November 4, 2016

From false micro to true macro: the new economic Paradigm

Comment on Lars Syll on ‘Why should economics demand what harder sciences do not?’


The inevitable failure of economics started with this fundamental methodological blunder: “It is a touchstone of accepted economics that all explanations must run in terms of the actions and reactions of individuals. Our behavior in judging economic research, in peer review of papers and research, and in promotions, includes the criterion that in principle the behavior we explain and the policies we propose are explicable in terms of individuals, not of other social categories.” (Arrow, 1994)

The definition of the subject matter translates into the following hardcore propositions, a.k.a. axioms: “HC1 economic agents have preferences over outcomes; HC2 agents individually optimize subject to constraints; HC3 agent choice is manifest in interrelated markets; HC4 agents have full relevant knowledge; HC5 observable outcomes are coordinated, and must be discussed with reference to equilibrium states.” (Weintraub, 1985)

From these premises follows what Leijonhufvud famously called the Totem of Micro/Macro, that is, SS-curve―DD-curve―equilibrium. For 150+ years, this construct is the analytical workhorse of economics.

For every person with keen scientific instincts, this construct is immediately and forever unacceptable. Economists, to their disgrace, have no scientific instincts at all. They simply swallow every piece of garbage. Obviously, the Walrasian axiom set contains three NONENTITIES: (i) constrained optimization HC2, (ii) rational expectations HC4, (iii) equilibrium HC5. Every theory/model that contains a NONENTITY is a priori false. As a consequence, the economics from Jevons/Walras/Menger to DSGE/RBC is false.

The microfoundations speak about human behavior. Now, human behavior is the subject matter of psychology, sociology, anthropology etcetera, and NOT of economics (Hudík, 2011). What is worse, NO way leads from the understanding of human behavior to the understanding of how the monetary economy works.

So, the definition of the subject matter has to be changed from Arrow’s methodological individualism to Economics is the science that studies how the monetary economy works. Or, as Victor Beker puts it: “Economics deals with the study of the economic system. Why not starting by studying the economy as a system?” (See intro)#1

So, first of all, the behavioral axioms HC1/HC5 have to be replaced by objective systemic axioms (2014). (A0) The most elementary configuration of the economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm and is given by these three objective-structural-systemic-macroeconomic axioms: (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) Ec=PX consumption expenditure Ec is equal to price P times quantity bought/sold X.#2

(A1) to (A3) define the elementary production-consumption economy. Note that the set of foundational equations is FREE of green cheese behavioral assumptions, i.e. the axiom set is purely systemic. A detailed description is given in this post ‘The future of economics: why you will probably not be admitted to it, and why this is a good thing’#3 and in this short paper (2015). In both places, the solution to the perennial profit conundrum is to be found.

From macroeconomics, one arrives at microeconomics by successive DIFFERENTIATION. Differentiation is top-down, and aggregation is bottom-up. The methodologically correct way is to start with macrofoundations and then differentiate.

The true macrofoundations (A1)/(A3) replace the false Walrasian microfoundations HC1/HC5 and Keynes' false macrofoundations.#4

To paraphrase a summary of Blaug: ‘At long last, it can be said that the history of general theory from Walras to Arrow-Debreu and on to DSGE has been a journey down a blind alley, and it is the set (A1)/(A3) to have finally hammered down the nails in the coffin.’

Egmont Kakarot-Handtke

Hudík, M. (2011). Why Economics is Not a Science of Behaviour. Journal of Economic Methodology, 18(2): 147–162.
Kakarot-Handtke, E. (2014). Objective Principles of Economics. SSRN Working Paper Series, 2418851: 1–19. URL
Kakarot-Handtke, E. (2015). How the Intelligent Non-Economist Can Refute Every Economist Hands Down. SSRN Working Paper Series, 2705395: 1–6. URL

#1 From microfoundations to macrofoundations
#2 Finalizing the Keynesian Revolution
#3 The future of economics: why you will probably not be admitted to it, and why this is a good thing
#4 How Keynes got macroeconomics wrong and Allais got it right

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

Wikimedia AXEC137b True macrofoundations