1920s. More significant in the long run was the (re)emergence of an uncontrolled global financial market. This began, with the creation of the ‘Eurodollar’ market, in which mostly European banks located outside the regulatory control of the US dealt in dollar-denominated securities, with liquidity provided by the shift of the US balance of payments from a century old pattern of surpluses to an almost equally durable string of deficits. in one of history’s ironies, the most important single player in the early years was Moscow’s Narodny Bank, which faced increasingly pressing needs for access to Western financial markets and an equally pressing imperative to avoid the control of US authorities.

But the most striking manifestation of the inflationary breakout took place in labour markets. There was an explosion of labour militancy, reflected in an upsurge in strikes and in wage demands that could not be met except through continuing inflation. Even without the militant push, low unemployment would have strengthened the bargaining power of unions and put upward pressure on wages. But the revolutionary utopianism of the 1960s, exemplified by the events of May 1968 in Paris, produced an atmosphere where any kind of restraint became impossible. Unions that sought to focus on realistic and sustainable demands were pushed aside by their own members.

By 1973, after the breakdown of the Bretton Woods system and a failed attempt by the Nixon Administration to halt inflation through a wage-price freeze, the era of Keynesian dominance was drawing to a close. The coup de grace came in October of that year when, in response to US support for Israel in the Yom Kippur war, the members of the Organization of Petroleum Exporting Countries first cut off oil supplies to the West, then raised prices fourfold.

The oil shock was a consequence, not a cause of the inflationary upsurge. Commodity prices were rising sharply across the board well before this event. However, the structure of the oil market, with a small group of oil companies (called the ‘Seven Sisters’) facing an increasingly well-organized OPEC meant that, when the price shift came, it took the form of a single dramatic leap. And, having been caused by stagflation, the oil shock amplified and entrenched it in the economic system, leading to decades of high unemployment and persistent inflation.

The stagflationary outbreak took a heavy toll on the Keynesian social-democratic welfare state and the organizations and ideas associated with it. In particular, the great wage push was disastrous for both for the unions and for the Keynesian/social democratic system. The seemingly-continuous strikes of the 1970s undermined popular support for unions and paved the way for a series of ever-more brutal assaults by governments and employers. Margaret Thatcher’s crushing victory over the National Coal Miners and Ronald Reagan’s equally successful action in firing striking air traffic controllers en masse brought an end to the idea that strikes represented a reliable route to improved wages and conditions, let alone to the collapse of the capitalist system. Particularly in the English-speaking world, union membership dropped rapidly as new laws made it easy for employers to keep unions out.

Keynesian economists were discredited and driven from positions of power by monetarist and new classical rivals. Only by making the massive theoretical and policy concessions involved in New Keynesianism were they able to regain a seat at the table.

Meanwhile, the financial sector, which had precipitated the crisis claimed victory, as did the economists who extolled its merits. Stagflation was seen as a demonstration that attempts to resist the logic of the market must ultimately fail. It took several decades to relearn the Keynesian lesson that an uncontrolled financial system will fail even more disastrously

The inflationary surge that began the late 1960s has some important lessons that must be learned if we are to avoid similar failures in the future. First, it is important to maintain a focus on keeping inflation rates low and stable as well as on maintaining full employment. Once inflation rates get signficantly above 3 per cent per year, the risk of embedding inflationary expectations, and the eventual cost of lowering those expectations, becomes greater. It is therefore important to maintain a commitment to low inflation and to adopting the policies necessary to contain and reduce inflation when some shock to the system produces a significant increase in the price level.

At a theoretical level, this does not involve huge modifications to the standard Keynesian view. The idea of a stable long-run trade-off between unemployment and inflation, represented by the Phillips curve, was a relatively late addition, and quickly abandoned. But the problem of how to deal with inflation remains largely unresolved.

In policy terms, inflation can’t be reduced unless macroeconomic policy acts to constrain excess demand and liquidity. So Keynesian policies must be used consistently throughout the cycle, to reduce excess demand in boom periods as well as stimulating demand during recessions.

This still leaves the problem of what to do if high inflation becomes established. A number of countries showed, in the 1980s and 1990s, that a co-operative approach could reduce inflation and unemployment simultaneously. In Australia, following a deep recession in the early 1980s, the newly elected Hawke Labor government reached an agreement with the trade unions referred to as ‘The Accord’. Under the Accord, unions agreed to reduce the rate of growth of wages in return for an increase in the social wage, most notably the introduction of a national system of health insurance, called Medicare.

At about the same time, and facing similar problems, unions and employer groups in the Netherlands negotiated the Wassenaar agreement. In this case, the trade-off for wage moderation was a reduction in working hours and the adoption of a range of measures designed to promote employment growth. The Wassenaar approach survived the stresses of the early 1990s and, according to the ILO was “a ground breaking agreement, setting the tone for later social pacts in many European countries.”

The co-operative approach that motivated these policies was ultimately swept away by the ever-growing power of the financial sector. But, if a Keynesian policy framework is to be successful, it must be revived. Hopefully, the memory of past disasters will promote a more cautious and co-operative approach in future.

[1] Unfortunately, discussion of these ideas tends to get bound up in more or less mystical claims and counterclaims about reductionism and holism. But nothing of that kind is intended here. In principle, without doubt, all social phenomena are determined by interactions between individual people, whose behavior is in turned determined by their genes and the environment in which they grew up. Genes are collections of DNA molecules which in turn are made up of atoms made up of subatomic particles behaving according to the laws of quantum physics. If we were the unboundedly rational individuals posited in the DGSE literature, , such we would presumably be doing quantum physical calculations whenever we made economic decisions.

86 thoughts on “Bookblogging: What next for macroeconomics ?

  1. “My own academic career got its start with a paper published a couple of years later, giving a tweak to the idea of probability weighting by showing that the model worked better if low-probability extreme events (large gains and large losses) were overweighted, while events leading to intermediate outcomes were overweighted. Kahneman and Tversky incorporated this idea in a revised version of their original model, called cumulative prospect theory.”

    See above. Probably a typo in here. I suppose that the second ‘overweighted’ must be ‘underweighted’

  2. ” von Neumann and Morgenstern’s classic Theory of Games and Economic Behavior was published in 1994 only two years before Keynes’ death”

    You need to rewind 50 years.

  3. Good stuff.

    In the lead-up to lending drying up for business and b/n banks, the US may be a good case study into how the credit-crunch evolved and what the big players were thinking as they moved towards a situation of everyone being too afraid to lend to each other. Since only a few too-big-to-fail institutions exist(ed) in the US, it may be feasible to get data concerning motivations and subsequent behaviour of individuals working for these institutions.

  4. I find your argument that low inflation/full employment equilibrium can be maintained via negotiation is based on a few historical examples and assume that the unions are non-militant and represent massive amounts of private and public sector workers.

    If you look at the United Kingdom with this massive recession, you will see that unemployment has not risen nearly as high as in the 1990s and 1980s. One key reason that has been sighted is the negotiation between employers and employees to reduce the number of days worked in a week. However this applies to the private sector which is not experiencing the type of broad-based union coverage that you would wish. It is a one-on-one agreement by the employer bypassing unions.

    I think that your solution shows your political bias.

  5. Probably not intended, but

    The last Keynesian golden age ended in stagflation. From the late 1960s onwards, rates of wage and price inflation rose steadily. There was an explosion of labour militancy, reflected in an upsurge in strikes and in wage demands that could not be met except through continuing inflation. Even without the militant push, low unemployment would have strengthened the bargaining power of unions and put upward pressure on wages. But the revolutionary utopianism of the 1960s, exemplified by the events of May 1968 in Paris, produced an atmosphere where any kind of restraint became impossible. Unions that sought to focus on realistic and sustainable demands were pushed aside by their own members.

    gives the impression that inflation was due to labour militancy. Perhaps – but I would want evidence before i encouraged the HR Nicholl’s Society. There are a number of competing explanations.

    More broadly – taking on board the insights of behavioural economists (including Keynes) would – as I think Keynes and certainly some of his opponents realised – render overall macro-economic outcomes incalculable. This would be sensible, but is it sellable?

  6. @SeanG

    Something you ignore is that this time, in the UK a pretty massive stimulus is being attempted and there is an interest in keeping people employed. It could be argued that in the 1980’s the Thatcher government’s objective was to keep workers unemployed. Even without accepting that, the Thatcher government’s objective was not to keep workers employed.

  7. @Peter T

    Stagflation was mainly a result of supply shocks. Before these there was a mishandling of macro policy which made things worse. Also, people react badly to a negative shock to their standard of living, and if they have some voice in setting their wages they attempt to remedy things through wage claims. CEOs just give themselves a productivity bonus.

  8. As someone who is chiefly interested in the classical economic tradition best represented by Sraffa, the implication in the quote from Animal Spirits that Smith was some sort of apostle for supply-and-demand curves, microeconomic rationality, and all the neoclassical baggage sets my teeth on edge. Smith taught us about the importance of labour specialisation and division, and the ability of free markets to meet people’s needs. He also, as a classical economist, believed that the prime concern of “political economy” was explaining the division of surplus, which was produced by labour and priced at its labour content, between the “three great classes” of landlords, capitalists and workers. Smith worked in an entirely different paradigm from any kind of general-equilibrium or even Keynesian theory (If Akerlof and Shiller want a distinguished pedigree for current economics, they should look to Malthus and Pareto).

    Why does this matter? Because this misconception feeds into even reformist programs like that Professor Quiggin espouses. “First, the program needs more realistic microfoundations”. Why? Acting as if the economy is entirely derived from individual economic atoms, whether realistically modelled or not, automatically abstracts away the issues that Smith, Ricardo and Marx were concerned with, like: families; institutions; social classes; the role of government; increasing returns, historical accident and technological/geographic “lock in”; and all the other events which a) shape the actual course of national and world economies and b) shape the individuals who live within them much more than the micro-individuals are able to recursively shape the institutions. Macro comes first.

    Sraffa and the Neo-Ricardians showed that prices, particularly of capital and capital goods, cannot be determined independently of the division of social surplus between wages and profits (Obvious example: The Accord). The Chartalists and neo-Chartalists have shown that “money” derives not from its economic convenience but from the taxation power of the state. The econophysicists have shown that the distinction between workers and capitalists is glaringly obvious in the patterns of income and wealth distribution within an economy. Paul Ormerod and the Post-Keynsians have shown that the disruption of Phillips-type relationships in the 70s was caused by the economic supply shocks of the oil crisis, itself an effect of the world geopolitics of religion and strategic goods, and not some kind of rational expectations feedback loop on inflation as Friedman claimed.

    All these schools seem to have committed the unforgivable sin of supporting their arguments with evidence rather than bad abstract mathematics of microfoundations, and so have been ignored by those hogging “the seats at the table”.

    Why steer Keynesians back towards microfoundations again, no matter how ‘realistic’, when this will inevitably cause history to repeat itself as the “New Old Keynesians” once again more make more and more concessions to “rational microfoundations” in order to be allowed to beg for the meager crumbs of relevance and the rewards which accrue to a priesthood whose gospel always supports the status quo? Keynes was a brilliant Macro theorist – why not openly embrace that, and screw microfoundations and all who build their microintellectual microeconomic microedifices upon them!

  9. why not openly embrace that, and screw microfoundations and all who build their microintellectual microeconomic microedifices upon them!

    Because if you don’t have microfoundations then you say pretty much anything you like. Same goes for microfoundations that are explicitly irrational.

  10. @Joseph Clark

    Plenty of sciences have progressed without trying to constrain themselves by remaining true to some reductionist perspective. Microfoundations aren’t needed, yet, if they ever will be. Better to get macro theories that seem to work than theories that are consistent with micro foundations that are somewhat dubious themselves.

  11. James :

    Sraffa and the Neo-Ricardians showed that prices, particularly of capital and capital goods, cannot be determined independently of the division of social surplus between wages and profits (Obvious example: The Accord).
    All these schools seem to have committed the unforgivable sin of supporting their arguments with evidence rather than bad abstract mathematics of microfoundations, and so have been ignored by those hogging “the seats at the table”.

    Is this true? I don’t recall any empirical analysis at all in Sraffa’s Production of Commodities, or in the Cambridge Capital Controversy. On a quick look, I found the following quote from Mark Blaug

    I claim that Sraffian economics, however rigorous in its use of the simultaneous equations method, the second of our three versions of mathematical rigor, is irrelevant to our understanding of the real world and, judging by its failure to draw any policy implications, is largely irrelevant to the major concerns of modern economists. I have in mind such issues as environmental pollution, poverty both at home and abroad, race and gender inequalities, the governance of corporate industry, and macroeconomic policies aimed at combating infl ation or defl ation …. In short, show me a pieceof research grounded in Sraffian economics and its principal method of long-period analysis that deals with poverty, inequality, defl ation, etcetera, and I have lost the argument. I have been unable to locate any such papers.

    Feel free to set me (and Blaug) straight on this. I would make exactly the same comment regarding econophysics except that (unlike Sraffa) most of it can’t be taken seriously as economics, any more than the efforts of those misguided economists who dabble in amateur climate science and claim to prove the experts wrong.

    Finally, the “oil shock” explanation of the crisis, while popular, has some obvious problems. Bretton Woods had already collapsed, and stagflation was a major concern well before the first oil shock of 1973.

  12. More generally, the suggestion that we should dispense with microfoundations entirely seems to me to throw the baby out with the bathwater. Keynes spent a lot of time talking about individual psychology, the process of wage determination and so on, and reasoned from these microfoundations to the likely form of macroeconomic relationships. What he avoided was the trap (fallen into by Joseph) of suggesting that the best way to do this is to aggregate from assumed perfectly rational individuals. It’s true that you can normally get a unique solution that way, but since the solution is wrong, it’s hard to see that this is a benefit.

  13. @jquiggin

    Yes. As I noted there were problems before the shocks. The US had spent a lot on the Vietnam adventure and when there is some power behind wage claims if those claims are not fully accommodated (by allowing as much inflation as necessary) people lose their jobs.

  14. @Freelander

    That’s true but economics is particularly prone to storytelling and motivated interpretation of evidence. Everybody wants agents to be more realistic and nobody believes that people are entirely rational in the way that simple models claim. But modeling an economic agent by pasting together various irrationalities and heuristics is unavoidably subjective. These Frankenstein agents say more about the prejudices of their creators than the complicated reality of real world economic decision making.

  15. @Joseph Clark
    Joseph, if this was true we would have had:
    No science of chemistry before we fully understood Quantum Mechanics;
    No science of biology before we fully understood DNA;
    No science of physics before we fully understood general relativity;
    and no mathematics before Godel.
    And that’s just the areas in which methodological reductionism does in fact seem to be justified.

    Let me give you a quick example of why methodological individualism is basically wrong in the social sciences, including economics. Consider an individual. Where did they come from? At a minimum, they had a biological mother and a father, and someone (not necessarily either M or F) who invested a large amount of time, money and care enabling them to become an independent individual. Unless a postulate of economics is the imminent extermination of the human race, this individual had better find a mate of the opposite sex. Furthermore, their M&F can’t supply their mate unless incest is to be the dominant method of reproduction. So the mate has to have their own, non-consanguineous family as well (as did the mother and father). Furthermore, there need to be other families out there to supply non-consanguineous mates for the individual and their mate’s children, all of which are prepared to direct their economic actions, for the majority of their productive lives, towards the upbringing, love and care of their own children. So the minimum unit of human society is not the individual but the multi-lineage system; anything less will die of cumulative genetic disorders.

    Why do you think we have a baby bonus in this country (beyond vote buying)? Because the more our government approved, methodological-individual-based economic system pushed people to act like rational economic maximisers, the less likely they were to have children.

    Furthermore, in many sciences (particularly thermodynamics) it is the case that lawlike regularities only emerge at the macro level from the random interaction of the components. It is not necessary and in fact hopeless to try to figure out the movement of a gas by computing the actions of all its atoms. This goes double for unpredictable people. The macro-regularities, on the other hand, constitute much more observable data on which social sciences can meaningfully be based.

  16. @jquiggin
    Fair cop, but I noticed your chapter doesn’t make any specific suggestions for what the new microfoundations should be. It’s interesting to look at departures from rationality but if you go too far away it’s easy to become untethered from reality like the Econophysicists.

  17. @jquiggin
    I may have made a composition error in lumping Sraffa in with the others like that, as the approach of PCMC is of course highly abstract as you say. I’ll also admit to getting carried away by my own rhetoric by the time I reached the last sentence 🙂

    However, the neo-Ricardians have made contributions of the kind you mention: for example, the Neo-Ricardian theory of International Trade would seem to be an example of the sort of thing Blaug wants; interesting work in economic geography; and the corporatist approach taken by the Accord, in which it is possible for desired price outcomes to arrive from a preagreed division between wages and profits, seems to me to be quite similar to a neo-Ricardian approach. I find it hard to see how that kind of macro-economic effecting agreement between institutions could be deduced from any set of microfoundations, “rational” or not. Microfoundations seem to me to implicitly obviate collective action, public goods, and institutional/historical effects, and leave us all stuck in prisoners dilemmas.

    It’s also a bit silly to accuse a small school represented by a handful of academics, who don’t subscribe to the same underlying assumptions as the majority of economists and therefore find it harder to publish in the “big name” journals, of not having made a large number of major contributions. This is an “I’ll cut their legs off, then call them Shorty” kind of dismissal.

    On econophysics: since, as one might deduce by reading my previous comment to Joseph, I came to the social sciences by way of physics, I think we will have to disagree. I would point out that (as Mirowski has written) a lot of economics is based upon 19th century, physics and economists as varied as Kenneth Arrow and Brian Arthur seem to support the econophysics project. It also does offer an internally consistent micro-macro bridge modelled upon thermodynamics (which, as I indicated above, starts with random individuals) which nevertheless produces lawlike regularities. I am particularly thinking of the work of Yakovenko on income distribution, here.

  18. @James

    Thermodynamics is perhaps not the best example for basing your analogy upon; statistical mechanics starts with the particles (or more properly, with the possible states of the system, which typically involves aggregation over particle states) and ends up with laws of thermodynamics. Physical kinetics starts with the particles in phase space and ends up with thermodynamic quantities. Thermodynamics laws are mainly empirical; statistical mechanics and physical kinetics are much closer to theoretical. SM, PK micro –> Thermo macro.

    Cheers,

    Don.

  19. @Freelander
    You know Freelander….sometimes I wonder whether all that ordinance used in Vietnam and the metal they packed up agent orange into and the state of the US economy when they went into the Vietnam war (already close to full employment) didnt start that inflation ball rolling? There has been so much blamed on some imaginary failure of Keynesianism……was the blame game just another form of denialism…? Could someone tell me when it has ever been good Keynesian policy to expand the economy with a war when it is close to full employment and keep it going into the early 1970s?

    Similarly unions copped the blame…but why wouldnt unions chase wage rises when the wage growth still wasnt keeping up with CPI increases. They had to eat and didnt want to go backwards either. In this country they never caught up. They did go backwards. After that with unions in demise, most of us have gone backwards relatively to the very wealthy if income inequality is a guide since 1980.Keynesianism failure and union bashing sounds like a denial of the underlying causes of inflation in the 1970s if you ask me. It wasnt Keynes who failed us. It was the lesser men left behind to interpret and apply Keynes theories, not so much in the 1970s but in the 1960s.

    Hey did you get let out of jail Sean G??

    Dont be causing any trouble now!

  20. jquiggin :I don’t recall any empirical analysis at all in Sraffa’s Production of Commodities…I would make exactly the same comment regarding econophysics except that (unlike Sraffa) most of it can’t be taken seriously as economics, any more than the efforts of those misguided economists who dabble in amateur climate science and claim to prove the experts wrong.

    Surely you don’t mean this. Of all the criticisms to be made of econophysicists – and I agree that many are just amateurish dabblers – it’s hard to accuse them of neglecting data. The major concern of many has been to more adequately fit time series of prices to models by using a different class of distributions. Problems have generally arisen because of naive theory, not any absence of empirical work.

  21. @Donald Oats
    I’m aware of that Don, but we humans are so much less predictable than ideal-gas atoms that I doubt we will get beyond the thermodynamic stage of social science.

    More generally, I was objecting to the idea that no macro-science was even possible without well understood microfoundations. The principles of thermodynamics were empirically confirmed and well understood before strong statistical mechanics was derived from QM, and if stat.mech. had produced predictions wildly at variance with thermodynamics then I think scientists would have revised stat.mech first. Of course stat-mech is ultimately more powerful and lets you get cool (literally) things like superfluid helium, but you don’t need it to build a steam engine that doesn’t explode. Economics often seems to me to “boil down” to saying that because each atom of steam obeys newtonian laws, our economic steam engine doesn’t need a regulator or negative feedback loop to work without exploding.

  22. Good stuff! As an ordinary but interested non-economist citizen I find it informative and thought provoking.

    //In the future, and particularly in macroeconomics, economists need to start looking where the keys are, and try to build tools that will improve the chances of success.

    I suggest changing that to “in the future, macroeconomists need to start…” I also had to think about the analogy to the drunk who lost his keys for a minute, but once I did I found it very amusing and apt. 🙂

    //An economy can settle for long periods in a low-output, high-unemployment state that may not meet the neoclassical definition of equilibrium, but does match the original concept, borrowed from physics of a state in which the system tends to remain and to which it tends to return.

    I’d break that up into 2 sentences.

    //

    On microfoundations, I’d say we should at least remain openminded to the possibility that there could be some truly emergent phenomena for which all the microfoundations we may find serve only to confuse and mislead rather than to illuminate.

    Why are there not more simulations in Economics? Neuroscience, for example, has the Blue Brain Project which is trying to reverse engineer the human brain. Where is the great project to reverse engineer the real existing empirical really out there macroeconomy? I know – that sounds and would be insanely difficult, but the neuroscience folks seem at least to be making progress on it. But more to the point, where are the less ambitious simulations? The attempt at this sort of thing – even if it resulted in many utter failures – would at least expose errors, and given the lack of many other quasi-experimental methodologies, I am surprised at the lack of simulation.

    Since you can’t really do grand scale controlled experiments in macroeconomics, the difficulty is that you would have to decide whether the results of the simulation seemed plausible. But apparently “real business cycle” seemed plausible to many economists… And if Economists were any good at judging what seemed plausible, they would have called it “imaginary business cycle theory” instead. Yeah, that was a cheap shot. 😉

  23. To make that analogy complete, I should have added “and Prof Quiggin’s program suggests that he believes we can stop the engine exploding by realistically modelling the steam as composed of actual H2O molecules obeying QM laws rather than as ideal gas billiard balls”. Good lord I’m bombing the comments today. It must be all this coffee. Sorry.

  24. @Nick
    I’ll admit to having only a limited acquaintance with econophysics – I recall one physicist announcing that, contrary to the claims of economists to be able to predict stock prices, they actually follow a random walk :-).

    The other social scientists at Crooked Timber complain of the same kind of thing. I guess it’s unfair to say they don’t do anything empirical, more that what they do is trivia (discovering power laws and so on) backed up by nonsense analogies with physics. If there are actual applications to policy issues (as opposed to policy opinions unsupported by analysis) I haven’t seen them.

    OTOH, I find Mirowski more appealing, though I think he takes a good point too far.

  25. @James
    I certianly agree that the micro foundations part of my story suggests that, if we want to model steam engines it would be good to know something about the properties of H2O, something you seem by analogy to deny. But if you read the discussion of equilibrium, it’s pretty clear that I don’t claim we can find out all we need to know by aggregating over molecules.

  26. @jquiggin

    I think we have a different view on micro foundations. Of course ideas about wage determination and psychology could be used when developing macro theories. There is no a priori reason why we should exclude any particular source of ideas from theory building. But the attempt at reductionism, where great energy is spent trying to derive a macro model from some explicit model of individuals seems to be unnecessary and not at all helpful.

    So far econophysics doesn’t seem to have yielded much but I can’t see that they are doing any great harm. The harm is where claims are made that lack support and I am not sure they have done a lot of that but I could be wrong.

  27. @Joseph Clark

    A real test of a theory is when it provides a description that work well enough (in some domain) that we can start to manipulate nature with some degree of confidence. The evidence that science has acheived good representations is the ability of engineers to use scientific knowledge, successfully, in various areas.

    More realist theories, in economics, will ultimately be tested by evidence and experience. In a science, whether anindividual theory was inspired by a ‘political bias’, a good meal, a dream, a bottle of wine, or some other drug taking will ultimately be irrelevant.

  28. @Freelander
    True again but sometimes predictive success isn’t enough. It is possible to explain any set of economic facts with an infinite number of theories. The more complicated the model the easier it is to generate a result consistent with the data. From there theories can only be separated by intuitive appeal or some other aesthetic criteria.

    Unlike physical systems, economic systems are capable of changing at very basic levels. Imagine if the laws of thermodynamics changed over time. It would be difficult to construct experiments to test any theory. It’s like that in economics.

    It’s interesting and useful to use data but it has to be done with caution. Economic systems are not like physical systems and treating them as if they were leads to bad empirical work and bad theory.

  29. The questions studied under the heading “Macroeconomics” would be better removed from the Economics discipline altogether. The ideal training in Macroeconomics would consist 1/3 Cognitive Psychology/Neuroscience, 1/3 World History, and 1/3 Applied Math/Statistics.

    At present, Macroeconomics is in a scandalous state of irrelevance. Suggestions to go back a couple of generations are bizarre and must be resisted.

  30. I enjoyed reading this excerpt.

    IMHO, JQ, you found an elegant way to introduce non-technical readers to several ideas which tend to be muddled up in various places. To name a few: non-uniqueness of an equilibrium, the idea that there is not only one possible concept of ‘an equilibrium’, coordination failure (binding in behavioural notions) and that there is not only one possible institutional environment. And you brought out some further restrictive features of the dynamic macro ge models.

  31. @Ernestine Gross
    Ernestine – you amaze me (so does the Prof). When it comes to the models…

    Now can anyone tell me why testing stationarity for time series variables and then demanding stationarity variables for tests may not necessarily work?? Im not sure I fully subscribe to modern econometrics in this area…it seems to give results that are perverse in this and when you go to the trouble of straighjacketing data – it cant speak at all. Am I being sacriligious?
    Maybe Ernestine has an empirical a clue, but I dont. I just dont beleive some results of papers I see about.they make no sense..Is there something wrong with me or assumptions on needing to render time series data staionary?

    Sorry – I know this is a total derail.

  32. Alice, the requirement to use stationary time series is fairly straightforward. Time series data are often autocorrelated, i.e., the value at time t+1 depends on the value at time t.

    This can cause problems when we want to check whether time series (a) is correlated with time series (b), e.g. is there a relationship between house prices and interest rates. When each time series is autocorrelated (i.e. correlated with itself), we can get the correlation between the variables mixed up with the correlation with themselves.

    If we do a naive regression, it can look like there is a strong correlation between the two variables, when in fact there isn’t, i.e. spurious regression. Two completely unrelated random walks might look like they’re highly correlated.

    The easiest way to deal with this is to remove the autocorrelation from the variables, by looking instead, for example, at change in the variables rather than the absolute values of the variables. So then we’re asking a question like “are changes in house prices related to changes in interest rates”. Removing the autocorrelation is another way of saying that you’re making the series stationary.

    Note that the removal of the autocorrelation can get quite complicated, if the series also involve trends (like house prices would), or cyclical elements (e.g. monthly data show a yearly cycle).

  33. So John why are you singling out dsge and not the whole general equilibrium hog? Do you really think there was something of real-world value in traditional static models of general equilibrium that was lost in dsge?

  34. @SJ
    Thanks SJ. Yet….does this apply if you are using eg decile shares of income (endogenous covariates) and doing a simulatenous equation set technique? I have found some bizarre and unexpected results in inequality literature and papers using modern econometrics (making variables stationary)…

    I was thinking some of these results in the papers dont look or smell right.

    Then..I find this from a paper by Jantti (09) Ill condense here – apologies if it doesnt make sense – it only half makes sense to me – consider quintile group shares of income – it follows from the boundedness of the income shares that their variance is finite. Then a single variable that is 1(1) (random walk) ..then that implies variance goes to infinity as t increases. The properties that the income shares are bounded and that the variances of the income shares grow without bound is mutually contradictory.

    variables that are bounded in the unit interval cannot have an infinite variance.

    Standard unit root tests in the dynamic economics tradition cited above (I cant put the notation in) have typically led their users to accept an hypothesis that cannot on logical grounds be true. Most common inequality measures are bounded and they are often restricted to lie in the unit interval.”

    I think Im on to something here!

  35. @Skeptikus Autarktikus
    Irony alert

    ahh we have the wise Skeptikus back…
    with this

    “The questions studied under the heading “Macroeconomics” would be better removed from the Economics discipline altogether. The ideal training in Macroeconomics would consist 1/3 Cognitive Psychology/Neuroscience, 1/3 World History, and 1/3 Applied Math/Statistics.”

    Gee Skepticus…Im surprised at this carefully thought out list of subjects inclusions.

    I note the list excludes
    1. national economic history – we dont want any economists digging up our messy past policy mistakes.
    2. Political economy – so economists dont get to comment on whether government policy is right or wrong

    Your list does include lots of 1. applied math / stats – so that the vox populi do not understand what macroeconomists are saying and given that subjects 1. and 2. above are excluded, macroeconomists then only get to talk to each other and not make a nuisance of themselves.

    It also includes 2. Neuroscience – I presume thats so that after macroeconomists are lobotomised under your plans they will be able to understand each other better? But perhaps this subject could be useful to help macroeconomists deal with the moonbats who think they know better how to manage the economy with tribalism.

    Im rather surprised you left out 3. home science Skepticus – so you can confine all macroeconomists to the kitchen to bake scones for you.

  36. Skeptikus, in my opinion the major problem with macro as it was taught, and I assume is still, is that it contains little or no discussion of the role of financial markets in the economy.

    Making this addition would of course mean going a few of generations to what Keynes was really on about rather than the bastardised version you get in undergrad courses. If you don’t want to go back as far as Keynes you could always incorporate a little Minsky.

  37. “…a general macroeconomic theory must encompass the reality of booms and slumps, and, particularly of sustained periods of high unemployment that cannot be treated as marginal and temporary deviations from general equilibrium. We must model a world where people display multiple and substantial violations of the rationality assumptions of microeconomic theory… An economy can settle for long periods in a low-output, high-unemployment state that may not meet the neoclassical definition of equilibrium”

    Isn’t that rather begging the question, assuming that only irrationalities could be involved? Why shouldn’t those things at least sometimes be perfectly rational consequences of poor structures, externalities that distort an equilibrium, say? I have elsewhere suggested that (for instance) there is an externality favouring unemployment, so shouldn’t analysis test whether this sort of thing is in fact the case and/or sufficient to account for observations, and isn’t that sort of test best handled by treating things as an ideal case together with perturbations from it? Indeed, if as I suspect irrationalities and other things also occur and are material, why shouldn’t analysing them be handled within a perturbation framework anyway? (And see Joseph Clark’s point.)

    “…the model worked better if low-probability extreme events (large gains and large losses) were overweighted, while events leading to intermediate outcomes were overweighted”.

    Shouldn’t one of those be “underweighted”? I see that Dick Veldkamp has already spotted this, but it’s still there, as is the “Keynes’ death” typo.

    “…the problem of unknown unknowns…”.

    Is it appropriate to use the techniques for estimating undiscovered outstanding typos or bugs? You use some independent techniques to find samples, then analyse the number found separately by 1, 2, … techniques; the distribution lets you estimate how many have been found by 0 techniques, i.e. not found at all and still outstanding.

    “But there is a more fundamental problem… Dynamically consistent economic agents never change their view of the world in any fundamental way. They respond to new information by changing their subjective probabilities for particular events, but they never change their underlying prior beliefs and preferences about the world… they can fully anticipate how they will respond to any possible future situation, and would never wish to change their mind about this, or to ‘lock themselves in’ to a course of action they might be unwilling to carry through when the time comes… it is far from realistic. It turns out, however, that the decisions predicted by such models always display dynamic inconsistency under certain circumstances.”

    Actually, that is not a more fundamental problem. It can “easily” be dealt with by incorporating more variables and states into the model, perhaps hidden ones. That presents a problem of the model becoming less tractable and/or computable – and that is a more fundamental problem.

  38. @SJ
    SJ – thanks heaps. I dont want to derail this blog into areas that are twisting my mind…Im already swearing at Stata enough !!.

  39. Having just read your post John, which I should have done before responding to Skeptikus, I realise that my comment is somewhat redundant.

    One comment I will make however in relation to the great inflation, and forgive me if I have missed this in your post, is that you seem to have missed the Fed’s role in the great inflation in that it maintained a loose monetary stance through much of the period in question.

  40. Alice, I think your assumption that the variance must go to infinity is faulty. If your variable follows a random walk and is bounded (0,1), then for large t the the mean should be 1/2 and the variance should be 1/12, that is, I would expect it to look like a uniform distribution.

  41. Oops, I think I might have made an unwarranted assumption there about what happens when the variable hits 0 or 1. In any case, the variance can’t be bigger than 1/4.

  42. @jquiggin

    I think you need to fix up this sentence: “The oil shock was a consequence, not a cause of the inflationary upsurge.” As you point out earlier the oil shock was a consequence not of the inflationary upsurge but was a result of Arab nations trying a different tactic after the loss of the Yom Kippur war. You could say, which you do, that an inflationary upsurge had begun before the oil shock. It is a counterfactual question and speculative exactly what would have happened without the oil shocks. I don’t think we really know enough to confidently answer the question.

    I agree with criticism of militant unionism (which frequently faced equally militant and ignorant bosses). Unfortunately union leaders were relatively ignorant in the ’60s and ’70s and hence played a large role in creating inflation, and stagflation where their wage agreements were not fully accommodated by policy makers (which is not to say that policy makers should have accommodated them). A significant portion of the union movement was comprised of the ‘looney left’ who were intent on achieving the unachievable. There was considerable silliness in the ’60s, which continued on into the ’70s. The last 30 years, however, have been dominated by the silliness on the right.

    Re: reductionism… There is nothing wrong with having a grand unified theory were everything can ultimately be reduced to a micro level. However, as a practical research strategy concentrating on constructing grand unified theories does not seem to have the pay off that less ambitious goals have had. As James has pointed out even where reductionism has eventually proved possible the reductionist explanations came after the bit by bit advances not before. And if there is some eventual reductionist grand unified theory for economics I expect it will also be after rather than before.

  43. @Freelander

    I’ve added “broader”, but I remain of the view that a substantial increase in oil prices was inevitable. OPEC meant that the increase was delayed, but all the more dramatic when it came.

  44. John, I wonder if whatever comes next for macroeconomics should concern ends as well as means. In relation to the business cycle, you make a strong case for better theories and policies aimed at stability. But in relation to growth, doesn’t the recent literature showing only a poor relation between income and happiness (at least in rich countries) also give some indication as to where macro is (or should be) headed? The apparent importance of interpersonal relationships seems to strengthen the case for a less reductionist approach to modelling. Policy-wise, there’s also an implication that we should be more willing to trade off some growth for better environmental or distributional outcomes than previously, when people could more easily invoke the assumption that wealth generation should be the main objective.

    My guess is that many macroeconomists working in policy circles would concede that these are serious issues, but somehow “not quite economics” (where only certain, mostly subterranean value judgements are allowed). Presumably the resulting boundary between economics and other disciplines serves as a language barrier which ultimately damages policy advice. I guess this is a long-winded way of saying that a more interdisciplinary kind of macroeconomics would ultimately be more fruitful, and the happiness literature provides something of a rationale.

  45. Can you explain this: “Business leaders ceased to be the sober, socially-minded, technocrats described in works like JK Galbraith’s New Industrial State and started on the path that would lead to the lionization of figures like ‘Chainsaw Al’ Dunlap and Jack Welch.”

    I am trying to understand what a business leader is meant to do when the company is stagnating, divisions should not longer be used, and shareholders are losing out.

  46. While I take Professor Quiggin’s point that I (or others) can’t blame everything on the oil shock, I’m not sure of the extent to which Stagflation actually shows up in the economic data “well before 1973”. For example, glancing at a plot of annual inflation and unemployment for the US 1965 to 1975 shows only 2 periods, 1969-70 and 1973-74, in which inflation and unemployment actually move in tandem. Inflation, which climbed from 65 on, was heading downwards by 1971. Unemployment stayed constant until 1969. As inflation declined in 70-72, unemployment increased, and as inflation began to expand in 72-73, unemployment declined again – which suggests that the “Nixon shock” may have had some positive effect? It’s only with the 1973 oil shock that the two figures definitively move out of anti-sync.

    As I mentioned earlier, Paul Ormerod showed (1994, “on inflation and unemployment”) that change in inflation and change in unemployment are very strongly correlated: that is, the two will tend to fluctuate in anti-sync around an equilibrium point set by external factors – such as the oil shock, the vietnam war as Alice pointed out, or, as Quiggin and Freelander point out, widespread radicalism which aims in negotiation to break the system rather than to work within it.

    Since I wasn’t alive then and haven’t made any study of this period, I am sure there are many other factors I have failed to take into account, and someone out there will probably hose me down on this; but the figures and a bit of history suggest to me that the original Phillips curve broke down less because of everyone’s expectations suddenly becoming rational than because of the macro-level political/economic shocks of the period. Again, I submit that macro will be more important than micro for the forseeable future.

    On this point, I’m surprised that Prof Q describes the discovery by econophysicists of power laws in, for example, stock market fluctuations as “trivia”. A power law shows an inverse relationship between the size of a fluctuation (to some power or other) and its frequency. If the power is 1, then one would see, for example, a fluctuation of size 3 occur 1/3 as often as a fluctuation of size one (bear with me, there’s a point coming).

    Power law distributions of events blow the efficient market hypothesis out of the water. If the EMH was correct, prices would follow a random walk and this leads (IIRC) to a normal distribution of market movements. Under a normal distribution, if we define one standard deviation as size 1, an event of size 3 (3 standard dev) will happen less than 1% of the time. Under a power law distribution of power 1, an event of size 3 will happen 1/3 of the time. In other words, power laws are much more fat tailed.

    Power laws of fluctuation tend to be found in semi-sparsely connected networks, such as neural nets or networks of people (6 degrees of kevin bacon, anyone?) and tend to be characteristic of systems with a “memory”, that is, where the effects of past events can reverberate for long periods of time and which therefore react to their own dynamics and history as much as they do external events. Again, this is totally opposite to the EMH in which the past is a sunk cost and the random arrival of information about external events is all that affects market dynamics.

    In sum, I think power law fluctuations in the marketplace are a good example of empirical evidence against the EMH, which I presume Prof Q would like to present, and of how we can deduce characteristics about the micro level (that traders have sparse networks, memory, and react to the dynamics of other traders) from observables at the macro level rather than vice versa.

  47. @James
    Inflation is caused by too much money chasing too few goods. If the money supply expands unemployment usually falls in the short run because people think they have more money than they actually do. When they figure it out you get inflation.

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