Some curious Neoclassical rumblings

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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.

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.