Where to next? The Lost Map and the Territory
The model that has dominated macroeconomics, DSGE (dynamic stochastic general equilibrium model), has been suffering some heavy criticism. Economics has some very powerful tools. By all means, attack what they build and how they used it but don't throw away the tool box.
John Kay (The Map is Not the Territory: An Essay on the State of Economics) writes:
I don't have a problem with this. I have a problem when the only game on the shelf for policy makers to play with is 'Grand Theft Auto'. Politics in Europe decides what can or cannot placed be on the shelf.
'Economists have tried to do something that even physicists have failed to do - unify the micro and macro cosmos' (Hitch Hiker's Guide to Macroeconomics). This is not as an argument to throw away science, Newtonian Physics or a Theory of Relativity. We retain our the models because of their usefulness, but in Economics we also have to ask useful for who and for what purpose?
Rational expectations was a powerful breakthrough. Its interesting to know both when and where they do or do not apply, and what happens in these situations. One may build a complex/algorithm or computer model that describes a baby's movements; it does not imply that a baby crawls around with a laptop in his hand. There might be reason to dismiss the model if it predicts that the baby should be bouncing with joy, when in fact it needs toilet training. On there other hand, such a model error might be flashing lights to tell you its time to change the baby.
So is the efficient market hypothesis a bad model because it not describing the financial markets, or is it good one as it can tell you there is something wrong with the markets (eg imperfect information, uncertainty or moral hazard) that need dealing with? The point being it is a tool not an ideology to believe in.
What people think they “know” and cannot know and how far they can see into the future is not constant. (also see Paul Davidson: The State of Economics). The world of 2007 is different from that of 2011. Such variables should not be treated as constants. The various families of ARCH models in various ways recognise this. It is neither 'animal spirits' or perfect information rationality, but something that varies between.
One problem, or decision to deal with, in macroeconomic modeling is the focus; the degree or over what we abstract. It determines the story that is to be told. This was one of the initial points of Macroeconomics.
For instance, the case against DSGE models blindly adopting the equivalence property could be made not because it is essentially wrong, but because it buries essential economic information. Ricardian equivalence is often used in a particular way to tell one type of story: a government carrying out austerity measures to reduce government deficits will result in people recognising (rational expectations) the policy to mean lower taxes or higher spending in the future. They feel worse off today, but as they realise that they will be richer tomorrow, they will increase spending.
This has not happened and something is very wrong. (and even at this level as Krugman argues Ricardian Equivalence does not imply this outcome). There might be a different story. Reducing deficits (and austerity measures) may be someones pain today and someone's else gain tomorrow.
In a similar way, I don't have a problem with real wages per se in models. Given a shock that results in the price level and wages going up by 10% and 25%, we may well conclude that there is an increase living standards. This might miss an important story. To say that everyone is better off is to assume the effects on everyone are symmetrical, there are no redistribution effect and that there are no change in relative prices. If the relative price of what the poor consume rises faster than that of the rich, and the numbers of poor have increased, then there is a completely different story to tell. The problem of non-asymmetric shocks happens within an economy as well as the EuroZone - not just geographically but amongst agents themselves.
Politicians, however, can't seem to separate reality from fantasy, can't understand them and cut and paste them into their own versions of Middle Earth: the 'Euro's one ring to rule them all'. The blindness, or deliberate refusal to turn away from such a world, leads them to select and finance only models that produce the desired answer. Politicians then use maps that have nothing to do with the territory they supposedly represent. Or, as the New York Times puts it, 'Austerity a political ideology masquerading as an economic policy' ('Britain’s Self-Inflicted Misery'). Europe is a particular tragedy, as a new road map is issued every two months.
Some random wonkish thoughts and a little cutting and pasting:
One neglected political business cycle theory, at the time of Keynes is from Michał Kalecki with a 1933 essay and important 1939 work "Essays in the Theory of Economic Fluctuations". He put forward the argument that political decision processes of Oligarchic or Imperfectly Competitive system would not allow the persistence of full employment.
During the war he work with other Polish escapees for the British War time Government and eventually moved to the US in 1946. McCarthy's witch hunts of his close contacts and friends convinced him to move back to Poland and live behind the Iron curtain where his influence dwindle.
Kalecki towards the end of life 'made the sad but true observation that the story of his life could be compressed into a series of resignations in protest-against tyranny, prejudice, and oppression' (George Feiwel).
Whereas Keynes argued that governments could impose their plans on the economy to control the business cycle, Kalecki argued the reverse. The market structure would restrict any management of the economy and the business cycles would impose itself on governments.
It is of interest because it is built on the oligarchies, cartels and Monopolies and is about inequality.
Let me describe a story it can tell:
1) There are two groups in the global economy. Those who need to work earn wages and salaries and those who can just live off profits.
2) One group is defined as those working but cannot save significantly more than what they need to service debts. (eg Debt-Serfdom Is Now The New American Norm)
3) The other group can save and accumulate funds to invest or manage large portfolios that are highly mobile, moving with ease from one part of the world to another.
Now lets do a different type of Creative accounting. To be provocative, I will use different labels than Kalecki:
Total Profits + (Total Wages - Debts) = Workers Consumption + (Corporate profits + Creditors)
Consumption + actual InvestmentAs most workers can't save or are enslaved to there debts we have:
(Total Wages - Debts) = Workers ConsumptionAnd canceling this from both this sides, gives:
Total Profits = (Corporate profits + Creditors) Consumption + actual Investment
This is his famous profits equation, which simply says that profits are equal to the sum of investment and capitalist’s consumption. Now ask a cause and effect question.
a) Does corporate owners’s consumption and investment determine profits or
b) Profits determine corporate owners’ consumption and investment?
Kalecki would argue the answer depends on who can decide. Corporate owners can choose to consume less now and invest for high expected returns in the future. Higher or lower than expected profits leads to an adjustment in their decisions. Here we could introduce all sorts of things (Kareken and Wallace model?). My second quote from Tom Sargent, rational expectations is "helpful in predicting the crisis, not the timing of the crisis because there are random variables, but in terms of predicting the measures that increase the probability of a crisis, and that’s the Kareken and Wallace model." So from above a) is the prime cause and b) the revision: profit rates leads to corrections
If corporate owners’s consume more, then one would image that they have less funds at the end of the period. This consumption, however, would also feeds backs in each other's profits. In a way, Kalecki views them as masters of their fate. .... http://en.wikipedia.org/wiki/Micha%C5%82_Kalecki#Theoretical_contributions
It is interesting as it can leads use to model, income distribution, inequality and the economy being at inefficient allocations of wealth and income. We could of course look at other alternative models that might be better. Isn't that the point of Econometrics? Or is it just to make sure the data fits our favorite model?