I’ve seen the view that DSGE models fail the Lucas Critique come up a bunch in recent years, and nodded my head in agreement. But I’ve never popped a post down saying it – so this speech by Plosser gives me that opportunity (ht Stephen Williamson). I find it hard to disagree with this statement:
Via Mark Thoma’s twitter feed came this gem on “neo-classical economics”. It strongly supports my view on what economics is so let’s have a peak at the conclusion:
I sometimes argue that the main version of economics, at its best, is that it is a disciplined way of thinking and arguing that makes clear where people disagree. If two economists disagree, they can unpack each other’s arguments. Do they disagree in their underlying assumptions? In their model of how those assumptions fit together? In their arguments over cause and effect? In their beliefs about what data to use? In the statistical methods they use? Even when economist end up disagreeing, they should be able to pinpoint the sources of their disagreement–and thus to agree on what issues need to be further researched and resolved. From this process, provisional truths (and is there really any other kind?) do emerge.
This is completely true, and the way a vast vast majority of economists see economics and developing economic knowledge.
However, the sentence prior to this description also raises an interesting point for me:
For noneconomists, I guess the obvious question is: “If economics doesn’t give a correct and clear answer most of of the time, what good is it?”
This quote is golden, and since I’ve removed it from my paper at NZAE I have to put it somewhere … lest I lose it from my memory!
Observed facts are necessarily finite in number; possible hypotheses, infinite. If there is one hypothesis that is consistent with the available evidence, there are always an infinite number that are.
There has been a lot of ink spilled out there about whether it is production or consumption that matter. Without production we have nothing to consume! Without the urge to consume we wouldn’t produce anything!
People will talk about “Says Law” (supply creates its own demand), or jump around talking about Keynes or Malthus (effective demand can be too low, demand creating its own supply, underconsumption!).
This all sounds grand, and makes great soundbites as it lets us say one drives the other. But I’m always struck by the question “who cares”. Production, consumption, output, in our models none of this has any inherent value unless we “assume” value. And in the world we want to make conclusions about, the inherent subjective value is something that exists that we can’t necessarily observe.
When looking at an economy as a whole, we are not a “large firm” trying to maximise output, or maximise consumption. We are a series of individuals making choices for some reason. Understanding the choices, how they relate to value, is the starting point of any thought.
This is the kicker. When we turn around an apply models (either explicit or implict in our description and conclusion) we are apply our own value judgments. If we haven’t separated them out, we will sneakingly include value judgments solely based on our own experience “because they seem natural”. However, other individuals are inherently different beasts, rules we follow aren’t necessarily the same as the ones other follow, and the rules we have to understand the actions of a social group don’t necessarily have much relation to the true nature of those groups!
In this context, both production and consumption should be seen as a means to an end. And we should analyse them in this context – in what ways does this impact on our view of “social value” or welfare. This is a question we have to answer before concluding – and the assumptions involved can only be validated through the acceptance of a community, not by strict scientific measurement of value.
Overall, this is why economics is the study of trade-offs involved in scarcity, not the study of how we should allocate scarce resources. Economists merely ask that lessons involved from our series of descriptions are taken into account when society gets together to try to discuss what they believe is “fair” and “just”. And non-economists are merely asking economists to recognise that their framework allows description, but doesn’t give them a monopoly on understanding moral questions of value!
A lot of things in economic models are ‘exogenous’ and outside our usual frame of investigation. Not just little, unimportant things but big things, too: innovation and technological change, recessions, bubbles in markets. On some reading of economic models each of these things is unknowable and unpredictable. Obviously that’s far from satisfactory and lots of people are working hard to change things. Via Mark Buchanan, here is an interesting perspective on why things turned out this way:
To look at the economy, or areas within the economy, from a complexity viewpoint then would mean asking how it evolves, and this means examining in detail how individual agents’ behaviors together form some outcome and how this might in turn alter their behavior as a result. Complexity in other words asks how individual behaviors might react to the pattern they together create, and how that pattern would alter itself as a result. This is often a difficult question; we are asking how a process is created from the purposed actions of multiple agents. And so economics early in its history took a simpler approach, one more amenable to mathematical analysis. It asked not how agents’ behaviors would react to the aggregate patterns these created, but what behaviors (actions, strategies, expectations) would be upheld by–would be consistent with–the aggregate patterns these caused. It asked in other words what patterns would call for no changes in micro-behavior, and would therefore be in stasis, or equilibrium. (General equilibrium theory thus asked what prices and quantities of goods produced and consumed would be consistent with—would pose no incentives for change to—the overall pattern of prices and quantities in the economy’s markets. Classical game theory asked what strategies, moves, or allocations would be consistent with—would be the best course of action for an agent (under some criterion)—given the strategies, moves, allocations his rivals might choose. And rational expectations economics asked what expectations would be consistent with—would on average be validated by—the outcomes these expectations together created.)
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If we assume equilibrium we place a very strong filter on what we can see in the economy. Under equilibrium by definition there is no scope for improvement or further adjustment, no scope for exploration, no scope for creation, no scope for transitory phenomena, so anything in the economy that takes adjustment—adaptation, innovation, structural change, history itself—must be bypassed or dropped from theory.
In a great interview, Dani Rodrik asks why
You get trade theorists who have built their entire careers on “anomalous” results who are at the same time the greatest defenders of free trade. …the minds of analytically sophisticated [economists] turn into mush when they are forced to take seriously the policy implications of their own models.
This is something that we all encounter constantly: people who ‘should know better’ advocating a policy that seems poorly designed. Why might it happen? It is common to resort to explanations that involve mendacity and duplicity, but they are as unsatisfying as they are implausible. It is highly unlikely that everybody we disagree with lies, while we ourselves are paragons of virtue and transparency. In fact, Rodrik identifies the most convincing explanation later in his essay: “There are powerful forces having to do with the sociology of the profession and the socialization process that tend to push economists to think alike.” Exactly, and none of us are immune to it.
Psychologists have demonstrated that logic tends to be used only as a post-hoc rationalisation of our intuitive response to ideas. When economists respond to a new policy idea they will tend to draw on their toolbox of ideas to defend whatever intuitive response they have to it. Those intuitions are greatly influenced by our social identity, which develops to align the intuitions of social groups. As Rodrik points out, the prevailing view of economists at the time that free trade and unfettered markets are a good thing was far more influential than the, more ambiguous, implications of current research. Of course, economists had a vast stock of reasons why governments might fail and could mount a very convincing justification for their free market intuitions. It takes other experts with different intuitions to cut through that fog as they justify their own beliefs.
What does this mean for the way we listen to experts and interpret their opinions? As Tyler Cowen says, “Evaluate literatures not individual papers.” Individuals are incredibly unreliable for the reasons outlined above. The aggregated view of a range of people with different intuitions is much likelier to represent the truth. No individual is an oracle and following the teachings of a few people is likely to lead us astray. That is why economists tend to be sceptical of ‘surgical policy interventions’ and far more trusting of markets than most people. Of course, in saying that I’m probably exhibiting my groupish bias in favour of market solutions!