September 9, 2017

The flat-earth realism of economists

Comment on Noah Smith on ‘Realism in macroeconomic modeling’


Noah Smith discusses a cool paper: “Ljungqvist and Sargent have a new paper synthesizing much of the work that’s been done in labor search-and-matching theory over the past decade or so.”

Like Ljungqvist and Sargent and the 99-percent majority of scientifically incompetent economists, Noah Smith has not realized that microfoundations is a failed approach for 150+ years. This becomes as obvious as anybody could wish when microfoundations are applied to macroeconomic issues.

The Iron Law of Economic Methodology says: NO WAY leads from the explanation of individual/social human behavior to the explanation of how the monetary economy works. In other words, the microfoundations approach has already been dead in the cradle because it is bound to crash with absolute necessity into the Fallacy of Composition.

By consequence, not only macroeconomics but the whole of economics has to be macrofounded.#1 Macrofoundations provide a consistent framework for microanalysis. Economic analysis has to switch from bottom-up to top-down.

In the following, a sketch of the formally and empirically correct employment theory is given.#2 The basic version of the objective-structural-systemic Employment Law reads (Wikimedia AXEC62)
This macroeconomic equation is not merely “realistic” but REAL because it consists alone of measurable variables. It follows:
(i) An increase in the expenditure ratio ρE leads to higher employment (the Greek letter ρ stands for ratio). An expenditure ratio ρE greater than 1 means dissaving or credit expansion, a ratio ρE less than 1 means saving or credit contraction.
(ii) Increasing investment expenditures I exert a positive influence on employment.
(iii) An increase in the factor cost ratio ρF≡W/PR leads to higher employment.

The complete AND testable Employment Law is a bit longer and contains in addition profit distribution, public deficit spending, and foreign trade.

Item (i) and (ii) cover the familiar arguments about aggregate demand. The factor cost ratio ρF as defined in (iii) embodies the price mechanism which, however, does not work as the microfounded cargo cult economist hallucinates. The fact is that overall employment INCREASES if the average wage rate W INCREASES relative to average price P and productivity R. THIS is the key to full employment policy.

It is pretty obvious to anyone with one iota of scientific instinct that one cannot figure out the determinants of overall employment by applying a brain-dead, microfounded, “realistic”, maximization-and-equilibrium labor search-and-matching model.

It is time now for Ljungqvist and Sargent to retire and for Noah Smith to follow suit.

Egmont Kakarot-Handtke

#1 This is the minimalist set of macroeconomic axioms: (A0) The objectively given and most elementary systemic configuration of the production-consumption economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm. (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.
#2 For the comprehensive treatment see Keynes’ Employment Function and the Gratuitous Phillips Curve Disaster