The Future of Economics
I was approached by Bloomberg to write an 800-word feature on “The Future of Economics” for the World Economic Forum, which starts today in Davos. Here is the Bloomberg newsletter, with my commentary on page 5.
For its entire history, macroeconomics has been dominated by mathematical models that ignore the existence of money, debt and banking, and that perceive the economy’s movement through time as transitions from one state of equilibrium to another.
At any point in history, these would be heroic assumptions. Could it really be true that models without either money or instability are provably superior at predicting the economy’s future course than models in which money and banking exist, and in which the model economy can be out of equilibrium? If not, is it the case then that such models are simply too difficult to construct—that the best we can do is pretend that the economy doesn’t have banks or money, and that it’s always in equilibrium, even if we know these assumptions are false?
Before the crisis of 2007, few non-economists even asked those questions, because there seemed to be no need to challenge what economists did. The economy, after all, was going gangbusters. Professional economists, using the very latest mathematical models of the economy, took credit for its sterling performance, and predicted more of the same for the foreseeable future.
Robert Lucas, the father of “Rational Expectations Macroeconomics”, asserted that the “macroeconomics … has succeeded. Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades.”[1] Ben Bernanke lauded “improved control of inflation” as the cause of “the Great Moderation”, which he described as “this welcome change in the economy.” [2] In June 2007, the OECD, guided by its macroeconomic model, opined that “the current economic situation is in many ways better than what we have experienced in years… Our central forecast remains indeed quite benign”. [3]
Then all hell broke loose, and almost five years later, it shows no signs of abating. Now non-economists are challenging what economists do, and finally realizing what a minority of dissidents within economics have long known: these assumptions are not merely heroic, they are both false and unnecessary. Money, debt and disequilibrium dynamics play crucial roles in the actual behaviour of the economy, and it is relatively easy to develop mathematical models which include money and banks, and in which the economy is always in disequilibrium. I should know: it’s what I do, and it’s why I was one of two mathematical economists who saw this crisis coming, and warned of it publicly before it happened (the other was the late Wynne Godley). [4]
For economics to have a future, it has to abandon the obsession with equilibrium modelling, and realistically incorporate money, banking and finance into macroeconomics. Both things are, as I’ve said, not hard to do.
The starting point for modelling any process in a true science is a position of disequilibrium—Newton, after all, modelled gravity by considering a falling apple, not one at rest! Economists have to abandon their fetish with “comparative statics” and instead model processes of change. Dynamics has to be the core of economic analysis, not equilibrium.
Money is also easily modelled by borrowing the basic tool of the accountant, double-entry bookkeeping. [5] Money and debt are created by bookkeeping entries, and the same paradigm can be used to derive dynamic models of the flow of money in one direction, propelling the movement of goods and financial assets in the other.
The difficulty in developing a monetary dynamic macroeconomics comes not from the tools themselves, but from the beliefs that have to be abandoned to employ them sensibly—from other assumptions that Neoclassical economists have made to “simplify” analysis that instead have made it almost impossible to understand the real world. There are enough of these to literally fill a book—to whit, my Debunking Economics [6]—but I’ll single out just three:
- “Rational” expectations—which really means assuming that everyone can accurately predict the future (and therefore avoid any calamities like the one we are in right now);
- Representative agents—which really means assuming that there’s only one person in the economy, who produces and consumes just one commodity; and
- Perceiving macroeconomics as applied microeconomics
This last false belief, and not a quest for greater realism, was the driving force behind the development of macroeconomics since WWII. It was a fool’s errand, since as physicists realized decades ago, “More Is Different”—to quote the title of a famous paper from Physics Nobel Laureate Philip Anderson. [7] Biology cannot be treated as merely applied chemistry, even though the elementary building blocks of living entities are chemicals, because properties emerge from the interactions of these chemicals that can’t be explained from the chemicals alone.
We call one of these emergent properties “Life”. We know a great deal about chemistry, but no chemist has as yet created life. The attempt to reduce macroeconomics to applied microeconomics was as futile a quest.
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[1] Robert E. Lucas, Jr, “Macroeconomic Priorities”, his 2003 Presidential Address to the American Economic Association, January 10, 2003. http://oldweb.econ.tu.ac.th/archan/chaiyuth/New%20growth%20theory%20Review%20in%20Thai/macro%20perspectives_lucas.pdf.
[2] Bernanke, B. S. (2004). Panel discussion: What Have We Learned Since October 1979? Conference on Reflections on Monetary Policy 25 Years after October 1979, St. Louis, Missouri, Federal Reserve Bank of St. Louis. http://www.federalreserve.gov/boarddocs/speeches/2004/20041008/default.htm.
[3] Cotis, J.-P. (2007). Editorial: Achieving Further Rebalancing. OECD Economic Outlook. OECD. Paris, OECD. 2007/1: 7-10. http://www.scribd.com/doc/43756565/Oecd-Economic-Outlook-2007
[4] Fortunately Godley (http://en.wikipedia.org/wiki/Wynne_Godley), has many young followers carrying on his work. For the list of economists who warned of the crisis, see Bezemer, D. J. (2009). “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models. Groningen, The Netherlands, Faculty of Economics University of Groningen. http://mpra.ub.uni-muenchen.de/15892/1/MPRA_paper_15892.pdf.
[5] For an example of modelling a simple 19th century paper money system, see http://www.economics-ejournal.org/economics/journalarticles/2010-31.
[6] Steve Keen (2011), Debunking Economics: the naked emperor dethroned?, Pluto Press, London. http://www.amazon.com/Debunking-Economics-Revised-Expanded-Dethroned/dp/1848139926/ref=sr_1_1?s=books&ie=UTF8&qid=1326839803&sr=1-1
[7] Anderson, P. W. (1972). “More Is Different.” Science 177(4047): 393-396. http://www.andersonlocalization.com/pdf/more_is_different.pdf.
This guy should be working with Steve, if not already:
http://ineteconomics.org/video/30-ways-be-economist/moritz-schularick-credit-booms-gone-bust
“The best argument against the “print money will cause hyperinflation” case is the data. US Bank reserves are through the roof, and lending hasn’t taken off, and neither has inflation.”
Professor Keen, there seems to be growing evidence that excess reserves from QE are not idle. The claim is that they are being used to support equity and commodity prices: http://www.guardian.co.uk/business/2011/jun/29/quantitative-easing-fuels-commodities-boom.
If that is true then President Barack Obama’s claim of a “multiplier effect” is sort of correct. Since share prices are set on the margin then a few high bids at low volume is enough to keep the share market high. Conspiracy types have dubbed this the “plunge protection team”.
Inflation hasn’t taken off, but neither has deflation.
Cyrusp
But how much more has QE pushed down interest rates
http://www.cnbc.com/id/46148704
The Federal Reserve knows full well that solvency is not an issue for the government of the United States, short term or long term.
It knows as operational fact there is no such thing as the U.S. government ‘running out of money’ or ‘being dependent on China’ for funding. Or ‘leaving the tab to our grand children.’
The Fed knows debt management is nothing more than shifting dollar balances between reserve accounts at the fed to securities accounts at the Fed, and that paying off the debt is nothing more than shifting dollar balances from securities accounts at the Fed to reserve accounts at the Fed, with no grand children involved.
And the Fed knows that they, and not markets, necessarily set interest rates by voting on them, as the fed is the monopoly supplier of clearing balances (reserves) for the banking system and therefore what’s called ‘price setter’ in economics 101.
Yes, I’ve seen that argument Cyrusp, and I’m waiting on a more analytic paper by Dirk Bezemer on the issue. The funds haven’t boosted activity or lending in the industrial sector, but they may well have financed a speculative bubble in commodity prices, as this article claims.
And yes, deflation has been minor compared to the GD. One feasible reason for the difference–in addition to the relative impact of Government spending–is the composition of debt, which was much more in non-financial business debt back in the GD compared to this time round.
And who mainly exchange reserves for other assets
Isn’t it the banks. So in effect it makes no difference. Except for very marginally lower interest rates
The key MAYBE is the low interest rates no QE
“but they may well have financed a speculative bubble in commodity prices, as this article claims”
How can this be correct?
QE exchange one bank asset like a govt bonds for another one (reserves). So the banks asset position does not change. Except the assets earn lower interest.
Are you saying the bank is more likely to loan money at lower interest rates because of this which then encourage more lending that flows into commodities
But note that even if they do the total bank reserve holding do not change. They just flow from one bank to another one.
Utterly agree Frank! Unfortunately he’s not attending the INET conference in Berlin, but I hope to meet up with him when I’m there since his is in Berlin.
Read the article RJ.
Steve
I have. But isn’t this article mostly total garbage. For the reasons I have given above
RJ, there was also this article on Naked Capitalism a couple of weeks ago regarding the inflation of commodities – well worth look.
One thing that I’ve heard about the transmission mechanism between asset speculation and QE is that hedge funds have been borrowing money directly from conservative institutions that used to hold US treasuries in order to speculate with the money on a highly leveraged basis. In other words, the lending occurred via the shadow banking system, with conservative institutions acting as the shadow lender and hedgefunds acting as the shadow borrower:
http://www.youtube.com/watch?v=qzIq_T3lId0
It has been my theory that this is the market’s way of getting around the artificial barrier raised by the fact that the decision was made not to charter new, well capitalized banks in the wake of the crisis. If the government won’t create well capitalized “banks”, the shadow sector will. The effect of this is that the problem of a lack of capital in the banking system is circumvented somewhat, but the existing banks are under more competition than the government initially wanted them to be exposed to (i.e. why it did not allow new chartering). A nasty side effect is that the shadow banking system has grown to proportions that exceed those of regular banking in the US (Lew Spellman’s videos in the same series as the one I post above explain a lot of this).
Now, does this mean that the excess reserves that banks are reported to hold are being used actively? I don’t immediately see how. I would expect the money being lent out by these insitutions not to appear as “excess reserves” anymore. Maybe I’m wrong. I’m out on a limb on most of this.
This kind of hyperfinancialization is nuts. Its the ultimate “Eat, drink and be merry for tomorrow we die philosophy.
Ted,
The last paragraph in that Naked Capitalism article is a screaming justification for a Distributist economy with strict regulation of speculation.
The fallacy of expansionary fiscal consolidation
Cracking paper from Simon Tilford
http://centreforeuropeanreform.blogspot.com/2012/01/baltic-states-and-ireland-are-not-model.html
‘Eurozone policy-makers – from President Sarkozy and Wolfgang Schäuble to the former President of the ECB, Jean-Claude Trichet – advocate that Italy and Spain should emulate the Baltic states and Ireland. These four countries, they argue, demonstrate that fiscal austerity, structural reforms and wage cuts can restore economies to growth and debt sustainability.
Latvia, Estonia, Lithuania and Ireland prove that so-called “expansionary fiscal consolidation” works and that economies can regain external trade competitiveness (and close their trade deficits) without the help of currency devaluation. Such claims are highly misleading. Were Italy and Spain to take their advice, the implications for the European economy and the future of the euro would be devastating….
What have the three Baltic economies and Ireland done to draw such acclaim? All four have experienced economic depressions. From peak to trough, the loss of output ranged from 13 per cent in Ireland to 20 per cent in Estonia, 24 per cent in Latvia and 17 per cent in Lithuania. Since the trough of the recession, the Estonian and Latvian economies have recovered about half of the lost output and the Lithuanian about one third. For its part, the Irish economy has barely recovered at all and now faces the prospect of renewed recession.
Domestic demand in each of these four economies has fallen even further than GDP. In 2011 domestic demand in Lithuania was 20 per cent lower than in 2007. In Estonia the shortfall was 23 per cent, and in Latvia a scarcely believable 28 per cent. Over the same period, Irish domestic demand slumped by a quarter (and is still falling). In each case, the decline in GDP has been much shallower than the fall in domestic demand because of large shift in the balance of trade.
The improvement in external balances does not reflect export miracles, but a steep fall in imports in the face of the collapse in domestic demand. ..
Spain and Italy could close their trade deficits if they engineered economic slumps of the order experienced by the Baltic countries and Ireland. But a collapse in demand in the EU’s two big Southern European economies comparable to that experienced in the Baltic countries and Ireland would impose a huge demand shock on the
European economy. Taken together, Italy and Spain account for around 30 per cent of the eurozone economy, so a 25 per cent fall in domestic demand in these two economies would translate into an 8 per cent fall in demand across the eurozone. The resulting slump across Europe would have a far-reaching impact on public finances, the region’s banking sector and hence on investor confidence in both government finances and the banks. The impact on sovereign solvency in Spain and Italy and on the two countries’ banking sectors would be devastating.’
Any mention in that paper that the ‘miracle’ in those countries involves vast numbers of their population leaving the country?
Which goes to my suggestion that neo-classical economics is actually a form of eliminationism. The ‘surplus’ population is expected to die quietly or leave the country and become somebody else’s problem.
Ted
Thanks
The Guardian artilce is utter garbage
This one is much better (inflation FEARS etc not directly due to QE )
“This bubble, Cook argues, was inflated due to inflation fears after the QE programs undertaken by the Federal Reserve and the Bank of England. With the markets awash with dollar and sterling liquidity, banks and investors piled into commodities to escape what they saw to be a looming inflation.”
RJ, others – perhaps some time spent reading articles on Zerohedge might help. The work done by authors is usually spot-on and provides insight only gained from those who truly know how the system works (and does not) at the level where greed and power come to bear on the world economics (and consequently use the tools of modern economics to pull the wool over peoples eyes).
LCTesla –
In my opinion you are right into the heart of the matter, the shadow banking system.
One the key difference between now and any other item is how the financial sector has managed to create such incredible instruments of leverage – and do so virtually completely outside of regulated space.
The kicker here is how firms have utilized bilateral netting as a means of keeping the essential double-entry books in balance. Reality however is that net exposure becomes gross exposure the moment liquidity seizes up. AIG was clearly an example of this.
Likewise, we all the know the mechanics here depend on perpetual growth. Lacking organic economic growth, there has only been synthetic (recursive) gains keeping the current system outside of systemic default. Meanwhile, ZIRP has forced pension funds and other similar funds desperate for yield into riskier and riskier classes of investment (yeah, that will end well… LOL).
Check out articles on “rehypothecation” if you want to really frighten yourself.
Centre line
You are kidding about zerohedge I hope
‘As the economist Steve Keen puts it: “Most economists are deluded.”‘
http://www.guardian.co.uk/business/2012/jan/30/excessive-pay-not-bankers-academics