Friday, October 03, 2014

Neo-Classical voodoo economics

David Glasner gives an explanation in EconomistSpeak of how neo-classical economics displaced reality-based Keynesian economics in many institutions and in the most prevalent public narratives about economics. From Explaining the Hegemony of New Classical Economics Uneasy Money 09/30/2014:

These early attempts at providing microfoundations were largely exercises in applied price theory, explaining why self-interested behavior by rational workers and employers lacking perfect information about all potential jobs and all potential workers would not result in immediate price adjustments that would enable all workers to find employment at a uniform market-clearing wage. Although these largely search-theoretic models led to a more sophisticated and nuanced understanding of labor-market dynamics than economists had previously had, the models ultimately did not provide a fully satisfactory account of cyclical unemployment. But the goal of microfoundations was to explain a certain set of phenomena in the labor market that had not been seriously investigated, in the hope that price and wage stickiness could be analyzed as an economic phenomenon rather than being arbitrarily introduced into models as an ad hoc, albeit seemingly plausible, assumption.

But instead of pursuing microfoundations as an explanatory strategy, the New Classicals chose to impose it as a methodological prerequisite. A macroeconomic model was inadmissible unless it could be explicitly and formally derived from the optimizing choices of fully rational agents. Instead of trying to enrich and potentially transform the Keynesian model with a deeper analysis and understanding of the incentives and constraints under which workers and employers make decisions, the New Classicals used microfoundations as a methodological tool by which to delegitimize Keynesian models, those models being insufficiently or improperly microfounded. Instead of using microfoundations as a method by which to make macroeconomic models conform more closely to the imperfect and limited informational resources available to actual employers deciding to hire or fire employees, and actual workers deciding to accept or reject employment opportunities, the New Classicals chose to use microfoundations as a methodological justification for the extreme unrealism of the rational-expectations assumption, portraying it as nothing more than the consistent application of the rationality postulate underlying standard neoclassical price theory. [my emphasis]
A brief unpacking: Microeconomics is about transactions at the business level; macroeconomics is about the functioning of economies on the national and international levels.

The famous supply-and-demand charts of microeconomics, featuring things like "marginal pricing," are based on several abstract assumptions, including consumers make rational choices based on full information about the prices and products available in the market.

Now, this is valid up a point. If you're going to make a mathematical model of any process, you have to have some limiting assumptions. Otherwise, you'd have to recreate all of the science of astrophysics to model even the simplest process.

The obvious problem with a model that assumes a world of rational customers, with perfect competition, and all actors have full and perfect knowledge of the markets is that it's plainly not the real world. In such world, the entire fields of marketing and advertising wouldn't exist, to mention just one problem.

But expanding these "microfoundations" to macroeconomics allowed conservative economists to demonstrate with impressive mathematical edifices to show, for instance, that a company's stock valuation always represents its real economic value, that the stock market moves are directly connected to real economic activity, that arbitrage and rent-seeking basically can't exist, and that anything corporations actually do makes perfect economic sense. There are never irrational market panics, or corporate conspiracies against the public interest and - most importantly - economic crises like that of 2008 are impossible.

And if the impossible happens, well, the gubment must be to blame. And black people, of course. (Update: the latter refers in particular to the US Republican version of this ideology.)

Yes, a very large part of respectable economics is just that crude. It comes in various packaging. But its based on the same highly ideological construct. Robert Lucas won the Nobel Prize for Economics in 1995 for a variant called "rational expectations theory," (also known as the rational expectations hypothesis [REH]) which basically argued that no government policies can ever have any substantial effect on an economy's performance, except occasionally to muck things up. The basic concept was developed by John Nash, Jr., continued by John Muth and eventually elaborated into its most famous form by Lucas and Thomas Sargent, as related by Yanis Varoufakis, Joseph Halevi and Nicholas Theocarakis in their textbook Modern Political Economics: Making Sense of the Post-2008 World (2011). As they explain:

If the world behaves like this type of theory suggests, it is impossible for output, employment or any other variable that society cares about to be positively affected by means of government intervention. If agents always entertain the correct expectations plus some random noise), then aggregate output and employment is always going to be as high as it can. Inevitably, meddling governments can only undermine perfection!

Remarkably, the REH literature dominated at a time of historically high unemployment. How did it manage that? To be consistent with their model, they had to claim that if observed unemployment is, say, 8 per cent, then 8 per cent is the level of unemployment that it is 'natural' for the economy to have at that point - the 'natural' rate consistent with agents' rational, i.e. correct, expectations. Suppose, they added, government tried to suppress unemployment to below that 'natural' level by means of 'Keynesian' meddling. The ensuing increase in the quantity of money cannot, in this context, change what people expect (in terms of actual output, employment, etc.) since everyone harbours the correct expectations. Everyone will then know in advance, on the basis of their rational expectations, that the government's effort will leave output and employment unaffected. Immediately they will surmise that prices must rise (since there is now more money in the economy chasing after the same quantity of goods and the same amount of actual labour). [my emphasis in bold]
This is kind of thinking that Glasner accurately calls "extreme unrealism."

No comments: