Feb18

Some curious Neoclassical rumblings

by Steve Keen on February 18th, 2009 at 11:42 am
Posted In: Debtwatch

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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.