Putting Economic Models in Their Place

Over at Project Syndicate: Putting Economic Models in Their Place:

Among the voices calling these days for new — or at least substantially different — economic thinking http://ineteconomics.org is the very sharp Paul M. Romer http://paulromer.net/ of New York University, with his critique of what he calls “Mathiness” in modern economics http://paulromer.net/mathiness/. He seems, to me at least, to be very worried principally about two aspects of modern economic discourse. The first is to take what is true about one restricted class of theories and generalize it, claiming it is true of all theories and of the world as well.

Romer’s prime example is Robert Lucas, in the claim:

Some knowledge can be ‘embodied’ in books, blueprints, machines, and other kinds of physical capital, and we know how to introduce capital into a growth model, but we also know that doing so does not by itself provide an engine of [permanently] sustained growth…

That is true in the theory — if and only if the growth model is set up so that the return on that kind of embodiment capital drops to zero eventually as capital accumulates. As Romer notes, there are models in which things are otherwise, including: those “with an expanding variety of capital goods or a ladder of capital goods of improving quality…” Thus what Lucas claims must be true about the world as a matter of correct theory — that the big secret to successful economic growth cannot lie in creating and acquiring the kind of knowledge that gets “’embodied’ in books, blueprints, machines…” — rests on the barely-examined decision to restrict attention to only a few kinds of models.

That restriction to examining implications of only a few classes of theories would not be so bad if the classes of theories examined were those that might be correct. Suppose the theories examined are those that model the salient and important aspects of individual decision-making and action, properly setup their strategic and non-strategic actions, and end up with a bestiary of visible aggregate-level patterns into which the economy might fall — what could be wrong with that? The problem comes with the second principal aspect of “mathiness”: to claim that one and only one mode of interaction and one and only one mode of individual decision-making is admissible at the foundation level of economic models. Here Romer attacks the assumption that the only allowable interaction is one of price-taking behavior: selling (or buying) as much as one wants at whatever the single fixed price currently offered by the market is. And here I would attack the assumption that individual decision-making is always characterized by rational expectations.

These might be adequate as foundations on which to build models that will fit and help us understand the world. But that is so only if and where we be lucky enough that market processes be structured exactly right. They must iron out at the macro level all the deviations from price-taking and rational expectations we see at the individual level. And as we look around, we see them everywhere. It is theoretically false to claim that market processes must be so structured. It is an empirical question as to whether, which, and when market processes are so structured.

Thus Paul Romer sees, in growth theory, the current generation of neoclassical economists grind out paper after paper imposing on the world “the restriction of 0 percent excludability of ideas required for [the] Marshallian external increasing returns” necessary for there to even be a price-taking equilibrium. And he judges — and I agree — that such papers are useless for any purpose other than advancing the writers in academic status games. And I see, in macroeconomics, paper after paper and banker after banker and industrialist after industrialist and technocrat after technocrat and politician after politician claiming that everything that governments might to to speed recovery must be counterproductive, or at least too risky — because that is what is in the case in a very restricted class of rational-expectations models.

This has now been going on for a long time: yesterday they crossed my desks critiques of expansionary fiscal and monetary policy made by Jacob Viner http://delong.typepad.com/viner-on-keynes.pdf and Étienne Mantoux http://classiques.uqac.ca/classiques/mantoux_etienne/theorie_generale_keynes/theorie_generale_keynes_texte.html in the 1930s — in the middle of the Great Depression! — claiming that such policies could only boost employment if they were accompanied by undesirable and unwarranted inflation, and would probably reduce production in the long run as well.

The depressing thing is that while academic economists in universities may be a little more willing to entertain the possibility that what is needed is a general theory rather than a classical price-taking rational-expectations theory, are the others? Are bankers and industrialists and technocrats and politicians?

Originally published at www.bradford-delong.com.