Noah Smith has a new post on the failure of mainstream macroeconomics and what he perceives as the lack of ‘heterodox’ alternatives. Noah is correct about the failure of mainstream macroeconomics, particularly the dominant DSGE modelling approach. This failure is increasingly — if reluctantly — accepted within the economics discipline. As Brad Delong puts it, DSGE macro has ‘… proven a degenerating research program and a catastrophic failure: thirty years of work have produced no tools for useful forecasting or policy analysis.’
I disagree with Noah, however, when he argues that ‘heterodox’ economics has little to offer as an alternative to the failed mainstream.
The term ‘heterodox economics’ is a difficult one. I dislike it and resisted adopting it for some time: I would much rather be ‘an economist’ than ‘a heterodox economist’. But it is clear that unless you accept — pretty much without criticism — the assumptions and methodology of the mainstream, you will not be accepted as ‘an economist’. This was not the case when Joan Robinson debated with Solow and Samuelson, or Kaldor debated with Hayek. But it is the case today.
The problem with ‘heterodox economics’ is that it is self-definition in terms of the other. It says ‘we are not them’ — but says nothing about what we are. This is because it includes everything outside of the mainstream, from reasonably well-defined and coherent schools of thought such as Post Keynesians, Marxists and Austrians, to much more nebulous and ill-defined discontents of all hues. To put it bluntly, a broad definition of ‘people who disagree with mainstream economics’ is going to include a lot of cranks. People will place the boundary between serious non-mainstream economists and cranks differently, depending on their perspective.
Another problem is that these schools of thought have fundamental differences. Aside from rejecting standard neoclassical economics, the Marxists and the Austrians don’t have a great deal in common.
Noah seems to define heterodox economics as ‘non-mathematical’ economics. This is inaccurate. There is much formal modelling outside of the mainstream. The difference lies with the starting assumptions. Mainstream macro starts from the assumption of inter-temporal optimisation and a system which returns to the supply-side-determined full-employment equilibrium in the long run. Non-mainstream economists reject these in favour of assumptions which they regard as more empirically plausible.
It is true that some heterodox economists, for example Tony Lawson and Ben Fine, take the position that maths is an inappropriate tool for economics and should be rejected. (Incidentally, both were originally mathematicians.) This is a minority position, and one I disagree with. The view is influential, however. The highest-ranked heterodox economics journal, the Cambridge Journal of Economics, has recently changed its editorial policy to explicitly discourage the use of mathematics. This is a serious mistake in my opinion.
So Noah’s claim about mathematics is a straw man. He implicitly acknowledges this by discussing one class of mathematical Post Keynesian models, the so-called ‘stock-flow consistent’ models (SFC). He rightly notes that the name is confusing — any correctly specified closed mathematical macro model should be internally consistent and therefore stock-flow consistent. This is certainly true of DSGE models.
SFC refers to a narrower set of models which incorporate detailed modelling of the ‘plumbing’ of the financial system alongside traditional Keynesian macro behavioural assumptions — and reject the inter-temporal optimising assumptions of DSGE macro. Marc Lavoie, who originally came up with the name, admits it is misleading and, with hindsight, a more appropriate name should have been chosen. But names stick, so SFC joins a long tradition of badly-named concepts in economics such as ‘real business cycles’ and ‘rational expectations’.
Noah claims that ‘vague ideas can’t be tested against the data and rejected’. While the characterisation of all heterodox economics as ‘vague ideas’ is another straw man, the falsifiability point is important. As Noah points out, ‘One of mainstream macro’s biggest failings is that theories that don’t fit the data continue to be regarded as good and useful models.’ He also notes that big SFC models have so many parameters that they are essentially impossible to fit to the data.
This raises an important question about what we want economic models to do, and what the criteria should be for acceptance or rejection. The belief that models should provide quantitative predictions of the future has been held too strongly. Economists need to come to terms with the reality that the future is unknowable — no model will reliably predict it. For a while, DSGE models seemed to do a reasonable job. With hindsight, this was largely because enough degrees of freedom were added when converting them to econometric equations that they could effectively project past trends forward, along with some mean reversion. This predictive power collapsed totally with the crisis of 2008.
Models then should be seen as ways to gain insight over the mechanisms at work and to test the implications of combining assumptions. I agree with Narayana Kocherlakota when he argues that we need to return to smaller ‘toy models’ to think through economic mechanisms. Larger econometrically estimated models are useful for sketching out future scenarios — but the predictive power assigned to such models needs to be downplayed.
So the question is then — what are the correct assumptions to make when constructing formal macro models? Noah argues that Post Keynesian models ‘don’t take human behaviour into account — the equations are typically all in terms of macroeconomic aggregates — there’s a good chance that the models could fail if policy changes make consumers and companies act differently than expected’
This is of course Robert Lucas’s critique of structural econometric modelling. This critique was a key element in the ‘microfoundations revolution’ which ushered in the so-called Real Business Cycle models which form the core of the disastrous DSGE research programme.
The critique is misguided, however. Aggregate behavioural relationships do have a basis in individual behavour. As Bob Solow puts it:
‘The original impulse to look for better or more explicit micro foundations was probably reasonable. It overlooked the fact that macroeconomics as practiced by Keynes and Pigou was full of informal microfoundations. … Generalizations about aggregative consumption-saving patterns, investment patterns, money-holding patterns were always rationalized by plausible statements about individual — and, to some extent, market-behavior.’
In many ways, aggregate behavioural specifications can make a stronger claim to be based in microeconomic behaviour than the representative agent DSGE models which came to dominate mainstream macro. (I will expand on this point in a separate blog.) [edit: here it is]
Mainstream macro has reached a point where only two extremes are admitted: formal, internally consistent DSGE models, and atheoretical testing of the data using VAR models. Anything in between — such as structural econometric modelling — is rejected. As Simon Wren-Lewis has argued, this theoretical extremism cannot be justified.
Crucial issues and ideas emphasised by heterodox economists were rejected for decades by the mainstream while it was in thrall to representative-agent DSGE models. These ideas included the role of income distribution, the importance of money, credit and financial structure, the possibility of long-term stagnation due to demand-side shortfalls, the inadequacy of reliance on monetary policy alone for demand management, and the possibility of demand affecting the supply side. All of these ideas are, to a greater or lesser extent, now gradually becoming accepted and absorbed by the mainstream — in many cases with no acknowledgement of the traditions which continued to discuss and study them even as the mainstream dismissed them.
Does this mean that a fully-fledged ‘heterodox economics’ is waiting in the wings waiting to take over from mainstream macro? It depends what is meant — is there complete model of the economy sitting in a computer waiting for someone to turn it on? No, but there never will be — either within the mainstream or outside it. But Lavoie argues,
‘if by any bad luck neoclassical economics were to disappear completely from the surface of the Earth, this would leave economics utterly unaffected because heterodox economics has its own agenda, or agendas, and its own methodological approaches and models.’
I think this conclusion is too strong — partly because I don’t think the boundary between neoclassical economics and heterodox economics is as clear as some claim. But it highlights the rich tradition of ideas and models outside of the mainstream — many of which have stood the test of time much better than DSGE macro. It is time these ideas are acknowledged.
Originally published at criticalfinance.org on August 9, 2016.