Economics Education “After” the - PowerPoint Presentation

Slide1

Economics Education “After” the Crisis

Steve KeenUniversity of Western SydneyDebunking Economicswww.debtdeflation.com/blogswww.debunkingeconomics.comSlide2

Before the CrisisOliver Blanchard, founding editor of AER Macro“The state of macro is good…”

“Dynamic Stochastic General Equilibrium” model is…“simple, analytically convenient, and has largely replaced the IS-LM model as the basic model of fluctuations in graduate courses…”“Unlike the IS-LM model, it is formally, rather than informally, derived from optimization by firms and consumers.” (Blanchard 2009, pp.214-215)Slide3

“After” the crisis…“The great moderation lulled macroeconomists and policymakers alike in the belief that we knew how to conduct macroeconomic policy.The crisis clearly forces us to question that assessment…It is important to start by stating the obvious, namely, that

the baby should not be thrown out with the bathwater…” (Blanchard Dell'Ariccia et al. 2010; emphasis added)Wrong: this baby should never have been conceivedDSGE models logically flawedDeep neoclassical research proved cannot reduce macro to applied micro before DSGE models developed

Why don’t neoclassical economists know this?Slide4

A paradoxical but transcendental truth…Learn theory from textbooks: Mankiw, Varian, Mas-Colell

Ignore fundamental research in good faithShould be able to trust textbooks to truthfully summarize fundamental researchBut textbooks teach sanitized “as if” version of theoryMacro “as if” can model whole economy as one agentFundamental research: “as if” conditions falseConsequently:Neoclassical economists don’t understand neoclassical economics; and

Neoclassical models violate neoclassical theoryIllustration: DSGE models, SMD conditions, & SolowSlide5

Solow rejects DSGESolow (2001 p. 19; emphases added)“The prototypical real-business-cycle model goes like this. There is a single, immortal household—a representative consumer—that earns wages from supplying labor

. It also owns the single price-taking firm…This is nothing but the neoclassical growth model…[When I built it] … It was clear … what I thought it did not apply to, namely short-run fluctuations ... the business cycle...Now ... an article today [on the] 'business cycle' … will be ... a slightly dressed up version of the neoclassical growth model.The question I want to circle around is: how did that happen

?” Slide6

Solow: SMD conditions invalidate DSGE“Suppose you wanted to defend the use of the Ramsey model as the basis for a descriptive macroeconomics. What could you say? ...You could claim that … there is no other tractable way to meet the claims of economic theory.

I think this claim is a delusion.We know from the Sonnenschein-Mantel-Debreu theorems that the only universal empirical aggregative implications of general equilibrium theory are that excess demand functions should be continuous and homogeneous of degree zero in prices, and should satisfy Walras' Law.Anyone is free to impose further restrictions on a macro model, but they have to be justified for their own sweet sake, not as being required by the

principles of economic theory.…” (Solow 2008, p. 244; emphasis added)Slide7

Sonnenschein-Mantel-Debreu Conditions“Law of Demand” applies to individual Hicksian-compensated demand curve

Reduce price, demand necessarily risesDoes it apply to a market demand curve? No!:“we prove that every polynomial … is an excess demand function for a specified commodity in some n commodity economy… (Sonnenschein 1972 , pp. 549-550)

That is, a demand curve for a single market can have any (polynomial) shape at allEven study of a single market demand curve can’t be reduced to study of a demand curve derived from a single utility-maximizing agentYet Neoclassical DSGE macro models the whole economy as a single utility/profit-maximizing agentSlide8

SMD: “Anything goes” for market demand curvesSMD Conditions (Sonnenschein 1973; Shafer & Sonnenschein 1993;):Market demand curves do not obey the "Law of Demand

"Even if summing "well behaved" individual demand curves

An accidental "Proof

by

contradiction":

Assume market demand curves do obey Law of Demand

Derive conditions under which this is true

These contradict

initial

assumptions

Therefore

market demand curves don‘t

obey

the "Law" of Demand

q

P

Crusoe

q

P

Friday

+

=

Market

Q

PSlide9

Logic: Price changes alter income distributionLogic:“Law of Demand” derived from Hicksian compensated demand curve procedure

Take individual with well-behaved utility functionVary price of one commodity while keeping others constant and consumer income constant

Bananas

Coconuts

W

Y

X

Z

B

q

1

q

2

q

3

Bananas

Price of Bananas

p

1

q

1

p

2

p

3

q

2

q

3

I

II

III

Key assumptions:

(1) Can vary Price without altering income

Pivot point does not moveSlide10

Individual demand curve derivation(2) Can change income and perfectly compensate for income effect of lower price (Hicksian-compensation)

Bananas

Coconuts

X

q

1

q

2

q

3

Bananas

Price of Bananas

p

1

q

1

p

2

p

3

q

2

q

3

Outcome:

Hicksian

-compensated individual demand curve

necessarily

slopes down: the “Law of Demand”

Motivation behind SMD research: Does this result survive aggregation to market demand?

Answer:

No!Slide11

With more than one consumer…Logic: “individual demand curve” model ignores impact of price changes on incomeBut price changes will change income distributionIn 2 (or more) consumer model, each

must haveDifferent income sources; andDifferent tastesOtherwise, there’s only one consumerTastes must change with incomeOtherwise, there’s only one commodityConsider 2-consumer, 2 commodity worldCrusoe and Friday; Coconuts and BananasCrusoe the Banana owner, Friday Coconut owner

Coconuts necessity, Bananas luxuryFriday higher preference for coconuts than CrusoeSlide12

Change in relative price alters incomesStart with arbitrary price ratio;

Bananas

Coconuts

Crusoe

Bananas

Coconuts

Friday

Keep aggregate income constant;

Consider lower price for bananas

Crusoe’s (banana owner) income falls; Friday’s rises

Market demand for bananas

falls

because of lower price

Crusoe’s income fell

Friday’s income rose

But his preferences for bananas less than Crusoe’sSlide13

Income growth alters distribution if tastes differHicksian procedureKeep relative prices constantIncrease income equally

Bananas

Coconuts

Crusoe

Bananas

Coconuts

Friday

Banana demand (luxury) rises more than Coconut

Crusoe’s income rises more than Friday’s

Cannot “compensate” for income effect of price change:

“Uniform” increase in income alters income distribution, because varying consumption as income rises favours luxury-producing agent over the otherSlide14

Market demand curve any polynomial at allOutcome: market demand curve can have any (polynomial) shape at allNeed not obey “Law of Demand”Only way to avoid this:

Assume all consumers have identical tastesSo there is only one consumer!And assume that tastes don’t change with incomeSo there is only one commodity!Contradicts starting assumption:Two consumers with different tastesTwo different commoditiesProof by contradiction that “Law of Demand” does not apply to market demand curveHow is this communicated to students?Slide15

Textbooks hide SMD resultsSamuelson and Nordhaus 2010 (p. 48)“The market demand curve is found by adding together the quantities demanded by all individuals at each price.

Does the market demand curve obey the law of downward-sloping demand? It certainly does…”A provably false statement misleading undergraduatesVarian 1984 (p. 268)“it is sometimes convenient to think of the aggregate demand as the demand of some ‘representative consumer’…The conditions under which this can be done are rather stringent, but a discussion of this issue is beyond the scope of this book…”A vague statement reassuring PhD studentsSlide16

Macro an “emergent property”Real meaning of SMD conditionsMacroeconomic behavior an “emergent property” of interaction of agents in a complex system

Cannot deduce behavior of macroeconomy from behavior of utility-maximizing individualsCannot reduce macroeconomics to “applied microeconomics”But that is what DSGE models do!Believe “macroeconomics is applied microeconomics”But SMD conditions prove otherwise“macroeconomics

cannot be applied microeconomics”Neoclassical theory commits the fallacy of “Strong Reductionism”…Slide17

Fallacy of Strong ReductionismCommon knowledge in real sciencesPhysics Nobel Laureate Anderson in “More is Different”, Science (1972, Vol. 177, p. 393)

“The behavior of large and complex aggregates of elementary particles, it turns out, is not to be understood in terms of a simple extrapolation of the properties of a few particles.Instead, at each level of complexity entirely new properties appear, and the understanding of the new behaviors requires research which I think is as fundamental in its nature as any other.”Slide18

Fallacy of Strong Reductionism“one may array the sciences roughly linearly in a hierarchy, according to the idea: “The elementary entities of science X obey the laws of science Y”

XY

Solid state or many-body physics

Elementary particle physics

Chemistry

Many-body physics

Molecular biology

Chemistry

Cell biology

Molecular biology

…

…

Psychology

Physiology

Social sciences

Psychology

But this hierarchy does not imply that science X is “just applied Y”. At each stage entirely new laws, concepts, and generalizations are necessary, requiring inspiration and creativity to just as great a degree as in the previous one. Psychology is not applied biology, nor is biology applied chemistry.”Slide19

Neoclassical macro didn’t see “It” comingStrong reductionism blinded neoclassical macroeconomists:“The preferred model has a single

representative consumer optimizing over infinite time with perfect foresight or rational expectations, in an environment that realizes the resulting plans more or less flawlessly through perfectly competitive forward-looking markets for goods and labor, and perfectly flexible prices and wages.How could anyone expect a sensible short-to-medium-run macroeconomics to come out of that set-up? …we want macroeconomics to account for the occasional aggregative pathologies that beset modern capitalist economies, like recessions, intervals of stagnation, inflation, “stagflation”

…A model that rules out pathologies by definition is unlikely to help.” (Solow 2003, p. 1; emphases added)Slide20

Many other flaws in neoclassical doctrineMoney is not neutral in a credit economy:“nothing is so unimportant as the

[nominal] quantity of money … let the number of dollars in existence be multiplied by 100; that … will have no other essential effect provided that all other nominal magnitudes (prices of goods and services, and quantities of other assets and liabilities that are expressed in nominal terms) are also multiplied by 100.” Friedman 1969 (p. 1)

Debts aren’t increased when prices risehence money is not neutral in a credit economyRational expectations = “capable of accurate prophesy”Lucas 1972 (p. 54)

“

one

is led simply to adding the assumption that

[the gap between actual and expected inflation]

is zero as an additional axiom

…

or to assume that expectations are

rational

in the sense of

Muth

.”

No wonder neoclassical macro couldn’t explain the crisis!Slide21

Neoclassical macro can’t explain “It” continuing…US Unemployment rising again after brief fall:

“We

don't have a precise read on why this slower pace of growth is

persisting” (

Bernanke, June 23 2011

)

The Economist

: “His

admission of ignorance reflects genuine puzzlement with the economy’s failure to reach what he likes to call escape velocity

.”

Non-neoclassical macro can explain “It

” and why “It” is continuing…Slide22

R

2

=-0.79

R

2

=-0.96

Private

debt crisis

,

just like the

Great

Depression

Debt-focused analysis is why “

Bezemer

12

” did see the crisis coming:

http

://mpra.ub.uni-muenchen.de/15892

/

Bezemer

2010, 2011Slide23

Dilemma for economics educatorsWhat do you do when all you know

is that you don’t know?Continue teaching neoclassical economicsBut from the originals, not the textbooksLearn/teach your own school of thought properlyTeach the theory “warts and all”Hire economists who know non-neoclassical economicsTeach parallel classes in the real Classical Economists

Attend those classes & learn some different questionsEngage with part of the discipline you have ignored for 40 yearsSlide24

It ain’t Walras, Babe…Neoclassical macro direct

descendant of Bentham, Say, Walras, MarshallEquilibrium, methodological individualism, strong reductionism, linearityUnrelated to Classical Economists Smith, Ricardo, Marx, Keynes, Schumpeter, Fisher, Minsky, GoodwinDynamics, social classes, emergent phenomena, complexity & evolutionNon-neoclassical economics underdeveloped compared to neoclassicalDoesn’t have all the answers…

Many wrong ones—e.g., Labor Theory of Value in MarxSome correct—e.g., Financial Instability HypothesisSlide25

It might be Marx, Schumpeter, Minsky…But many correct questionsFocus on

instabilityUncertaintyCrucial role of moneyDisequilibrium dynamicsBetter to ask the right questions than give accurate answers to the wrong onesEquilibrium fetishRisk as proxy for

uncertaintyBarter model of monetary economyEquilibrium Dynamicsan oxymoron in any real scienceGiven manifest failure of neoclassical macro, students must be exposed to non-neoclassical ideasSlide26

Some resourcesDebunking Economics II: almost all the economics you didn’t learn from the textbooks…

Available September 2011

My blog

www.debtdeflation.com/blogs

Minskian

explanation of the crisis

Free software program

“

Minsky

”

“Monetary Macro-dynamics for dummies”

Recently received INET grant

Mathematica

version in development (Mike

Honeychurch

mike.honeychurch@gmail.com)

Prototype available on my blog:

www.debtdeflation.com/blogs/QED

Lectures on history of economic thought, non-neoclassical monetary macroeconomics:

http://

www.debtdeflation.com/blogs/lecturesSlide27

ReferencesAnderson, P. W. (1972). "More Is Different." Science 177(4047): 393-396.

Bezemer, D. J. (2009). ““No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models.” Groningen, The Netherlands, Faculty of Economics University of Groningen.Blatt, J. M. (1983). Dynamic economic systems : a post-Keynesian approach. Armonk, N.Y, M.E. Sharpe.Bezemer, D. J. (2009). “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models. Groningen, The Netherlands, Faculty of Economics University of Groningen.Bezemer

, D. J. (2011). "The Credit Crisis and Recession as a Paradigm Test." Journal of Economic Issues 45: 1-18.Bezemer, D. J. (2010). "Understanding financial crisis through accounting models." Accounting, Organizations and Society 35(7): 676-688.

Clark, J. B. (1898). "The Future of Economic Theory."

The Quarterly Journal of Economics

13

(1): 1-14.

Friedman, M. (1969). The Optimum Quantity of Money.

The Optimum Quantity of Money and Other Essays

. Chicago, MacMillan

:

1-50.

Goodwin, R. (1967). A growth cycle.

Socialism, Capitalism and Economic Growth. C. H. Feinstein. Cambridge, Cambridge University Press

:

54-58.

Keen, S. (1995). "Finance and Economic Breakdown: Modeling

Minsky's 'Financial Instability Hypothesis.'." Journal of Post Keynesian Economics 17(4): 607-635.Keen, S. (2011). "A monetary Minsky model of the Great Moderation and the Great Recession." Journal of Economic Behavior & Organization In Press, Corrected Proof.Kirman, A. (1989). "The Intrinsic Limits of Modern Economic Theory: The Emperor Has No Clothes." Economic Journal 99 (395): 126-139.Lucas, R. E., Jr. (1972). Econometric Testing of the Natural Rate Hypothesis. The Econometrics of Price Determination Conference, October 30-31 1970. O. Eckstein. Washington, D.C., Board of Governors of the Federal Reserve System and Social Science Research Council: 50-59.Slide28

ReferencesLucas, R. E., Jr. (2004). "Keynote Address to the 2003 HOPE Conference: My Keynesian Education." History of Political Economy

36: 12-24.Kydland, F. E. and E. C. Prescott (1990). "Business Cycles: Real Facts and a Monetary Myth." Federal Reserve Bank of Minneapolis Quarterly Review 14(2): 3-18.Marx, K. and F. Engels (1885). Capital II. Moscow, Progress Publishers.Mas-

Colell, A., M. D. Whinston, et al. (1995). Microeconomic theory. New York :, Oxford University Press.Minsky, H. P. (1982). Can "it" happen again? : essays on instability and finance. Armonk, N.Y., M.E. Sharpe.Solow, R. M. (2001). From Neoclassical Growth Theory to New Classical Macroeconomics.

Advances in Macroeconomic Theory. J. H.

Drèze

. New York, Palgrave.

Solow, R. M. (2003). Dumb and Dumber in Macroeconomics.

Festschrift for Joe

Stiglitz

. Columbia University.

Solow, R. (2008). "The State of Macroeconomics."

The Journal of Economic Perspectives

22

(1): 243-246

.

Samuelson, P. A. and W. D.

Nordhaus

(2010).

Microeconomics. New York, McGraw- Hill Irwin.Schumpeter, J. A. (1934). The theory of economic development : an inquiry into profits, capital, credit, interest and the business cycle. Cambridge, Massachusetts, Harvard University Press.Shafer, W. and H. Sonnenschein (1993). “Market demand and excess demand functions”. Handbook of Mathematical Economics. K. J. Arrow and M. D. Intriligator, Elsevier. 2: 671-693.Sonnenschein, H. (1973). "Do Walras' Identity and Continuity Characterize the Class of Community Excess Demand Functions?" Journal of Economic Theory 6(4): 345-354.Varian, H. R. (1984, 1992). Microeconomic analysis. New York, W.W. Norton.