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Sunday, October 27, 2013

Faulty Assumptions and Verification

Paul krugman today writes in his article "Macrofoundations (Wonkish)"

"John Quiggin has a fun post debunking the notion, all too common among economists, that macroeconomics — the study of inflation, depressions, and all that — is somehow flaky and unworthy of the field’s grandeur, that only microeconomics, derived rigorously from rational behavior, is real science. Keynesian macro, in particular, is often regarded with intense distaste, and a lot of economists would like to ban it from the field."

Some Economists have come to that conclusion because of dogmas that haven't worked and their unwillingness to deviate from faulty assumptions, which are microeconomic assumptions:

"Quiggin points out, rightly, that almost all microeconomics depends crucially on the assumption that the economy is at full employment; this assumption is false, but what makes it not too false in normal times is the existence of stabilization policies, monetary and fiscal, that usually produce fairly quick recoveries from slumps. Macro is what makes micro work, to the extent that it does."

Every rational endeavor depends on observation, assumptions and verification. When assumptions are faulty, the results will be faulty. That is why we verify, debate, argue and sometimes have to change our minds. Krugman continues:

"I would add that macro is the only reason anyone listens to all those microeconomists who think they’re being rigorous. To see why, we need to think about the history of thought."

Because of the unwillingness to challenge authority, or even verify authority, science and scientists keep getting stuck. The unwillingness to verify has allowed dogma and faulty faith to substitute for reason, due to reasonable seeming theories turning out to be faulty:

"If you go back to the state of American economics in the 1930s and even into the 1940s, it was not at all the model-oriented, mathematical field it later became. Institutional economics was still a powerful force, and many senior economists disliked mathematical modeling. When Paul Samuelson published Foundations of Economic Analysis in 1947, the chairman of Harvard’s economics department tried to limit the print run to 500, grudgingly accepted a run of 750, and ordered the mathematical type broken up immediately."

And he continues:

"So why did model-oriented, math-heavy economics triumph? It wasn’t because general-equilibrium models of perfect competition had overwhelming empirical success. What happened, I’d argue, was Keynesian macroeconomics."

The thirties were a catastrophe not only for the nation but for mainstream economists like Von Mises, Hayek, and their classical counterparts all over the world. Their response to failure was to double down on their theories, but others challenged those theories by trying to examine assumptions and model out cause and effect.

"Think about it: In the 1930s you had a catastrophe, and if you were a public official or even just a layman looking for guidance and understanding, what did you get from institutionalists? Caricaturing, but only slightly, you got long, elliptical explanations that it all had deep historical roots and clearly there was no quick fix. Meanwhile, along came the Keynesians, who were model-oriented, and who basically said “Push this button”– increase G, and all will be well. And the experience of the wartime boom seemed to demonstrate that demand-side expansion did indeed work the way the Keynesians said it did."

Of course the reality of the models is that they too are based on assumptions, and the underlying assumptions are either things that can be held fixed, or they tend to blow up the models. Sometimes we can hold a variable fixed for calculation purposes, but we always have to be aware of the assumption and treat it as a modeling risk. Still, Keynesian concepts worked within the realm of those assumptions. Krugman continues:

"It’s not an accident that Samuelson, even as he was raising the math level of microeconomics, was a key figure in the triumph of Keynesian economics. Nor was it at all an accident that his intro textbook, in its 1948 edition and for a long time thereafter, started with macro, and only got to micro later. The perceived success of macroeconomics did double duty, establishing the bona fides of a model-oriented approach and also suggesting that full employment was not too bad an assumption — given the right monetary and fiscal policies."

Given the right monetary AND fiscal policies. Without responsible officials, again, the assumptions blow up. Krugman continutes:

"Oh, and economists who are upset that the public seems to judge the profession by its success at macro diagnosis and prediction are missing the point: it has always been thus, and purists who disdain macro are making mock of the only reason anyone takes them at all seriously."

So much for "praxeology." He continues:

"The academic enterprise of economics as we know it, in other words, rests on a macro foundation, and in fact a Keynesian foundation — and economists who denounce all of that as witchcraft are busily sawing off the branch they’re sitting on."

Of course the other reason the micro-economists folks don't like admitting they depend on macroeconomics is that most of them are conservatives who feel "in their bones" that the old classical assumptions always hold. That is why they jumped all over Friedman's ideas and monetarism. It was classical economics with a monetary stick they could wave like a magic wand.

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