December 31, 2014

Between the devil and the deep blue sea: on framing false alternatives

Comment on  'The DSGE emperor has no clothes. But he does have a hat. And a rabbit.'

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Imagine for a moment that you drop into a discussion. Two experts talk about the respective merits and demerits of the A-car and the B-car. There is a lot of technical argument about acceleration, fuel consumption, operating distance, cylinder capacity, electronic injection, etcetera. Both debaters are engaged and obviously conversant with the technicalities. At the end the A-car proponent seems to have the better arguments. Good discussion, applause. Then you learn that the original question was: How can we get to the moon?

Much of the discussion about DSGE and WUMM is of this sort. The question was: After the recent spectacular failure of macroeconomics, how can we do better in the future? How to proceed theoretically and analytically and empirically? Is DSGE or WUMM more promising? This is false framing. The correct answer is, neither DSGE nor WUMM, both have to be abandoned.

Why? Because there is something like falsification.

“In economics we should strive to proceed, wherever we can, exactly according to the standards of the other, more advanced, sciences, where it is not possible, once an issue has been decided, to continue to write about it as if nothing had happened.” (Morgenstern, 1941, pp. 369-370)

Of course, after a severe crisis, economists do not simply continue, they promise to to better in the future. Yes, and they have already an idea. More complexity, for example. Mea culpa, we failed in the past, but this time we fix it.

Not much will come from this cosmetic surgery. Why?

To make a long argument short please accept for a moment the assertion: There is no such thing as a law of human behavior. From this follows trivially:
• historical correlations are unreliable for forecasting purposes, particularly in the case of an entirely new situation, e.g. a regime change,
• demand and supply functions are nonentities,
• preferences change over time,
• parameters change over time,
• there is no equilibrium or steady state.

All these difficulties that make model testing such a challenging task have their root in the foundational assumption that there is such a thing as a behavioral law or at least a regularity. After all, that is what we are ultimately looking for. Because if there is no law nobody can make a prediction (except charlatans and doomsayers).

DSGE claims to be based on “deep structural parameters.” This would be fine if it indeed were the case. Yet the whole microfoundations project is essentially about optimizing behavior. This crucial assumption is put squarely into the premises:

“Modern macro models have the five following properties:
• They specify budget constraints for households, technologies for firms, and resource constraints for the overall economy.
• They specify household preferences and firm objectives.
• They assume forward-looking behavior for firms and households.
• They include the shocks that firms and households face.
• They are models of the entire macroeconomy.”

Two of the five premises are about human behavior and most people are aware that they are far off the mark. This, however, is the minor problem. The Iron Law of Economic Theory Design says: No way leads from the understanding of human motivations and behavior or from purely speculative behavioral assumptions to the understanding of how the economy works (for details see 2014).

Hence, what is needed is not cosmetic surgery but a paradigm shift. The whole set of DSGE premises, which is in the main shared by WUMM, is methodologically mistaken and ultimately indefensible.

Therefore, the choice is not between DSGE or WUMM. The real choice is between the defunct subjective-behavioral approach and a new paradigm. This, though, is obvious since Keynes and the Great Depression. The real problem is not in statistical technicalities but in “... a failure of reason to find suitable alternatives which might be used to transcend an accidental intermediate stage of our knowledge.” (Feyerabend, 2004, p. 72)

There are many popular and even good reasons to blame Orthodoxy for the latest crisis, but -- to set the record straight -- Heterodoxy, too, did not come up with a “suitable alternative” since Keynes proposed to “throw over” the classical axioms (Keynes, 1973, p. 16).

Heterodoxy has a mission: Don't waste time with blaming and false alternatives; dig deeper; there are economic laws, but there are certainly no behavioral laws.

Egmont Kakarot-Handtke


References
Feyerabend, P. K. (2004). Problems of Empiricism. Cambridge: Cambridge
University Press.
Kakarot-Handtke, E. (2014). The Synthesis of Economic Law, Evolution, and
History. SSRN Working Paper Series, 2500696: 1–22. URL
Keynes, J. M. (1973). The General Theory of Employment Interest and Money.
The Collected Writings of John Maynard Keynes Vol. VII. London, Basingstoke:
Macmillan. (1936).
Morgenstern, O. (1941). Professor Hicks on Value and Capital. Journal of Political
Economy, 49(3): 361–393. URL