Sunday, October 28, 2012

New Economic Thinking and Models

Brad DeLong calls attention to Howard Davies: "Economics in Denial", to which Stephanie Kelton alerted me. Davies writes:
In an exasperated outburst, just before he left the presidency of the European Central Bank, Jean-Claude Trichet complained that, “as a policymaker during the crisis, I found the available [economic and financial] models of limited help. In fact, I would go further: in the face of the crisis, we felt abandoned by conventional tools.”

Trichet went on to appeal for inspiration from other disciplines – physics, engineering, psychology, and biology – to help explain the phenomena he had experienced. It was a remarkable cry for help, and a serious indictment of the economics profession, not to mention all those extravagantly rewarded finance professors in business schools from Harvard to Hyderabad.
So far, relatively little help has been forthcoming from the engineers and physicists in whom Trichet placed his faith, though there has been some response. Robert May, an eminent climate change expert, has argued that techniques from his discipline may help explain financial-market developments.
Epidemiologists have suggested that the study of how infectious diseases are propagated may illuminate the unusual patterns of financial contagion that we have seen in the last five years.
These are fertile fields for future study, but what of the core disciplines of economics and finance themselves? Can nothing be done to make them more useful in explaining the world as it is, rather than as it is assumed to be in their stylized models?
Professor Davies then proceeds to mention the Institute for New Economic Thinking (INET) and its recent conference where some new ideas were put forward, as well as recent developments at the Bank of England.
But it is not clear that a majority of the profession yet accepts even these modest proposals. The so-called “Chicago School” has mounted a robust defense of its rational expectations-based approach, rejecting the notion that a rethink is required. The Nobel laureate economist Robert Lucas has argued that the crisis was not predicted because economic theory predicts that such events cannot be predicted. So all is well.
The EMH fared no better than REH, But Eugene Fama is also unphased.
On the contrary, the University of Chicago’s Eugene Fama has described the notion that finance theory was at fault as “a fantasy,” and argues that “financial markets and financial institutions were casualties rather than causes of the recession.” And the efficient-market hypothesis that he championed cannot be blamed, because “most investing is done by active managers who don’t believe that markets are efficient.”
Davies concludes by noting that a reworking of the profession's economic models is in order.

Paul Krugman then jumped into object to the charge Davies makes that economics lacks suitable models.
Brad DeLong points us to Howard Davies, who accuses economists of being in denial, and of having had nothing useful to say in the crisis. The first part is definitely true for much of the profession; the second charge is just false. The truth is that basic macroeconomics, the stuff that is still taught in textbooks, has been very, very useful in this crisis. The problem is that half the profession and most policy makers turned their back on this kind of economics.
But Professor Krugman doesn't tell us what those models are. His own favorite model is the Hicksian ISLM, which Hicks later distanced himself from the way it was being used — as Lars Syll reminds us.

So Professor Krugman tells us that new thinking is unnecessary.
What that says, however, is that while we obviously need new thinking — we always do! — the biggest problem these days has been the rejection of knowledge we used to have.
In an article in Thought and Action Fall 2009, James K. Galbraith notes that Professor Krugman does not mention one person that got it right. Professor Galbraith rephrased the question in his article, which was entitled Who Are These Economists Anyway? Dirk Bezemer wrote a similar article in 2009, entitled "No One Saw This Coming": Understanding Financial Crisis Through Accounting Models (June 2009). Professor Bezemer summarizes it in a VOX post.

However, neoclassical economists and neoclassical synthesis Keynesians not only don't cite any of these economists, but also avoid considering them even when they are brought up. I was a bit nonplussed by this, since I had brought this up on several occasions in blog comments, only to be ignored or to get some perfunctory excuse.

Then I ran into a Twitter exchange yesterday that alerted me to what seems to be going on. Noah Smith rejected any "commonsense approach," which I realized is code for "no model." It's also a criticism Paul Krugman often makes. I could not understand that since Wynne Godley predicted the crisis using his stock-flow consistent macro model based on sectoral balances.

Matias Vernengo then brought in Godley and Professor Smith apparently took a look. (I had mentioned Godley to him on several occasions previously in the comments at Noahpinion.) Here's the Twitter feed:
Noah Smith ‏@Noahpinion: If macroeconomics had real forecasting power, people using "common sense" would be laughed off the stage.
Naked Keynes [Vernengo]: @Noahpinion Bezemer shows in this paper that some models (e.g. Godley's) did pretty well …
Noah Smith ‏@Noahpinion: @NakedKeynes Hmm...didn't predict timing, size, or features of crash...but not bad.
Naked Keynes ‏@NakedKeynes: @Noahpinion agreed, but stock-flow models emphasize the interaction of spending flows & debt accumulation essential for macro analysis
Noah Smith ‏@Noahpinion: @NakedKeynes Maybe. Or maybe it'll turn out not to be very useful to include that as a variable... ;-)
So the upshot is that anything advanced with "no (neoclassical) model" doesn't count as "scientific"in the sense of predictive, as a hypothesis must be. Therefore, no one actually saw the crisis coming since they didn't have a credible model — and even a broken clock is correct twice a day.

Too bad for Professor Godley, and so much for new economic thinking.


Matt Franko said...

I'm starting to think that eventually it will be a female that leads us out of this mess... rsp,

paul meli said...

"So far, relatively little help has been forthcoming from the engineers and physicists in whom Trichet placed his faith, though there has been some response. Robert May, an eminent climate change expert, has argued that techniques from his discipline may help explain financial-market developments."

Question. Financial markets can never do anything other than extract money from the worker class or each other, so how are they of any use? The math is wired that way.

If we define society as the top 0.1% and the rest of us chattel, then it's all good.

Engineers invented the refrigerator. Who uses more refrigerators, the 315,000 or the other 315, 685,000 people (in the US)?

Tom Hickey said...

I'm starting to think that eventually it will be a female that leads us out of this mess... rsp,

That's why the alpha males (sociopaths) do everything in their power to prevent them from getting the opportunity.

Anonymous said...

I left such a comment at Krugman's

Howard Davies article mentions the Institute for New Economic Thinking (INET) where interesting research is being done. This is reality-based economics: debt and financial sector are central, households are revenue and debt constrained, and governments aren't. This is the type of economics that predicted the crisis

unlike anybody from your tradition. It is on the record, so who are you kidding?

No wonder policymakers are exasperated, you offer them no tools. What should they trust? IS-LM that ignores debt constraint and uncertainty and that Keynes and eventually Hicks himself rejected? That was wrong 28 years in predicting the behavior of US debt markets? Why would policymakers trust it? They bear actual responsibility.

You didn't go to the INET conference, you represent the old failed thinking. You claim that banks do not create money out of nothing , something every practioner rejects, the debate you had with Steve Keen didn't go well for you, did you read the comments you received? Your readers were deeply disappointed in how you handled your defeat.

I left similar comments on many occasions, he doesn't care and writes 2x a week how well IS-LM did "after the crisis". What a joke. The operative word is "after", as nobody using IS-LM was successful in predicting the crisis.

Bullish_Bear said...

Did any of the MMT economist forecast the crisis?

Tom Hickey said...

See Wynne Godley and L Randall Wray, Can Goldilocks Survive? (1999)

Bullish_Bear said...


Thank you for your reply. I was referring to the most recent crisis (i.e., 2007-2009). The article that you linked was written in 1999. Am I missing something?

Tom Hickey said...

The article was written in 1999, predicting the dotcom bubble crashing. That bubble was immediately reflated with the housing bubble, which meant that the ultimate crash was just postponed. While, the paper does not see the reflation and ensuing housing bubble coming to the "rescue," the logic remains the same. Of course, the financial crisis was only catalyzed by the housing bubble within the Ponzi stage of a long Minskyan financial cycle. The MMT pros and close allies like Bill Black and Michael Hudson were also warning all along in this developing scenario.

Bullish_Bear said...

If that is your evidence, I have to assume that the answer is "no".

Can you provide 1 article that demonstrates that an MMT economist forecasted the '07-'09 crisis?

I am trying to warm up to MMT. If not even 1 economist forecasted the most recent crisis, I will have start questioning the validity of MMT. Are there major flaws with respect to MMT? Is MMT capable of forecasting the economy? If it didn't forecast the previous crisis, can it forecast the next crisis? If it can't forecast crises, does it properly define what causes a crisis? Furthermore, if it can't forecast a crisis, how can the solutions to remedy to crisis be correct? In other words, if MMT can't properly diagnose the patient, how in the world can it prescribe the correct medicine/therapy to treat the patient?

Tom Hickey said...

I am not neither an economist nor a finance professional, so I can't give you a definitive answer to this, but this is the way I understand it.

The is no mathematical model currently available that is capable for forecasting future macroeconomic events with any degree of precision and there isn't one on the horizon either.

The sectoral balance model that MMT uses in conjunction with other models like the Fisher model of debt-deflation and the Minsky model of financial cycles is an accounting model and accompanying narrative rather than a mathematical model, e.g., neoclassical models. It depend on government policy, which is impossible to predict, changing saving-consumption-investment of the private domestic sector and foreign trade flows.

Essentially, the problem is that the subject matter being investigated is a complex adaptive system complicated by human societies being complex developmental systems that involve article as well as natural factors — knowledge, culture, institutions. In addition, human societies also have the complicating natural factor of reflexive intelligence in a much more highly developed degree than non-human social groups. This means that emergence is a feature of the system and it acts as a bug in models that are not capable of dealing with emergence. The math models economists use are not.

What the MMT approach can do is elaborate possible scenarios resulting from different combinations in sector activity and prescribe policy options for dealing with those scenarios. Related to this, it can also show what national accounting reveals about following the current trend and how the different policy proposals being discussed would affect it.

John Zelnicker said...

Tom -- I like this "understanding" of yours. Makes a lot of sense to me and gives me some ideas for passing along the MMT concepts to others.