January 17, 2016

The creative destruction of Wren-Lewis

Comment on Lars Syll on ‘Wren-Lewis on macroeconomic eclecticism’

Blog-Reference and Blog-Reference and Blog-Reference on Dec 18

1. Destruction

Boiled down to the essentials Wren-Lewis’ methodological position is “most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point ...” (Krugman).

More explicitly and formally, i.e. axiomatically, the position has been defined as “The [neo-Walrasian] program is organized around the following hardcore propositions:
HC1 There exist economic agents.
HC2 Agents have preferences over outcomes.
HC3 Agents independently optimize subject to constraints.
HC4 Choices are made in interrelated markets.
HC5 Agents have full relevant knowledge.
HC6 Observable economic outcomes are coordinated, so they must be discussed with reference to equilibrium states.” (Weintraub, 1985, p. 109)

The fact of the matter is that there is no such thing as an equilibrium in the economy. Methodologically, HC6 is what is known since antiquity as petitio principii. This is an inexcusable methodological blunder. Likewise for HC3.

HC6 and HC3 are, for reasons given in more detail in prior debates, methodologically unacceptable. Because of this the whole set of hardcore propositions — the sorta-kinda starting point — breaks apart and with it the whole theoretical superstructure of DSGE.

2. Keynesian Revolution 2.0

“The [neo-] classical [sorta-kinda] theorists resemble Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight — as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels [i.e. HC6 and HC3] and to work out a non-Euclidean geometry. Something similar is required to-day in economics.” (Keynes, 1973, p. 16)

3. Creation

The new set of hardcore propositions must not contain the concepts of equilibrium and constrained optimization. The non-Euclidean paradigm is macrofounded instead of microfounded.

(A0) The most elementary configuration of the (world-) economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm and is defined by three hardcore propositions:
(A1) Yw=WL wage income Yw is equal to wage rate W times working hours L,
(A2) O=RL output O is equal to productivity R times working hours L,
(A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.

These premises are certain, true, and primary, and therefore satisfy perfectly all methodological requirements. To recall “When the premises are certain, true, and primary, and the conclusion formally follows from them, this is demonstration, and produces scientific knowledge of a thing.” (Aristotle, Posterior Analytics)

For the graphical representation of the new hardcore propositions, see Wikimedia.

At any given level of employment L, the wage income Yw that is generated in the consolidated business sector follows by multiplication with the wage rate W. On the real side, output O follows by multiplication with the productivity R. Finally, the price P follows as the dependent variable under the conditions of budget balancing, i.e. C=Yw, and market clearing, i.e. X=O. Note that the ray in the southeastern quadrant is not a linear production function; the ray tracks any production function. Note also that the wage rate W is an average if the individual wage rates are different among the employees, which is the general case.

Under the conditions of market clearing and budget balancing in each period the price follows from the three equations as P=W/R (1), i.e. the market-clearing price is always equal to unit wage costs. This is the elementary form of the macroeconomic Law of Supply and Demand. Note that the price is explicitly taken as the dependent variable, of course, it can be treated as an independent variable. Note also that the initial conditions of market clearing and budget balancing have to be lifted eventually.

The elementary economy works as follows. If the wage rate W is lowered, the market-clearing price P falls. If the number of working hours L is increased the price remains constant, provided productivity R does not change. If productivity decreases the price P rises. If productivity increases the price falls. In any case, labor gets the whole product, the real wage W/P is invariably equal to the productivity R according to (1), and profit for the business sector as a whole is zero. All changes in the system are fully reflected by the market-clearing price P. The elementary economy is reproducible for an indefinite number of periods.

Given the new hardcore propositions (A1) to (A3), one has to proceed top-down by successive differentiation until one arrives at the individual agent. The Copernican turn in economics consists in the methodological switch from behavior-centered bottom-up, i.e. microfoundations, to structure-centered top-down, i.e. macrofoundations.

HC1 to HC6 is fully replaced by (A1) to (A3). There is no such thing as pluralism or eclecticism. Only one set can be the true one — and it is definitely not Wren-Lewis’ sorta-kinda maximization-and-equilibrium.

Egmont Kakarot-Handtke

Keynes, J. M. (1973). The General Theory of Employment Interest and Money. The Collected Writings of John Maynard Keynes Vol. VII. London, Basingstoke: Macmillan.
Weintraub, E. R. (1985). General Equilibrium Analysis. Cambridge, London, New York, NY, etc.: Cambridge University Press. See also URL.

For details of the big picture see cross-references Paradigm Shift.