As regular readers of this blog know, I argue that the dominant school of thought in economics, “Neoclassical economics”, is not only incapable of explaining this crisis, but actually helped contribute to it by its deluded analyses of finance and money.
I wrote Debunking Economics eight years ago to explain why Neoclassical economics was inherently flawed and should be abandoned. In that book I was merely collating the many compelling critiques that have been developed by economists of this theory over the years, that this school of thought has blithely ignored (I unexpectedly added one of my own, critiquing the theory of the firm, and also discussed flaws in conventional Marxian economics, but that’s by the bye here).
Even so, I never expected that the real world would throw up as dramatic a proof of the damage that a poor theory can do to reality as this financial crisis (the GFC, to give it its current popular moniker). That leading economists had no inkling of this crisis before it struck, and the panicked confusion amongst neoclassically-trained policy makers once it took hold, were good signs to the public that the alleged economic experts didn’t understand the economy. Anatole Kaletsky has recently “got” that, and others doubtless will as the crisis rolls on.
But that hasn’t stopped neoclassical economists from touting how great their theory is, nor from making pronouncements that indicate they still really don’t get it.
One such contribution from a leading neoclassical theorist was brought to my attention via a link to this blog: Brad DeLong’s attack on a Marxist’s analysis of the crisis. In a post entitled Department of “Huh?”: In Praise of Neoclassical Economics, DeLong mounts an abusive attack on David Harvey’s post Why the U.S. Stimulus Package is Bound To Fail.
Harvey’s own post was hardly complimentary about neoclassical economics–and I’m not going into the merits of his critique here either–but I didn’t notice Harvey referring to the work of any neoclassical as “pointless intellectual masturbation”, as DeLong obliquely called Harvey’s post.
The intriguing aspect of DeLong’s post was the appeal he made to what is known as the IS-LM model of macroeconomics in his attempt to refute Harvey’s critique. DeLong states:
“And it is at this point that we draw on neoclassical economics to save us–specifically, John Hicks (1937), “Mr. Keynes and the Classics,” the fons et origo of the neoclassical synthesis…”
This is ironic to anyone who has read Hicks in detail (as I have), because about thirty years ago, Hicks rejected the IS-LM model as a totally inappropriate tool for analysing a capitalist economy. Writing in the non-orthodox Journal of Post Keynesian Economics, Hicks stated that:
“The IS-LM diagram, which is widely, though not universally, accepted as a convenient synopsis of Keynesian theory, is a thing for which I cannot deny that I have some responsibility.” (Hicks, J.R., 1980. “IS-LM: an explanation”, Journal of Post Keynesian Economics, Vol. 3, pp. 139-54)
He then went on to make a number of points against the model he built, which included that it was inappropriate unless we lived in a world in which the future was certain, because to derive the model he assumed that expectations of the future remained constant and were correct. He then derived what he called the LL curve (and which later neoclassicals relabelled the LM curve), in which the demand for money was a function of both the need to pay for transactions and … uncertainty about the future. As Hicks put it,
“for the purpose of generating an LM curve, which is to represent liquidity preference, it will not do without amendment. For there is no sense in liquidity, unless expectations are uncertain.”
The model also presumed that all markets were in equilibrium–something that an older and wiser Hicks realised was utterly inappropriate when applied to the real world. His final statement on this was damning:
“I accordingly conclude that the only way in which IS-LM analysis usefully survives–as anything more than a classroom gadget, to be superseded, later on, by something better–is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of equilibrium methods, is not inappropriate…
When one turns to questions of policy, looking towards the future instead of the past, the use of equilibrium methods is still more suspect. For one cannot prescribe policy without considering at least the possibility that policy may be changed. There can be no change of policy if everything is to go on as expected–if the economy is to remain in what (however approximately) may be regarded as its existing equilibrium.”
A point I made repeatedly in Debunking Economics–because I had no choice but to–was that when faced with compelling critiques of their theory, neoclassical economists responded by ignoring them. Often, this would follow the pattern of someone who, in his youth, had played a key role in formulating neoclassical dogma, but in later life recanted to some degree–and Hicks here is a perfect example. The “Young Turks” of the discipline would stick with the original idea, and–if they were even aware of the later recantation at all–would dismiss it as the ravings of a senile old man.
Brad DeLong gives me yet another instance of that.
All this wouldn’t matter if DeLong had no influence–just as neoclassical economics wouldn’t really matter if all it did was befuddle students’ brains. But DeLong has influence, as his profile indicates:
“Brad DeLong is a professor in the Department of Economics at U.C. Berkeley; chair of the Berkeley International and Area Studies Political Economy major; a research associate at the National Bureau of Economic Research; and a visiting scholar at the Federal Reserve Bank of San Francisco. From 1993 to 1995 he worked for the U.S. Treasury as a deputy assistant secretary for economic policy…”
And neoclassical economics has shaped the institutions of the modern world, the practice of finance markets, and the setting of government policy. While it is still in charge of setting policy, this crisis will go on, and on. Only when policy makers start showing practitioners of this dogma the door (to the retirement home) will a real attack on the causes of the crisis be possible.
On a more trivial note, Australia’s market economists are demonstrating their continuing ignorance of the private debt bubble, and how it caused the crisis, by their advice that banks should reduce mortgage payments when they cut interest rates (for non-Australian readers, variable interest rate home loans dominate here, but when a rate cut occurs, the banks leave it up to borrowers to alter their current $ payments. So a rate cut from, say, 6% to 5% on a $100,000 25 year mortgage results in no change in the payments the borrower is making unless the borrower elects to reduce them. As a result, the term of the mortgage effectively drops when the rate is cut, while the payments on the mortgage remain constant).
Jessica Irvine reports in today’s Sydney Morning Herald that
“MORTGAGE holders are taking advantage of lower interest rates to pay off their loans faster, rather than pocketing the savings upfront. This has prompted some economists to call for automatic reductions to monthly loan repayments to help better stimulate the economy.” (Interest rate cuts going to our loans, not pockets).
Saul Eslake is reported as making the following sensible comment:
“If people are able to keep their mortgage repayments up as interest rates decline, then they’re saving themselves tens of thousands over the life of the loan,” he said. However, “that does magnify the increase in saving that occurs when interest rates fall, that’s true”.
However my Kosciuszko mate Rory Robertson seems to be saying that we would be economically better off if banks changed their practice so that payments were cut when rates were reduced, because this would increase spending (and Nicholas Gruen apparently made a similar observation):
An interest rate strategist at Macquarie Bank, Rory Robertson, said interest rate cuts would “pack more of a punch” if banks had to automatically reduce repayments.
“If the Reserve Bank is cutting by 4 basis points and no one’s taking the option of lower loan repayments, it means that the policy is not particularly effective in putting cash in people’s pockets. I would have thought that was the point of the exercise. Just as you squeeze budget constraints by rate hikes, you remove budget constraints by rate cuts. If the money’s burning a hole in pockets, you have got a better chance of it being spent.”
Nicholas Gruen, the chief executive of mortgage broker Peach Home Loans and the economic consultancy Lateral Economics, said that while in the longer term it was better if people paid down debts, in the short term it was better if they spent the money.
“It’s pretty unfortunate that some of this is happening from inertia, not because anybody particularly wants it to happen,” he said.
Ahem. We got into this crisis by reckless debt-financed spending (on both assets and consumer durables); at its peak, the increase in debt (at A$259 billion in 2007) provided almost 20% of aggregate demand in the economy. Deleveraging from this level of debt is inevitable and painful, but delaying it is hardly an alternative. Just look at Japan–still in Depression 18 years after its debt-financed speculative Bubble Economy burst.
prudentsaver said: “I am really getting more into the view that the dotcom was a P/E bubble, and this is an earnings bubble, and that makes typical value investors forget that the whole economy is in a bubble where the fundamentals don’t count.”
prudentsaver, you might want to check out the first chart titled “US Inflation-Adjusted Asset Prices” at this link:
http://www.debtdeflation.com/blogs/2008/05/05/defer-the-rba-enhanced-independence-act/
How about there was a debt bubble (caused by cheap labor and consumer confidence to take on more and more debt) that greenspan managed to direct into real gdp, stock prices, and housing prices that led to those 3 being higher than they should be based on income in the USA???
I don’t believe the CPI adjusted asset prices are correct.
It’s more like this:
http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+Dow+5000+Gross+Dec+08.htm
http://www.rayservers.com/images/dow_gold_usd.gif
Steve,
I think you’re being silly.
This may be the first time that anyone has ever called me a neoclassical economist. Not everyone you disagree with is a neoclassical economist you know.
Dear Nicholas,
Yes I am well aware that there are practitioners of other schools of economics who disagree with me (and disagreement with me wasn’t the point of that post).
In fact, if you read it carefully Nicholas, you’ll see that my references to neoclassical economists were solely related to Brad DeLong and his references to John Hicks. The next section of the entry began “On a more trivial note, Australia’s market economists are demonstrating their continuing ignorance of the private debt bubble…”.
The way the rest of the entry was phrased could have seemed insulting to you, for which I apologise. When I prefaced it with “Australia’s market economists”, I was thinking specifically of those economists who work for banks as commentators, and the one person who I was criticising directly there was Rory. I included a reference to you there in parentheses, because you were quoted in the same story and with a similar comment to Rory’s.
As an economic consultant, you’re not a “market economist” as the term is normally used; but that was a quickly written blog entry, so I was somewhat hasty with phrasing.
However I am curious as to how you would classify your approach to economics, and what analytic tools you use to guide your arguments about economic policy.
Steve,
I joked just the other day that my own approach is ‘applied Socratic wisdom’, which is to say that I try to realise how ignorant we all are.
One of my favourite quotes is from Robert Solow (a neoclassical I guess).
A PhD advisor said my framework was ‘middle of the road’. He thought it was a good PhD, but the comment was nevertheless somewhat dismissive. It seemed to smack of a kind of fallacy in which the really important thing is getting the framework right and then the rest is the details of application. Now that’s definitely true of celestial physics as far as the choice between Ptolemaic and Newtonian frameworks are concerned when you’re sending a man to the moon. I think Keynes came up with a better view of what’s going on in a depression than the Treasury view that he challenged. And the IS-LM framework is pretty useful, and superior in many ways to what came before it in appropriate contexts
But my approach is to try to think things through as best I can using what resources I have – which is a suite of imperfect frameworks and some commonsense and experience to try to pay some attention to context (economists are often awful – in the way that you really have to be trained to be that awful – at this). I then to try to both avoid obvious errors and to think of policies that would be helpful sometimes in terms of several frameworks. One of the things I’ve found in my micro-economic work is that there is a hankering to have debates as if they are debates about frameworks, when in fact they need not be. I wrote one of these up recently and you can see it on Troppo.
The debate about the policy called ‘export facilitation’ in the Australian car industry was treated as a doctrinal question of whether you were in favour of protection and selective industry assistance or not, when I argued that it was actually an argument about the form assistance should take (whether it should be porous to intra-industry trade or not) all the participants in the debate accepting that there would be substantial assistance to the industry for a considerable time. Export facilitation ‘made sense’ both to protectionist and to anti-protectionist views of the world, and it seemed to me was so much the better for it. It meant you didn’t have to know what the ‘right’ framework was to figure out that it was a policy worth having.
People love high level ideological battles. It makes them feel they’re on ground that they understand. They can pretty much go to sleep and argue by word association “you would say that wouldn’t you?” yada yada. In fact we are always and everywhere on ground that we understand ever so slightly.
I fear you may see these things as an evasion – they’re certainly not jumping into the nitty gritty of your arguments on macro, but I hope you think they make some sense.
Dear Nicholas,
I certainly agree that economic debate has been far too doctrinal rather than empirical. It’s something I try to avoid, as you do too. Even when I criticise Austrian approaches, for example, I try to base my criticism on ways in which empirical data undermines some of their doctrinal beliefs, rather than simply rejecting them out of hand on the basis of their ideology, or their utilitarian theory of value.
And there are also ways in which an approach to economics with which I in general disagree can be correct on major points–as again with the Austrians because of their quite justified emphasis upon entrepreneurship, innovation and disequilibrium.
That said, I think there are methodological issues that pervade most schools of thought in economics that seriously hamper the discipline’s capacity to function as a science, even given the limitations imposed by the nature of economic enquiry. Chief here is the use of the equilibrium abstraction, which occurs not only when neoclassical economists use IS-LM to analyse macroeconomics, but also when Post Keynesian economists use Kalecki’s national accounting identities, and when Marxians apply Marx’s value identities. It then means that we are treating an obviously dynamic and indeed evolutionary system as fundamentally static, and whatever our ideological underpinnings, that “abstraction”–that time can be ignored, for heaven’s sake, when analysing a dynamic system–makes us fundamentally unscientific.
This is what John Hicks himself came to appreciate in the late 70s that led him to disavow the IS-LM tool that he himself had invented–though he never came up with a decent alternative.
It’s also why physicists I know and respect–such as Joe McCauley–have developed the attitude that the entire curriculum of economics should be evicted at universities, because it teaches a mindset that makes economists fundamentally incapable of understanding the economy.
Have you had a read yet of the Dahlem Report that I just posted to this site? I think this throws down the challenge to the economics profession in general. Whether Socratic or old-school Keynesian or staunchly Neoclassical, economics has let society down very badly, and fundamental reform is needed. I frankly doubt the capacity of economists to do this themselves, because as Keynes once put it so well, “The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.” Economists have used equilibrium methods to analyse the economy for so long that they are almost incapable of realising that this is fundamentally wrong, whether your equilibrium identities be Neoclassical, Austrian, Keynesian, or Marxian.
Yes,
All entirely fair enough. For me any discipline that takes anything as self evidently silly as real business cycles in any way seriously certainly doing its best to sabotage it’s chances.
This is a discipline that takes a few weeks out of serious discussion to discuss (apparently seriously) whether surging unemployment in the wake of the largest financial crisis since the great depression is a sudden decision to take a breather by workers? If you spend all your time trying to defend the obvious – and banish questions the astronomical equivalent of which is “how do we know the moon isn’t made of green cheese?” – then you haven’t got a discipline that is going to help much.
Then again there are sane people amongst them – including, IMO Brad Delong to whom you take exception. Well the passage you took exception to was preposterously arrogant. (Delong is like a number of America’s uber-economists – Larry Summers seems to be one and I suspect Martin Feldstein is another but I haven’t got around to posting my – somewhat flimsy – evidence). And your point about Delong’s quoting the IS-LM framework may be fair enough in the circumstances. But generally IMO he’s a guardian of sanity in a lot of respects.
Anyway, where we differ is that it seems to me that you think that cleaning the Augean stables will somehow get things much better sorted. I think economics is more like history. True it’s a practical subject and history is not – and so it’s a bit more like a science or like a practical subject like medicine in the sense that we know some fairly good regularities which enable us to know some things about what to do and not do. Increase interest rates and that slows the economy, introduce rent control (at least in an ill-considered way) and it will destroy cities. That kind of thing. But most of this is pretty obvious and doesn’t need anything very elaborate to understand. (I wonder how far we have got since Smith – though Keynes (and basically the idea of an economy riven with positive feedback) is obviously of great practical importance in managing the macro-economy.
Beyond these things, I think economics is more like history or military strategy (or perhaps even more depressingly, corporate strategy). Formal modelling a la economic theory, or in an empirical context can be worthwhile. But it usually takes us tiny steps forward (and sometimes large steps backward in our understanding).
I wonder what are the kind of questions we ask about in economics. Are they like the question “are planets always spherical, and within what tolerances?” or are they like the question “When is the strategy of encirclement of use in a military battle?”. I think a lot of the questions are like the latter. Should we continue the export market development grants scheme? Should we expand it, rejig it? Buggered if I know. One the one hand this, on the other hand that. The tools of economics, and the corpus of economic science gives one clues, hints, allows one to measure certain things. But that’s pretty much it.
So while I’d like to see us banish self evident nonsense from the corpus of subjects seriously discussed (it seems so little to ask!) I don’t think it would make such a huge difference to our finding out how best to run a given economy. I’d add that while the extraordinary status given to the cleverness of economists’ formal games does help to derange the discipline, part of my application of ‘applied Socratic wisdom’ runs to remembering that it was ever thus. Other disciplines have their moments of monumental triumphant stupidity. I’m thinking in particular of whomever it was’s campaign to establish that stomach ulcers were caused by bacteria. As I understand it, he was able to demonstrate this pretty clearly, and cure stomach ulcers, but it took about twenty years of struggle with the medical establishment before the obvious was finally accepted.
Hi BTB, Brightspark, ueberbaer,GSM, Prudentsaver et al
I post this for what it is worth. It comes from the itulip site and unfortunately I cannot remember the original poster to give adequate recognition. The Gold price is pretty well predicted by this function
257 * exp(0.00045 *x)
where x = the number of days since Feb 7 2001
R square = 98%.
The trade of selling if gold is 10% above or buying if 10% below has worked pretty well apparently…(IN THE PAST)
It implies a compound return of about 18% for Gold. BTB may well point out that it is in Gold’s rising period.
As I say FWIW.
BTB I think we all read your posts with great interest and include your opinions in trying to balance out our own position.
I’ve been following Gold since it was about US $320 so I have done OK. Lately the A$ has about cancelled out any increase in price. I suspect your 30% decline might just be matched by a similar decline in the A$…just my own feel for the thing.
One thing my Gold holding is quite a small portion of my overall assets. It’s just a bit of insurance. I have got out of quite a lot of my positions in Junior miners these past few months.
What has me beat is just where to put the money right now. If Steve is right cash looks good! If I’M right NOTHING looks good!!! (except the bottoms of beer stubbies and wine bottles!!)I guess it is cash for a while and a quick switch at some stage. (Who thinks he is a clever boy then? !!!!)
I always get beaten with timing trying to short things!!!Holding cash is about as short as I like just now.
Hi uberbaer
Thanks! Sorry for a late recognition of your post. I haven’t been around for a bit. I got a bit of a sour taste over in the forums section so i’ve not been visiting lately.
Yes, Michael and I used correspond a bit. He’s a really good bloke i reckon and really does his best within the constraints of his position.
Sorry in commenting I didn’t realise how old those posts were!!!!! Nevertheless the function stands
Flawse/Outback Oracle