More on Microfoundations

by Severin Reissl

Good news first. For anyone who has not noticed yet, it would appear that the Bank of England has (finally) come round to accepting Post Keynesian endogenous money theory, at least partially. People more capable than myself have already commented on this, so I am just mentioning it in passing.

After writing the post in which I criticise my macroeconomics textbook, in particular focusing on its commitment to microfoundations, I came across this article by John E. King, with the same title as his book, ‘The Microfoundations Delusion” (which was recently released as a paperback. Unfortunately, the university library does not hold a copy). The article is really worth reading as, I am sure, is the book, which has been discussed elsewhere. I want to focus on one point King makes at the end of the article:

“Finally, there is the issue of academic economists’ reactions to the global financial crisis that began in 2008. The microfoundations dogma has played an important role in the ‘business as usual’ strategy of the mainstream of the profession, in terms of both theory and policy, and it has exercised an indirect but very important influence on public opinion. This is evident in the widespread popular support for ‘fiscal consolidation’ in many European countries, where public services have been slashed in the name of ‘debt reduction’, reducing effective demand and further increasing unemployment – and government debt.”

Without specifically going into the austerity debate, this is indeed a general attitude I have encountered on various occasions – from academic economists and, more worryingly, also from (advanced) students. Ideas both new and old are dismissed out of hand because they are not based on microfounded models. By the same token, rational expectations in macroeconomics, just as, for example, efficient markets in finance, are not treated as hypotheses to be tested (indeed, these concepts are by their very nature largely untestable, irrefutable and, following Hans Albert’s criteria, utterly devoid of information) but rather as necessary presuppositions upon which any theoretical contribution must be based if it is to be taken seriously.  Alternatives are variously branded “unscientific”, “not rigorous”, or both. What does it mean for an approach to economics to be “scientific”? I think it was shown sufficiently in the previous post on this topic that there is nothing which makes the kinds of models developed in response to the Lucas critique preferable prima facie, and King makes a good case for why they are, in fact, inferior. In truth, such defenses are merely empty phrases, deployed by people unwilling to admit or incapable of recognising that their theories are based on ideological concepts, to reassure themselves that they are good scientists and that theirs is the only correct way. All this is very akin to Joan Robinson’s account in Economic Philosophy of pre-Keynesian attempts to turn economics into a “hard science”. In fact, if you changed a few names and terms, that chapter in her book, although published in 1962, could just as well describe the evolution of the discipline since the 80s. Everybody’s favourite textbook author Greg Mankiw goes as far as seeing the entire development of macroeconomics as a relationship, at times conflictual, between “scientists and engineers” as he puts it.

Another textbook I had to suffer this semester (Introduction to Economic Growth by Charles I. Jones) provides a prime example of this attitude, and specifically of how it is being transmitted at an undergraduate level:

[…] it is helpful to think of the economist as a laboratory scientist. The economist sets up a model and has control over the parameters and exogenous variables. The “experiment” is the model itself.  Once the model is setup, the economist starts the experiment and watches to see how the endogenous variables evolve over time. (p. 27)

Wonderful. Do I get a labcoat as well? This passage might seem trivial, but seen as part of a particular view of the greater whole as exemplified by Mankiw’s article, the objective is clear: there is one right, scientific, rigorous way of doing economics. This is what we will teach you, and everything else can safely be ignored without consideration.

One effect of all this, as King notes, is to stall change among the current mainstream practitioners of the discipline following the exposure of its glaring inadequacies in the wake of the financial crisis. The most devastating effect, though, is that such prejudices, through constant repetition over the course of a typical education in economics, are drilled into the student’s head over and over again, until they seem too self-evident to be open to question. Thus the academic inertia are reproduced. The most dangerous ideologue is the one who will not admit that he is one (closely followed by the one who does not know that he is one).

Loanable funds – 75 years later

by Severin Reissl

The recent discussion I had about Keynes’ article The Process of Capital Formation with Phil Pilkington (he wrote an excellent post about the paper) reminded me of a conversation I had with one of my lecturers some time ago. For a reason I cannot remember we were talking about saving and investment, and I voiced some criticism of the savings-cause/finance-investment view. She actually agreed with most of what I said (although she evidently believed that I was not saying anything new – a common attitude of the mainstream when confronted with criticism), and I ended up recommending a great working paper by Fabian Lindner of the Macroeconomic Policy Institute in Düsseldorf which debunks these notions quite skilfully.

Yet I remain puzzled about why, then, this same lecturer is prepared to keep teaching models that happily accept this erroneous view. Keynes, in the article mentioned above, is able to strike a quite critical blow to the loanable funds theory in the simplest terms possible. That was in 1939, and a lot has happened since then to complete the theory’s intellectual collapse (but, unfortunately, not its abandonment). 75 years later, I am confronted on my Macroeconomics module with the Solow model of economic growth. Now, there is a truckload of stuff that is wrong with this model and concepts related to it (reliance on the marginal productivity theory of income distribution; all the problems related to “growth accounting” and the “Solow residual” as analysed by Felipe & McCombie …), but what I want to focus on is that this model tells me that poor countries will become rich if they save more. The savings rate is a key determinant of an economy’s “steady state” level of income in this model, and the savings-investment identity is clearly presented to mean that a higher savings rate will cause more investment and hence growth. Yet this idea is just as false in the “long run” as it is in the “short run”. In fact, the distinction between short run and long run is particularly unhelpful in this context. The long run is itself just the result of a series of short runs and its character is determined by these. Therefore, if the paradox of thrift holds in the short run, there is no sense in saying that somehow, saving still magically causes investment and growth in the long run.  The trick is achieved by assuming that full employment prevails at any point in the Solow model, which amounts to assuming away the paradox of thrift altogether, at all points in (logical) time.

“[…] if households cut their consumption expenses by a certain amount because they plan to increase their financial net worth (believing in accordance with loanable funds theory that higher financial saving meant higher investment), corporations would immediately and mechanically see their revenues and profits from the sale of consumption goods fall by the same amount. […] As is rather obvious, there is no ex ante certainty that corporations, seeing their sales drop, will maintain their previous level of expenses – as loanable funds theory would like us to believe – or even increase their production of investment goods. Further, it is neither certain nor likely ex ante that firms would now borrow and increase their future debt service in the face of lower profits” (Lindner, 2012)

By assuming full employment at any point, we are assuming exactly this type of counterintuitive behaviour from agents in our model. It still does not mean that saving causes investment, but rather that we are imposing that there will always be sufficient outlays to maintain full employment at any desired rate of saving. Keynes reminds us in Chapter 21 of the General Theory that we use models “to provide ourselves with an organised and orderly method of thinking out particular problems; and, after we have reached a provisional conclusion by isolating the complicating factors one by one, we then have to go back on ourselves and allow, as well as we can, for the probable interactions of the factors amongst themselves. This is the nature of economic thinking “. And this is precisely what the Solow model does not do, by assuming away the complications pointed out through simply imposing full employment at all times.

I believe that this is an enormously important thing to point out. I am quite convinced that even many mainstream economists would agree with the analysis above, yet the Solow model is still being taught and, along with some other common culprits, contributes to forcing these erroneous views into students’ heads. The saving-causes/finances-investment view has a massive superficial appeal, because it is something we can metaphorically relate to our own lives. A big part of the problem is that, in my experience, the terms “investment” and particularly “saving” are notoriously liable to being ill-defined in economics courses. The crucial distinction between how they are used in everyday parlance and what they mean in an aggregate/national accounting sense is seldom pointed out. Indeed, the confusion is being encouraged, whether intentionally or not, by the way concepts such as the Solow model are presented. I would urge any student to read Lindner’s paper to get a grip on this distinction.

Since I am planning further posts on this blog, I should say that although I am an officer of Glasgow University Real World Economics Society, the views expressed in my posts do not necessarily represent the views of the society (although of course I hope that they do). Once this blog gets going properly (hopefully after our AGM), there will likely be posts from other members as well, and it will be used as a forum for expression of many different points of view.

Some random thoughts on my macro textbook

by Severin Reissl

With in-course exams coming up, I have started dipping into the recommended reading for my Macroeconomic Analysis module, specifically for the “short run” part of the course. Most of this comes from “Macroeconomics – Imperfections, Institutions & Policies” by Carlin & Soskice. This book claims to be presenting the state of the art of “modern” macroeconomics, and, sadly enough, that is probably true. Most of what I have read of it appears very similar to New Consensus Macroeconomics as described and critiqued, for example, by Arestis and Tcherneva. It covers a remarkably great amount of material, ranging from very basic stuff like IS-LM to a more advanced microfounded New Keynesian model. Most of the short run discussion centres on a “Three-Equation-Model” consisting of an IS curve, a Phillips Curve and a central bank monetary rule. Of course, being an 800 page tome, there will be no course in the world teaching the whole of this book. It will be taught selectively anywhere, just as it is on my course. I’ll admit I’ve not read the whole of it and I doubt I’d be able to. I’d probably soon throw the book or myself out the window.

Coming straight to the point, I think this book is full of crap and I am finding it exhausting and painful to read. While it is reasonably clear and concise, it is full of sweeping generalisations, frequent allusions to “empirical evidence” that are not elaborated upon and, most importantly, what I would consider to be pedagogically harmful methods of exposition. Focusing in particular on the “three equation model” it would have the student believe not only that there is such a thing as a well defined, stable IS curve, as well as a strictly upward sloping Phillips curve, but also that the central bank knows exactly just what these look like, and is consequently able to “choose” a point on the relevant PC according to its “indifference curves”, to pick a combination of output and inflation exactly to its liking. This is reached without any difficulty. No distinction is made between the fantasy-world of this model and reality. Transition between them is completely unproblematic. If it really was that simple, why not elect a bunch of monkeys to the monetary policy committee, if all this body does is to pick a point on a curve? Interest rate targeting by the central bank is presented as a deliberate choice, being merely preferable to money supply targeting. Possible problems with targeting the money supply are grossly understated and confined to one short paragraph in a different chapter (which, incidentally, is not being covered on the course). The exposition is typical of economics textbooks. Heavy on (admittedly quite basic) maths and pretty curves, very very light on reality and practice, methodology, and self-reflection. I’m not sure what this is supposed to prepare me for. But it is certainly trying to get me to think uncritically in terms of some half-baked models by wrongfully presenting them as analogous to reality and representative of some universal “consensus”. As a student, I feel strangely patronised by this. The authors ascribe to me the ability to comprehend the mathematical exposition of their model, yet obviously they think I am, or should be, incapable of critically evaluating what they present to me. Is this what higher education is supposed to achieve?

For instance, the book is utterly uncritical of the rational expectations hypothesis, presenting it as a genius insight, while the exposition itself is inconsistent and self-contradictory. The central bank is presented as being able to distinguish perfectly between temporary and permanent shocks to aggregate demand, but firms are unable to distinguish a rise in overall inflation from a change in relative prices. The most basic problem with rational expectations is ignored, namely that it turns  macroeconomics as such into a tautology.  Rational expectations imply that any policy to affect output will be ineffective because people have rational expectations, and hence they cannot be “fooled” by policy. Because they are rational, they have in their head the correct model of the economy, hence being able to perfectly predict outcomes. The correct model, of course, is the one that assumes rational expectations (as well as a bunch of other stuff). Therefore, the model is correct because it is correct. Wow. To put it another way, the model is correct because we assume that people think it is correct (which is why they use it). Why do they think it is correct? Because they are rational. Why are they rational? Because the model assumes it. The circularity here should be obvious.

The book claims that

“It is now accepted that macro models should be anchored in microfoundations with optimizing agents who have rational expectations and hence that such models should be immune to the Lucas critique (p. 545)”

It is quite remarkable how seriously the Lucas critique is taken, yet how uncritically other assumptions are accepted. The cutoff point, so to speak, is completely arbitrary. It is not ok to have a model without microfoundations, because a change in policy will change the parameters of the model, essentially the optimising decisions of individuals, which have to be modelled on a micro level. But it is ok to model these microfoundations using unchanging parameters such as the preferences of these individuals (for an elaboration on this see this post by Phil Pilkington on Robinson’s critque of marginal utility). So while the model may be “immune” to the Lucas critique in a narrow sense, it is still “vulnerable” to similar critiques pertaining to different aspects of the model. It is simply a matter of how far one chooses to take the critique.

Phil sums this up rather nicely in another post:

“The Lucas critique itself is similar in many ways to a small child asking the question “why?” over and over again until told to shut up by the adult. If properly and coherently formulated the critique would be bottomless. First the critic would ask why the analyst has not taken into account the “behaviour” of “individuals”. Then he would ask why the analyst has not taken into account the “psychology” of these “individuals”. Then perhaps he would ask why the analyst has not taken account of the “biological” and “genetic” features behind this “psychology”, and so on and so on ad infinitum. (The sharp reader will note that the words placed in quotation marks in the last three sentences all imply some sort of aggregation, whether of something called an “individual” or of some sort of “average” of behaviours of this “individual” and so on). This process of looking deeper and deeper into the micro or the molecular is, as we have seen in our discussion of schizophrenia and human cognition, by its very nature interminable. In order to stop at some point and stop the nattering questioning the analyst must come to a halt at some given level of abstraction. And this is precisely what Lucas and his followers – who pretty much constitute the entire of the mainstream economics profession – did.”

The chosen “cutoff” point is the rational, maximising, representative individual. Why this is so is not discussed or justified. This choice means we ignore any emergent properties at higher levels of aggregation as well as any “deeper” properties of the individual. Keep in mind that the predictions of “microfounded” models arise precisely from these arbitrary decisions and are in no way as inevitable as the textbooks would have you believe!

I realise this is a rather incoherent post, but this is an 800 page book and there is so much wrong with it that one could probably write at least another 800 page book just about that. The basic message should be this: Learn this stuff, by all means, because having done an economics degree you’ll be expected to know it. But don’t accept it uncritically. Just because it’s precise and mathematical doesn’t mean it is right! Don’t buy into any of it without reflecting upon it.

GURWES PKE Tutorials – A Note On Constant Marginal Cost

At this week’s voluntary tutorial on Economics 2B run by GURWES, some points came up which may need further clarification.
It was asserted that firms generally (and particularly firms in manufacturing) produce with constant marginal/unit cost. This is in contrast with neoclassical microeconomic theory, which typically holds that firms will produce at rising MC.

The first thing to note is that this question is of highest importance when discussing perfect competition. In the first tutorial, the point was made that an independent supply curve can only be derived for perfect competition (an independent supply curve traces out a unique relationship between quantity and price, i.e. each quantity is only produced at one specific price and vice-versa). All mainstream micro textbooks make this point, and usually have a diagram to show why a supply curve which is independent from the demand curve cannot be derived for a monopoly, for instance (see e.g. Pindyck & Rubinfeld, 2012, p. 366 (still the 2A textbook?)). So, keep in mind that whenever you are shown a diagram (e.g. to analyse the welfare impact of a sales tax) where supply and demand are depicted as independent, it is implicitly assumed that the investigated industry is perfectly competitive, even if this is not mentioned explicitly. I know, in the first tutorial we showed how even under perfect competition, an independent supply curve cannot be derived, but let’s accept the neoclassical reasoning for the moment, i.e. assume that a perfectly competitive firm is facing a horizontal demand curve at the prevailing market price.

How does a perfectly competitive firm behave? It observes the prevailing market price and then produces output until its marginal cost has risen far enough to equal that price. What would happen if the marginal cost was constant? Well, the firm would produce an infinite amount of output, since MC would never equal P (Yes, even the Post Keynesian firm experiences rising unit cost beyond full capacity, but bear with me). So marginal cost can’t possibly be constant, right? Well, this is where the theory really runs into trouble because, unfortunately, studies conducted by Alan Blinder (not exactly a heterodox economist, incidentally), as cited by Keen (2011, p. 126) show that only around 11% of US GDP are produced under conditions of rising marginal cost. So 89% aren’t. The point here is that if marginal cost at the point of production is constant, the firm cannot possibly be a profit-maximising perfectly competitive firm as envisioned by neoclassical theory, see the diagrams below:

PCMC

(Note: the second diagram is not the Post Keynesian production diagram but just a tool for illustration! The appropriate diagram can be found in Lavioe (2006) and in your lecture slides)
From the presentation in most micro textbooks, you could get the impression that at least 90% of the economy was perfectly competitive, by the relative weight given to the examination and application of that theory. A prime example is Mankiw (2012) who, in his treatment of income distribution, thinks it’s okay to model the entire economy as perfectly competitive. This is not the case (quite apart from the fact that the theory is unsound in the first place).

Studies like Blinder’s are also a good point of departure for discussing the Post Keynesian/Kaleckian theory of the firm. There are other studies also cited in Keen (2011, Ch. 5) showing that constant or falling marginal cost is appropriate to describe the vast majority of firms’ cost-conditions in industrialised countries. Then there is the data on excess capacity, also cited in that chapter as well as in Lavoie (2006), which we mentioned in the tutorial.

Observing this evidence, which are the most appropriate premises on which to construct a theory of production? The Post Keynesian theory of the firm, as presented to you in lectures and this week’s tutorial, would suggest itself since Leontief production functions result in constant or, under economies of scale, falling unit direct cost. In this sense, it is in accordance with the real world.

Leontief production functions also imply constant factor proportions, that is, labour and capital are used in a fixed ratio to produce output. Whether this always holds in practice I do not know, but keep in mind that the labour included in this ratio is only the labour physically required to produce the output, i.e. supervisors, managers, accountants, marketing and so forth are part of the overhead, the fixed cost! The Post Keynesian reasoning is that an existing plant embodies the technology prevailing when it was built. It was planned and constructed to be operated at maximum efficiency from the start by a specific number of workers, so that adding or removing a few does not make sense (one could add an additional shift though, if capacity permits, keeping the ratio constant). Similarly, if the plant can be divided into several assembly lines, it wouldn’t make sense to employ its entire capital at less than full efficiency by spreading workers evenly (which is what the neoclassical firm would do) but rather to operate one segment at full efficiency, leaving the rest idle (A point made by Sraffa and illustrated by an example in Keen (2011, p. 113)). As Lavoie (2006: 40) notes: “each firm usually has a number of physical plants, which are generally divided into a number of segments or assembly lines. The level of practical capacity is defined as the production capacity of a plant or a plant segment, as measured by engineers, the so-called engineer-rated capacity. Each segment is designed to operate with a given number of workers for a given number of hours. (…) Even if some flexibility is possible, bureaucratic rules and regulations, such as collective bargaining agreements, as well as customs and habits, dictate the number of workers on each machine.”

Is this a perfect description of reality? Probably not, but I would argue that it is a far more valid generalisation than neoclassical production functions given the empirical data.

Further (theoretical) underpinning comes from Piero Sraffa’s critique of diminishing returns, outlined in Keen (2011, Ch. 5). Sraffa observes that neoclassical economics makes two assumptions which are mutually contradictory:

–          Demand and supply curves are independent

–          There are factors of production which are fixed in the short run

Note that the “law” of diminishing returns has its origins in classical political economy. David Ricardo used it to derive a theory of aggregate rent on land. So it was originally conceived as a concept applying at the macro-level, connected to the distribution of income. Neoclassical economists picked up on the concept and applied it to the micro-level theory of production.

Sraffa goes on two make two critiques:

Sraffa’s broad arrow: If an industry is broadly defined (say, the agricultural sector), it is valid to treat one input as fixed. The industry utilises a large share (or, in extreme cases, all) of it and it will be costly and time-consuming to obtain additional doses of it. However, such a broadly defined industry can no longer be treated as a price-taker in input markets. If agriculture attempts to increase its output by employing more labour, the price of labour (the wage rate) will rise. This affects the distribution of income, and hence demand for the output of this broadly defined industry. Demand and supply are not independent, i.e. it is not possible to derive an independent supply curve. “Thus while diminishing returns do exist when industries are broadly defined, no industry can be considered in isolation from all others [which is what neoclassical theory of production does], as supply and demand curve analysis requires” (Keen, 2011, p. 111).

Sraffa’s narrow arrow: If an industry is narrowly defined, on the other hand, Sraffa argues that the assumption that some input is fixed is not reasonable. Sraffa argues that, if need be, such a narrowly defined industry will be able to draw marginal doses of this input from other industries, or to activate unutilised stocks of inputs, so that its unit-cost won’t increase appreciably. The former may, admittedly, not be the case with inputs such as specialised capital equipment, but the empirical observations on spare capital capacity in industry back up Sraffa’s point. This means that the ratio of inputs remains constant as output is increased.

The reasons firms have for keeping spare capacity were, I think, sufficiently discussed in the tutorial. An important point to note is that the output of a firm producing at constant marginal cost is constrained by demand. Sure, the firm would like to sell as much as it could possibly produce, but because in the real world firms aren’t perfectly competitive and products are differentiated, for a given demand there’s only so much output that can be sold. We could also add that a firm is constrained by available internal and external financing. Production takes time, and workers typically have to be paid before the output is sold.

I hope this makes the whole story a bit clearer, and if any questions remain please feel free to ask them next week! Also, I emphasise again that it’s really worth reading Keen’s book. If not all of it then at least those chapters with direct relevance to the course content. It covers not only the stuff you talk about in your tutorials, but also things you will be examined on (such as the Post Keynesian theory of the firm) and it really helped me get a better idea of the concepts, whilst at the same time it is quite entertaining.

Best,
Severin

References:

Keen, Steve (2011) Debunking Economics – The Naked Emperor Dethroned? Revised and Expanded Edition, London: Zed Books.

Lavoie, Marc (2009) Introduction to Post-Keynesian Economics, Basingstoke: Palgrave Macmillan.

Mankiw, Gregory (2012) Macroeconomics International Edition, 8th edition, Basingstoke: Worth Publishers/Palgrave Macmillan.

Pindyck, Robert and Rubinfeld, Daniel (2012) Microeconomics – International Edition, 8th edition, Boston: Pearson.