WeeklyWorker

12.12.2019
Model making

Fixing the plumbing

You will get nowhere if you do not understand the capitalist mode of production, says Michael Roberts.

Recently, Benoît Cœuré - a leading French member of the European Central Bank’s executive board - delivered an address to economics students at the job forum of the Paris School of Economics. He wanted to explain to the gathered students that becoming an economist was a great thing to do (and paid well):

For many, a master’s degree is a natural step towards a PhD. And a PhD is essentially a promise of employment. In the United States, for example, the unemployment rate for PhD economists is about 0.8% - the lowest among all sciences. Not a bad place to start from.1

But the money was less important, because “your PhD should be fuelled by your passion and your love for research rather than by hopes of earning more money”. That was the reason he studied economics and worked his way up as an economics bureaucrat in the public sector - in ministries of economy and finance, statistical institutes; in international organisations, such as the International Monetary Fund, World Bank and other development banks, and the Organisation for Economic Cooperation and Development; and central banks, such as the US Federal Reserve and the ECB. Working in these agencies, Cœuré reckoned, “is probably as close as it gets to applied economics”.

Cœuré’s experience in the public sector may be different from those of us who worked in the private sector. Having done that - in banks and other financial institutions in my ‘career’ - I know that economic policy advice is not the target, but instead ‘how to make money’. Economics is geared to either corporate strategy for profits in production and trade or to investment strategy for profits in financial speculation.

Models

For Cœuré, economics is “literally about taking the models, tools and methods that you learn at class to help design public policies”. And, as a considerable fraction of that work then ends up being published as new research, “there is a virtuous feedback loop between academia and public-sector institutions … Macroeconomic models underpin almost all of our work at the ECB,” says Cœuré. That raises the question of the utility of models in economics.2

Marxist economist Ben Fine has attacked mathematical models in economics, because they have replaced theory.3 “The goal “of modelling the economy is fundamentally misconceived … a model of the economy is not the economy itself”. For Fine, mainstream mathematical theory is “unfit for purpose”. Models have a place, but “their extreme limitations need to be recognised”. As such, macroeconomics remains divorced from what is going on in the real economy. For example, the famous accelerator-multiplier Keynesian model may show the instability in capitalism, but it does not show why.

On the other hand, Dani Rodrick reckons models are the strength of economics. They are what makes economics a science. Rodrik rejects the view that economics can provide “universal explanations or prescriptions”.4 All mainstream economics can do is “map bits of economic reality”. In other words, economics is not ‘political economy’ in the sense of the classical economists and Marx.

Cœuré recognises that models have their limitations:

That’s when art, or rather artisanat - craftsmanship - comes in. We need to interconnect these models, and fit them into a general equilibrium view of how the euro-area economy evolves dynamically - preferably in a tractable way.

Unfortunately, the track record of general equilibrium models leaves much to be desired.

With the collapse of Keynesian economics in the 1970s, the mainstream concentrated on explaining ‘business cycles’ or ‘fluctuations’ in an economy using ‘modern’ techniques of modelling from what it called ‘microfoundations’. Econometric analyses like the Phillips curve were ditched, because such ‘correlations’ between employment and inflation had been proved wrong. The job now was not to look at macro or aggregate data, but to work out some ‘model’ that started with some premises of agent (consumer) behaviour or preferences and then incorporated some possible ‘shocks’ to the general equilibrium of the market; and then consider the number and probability of possible outcomes.

Thus were born the Dynamic Stochastic General Equilibrium (DSGE) models. They were based on equilibrium assumptions, because they started from the premise that supply would tend to equal demand; they were dynamic, because the models incorporated changing behaviour by individuals or firms (agents); and they were stochastic, since ‘shocks’ to the system (trade union wage push, government spending action) were considered as random with a range of outcomes, unless confirmed otherwise. This is now what most macroeconomists spend their time doing. Forget empirical evidence, forget macro data: find a ‘micro’ foundation (model) that may help to at least offer a guide to what possibly might happen.

But DSGE models have proved to be worthless in explaining anything.5 They failed to predict the great recession or explain it afterwards, and are unable to explain the subsequent weak recovery, or long depression. And it is not hard to see why. There is a total absence of investment or profit as ‘shocks’ in these models. Everything starts with consumer preferences: the arch consumer is king, as in the neoclassical world, and Keynesian aggregate demand is reduced to just consumption.

Since the great recession, general equilibrium models have lost their glamour to some extent. Cœuré quotes our recent Nobel prizewinners, Abhijit Banerjee and Esther Duflo6:

We, the economists, are often wrapped up in our models and our methods, and sometimes forget where science ends and ideology begins. We answer policy questions based on assumptions that have become second nature to us, because they are the building blocks of our models, but it doesn’t mean that they are always correct.7

This is somewhat ironic. These Nobel prizewinners do not use DSGE models. Instead they use ‘randomised control trials’ (RCT). You see,

... good economics is much less strident, and quite different. It is less like the hard sciences and more like engineering or plumbing: it breaks big problems into manageable chunks and tries to solve them with a pragmatic approach - a combination of intuition and theory, trial and acknowledged errors.

The plumbing analogy follows closely Keynes’s view that economists are really like dentists, sorting out the aches and pains of capitalism.8 Unfortunately, as Sanjay Reddy and others have pointed out,9 there are just as many faultlines in RCT as in DSGE models. The Nobel prizewinners’ ‘economics of poverty’ actually shows the “poverty of economics”.10

That does not mean it is impossible to use mathematical models, as long as they are based on realistic assumptions and tested empirically. Marxist economics is based on scientific method. You start with a hypothesis based on realistic assumptions that have been ‘abstracted’ from reality and then construct a model or set of laws that can be tested against the evidence. The model can use mathematics to refine its precision, but eventually the evidence decides. Moreover, macro-economics is the world of the aggregate, not individual behaviour. That delivers measurable data to test a theory.11

Political economy

The mainstream economics that Cœuré promoted to the Paris students as the basis for public policy has hardly proved successful in practice. Just consider the ECB’s own attempt to deal with the banking crash of 2008-10, the euro debt crisis of 2011-13 and the subsequent attempt to revive the euro zone economy. Cœuré claims that “the forward-looking nature of monetary policy makes the use of models indispensable”, but it seems that these models have proved to be ‘too simple’, and so monetary policy operations have become much more complex; with “forward guidance in central bank speak” and unconventional monetary policy like quantitative easing.

Cœuré says: “When we started purchasing securities, we had no guidance.” But “over time, ECB staff have successfully filled this void. We now have state-of-the-art term structure models that help translate changes in the amount of bonds into changes in long-term interest rates.” Well, maybe.

But the ECB’s economic forward guidance on inflation and growth has been proved pretty much wrong. The ECB has failed to achieve its 2% inflation target and real GDP growth has persistently fallen below ECB forecasts. The long depression has defeated mainstream economics.12

Forget forecasting. Cœuré recognises that “uncertainty is a pervasive feature of our profession”, so he dismisses the claim that economists failed to predict the outbreak of the financial crisis:

This criticism is nonsense. Do we expect physicians to predict illnesses? We don’t, of course. But we expect them to help us cure illnesses. Economists should do the same. They should be judged by the quality of the advice they give.

Again, we get the view that economists are like dentists, doctors or plumbers, who clear up messes once they have happened. But are doctors all that matter in human health? Actually, improved doctoral skills in treating patients once they have become ill comes from scientific discovery about diseases, biology and the environment. Successful drugs and medical practices are the result of learning what the cause of the illness is. In medieval times, doctors applied all sorts of useless and dangerous treatments (leeches, etc), because they did not know about ‘germs’ (bacteria or viruses). Cholera was eventually abated by a geographical study in London, showing it was prevalent near bad drinking wells. Malaria and smallpox were resolved by discovering the carriers of the bacteria in various animals. Treatments by doctors then followed.

There is no substitute for the ‘big picture’. Economists should not be doctors, but social scientists - or, more accurately, they should develop an economics that recognises the wider social forces that drive economic models: in particular, the social mode of production that is capitalism. That is, political economy which is mostly not taught in universities - and certainly not practised in international agencies.

In his address, Cœuré recognised that central banks had failed before the great recession. This was because their models expressed “an absence of a meaningful financial sector, which left models at a loss to explain the origins of the crisis and its consequences for the economy”. And “prevailing models were built on a standard linear Gaussian set-up and hence proved inadequate to examine shocks on the scale of the global financial crisis”. In other words, they assumed a normal, steadily growing capitalist economy, where there were no underlying contradictions that could erupt violently.

Remember the words of the then Fed chair Ben Bernanke back in 2004, just before the great recession. He was proclaiming the “Great Moderation” that capitalism had become:

... the substantial decline in macroeconomic volatility over the past 20 years is a striking economic development. Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question, about which no consensus has yet formed. This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s.13

Mainstream economics underestimated the depth and length of the long depression that followed, where even negative interest rates have no effect on the ‘real economy’ and where attempting to reduce public debt (as in the Greek crisis) made things so much worse “in the aftermath of the crisis, with tragic social consequences”. But don’t worry - Cœuré told the students: “Our general equilibrium models now feature a fully-fledged banking sector that accounts for the presence of financial frictions and that also allows us to analyse the effects of macroprudential policies.” And we are getting much more data that can help economists solve problems: “big data and richer and timelier datasets will help improve the input to our models.”

Cœuré cited climate change as perhaps the most far-reaching of the challenges ahead for economists.14 But he was delighted to tell the students that economics was making great strides in helping in that area: “William Nordhaus was awarded the Nobel Prize in Economic Sciences last year for integrating climate change into macroeconomic analysis.” Again, there is a certain irony here. For heterodox economist Steve Keen, among others, has done an effective debunking job on the Nobel laureate’s assumptions and forecasts.15 Actually, mainstream economics is doing little or nothing to come up with a social scientific analysis and solutions on this literally burning issue.16

Having expressed confidence in monetary policy as the tool to revive demand - despite evidence to the contrary - Cœuré finished by reminding his audience that

economics is a social science. Models will not take away the burden and responsibility of making judgements. Economics involves much trial and error - you have to take decisions in the fog when you can barely see your hand in front of your face. This makes our profession exciting!

Maybe exciting, but also fraught with failure in that “fog” - with serious consequences.

Michael Roberts blogs at https://thenextrecession.wordpress.com


  1. www.ecb.europa.eu/press/key/date/2019/html/ecb.sp191128~9216194199.en.html.↩︎

  2. See https://thenextrecession.wordpress.com/2016/09/22/paul-romer-the-mainstream-and-reality.↩︎

  3. https://thenextrecession.wordpress.com/2016/06/10/modelling-the-mainstream-by-fine-and-rodrik.↩︎

  4. www.nytimes.com/2015/11/22/books/review/chicagonomics-and-economics-rules.html.↩︎

  5. https://thenextrecession.wordpress.com/2013/04/03/keynesian-economics-in-the-dsge-trap.↩︎

  6. See https://thenextrecession.wordpress.com/2019/10/14/poverty-prize.↩︎

  7. www.ecb.europa.eu/press/key/date/2019/html/ecb.sp191128~9216194199.en.html.↩︎

  8. See https://thenextrecession.wordpress.com/2017/01/11/assa-2017-part-2-economists-and-the-state-of-economics.↩︎

  9. https://foreignpolicy.com/2019/10/22/economics-development-rcts-esther-duflo-abhijit-banerjee-michael-kremer-nobel↩︎

  10. www.ids.ac.uk/opinions/2019-nobel-prize-reveals-the-poverty-of-economics/?fbclid=IwAR2Br5QR-CQv-Qo3PpNxkVH_JVa9DyrLYcdYFwGIGzn3_KVyj3imh5BiMbU.↩︎

  11. See https://thenextrecession.wordpress.com/2012/11/22/bayes-law-nate-silver-and-voodoo-economics.↩︎

  12. See https://thenextrecession.wordpress.com/2015/01/23/the-ecb-qe-and-escaping-stagnation.↩︎

  13. www.federalreserve.gov/boarddocs/speeches/2004/20040220.↩︎

  14. For my view on this question, see https://thenextrecession.wordpress.com/2019/09/06/climate-change-and-mitigation.↩︎

  15. https://evonomics.com/steve-keen-nordhaus-climate-change-economics.↩︎

  16. https://voxeu.org/article/why-are-economists-letting-down-world-climate-change.↩︎