David Glasner — Thinking about Interest and Irving Fisher

Economic history and the theory of interest. There's a lot packed into this post.

Uneasy Money
Thinking about Interest and Irving Fisher
David Glasner | Economist at the Federal Trade Commission

Jason Smith — The representative macro-theory agent differs from micro-theory agents

Jason Smith comments on David Glasner's recent post.

Here is my comment, which I tried to post there without success. The problem is not unique to that site and it affects other blogs using Blogger, although not MNE. Seems to be a Blogger issue:

I think that what Glasner is saying in summary is that the representative agent plays a key role in general equilibrium theory in economics to make GE modeling tractable. The basic idea is that "free" economies tend to general equilibrium naturally, even though they may never actually converge on it at a point in time.

Then the question logically arises that if human agency expressed in markets is always tending toward GE, whhy the chronic boom-bust cycles that affect free market economies.

Glasner is saying that the reasons given are either implausible or conveniently accidental, and not the result of human agency, which is assumed to be "rational." The representative agent is an aggregate of rational actors rationally pursuing somewhat homogenous preferences targeted at utility maximization.

The implication is that such models are really just tautologies that can't be tested because of the role the representative agent plays in the model. The definition of representative agent embeds equilibrium in the assumptions.  The model is internally consistent and can't be disproved from within.

In fact, we regularly heard that the model did not fail when it failed to predict the GFC because the shock that resulted in the crisis was "exogenous to" the model. How can a model be expected to foresee "acts of God." Econ is not fortune-telling.

Then, when narrative alternative explanations were offered, such as the financial fraud that the FBI warned was rampant at the end of 2004, the retort was, "Where's your model?"

Information Transfer Economics
The representative macro-theory agent differs from micro-theory agents
Jason Smith

See also

Lars P. Syll’s Blog
Representative agent models — macroeconomic foundations made of sand
Lars P. Syll | Professor, Malmo University

"We believe that the confounding of the aggregate with the individual is as dangerous as it is pervasive...."
—Angus Deaton and John Muellbauer, Economics and Consumer Behavior, page 81.

Richard's Real Estate And Urban Economics Blog
A book that changed my life

Richard Green

Jason Smith — What does the AD-AS model mean?

Cameron Murray has a new post up about logical fallacies and contradictions involved in setting up the AD-AS model in macroeconomics. I personally like the AD-AS model as a toy model of how an economy works. It misses out on a bunch of details, but I think it forms a fine basis from which to depart with more detailed model.

The focus of the Murray's post is the fallacy of composition, which I've seen used as a rhetorical device in many instances (the sum of government spending effects on local spending doesn't mean there is an aggregate effect, or prudent increased saving by individuals isn't prudent for the overall economic situation in the paradox of thrift). As a physicist, I've always thought of it as a strange rhetorical device. In physics we have large numbers of examples where the fallacy applies, but it is never used. I think the reason it is never used is that in general there is a specific effect at work and we'd refer to that effect instead of the "fallacy of composition" -- quark confinement, entropic forces, emergent dimensions in string theory, pretty much all of materials science.
I think the fallacy of composition would better be called the warning of composition -- an idea that warns you of:

• Effects that might go away at the macro scale (an example is the SMD theorem, and on this blog most of the details of how economic agents operate)

• Effects that might not exist at the micro scale, but do at the macro scale ("entropic forces", emergent properties, and on this blog nominal rigidity)

The warning of composition can help prevent you from making unwarranted jumps in logic. But sometimes those jumps are warranted (or you have explicit machinery for adding the effects together).

So let's look at the AD-AS model in the information equilibrium framework. It essentially lives entirely on the macro scale, so there isn't any fallacy of composition. We instead have failures of information equilibrium, exceptions and other micro effects.

Jason Smith is a physicist whose hobby is economic theory and modeling.

Information Transfer Economics
What does the AD-AS model mean?
Jason Smith

Mark Buchanan — Economics beyond shocks??

Place a lit cigarette in an ashtray in a closed room where the air is perfectly still. As everyone knows, the smoke will rise, but not in a simple regular flow; the rising flow is unstable, begins to wobble, and then breaks out into a tangled mess -- turbulence. You don't need any outside cause or shock to the rising smoke to make it happen. 

Economies do highly irregular things too, as a rule, going through repeated booms and busts, and yet economists seem quite hesitant to see such fluctuations as the result of similar natural instability. In recent decades, at least, they seem to have greatly preferred the idea that fluctuations around average growth must be caused by "shocks" to the economy of some kind.…

In Bloomberg, I've written about some new work that puts this RBC theory into a very new light. It suggests, in fact, that theories of this basic class, if examined more closely, actually predict the existence of inherent instabilities in economies.…

The Physics of Finance

Economics beyond shocks??
Mark Buchanan

David Glasner — G. L. S. Shackle and the Indeterminacy of Economics

Analysis of rational expectations more than Shackle.

So in the end , I find myself unable to make sense of rational expectations except as a test for the internal consistency of an economic model, and, perhaps also, as a tool for policy analysis. Just as one does not want to work with a model that is internally inconsistent, one does not want to formulate a policy based on the assumption that people will fail to understand the effects of the policy being proposed. But as a tool for understanding how economies actually work and what can go wrong, the rational-expectations assumption abstracts from precisely the key problem, the inconsistencies between the expectations held by different agents, which are an inevitable, though certainly not the only, cause of the surprise and regret that are so characteristic of real life.

Uneasy Money
G. L. S. Shackle and the Indeterminacy of Economics
David Glasner

Noah Smith — What is an economic equilibrium?

I get asked about this one a lot. And it's also a source of controversy...on one hand you have some econ critics who say "Econ models wrongly assume that the economy is always in equilibrium," and on the other hand you have economists responding that "No, economics models are defined to always be in equilibrium." So I thought I'd try to clear things up...hopefully I don't just end up muddling them further. But anyway:

"Equilibrium" can mean many different things.

There are many different types of equilibria in economics. This may sound intellectually dishonest, but it's not; the same is true in biology, physics, or any other science. "Equilibrium" just means "balance", and there are lots of different kind of things that can balance. In fact, any equation you write down that isn't true by definition can be interpreted as an "equilibrium" relationship, or "equilibrium condition" - the equation is simply a statement that whatever's on the left-hand side of the equation is balanced with whatever's on the right-hand side.

Different economic models have different kinds of equilibria, so it's not like there's one kind of "equilibrium" that is all-important to modern economics....

Noahpinion
What is an economic equilibrium?
Noah Smith | Assistant Professor of Finance, Stony Brook University

Mark Buchanan — The Insupportable Equilibrium of Economic Thought

A theoretical physicist on why equilibrium models in economics are BS. It's the complexity, stupid.

Bloomberg
The Insupportable Equilibrium of Economic Thought
By Mark Buchanan | author of “The Social Atom: Why the Rich Get Richer, Cheaters Get Caught and Your Neighbor Usually Looks Like You.” This is the first in a series of three excerpts from his new book, “Forecast: What Physics, Meteorology and the Natural Sciences Can Teach Us About Economics,” to be published March 26 by Bloomsbury.

(h/t Ryan Harris in the comments)

Lars Syll — Macroeconomic quackery (from Robert Lucas)

In a recent interview Robert Lucas says he now believes that “the evidence on postwar recessions … overwhelmingly supports the dominant importance of real shocks.”

So, according to Lucas, changes in tastes and technologies should be able to explain the main fluctuations in e.g. unemployment that we have seen during the last six or seven decades.

Lars P. Syll's blog
Macroeconomic quackery
Lars P. Syll | Professor of Economics, Malmo University

Philip Pilkington: Purging Economics of Religion – A Rebuttal to Robert Nelson’s Defence of The Great Chain of Being

On several occasions I've referred to Robert Nelson's Economics as Religion: From Samuelson to Chicago and Beyond. Philip Pilkington provides an excellent review and critique, explaining neoclassical general and partial equilibrium v. Wynne Godley's stock-flow equilibrium.

Central to the Old Keynesian and Post Keynesian v. Neoclassical and New Keynesian controversy, as well as calling out economic moralizing for what it is.

Naked Capitalism
Philip Pilkington: Purging Economics of Religion – A Rebuttal to Robert Nelson’s Defence of The Great Chain of Beingg

The only way I can think to improve on this post is to add a quotation from Randy Wray about High Priest Paul Samuelson:

The reaction to our post on the nine myths also reminded me of an interview Nobel winner Paul Samuelson gave to Mark Blaug (in his film on Keynes, “John Maynard Keynes: Life/Ideas/Legacy 1995″). There Samuelson said:

“I think there is an element of truth in the view that the superstition that the budget must be balanced at all times [is necessary]. Once it is debunked [that] takes away one of the bulwarks that every society must have against expenditure out of control. There must be discipline in the allocation of resources or you will have anarchistic chaos and inefficiency. And one of the functions of old fashioned religion was to scare people by sometimes what might be regarded as myths into behaving in a way that the long-run civilized life requires. We have taken away a belief in the intrinsic necessity of balancing the budget if not in every year, [then] in every short period of time. If Prime Minister Gladstone came back to life he would say “uh, oh what you have done” and James Buchanan argues in those terms. I have to say that I see merit in that view.”

In other words, the need to balance the budget over some time period determined by the movements of celestial objects, or over the course of a business cycle is a myth, an old-fashioned religion. But that superstition is seen as necessary because if everyone realizes that government is not actually constrained by the necessity of balanced budgets, then it might spend “out of control”, taking too large a percent of the nation’s resources. Samuelson sees merit in that view.

It is difficult not to agree with him. But what if the religious belief in budget balance makes it impossible to spend on the necessary scale to achieve the public purpose? In the same film James Buchanan argues that the budget ought to be balanced except in wartime—and while he does not explicitly endorse Samuelson’s argument that this is nothing but a useful myth, he does imply that there is no financial/economic/solvency reason for balancing the budget. Rather, it is to keep government in check, to ensure it does not grow and absorb too many of the nation’s resources. Ironically, Buchanan’s willingness to deficit-spend in wartime seems to imply that the US ought to almost always run deficits since we are almost always at war with someone. Hence, he seems to advocate nearly permanent budget deficits—no doubt unintentionally. Many might question that position on the argument that if it is OK to run deficits to destroy one’s enemy then it surely makes sense to run deficits to build a strong nation. Indeed, older readers of this blog will remember that our nation got interstate hiways on the argument that this is good for national defense, and that many of us got through college on “national defense student loans”. [emphasis added]

Joshua Wojnilower — The Role of Money in Mainstream Macro

Based on my initial exposure to advanced macroeconomics, it appears true that “money would be at most a unit of account, but never a store of value.”

Bubbles & Busts
The Role of Money in Mainstream Macro
Joshua Wojnilower

The functions of money are 1) unit of account, 2) medium of exchange, 3) store of value, and 4) method of deferred payment. That is, 1) nominal price and record, 2) settlement of transactions in a payments system, 3) saving vehicle, and 4) credit. Mainstream macro does what?

Lars Syll — Paul Samuelson and the ergodic hypothesis

Paul Samuelson claimed that the “ergodic hypothesis” is essential for advancing economics from the realm of history to the realm of science.
But is it really tenable to assume that ergodicity is essential to economics?
The answer can only be – as I have argued
here
here
here
here
and
here – NO WAY!

Read it at Lars P. Syll's Blog
Paul Samuelson and the ergodic hypothesis
Lars P. Syll

Lars P. Syll — Why general equilibrium economics is a dead end

As long as we cannot show, except under exceedingly special assumptions, that there are convincing reasons to suppose there are forces which lead economies to equilibria - the value of general equilibrium theory is nil. As long as we can not really demonstrate that there are forces operating – under reasonable, relevant and at least mildly realistic conditions – at moving markets to equilibria, there can not really be any sustainable reason for anyone to pay any interest or attention to this theory.

A stability that can only be proved by assuming “Santa Claus” conditions is of no avail.

Read it at Lars P. Syll's Blog
Why general equilibrium economics is a dead end
by Lars P. Syll

Lars concludes:

Continuing to model a world full of agents behaving as economists – “often wrong, but never uncertain” – and still not being able to show that the system under reasonable assumptions converges to equilibrium (or simply assume the problem away), is a gross misallocation of intellectual resources and time.

We have to ask why this would continue for so long, when it is clearly unfruitful, and, moreover, both inefficient and damaging.

There are at least three possible explanations.

First, the people involved are excessively stubborn to the degree of being in denial wrt feedback. Check.

Secondly, it might be due to institutional momentum resulting from prior investments. Check.

Thirdly, as Ravi Batra asserts based on his analysis of historical evidence, it results from co-optation of the upper-echelon intelligentsia by the ruling elite, in this case the acquisitors that benefit from and support research recommending policy that favors the elite. Hmmm?

I recall some wag saying that since Marriner Eccles, the elite have never permitted anyone to be appointed as a central banker who actually understood central banking.

It seems like something similar happened in economics after Lorie Tarshis wrote the first introductory exposition of JMK, The Elements of Economics. Tarshis was promptly denounced as a communist sympathizer (sound familiar today?), The book was withdrawn as a textbook and is long out of print. (It's available for free download here).

Paul Samuelson tried to save Keynes by sanitizing him though a "synthesis" whose result was "bastard Keynesianism." Now "Keynesianism" of any sort is synonymous with "socialism."

And we are stuck with policy models that don't work other than for those benefitting from them most, and resistance to change is fierce. Accidental, or coincidental?

Noah Smith — DSGE vs. Weather Forecasting

Why would "disequilibrium dynamics" be important? I can think of several reasons.

Reason 1: The equilibrium may shift at about the same speed that convergence happens. If the economy is trying to hit a moving target, chaos will result. See this paper by Andrew Lo for a semi-technical explanation of why this true. (In math-speak, this happens when the rate of convergence, k, may be of the same order as the parameters governing the time-scale of the shock process.)

Reason 2: The equilibrium may not be stable. See this blog post by Jonathan Schlefer (whosebook I just ordered off of Amazon):In 1960 Herbert Scarf of Yale showed that [even the most ideal kind of] economy can cycle unstably. The picture steadily darkened. Seminal papers in the 1970s, one authored by [General Equilibrium inventor] Debreu, eliminated "any last forlorn hope," as the MIT theorist Franklin Fisher says, of proving that markets would move an economy toward equilibrium. Frank Hahn, a prominent Cambridge University theorist, sums up the matter: "We have no good reason to suppose that there are forces which lead the economy to equilibrium."In other words, the smooth convergence equation that Lucas wrote down may simply not be true.

Reason 3 (the biggie): There may be multiple equilibria. You rarely see famous and influential DSGE papers with multiple equilibria, and when you do see them, there are usually only two equilibria. But I know of absolutely no reason why the real economy should have a unique equilibrium. And I know of absolutely no reason why the number of equilibrium in the economy should be small! But there seems to be a huge publication bias in favor of smaller number of equilibria (Roger Farmer's efforts notwithstanding). This annoys me.

Read the whole thing at Noahpinion

DSGE vs. Weather Forecasting

by Noah Smith
(ht Mark Thoma)

Noah Smith asks whether macroeconomic methods politically biased

But I contend that in the case of DSGE models, conservative policy recommendations don't emerge because they come from the best models, but only because they come from the easiest models. Thus, the conservative slant of modern macro comes not from the weight of evidence, but from the combination of publication bias and the inherent unwieldiness of the DSGE framework.

Now here's something else that might be worth mentioning. The DSGE framework was invented in large part by Ed Prescott, a man with deeply conservative political beliefs. The insistence that microfounded models with individual optimization were the only believable "structural" models - i.e., the only models that could answer the Lucas critique - came mostly from people with deeply conservative political beliefs (including Robert Lucas himself). And the criticism of alternative modeling approaches - in particular, of SVARs - seems to be much louder from economists with deeply conservative political beliefs.

That by itself proves nothing. (Maybe they're conservative because they believe the results of their models! Maybe conservatives are more scientifically honest!) But it seems like circumstantial evidence against the alleged political neutrality of modern macro methods.

Read it at Noahpinion
Are macroeconomic methods politically biased?
by Noah Smith