Making tools work in economics

Comment on Lars Syll on ‘Econometrics — a Keynesian perspective’

Blog-Reference

Isn’t it curious that mathematics, which worked so well in the genuine sciences, came down to the caricature of mathiness in economics? Same with the state-of-the-art statistical tools of testing. Have any of the grand economic issues ever been settled by a statistically compelling appeal to facts? Same with simulations, which are prima facie the ideal tool for economics. There is a lot of fooling around with modeling packages, but no generally accepted canonical simulation exists.

So, why do sophisticated tools that work everywhere in the sciences regularly fail in economics? One reason is that the majority of economists are more oriented towards politics than towards science, and for political purposes, common sense and rhetoric have always been sufficient. Keynes instinctively opposed rigorous method and clear-cut results: “Another danger is that you may ‘precise everything away’ and be left with only a comparative poverty of meaning. ... Such a problem was avoided, said Keynes, by Marshall, who used loose definitions but allowed the reader to infer his meaning from ‘the richness of context.’ (Coates, 2007, p. 87). As a consequence: “In the early thirties he [Keynes] confessed to Roy Harrod that he was ‘returning to an age-long tradition of common sense’.” (Coates, 2007, p. 11). Until this day, people who have qualms with math and Econometrics find a quotable advocate in Keynes.

Apart from the traditionally strong preference of economists for inconclusive wish-wash in the no man’s land between true and false, the primary reason for the ineffectiveness of mathematical and statistical tools is elementary methodological mistakes with regard to theory construction. It is pretty obvious that a theory that is built upon axioms that contain more nonentities than entities can neither be properly formalized nor effectively tested. Take the neo-Walrasian axiom set as an example: “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, p. 147). HC2, HC4, and HC5 are apparent nonentities, and nothing testable can ever come of them.

What is needed as the very first step is a replacement of the formal foundations of economics (2014). From the correct macrofoundations then follows (i) a number of testable structural relationships, and (ii) a concise formula that represents the canonical simulation of the pure consumption economy. #1

The way forward for heterodox economists is to emancipate themselves from Keynes’s misjudgment of formal modeling and statistical testing.

Egmont Kakarot-Handtke


References
Coates, J. (2007). The Claims of Common Sense. Moore, Wittgenstein, Keynes and the Social Sciences. Cambridge, New York, etc.: Cambridge University Press.
Kakarot-Handtke, E. (2014). The Synthesis of Economic Law, Evolution, and History. SSRN Working Paper Series, 2500696: 1–22. URL
Weintraub, E. R. (1985). Joan Robinson’s Critique of Equilibrium: An Appraisal. American Economic Review, Papers and Proceedings, 75(2): 146–149. URL

#1 Simulation, download of the Excel spreadsheet from Dropbox
Graphic, exemplary depiction of the drifting consumption economy

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Graphic AXEC25, The Economics God Equation

The Economics God Equation

The future of economics: why you will probably not be admitted to it, and why this is a good thing

Comment on Merijn Knibbe on ‘Clarence Ayres on the economic concept of capital’

Blog-Reference and Blog-Reference

“... economics is a big omnibus which contains many passengers of incommensurable interests and abilities.” (Schumpeter, 1994, p. 827)

Economics is a scientific failure. Being stranded in the middle of nowhere, evidently, nobody else is more responsible than the confused drivers/passengers of the big omnibus themselves. These can be roughly divided into the major sects: Walrasians, Keynesians, Marxians, and Austrians. What they all have in common is substandard scientific abilities. Generally speaking, the four approaches are built upon unacceptable premises and therefore violate Aristotle’s first principle of science: “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.” (Posterior Analytics)

What are the premises that are accepted by the majority of economists? Krugman put it thus: “most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point ...”. This starting point has to be abandoned because these premises are by no stretch of the imagination certain, true, and primary.

At this critical juncture, the economist has to make up his mind: either to defend the indefensible beliefs of one of the four sects or to replace the foundational assumptions and to begin in earnest with the overdue reconstruction of the whole theoretical superstructure of economics. Based on the history of economic thought, it is a fair bet that the representative economist will mess up things. However, this has to be proved, so here is the challenge.

The most elementary economic configuration is the production-consumption economy, which consists of the household sector and the business sector, which in turn consists initially of one giant fully integrated firm. This minimalist configuration is defined for one period by three equations.

(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.

If you cannot understand or accept these almost self-evident equations, which hold for the world economy as a whole and every closed national economy, you are out of economics. These premises are certain, true, and primary, or stated in relative terms, obviously superior to the neo-Walrasian axioms (Weintraub, 1985, p. 147) or to Keynes’ defective formal basis (1973, p. 63).

For the graphical representation of the three equations, see Graphic AXEC31

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 underlying 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. To repeat, the price is, for a start, taken as the dependent variable; of course, it can be treated as an independent variable (2015). Also worth mentioning is that money as a transaction medium is left out here for brevity; for the full picture, see (2015).

The elementary production-consumption 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 production-consumption economy is reproducible for an indefinite number of periods.

The changes from period to period are formally given by:
(iv) W_t=W_t-1(1+w_t) The wage rate in period t — W_t — is given by the wage rate in the previous period W_t-1 and the rate of change for the current period w_t.
(v) R_t=R_t-1(1+r_t) analogous for productivity.
(vi) L_t=L_t-1(1+l_t) analogous for labor input.

The rates of change for future periods, wt, rt, lt are random variables with an a priori unknown distribution function. Because of this, we cannot predict the price in period t=10, but we can test it in period t=10 or any other future period. As a matter of principle, (1) is a testable proposition.

Given the enumerated premises and conditions, the market-clearing price performs a random walk, which is determined in turn by the random walks of wage rate and productivity. Equation (1) in combination with (iv) to (vi) replaces the ridiculous supply-demand-equilibrium model of Econ 101.

From the premises and conditions follows for a start:

• The elementary production-consumption economy constitutes itself through the interaction of real and nominal variables. There is no such thing as a ‘real’ economy; in other words, all ‘real’ models are a priori false.
• There is no such thing as equilibrium. The product market is cleared, and the budget is balanced, but the economy is not moved by an Invisible Hand toward some equilibrium, e.g., full employment. In other words, all equilibrium models are a priori false.
• The commonplace quantity theory does not hold. Inflation/deflation depends initially on the development of wage rate and productivity, and nothing else. If the period changes of the wage rate are exactly equal to the changes in productivity, i.e., wt=rt, absolute price stability prevails over all future periods despite the random variations of productivity and employment. Hence, price stability/inflation/deflation is not a monetary phenomenon.
• The marginal principle, which ultimately derives from the unacceptable behavioral assumption of utility maximization, does not apply and plays no role at all in price determination. All marginalist models are a priori false.
• Supply and demand functions are NONENTITIES. Well-behaved production functions and decreasing returns do not exist. These premises are neither required nor admissible.
• Neither the income distribution nor the distribution of the real product depends on the marginal principle. All marginalist distribution models are a priori false.

In the next analytical steps, the number of firms is increased, which leads to the determination of relative prices, and the conditions of market clearing and budget-balancing are lifted, which gives rise to the phenomena of inventory changes, profit/loss,#1, and the increase/decrease of the stocks of money and debt. It is pretty obvious that all economic phenomena can successively be derived from the three premises (i) to (iii). Stock-flow consistency is guaranteed ab initio.

In order to develop the first economic theory since Adam Smith that satisfies the scientific criteria of formal and material consistency, the unacceptable foundational propositions of Walrasianism, Keynesianism, Marxianism, and Austrianism have to be abandoned. Scientists would immediately perform the necessary Paradigm Shift, but economists are not scientists. Their acceptance of the maximization-and-equilibrium world for more than 100 years is forever disqualifying. Because of this, the still confused sorta-kinda economists are kindly asked to leave the big omnibus now.

Egmont Kakarot-Handtke


References
Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working Paper Series, 2624350: 1–40. 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.
Schumpeter, J. A. (1994). History of Economic Analysis. New York: Oxford University Press.
Weintraub, E. R. (1985). Joan Robinson’s Critique of Equilibrium: An Appraisal. American Economic Review, Papers and Proceedings, 75(2): 146–149. URL


#1 Profit and the collective failure of economists

Related 'Economics as a fool’s paradise'.

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POINTER on Economist's View

No, economists do not understand what is in their models.

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ANSWER to Bragi on Jan 4

This is the corpus delicti from the General Theory “Income = value of output = consumption + investment. Saving = income − consumption. Therefore saving = investment.” (Keynes, 1973, p. 63)

This two-liner is conceptually and logically defective because Keynes did not come to grips with profit theory.

“His Collected Writings show that he wrestled to solve the Profit Puzzle up till the semi-final versions of his GT but in the end he gave up and discarded the draft chapter dealing with it.” (Tómasson et al., 2010, pp. 12-13, 16)

Because profit is ill-defined, the whole theoretical superstructure of Keynesianism is false, in particular, all I=S and IS-LM models.

For the formal proof, see Why Post Keynesianism Is Not Yet a Science.

Keynesians will not make it into the future of economics because of proven logical incompetence over more than 80 years.

References
Keynes, J. M. (1973). The General Theory of Employment Interest and Money. The Collected Writings of John Maynard Keynes Vol. VII. London, Basingstoke: Macmillan.
Tómasson, G., and Bezemer, D. J. (2010). What is the Source of Profit and Interest? A Classical Conundrum Reconsidered. MPRA Paper, 20557: 1–34. URL

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REPLY Brain-dead blather, comment on anne on Jan 4

You give good advice: “Take a Krugman model, such as IS-LM and clearly explain what is not understood”.

Let me return the good advice: Read more, think more, and blog less.

IS-LM is provably false since the 1930s, but the representative economist has realized nothing for more than 80 years. This includes you and, of course, Paul Krugman, see Mr. Keynes, Prof. Krugman, IS-LM, and the End of Economics as We Know It.

Here is the core of the proof.

The formal basis of the General Theory is given with: “Income = value of output = consumption + investment. Saving = income − consumption. Therefore saving = investment.” (Keynes, 1973, p. 63)

This two-liner is conceptually and logically defective because Keynes did not come to grips with profit.

“His Collected Writings show that he wrestled to solve the Profit Puzzle up till the semi-final versions of his GT but in the end he gave up and discarded the draft chapter dealing with it.” (Tómasson et al., 2010, pp. 12-13, 16)

Because profit is ill-defined, the whole theoretical superstructure of Keynesianism is false, in particular, all IS-LM models. See also Why Post Keynesianism Is Not Yet a Science.

Keynesians will not make it into the future of economics because of proven logical incompetence — they have no idea of what is in their models. This includes you and, of course, Paul Krugman — the proto-scientific proponent of model bricolage.

The scary fact of the matter is economists cannot tell the difference between profit and income [“A satisfactory theory of profits is still elusive.” Desai, 2008, p. 10] but tell politicians and the central bank how to run the economy.


References
Desai, M. (2008). Profit and Profit Theory. In S. N. Durlauf, and L. E. Blume (Eds.), The New Palgrave Dictionary of Economics Online, 1–11. Palgrave Macmillan, 2nd edition. URL
Keynes, J. M. (1973). The General Theory of Employment Interest and Money. London, Basingstoke: Macmillan.
Tómasson, G., and Bezemer, D. J. (2010). What is the Source of Profit and Interest? A Classical Conundrum Reconsidered. MPRA Paper, 20557: 1–34. URL

Related 'Summary on "Musings on Whether We Consciously Know More or Less than What Is in Our Models…"' and 'Wikipedia, economics, scientific knowledge, or political agenda pushing?'

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

For more about Paul Krugman, see AXECquery.

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Graphic AXEC172

Predictably confused

Comment on Lars Syll on ‘Sir David Hendry on the inadequacies of DSGE models’

Blog-Reference

“The future is unpredictable.” (Feynman, 1992, p. 147) Four words! Compare this to what economists have uttered about this issue without getting one iota further. But wait, are physicists not famous for their accurate predictions? Could it be that economists have gotten something badly wrong?

Let us have a closer look. If you show a physicist an apple tree and ask him when every single apple will fall, then he will tell you that this kind of event is not predictable. But he can tell you something else. If an apple has started to fall, then he can tell you exactly its location and velocity after t seconds. The physicist ‘predicts’ the coordinates with high precision, and everyone can test them. (OK, you did not want to know this to begin with, and exactly these layman's expectations regularly cause irritations with science.)

Likewise, imagine somebody throws blindly three coins into a large sandbox. Clearly, the three coins form a random triangle, and no one can predict its form and size. Yet, the mathematician can ‘predict’ with certainty that the sum of angles is 180 degrees (if the sandbox is Euclidean).

While the future is ‘unpredictable’, certain aspects may be ‘predictable’ with high precision. Therefore, we can agree with Keynes that “the price of copper and the rate of interest twenty years hence” is unpredictable without accepting his famous all-round capitulation, “We simply do not know.” (Keynes, 1937, p. 214)

Example: an elementary consumption economy can be described by this deductively derived formula (Graphic AXEC06). This formula holds in every single period from the past to the future (2014, eq. (12)). In other words, we have a testable economic law. Test it twenty years hence, and you will find out that it is true. Where, then, does the difficulty with prediction come in? The crucial point is that the variables that underlie the four rhos are unpredictable random variables.

Perhaps it sounds a bit paradoxical: there are deterministic economic laws that hold ‘on the whole’ while the components vary at random or are even uncertain in Keynes's sense. So the concept of uncertainty can coexist with the concept of economic law. Hence, Keynesian uncertainty should not stop us from looking out for deterministic and testable economic laws. Attention, they are with absolute certainty not to be found where misguided Orthodoxy has looked for them in the past!

The otherwise redundant DSGE debate shows that the representative economist is still a bit confused about the different aspects of prediction.

Egmont Kakarot-Handtke


References
Feynman, R. P. (1992). The Character of Physical Law. London: Penguin.
Kakarot-Handtke, E. (2014). The Synthesis of Economic Law, Evolution, and History. SSRN Working Paper Series, 2500696: 1–22. URL
Keynes, J. M. (1937). The General Theory of Employment. Quarterly Journal of Economics, 51(2): 209–223. URL

Sales talk vs Science

Comment on Brad DeLong on ‘“We Always Thanked Robert Lucas for Giving Us a... Monopoly” Over Valuable Macroeconomics’

Blog-Reference and Blog-Reference

First of all, it is of the utmost importance to distinguish between political and theoretical economics. The main differences are:

• The goal of political economics is to push an agenda, and the goal of theoretical economics is to explain how the actual economy works.
• In political economics anything goes; in theoretical economics, scientific standards are observed.

Political economics is scientifically worthless. Most of the economics for more than 200 years has been political economics.

“In order to tell the politicians and practitioners something about causes and best means, the economist needs the true theory or else he has not much more to offer than educated common sense or his personal opinion.” (Stigum, 1991, p. 30)

Economists have produced gigabytes of opinion but failed to develop the true theory. What has been developed instead falls roughly into three categories: Walrasian, Keynesian, and Other. What these approaches have in common is that the representative WKO-economist cannot tell the difference between profit and income. Because of this, WKO-economists never captured the essence of the market economy. This is what unites them. This common lethal defect, though, gets regularly out of sight when relative merits/demerits are discussed.

It takes not much ingenuity to see that Lucas et al. is proto-scientific garbage. But to argue “Consider Macro Advisers. Macro Advisers makes a very good living today selling its simulation models.” and implying with this recommendation that the MA approach is methodologically superior is a non sequitur.

In fact, without going deeper into details, we can safely conclude that the MA model, too, is garbage, albeit somewhat different from the New Classical ilk. We can conclude this with certainty from this description: “The heart of this new synthesis — a dynamic general equilibrium system with nominal rigidities — is precisely what one finds in the early Keynesian models. Hicks proposed the IS-LM model, for example, in an attempt at putting the ideas of Keynes into a general equilibrium setting.” (See intro)

Now, we know

• all equilibrium models are false because equilibrium is a nonentity (2015),
• all IS-LM models are false because of misspecification of overall profit (2014).#1

Profit did not appear in Keynes' elementary formalism because he never came to grips with this foundational economic phenomenon. Neither did the Post Keynesians to this day (2011). What makes all WKO models worthless is the lack of understanding of what profit is.

The criterion of science has always been true/false. Whether New Keynesian models sell better than New Classical models is irrelevant. To recall, Kepler had figured out the laws of planetary motion. What he was paid for handsomely, though, was not this unique scientific achievement but the horoscopes he produced for the imperial court of the Holy Roman Empire. Clients never had sound judgment in scientific matters. This is why political economics and disqualified scientists are still among us.

Egmont Kakarot-Handtke


References
Kakarot-Handtke, E. (2011). Why Post Keynesianism is Not Yet a Science. SSRN Working Paper Series, 1966438: 1–20. URL
Kakarot-Handtke, E. (2014). Mr. Keynes, Prof. Krugman, IS-LM, and the End of Economics as We Know It. SSRN Working Paper Series, 2392856: 1–19. URL
Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working Paper Series, 2624350: 1–40. URL
Stigum, B. P. (1991). Toward a Formal Science of Economics: The Axiomatic Method in Economics and Econometrics. Cambridge: MIT Press.

#1 Mental messies and loose losers

The art of start

Comment on Bruce Edmonds on ‘The Context-Dependency of Human (Economic) Behaviour’

Blog-Reference

“I think it is the lack of quite sharply defined concepts that the main difficulty lies, and not in any intrinsic difference between the fields of economics and other sciences.” (von Neumann, quoted in Mirowski, 2002, p. 146 fn. 49), see also (2013)

Therefore, it is of utmost importance to consequently stick to sharp definitions and to stay clear of ambiguity and vagueness.

ad (i) First you quote me correctly asserting ‘the task of theoretical economics is to explain how the monetary economy works’ and then you ask ‘does this exclude barter systems.’ The answer is evidently yes. Then you go on asking ‘does it exclude the sharing of value within families and communities?' Again, the answer is evidently yes. The focus is on the economy we happen to live in and not on issues that belong to the domains of psychology and sociology. Apart from this, excluding some real-world phenomena at the start means only that they are to be included at a later stage. So nothing of importance is lost.

The economist's task is to incorporate valid results of PsySoc into his models but not to make ‘a fool of himself’ (Viner, 1963, p. 12) with utility maximization, rationality, bounded rationality, rational expectations, situational analysis, and all the rest. Economists have no correct theory of human behavior, neither do they have a correct theory of how the monetary economy works, and it is for the latter defect that economics is a failed science. As long as Heterodoxy is preoccupied with PsySoc it will share the cheerless fate of Orthodoxy.

ad (ii) You say: “There is a way from the understanding of individual human behavior to the understanding of the behavior of the economic system – it is called agent-based simulation.”

Generally speaking, a simulation is a proper tool for economic analysis and this has already been said in my paper on behavior (2015). However, a simulation presupposes the definition of the structural properties of the monetary economy. Hence, not any simulation will do. Here is the correct version.#1

“A simulation as defined by the four structural axioms and the probability distributions is a well-defined mathematical object just like a system of equations. While they are formally on the same footing, both mathematical objects yield different kinds of outputs: the system of equations yields a solution vector, a simulation yields a bundle of paths. This bundle has a counterpart in reality.” (2015, p. 5).

In sum: every economic analysis must start with the definition of the objective structure of the monetary economy because it is this structure, a.k.a. reality, that determines the outcome of individual and collective human action. The monetary economy is the meta-context of every partial analysis. To start with a specific behavioral assumption means to get off on the wrong foot and end up eventually in the scientific wood. Orthodox economics is a cautionary tale. Heterodoxy is expected to do much better. Constructive Heterodoxy does.

Egmont Kakarot-Handtke


References
Kakarot-Handtke, E. (2013). Confused Confusers: How to Stop Thinking Like an Economist and Start Thinking Like a Scientist. SSRN Working Paper Series, 2207598: 1–16. URL
Kakarot-Handtke, E. (2015). Essentials of Constructive Heterodoxy: Behavior. SSRN Working Paper Series, 2600523: 1–17. URL
Mirowski, P. (2002). Machine Dreams. Cambridge: Cambridge University Press.
Viner, J. (1963). The Economist in History. American Economic Review, 53(2): 1–22. URL

#1 For the details of the big picture see cross-references New Curriculum.