The Great Unwinding: Some Thoughts on the Incoherence of Mainstream Economics

Unwinding.

A recent post by Lord Keynes inspired me to write up some very general thoughts on the state of mainstream economics. Today, I believe, mainstream economics is completely incoherent. What do I mean by that? Well, basically if you are in the mainstream you can pretty much believe in whatever you want these days.

Mainstream economics today can be made to say anything. But in being able to do this it says nothing. All the new gimmicks that have been introduced into the mainstream — from asymmetric information to rational expectations — have rendered it a total free-for-all. So, some of the mainstream will tell you that fiscal stimulus will have zero effect on the economy (Ricardian equivalence) while others will tell you that it is the key to future prosperity. Many will fall somewhere in the middle, unable to articulate their actual beliefs in any concrete manner.

In my experience the mainstream has become so incoherent that most of the time these economists will formulate their policy stance completely arbitrarily. Their opinions on the real economy are formed very much so the way the man in the street formulates his: either by assimilation of whatever is in vogue or by engaging in largely arbitrary construction (usually in line with the political predilections of the person in question).

How did this occur? I would argue that there were two key moments in the history of mainstream economics that led to this Great Unwinding. The first was the Cambridge Capital Controversies (CCCs). The results of the CCCs led to a fracture within the more pragmatic side of the mainstream. The object of attack in the CCCs was the standard marginalist production function. The production function sought to show two things. These were as follows.

(1) That the distribution of income in a market economy would be dictated by relative productivities of labour and capital. In more straight-forward terms that means that labour and capital get what they contribute.

(2) That market economies are inherently self-stabilising in the long-run. While planned savings and investment might diverge in the short-run causing unemployment or inflation they would equalise in the long-run. This avoided what came to be known as ‘Harrod’s knife-edge’. Harrod maintained that capitalist economies were inherently unstable in that planned savings and investment would only equalise by a fluke. This implied that continuous and vigorous policy intervention was required to stabilise a capitalist economy. (For more details on Harrod’s knife edge see here and here).

I think that Harrod was right. If you look at really existing capitalist economies government deficits are required to keep them ticking over most of the time. Take a look at the sectoral balances of the US below if you don’t believe me. Government deficits are clearly used almost constantly to offset private sector savings.

sectoral_balances1

Government intervention to stabilise the economy when savings and investment diverge is the rule, not the exception. There is no ‘long-run’ process of adjustment. Otherwise we would see a balanced government budget in the long-run. We don’t. Not even in the 1950s and 1960s when there was no substantial current account imbalance (i.e. in what effectively amounts to a ‘closed economy’).

What the CCCs showed was that the marginalists could not even prove that a market economy was self-stabilising in the long-run in theory. This led the marginalists to retreat into ever more abstract and out-of-this world constructions. While the production function and the Solow growth model that grew out of it were at least somewhat realistic — that is, you could at least imagine applying them to the real-world — the general equilibrium models and later the microfounded models that came after them were blast-into-space unrealistic.

Solow himself noted this in his Nobel Prize lecture (he won the prize for his flawed work showing that the economy was self-stabilising in the long-run… which shows what passes for Nobel Prize-winning ‘science’ in mainstream economics). I will provide a long quote here because it is important to show how Solow felt about the tendencies generated in economics in response to the CCCs.

The end result [of the new highly abstract constructions] is a construction in which the whole economy is assumed to be solving a Ramsey optimal-growth problem through time, disturbed only by stationary stochastic shocks to tastes and technology. To these the economy adapts optimally. Inseparable from this habit of thought is the automatic presumption that observed paths are equilibrium paths. So we are asked to regard the construction I have just described as a model of the actual capitalist world. What we used to call business cycles – or at least booms and recessions are now to be interpreted as optimal blips in optimal paths in response to random fluctuations in productivity and the desire for leisure. I find none of this convincing…

But now I have to report something disconcerting. I can refer you to an able, civilized and completely serious example of this approach and suggest that you will find it very hard to refute. You can find non-trivial objections to important steps in the argument, but that would be true of any powerful macroeconomic model.

There is a dilemma here. When I say that Prescott’s [i.e. a proponent of rational expectations] story is hard to refute, it does not follow that his case can be proved. Quite the contrary: there are other models, inconsistent with his, that are just as hard to refute, maybe harder. The conclusion must be that historical time series do not provide a critical experiment. This is where a chemist would move into the laboratory, to design and conduct just such an experiment. That option is not available to economists. My tentative resolution of the dilemma is that we have no choice but to take seriously our own direct observations of the way economic institutions work. There will, of course, be arguments about the modus operandi of different institutions, but there is no reason why they should not be intelligible, orderly, fact-bound arguments. This sort of methodological opportunism can be uncomfortable and unsettling; but at least it should be able to protect us from foolishness. (My Emphasis)

Here you see the Great Unwinding in full force. Solow knew that on their own logical terms the new models were impossible to refute. In order to dismiss them he had to basically say that in his opinion they were unrealistic and also point out that there were a whole multitude of models that were logically consistent but arrived at different conclusions. This is where the debate remains today and it is this that accounts for what I have referred to above as the free-for-all within the discipline. But of course the data shows Solow’s own work not be realistic with respect to the real world. So, the invocation of realism — something that I would generally applaud — inevitably comes back to bite Solow firmly on the buttocks.

This confusion was amplified when the neo-Keynesian policy consensus began to unwind in the 1970s due to the inflation. Into this vacuum stepped Milton Friedman and his monetarism. It was noted many times that there were altogether mystical elements in Friedman’s argument and that it ran contrary to the facts but the profession swallowed it. This was because it gave them a common cause to rally to away from the confusion within the discipline.

The second point at which the Great Unwinding took place was when the monetarist policies failed. I have written about this before in extensive detail and if the reader is interested they can consult that writing for an account of the failure. After monetarism had failed the profession once again slipped into incoherence. Rather ironically, this gave rise to the profession asserting that they had reached a ‘New Consensus’. But they had done no such thing.

Whereas in the 1970s and 1980s everyone was talking about monetary control to stop the inflation, in the 1990s there was confusion all around. Economists became rather obsessed with the NAIRU — that is, the idea of a natural rate of unemployment which if the economy fell below it there would be inflation — but this quickly fell apart when unemployment in the US fell below the NAIRU level and no inflation resulted.

After the crisis of 2008 the incoherence became amplified. Today the lack of consensus and the confusion is shocking. While policy-making economists in central banks and the like have a fairly good idea of what is going on the profession is in complete turmoil. This, I think, accounts for why the chief economist at the Bank of England Andy Haldane and Benoît Cœuré at the ECB are calling for substantial curriculum reform. When I speak to people like Haldane they seem to agree with me that the discipline is in turmoil and has no clear-cut answers to the questions of today. The opinions of the leading lights seem formed arbitrarily according to their political or ideological temperament. (The more progressive elements like Summers and Krugman are scrambling to make sense of the world but in refusing to dump the theoretical baggage they have accumulated over the years their attempts appear weak and unconvincing).

What I have always found refreshing about Post-Keynesian economics is that there is and has always been a strong consensus on real-world issues. I may vehemently disagree with the politics of, say, a Marxist-Kaleckian but it is very likely that we will hold basically identical opinions on practical matters. This consensus exists not only across space but also through time. What I mean by that is that Post-Keynesians rarely change their stances on real-world issues after the fact. This is because they usually get it right first time so there is simply no need.

Because of this you also see a smooth evolution of Post-Keynesian theory over the years. You do not see it wracked by ‘crises’ thrown up by the real-world as you do the mainstream. Rather you see it build upon itself in different directions. While the mainstream have a seeming crisis of faith every five to ten years that calls for a complete shake-up of the discipline, the Post-Keynesians roll calmly from one development in the theory to another.

This is why I strongly support the pluralist movement among students. I believe that if all the options are put on the table the students will likely gravitate toward Post-Keynesian economics for the simple reason that it is the most comprehensive and coherent body of theory available. I am perfectly willing to let students make this decision on their own. It seems that it is the mainstream who insist that only their approach is taught. Their insistence on monopoly is, I believe, a sign of enormous insecurity.

Update: The following paper by Kevin Hoover provides a fantastic overview of the Harrod versus Solow issue as to whether capitalist economies are inherently stable or unstable. Hoover, whose work I have discussed here before, strikes me as very Post-Keynesian in this paper.

About pilkingtonphil

Philip Pilkington is a London-based economist and member of the Political Economy Research Group (PERG) at Kingston University. You can follow him on Twitter at @pilkingtonphil.
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31 Responses to The Great Unwinding: Some Thoughts on the Incoherence of Mainstream Economics

  1. LK says:

    Enjoyed this post very much — and liked this point very much:

    “Because of this you also see a smooth evolution of Post-Keynesian theory over the years. You do not see it wracked by ‘crises’ thrown up by the real-world as you do the mainstream. Rather you see it build upon itself in different directions. While the mainstream have a seeming crisis of faith every five to ten years that calls for a complete shake-up of the discipline, the Post-Keynesians roll calmly from one development in the theory to another.”

    Well said. And this is actually how an economic science that — in contrast to its snake oil salesmen opponents — describes the real world would develop.

  2. Rob Rawlings says:

    You say:

    “If you look at really existing capitalist economies government deficits are required to keep them ticking over most of the time.”

    and

    “Government deficits are clearly used almost constantly to offset private sector savings”.

    You show a sectoral balances chart as evidence.

    The chart appears to be based on the accounting identity that shows that all spending in the economy must equal all expenditure. If govt expenditure exceeds tax revenues then clearly private income must exceed private spending (ignoring import/exports) by the same amount.

    Its not at all clear to me how your chart backs up your two statements. If a government decided to run a deficit for purely political reasons then the sectoral balances chart would be identical, wouldn’t it ? It would not necessarily tell us anything useful about what levels private sector spending and savings would be in the absence of the deficit.

    • We can only look at real-world data. Your fantasy-world without government intervention does not exist. When it does you can present your data. Until then I must use the existing data.

      • Rob Rawlings says:

        FYI: I also believe that inadequate aggregate demand is possible in economies.

        In your post you list a number of things that you see as wrong with modern economics.

        Here’s another one: The tendency to use accounting identifies in lieu of proper economic analysis.

      • I did not posit the chart as a causal argument. I used it to show that the US government has run persistent deficits since WWII. Given that there was not substantial inflation in most of these years (outside of the 70s) this implies that planned private sector investment was lower than planner private sector savings. If you have an alternative interpretation I’m all ears.

      • ivansml says:

        So out of curiosity, this:

        If you look at really existing capitalist economies government deficits are required to keep them ticking over most of the time. Take a look at the sectoral balances of the US below if you don’t believe me. Government deficits are clearly used almost constantly to offset private sector savings.

        is not a causal argument?

      • No, ivansml. That is a statement of fact. Here it is put differently:

        In the US government deficits are the norm. This is evidence that planned savings falls short of planned investment over very long periods of time and requires government intervention to stabilise effective demand.

        Anyway, let’s stop this ridiculous sniping.

      • ivansml says:

        Uhm, no, that’s not what you said. You clearly suggested the chart supports Harrod’s view that “continuous and vigorous policy intervention was required to stabilise a capitalist economy”. This is a causal claim, which presents a specific counterfactual (if governments didn’t run deficits, capitalist economies would become unstable and presumably collapse). The chart of course doesn’t prove any such thing, because it shows *actual*, not planned expenditures and savings, and the fact is that by definition, actual government debts (if there are such) must be counterbalanced by actual private surpluses (or trade deficits).

        You may think it’s ridiculous, but in my opinion this exchange nicely illustrates more general tendency. If Post-Keynesian theory really was so much better and so much more true, there would be no need at all to engage in meta-criticisms like you do in this post. You could instead fill your blog with empirical evidence proving superiority of your preferred theory. Yet you do the opposite, and most of the time even if you present some evidence, it’s nonsense, just like here. Thus either 1) you’re a weak defender of PK theory, or 2) PK theory is not superior to the mainstream one. Of course, those options are not mutually exclusive.

      • I have really simplify for you don’t I, you poor sod. Evidence shows government intervening to stimulate demand almost all the time over the past half century. This suggests that fiscal deficits are required over the long-run. That gives evidence in favour of Harrod and against Solow. I don’t provide data so much on the blog because I know people like you are immune to it. You invoke ceteris paribus clasues and refer to what if scenarios to wriggle away from it. Everyone else can see what you’re doing but you remain myopic. It would bve funny if it weren’t so sad.

      • ivansml says:

        Oh, it is fun. So now it’s causal argument again? I’ll make it simple too. Your data shows one thing only – that governments run deficits most of the time. That’s all, period. To say anything stronger, like causal claims about counterfactuals, you need a theory. But then of course you cannot use the same causal claims as an evidence for the theory! Well, you can, but you’d be engaging in circular argument and as a result, others might make fun of you.

        But anyway, I’m outta here for today. Have fun Friday night, y’all!

      • Not a causal argument. Not trying to explain again.

    • Rob Rawlings says:

      My view is as follows:

      For most of that period the economic tool of choice was monetary policy. The fed managed AD by adjustments to the size of the monetary base (via interest rate targeting).

      This offset the effects of fiscal deficits/surpluses and rendered their effects on AD very much secondary to the dominant monetary policy.

      • That would require evidence that interest rates were hiked when government deficits expanded. A good economist would intuitively know that the data will show the opposite to be the case. I wrote that last sentence before even looking up the data which, of course, shows exactly what I expected (outside of the high inflation 70s, of course).

        http://research.stlouisfed.org/fred2/graph/?g=Fp8

      • LK says:

        “This offset the effects of fiscal deficits/surpluses and rendered their effects on AD very much secondary to the dominant monetary policy.

        Offset their effects? How does a monetary policy remove the effects of fiscal policy? Magic?

      • Rob Rawlings says:

        Add unemployment to your chart and you see an alternative explanation. In response to falling AD (for which unemployment is a good proxy) :

        – deficits increase (because of increases in UI and other so called “automatic stabilizers”)
        – interest rates fall (becasue of the use of monetary policy to manage AD)

        In order to prove/disprove the “monetary offset” theory one would have to find a way to filter out fluctuations in AD from the data.

        Note: I’m not saying that fiscal policy doesn’t have an effect on AD, just that if the authorities are using monetary policy to hit a target, then this will render monetary policy dominant over fiscal policy operationally.

      • Right yeah. And that lends support to Harrod’s argument. Solow says no unemployment in the long-run. Harrod says there will be periodic unemployment. Congrats! You’re a Post-Keynesian today, Rob. Now explain the argument to our budding philosopher of induction ivansml above and we can have a party.

      • Rob Rawlings says:

        LK:

        Suppose the govt decided to slash spending but not decrease taxation.
        The theory of monetary offset says that a smart CB could prevent this having serious effects on AD by loosening monetary policy (and offsetting those effects).

        You may disagree that this would work, but the transmission mechanism described by monetary theory is far from magic.

  3. Claud says:

    Really interesting. As I was reading your post, I wondered whether this incoherence might not explain why the economics mainstream feels the need to be quite as Stalinist as it seems to be in imposing a single orthodoxy about what kinds of work can be published.
    There are all kinds of sacred cows and trendy methods in the fields I’m actually familiar with (polisci and history), but nothing I think quite so stark as what even Krugman or Wren-Lewis seem to describe as the “DGSE-or-die” litmus test imposed on journal papers.
    Perhaps this kind of ferocious coordination on method stems from a subconscious awareness that this most sober and strait-laced discipline has backed itself into a Feyerabend-like “Anything Goes”, so that only ceaseless enforcement of outward identity markers can preserve the appearance of coherence?
    Anyway, terrific post: book can’t come quick enough.

  4. pontus says:

    “So, some of the mainstream will tell you that fiscal stimulus will have zero effect on the economy (Ricardian equivalence) […]”

    Woah, you just failed a classic econ 101 question.

    • 😀

      Oh no, are you about to embarrass yourself again? Go on, get it over with…

      Or are you going to be a pedant and say “you should have said ‘zero effect on aggregate demand'”? Because that would be sad.

      • pontus says:

        No, because “zero effect on aggregate demand” is not the implication of Ricardian Equivalence. Fail again.

        Epic.

      • Sounds like you have a date with Wikipedia to make some alterations. I’m happy that you can take your argument to that particular jury.

    • pontus says:

      No quibble with Wikipedia who writes that

      “[Ricardian equivalence] is used as an argument against tax cuts aimed to boost aggregate demand”

      That has nothing to do with “fiscal stimulus” per se and particularly not expansionary government spending.

      So no, that “the mainstream will tell you that fiscal stimulus will have zero effect on the economy (Ricardian equivalence)” is as wrong as always.

      Although I don’t expect you to appreciate the nuances here.

  5. Devrim says:

    Hi Phil,

    I am enthusiastically watching your debates with your regular trolls here and loving them but I also think it is a total waste of time on your side arguing with these clowns. That is why I almost never comment on blogs but this time they’ve gone a little bit too far, and I cannot really hold myself.

    Here is Wyplosz, whose macro textbook I have used in my mainstream macro module for years, on Ricardian Equivalence:

    “The extreme implication of the intertemporal approach is the principle of Ricardian
    equivalence according to which every euro spent by the government is offset by an
    equivalent decline in private spending. Whether the extra public spending is financed
    through higher taxes or through a deficit is irrelevant since today’s borrowing
    represents future taxes. Budget deficits simply don’t matter and fiscal policy does not
    affect aggregate spending”

    http://people.ds.cam.ac.uk/mb65/library/wyplosz-2002-CEPR-DP3238.pdf

    And here is your troll: “That has nothing to do with “fiscal stimulus” per se and particularly not expansionary government spending” “No, because “zero effect on aggregate demand” is not the implication of Ricardian Equivalence. Fail again.”

    Did someone say Econ101? Pathetic…

    Question from my macro exam: How could fiscal expansion today have a positive effect on current/future output even if Ricardian equivalence holds? (25points for students, saving some face for the trolls)

    • Ha! Yeah, Devrim. Pontus is a bit of a posturer, I think. That’s why I told him to take the debate to Wiki because, if he was right, he could convince the people over there to change this:

      The Ricardian equivalence proposition is an economic hypothesis holding that consumers are forward looking and so internalize the government’s budget constraint when making their consumption decisions. This leads to the result that, for a given pattern of government spending, the method of financing that spending does not affect agents’ consumption decisions, and thus, it does not change aggregate demand.

      If he is confident in his assertions — and he seems to be nothing if not this — we should expect this Wiki page to change any day now. I wouldn’t hold your breath.

      • ivansml says:

        I cannot hold myself either. The certainty some people have about them being correct and others being clowns… very entertaining, especially when it’s precisely the other way round. But anyway, this particular issue should be straightforward to check with a few minutes of using Google. Doing that, one can easily find that nope, Pontus is right, wiki is right, Devrim is wrong and Wyplosz seems to be wrong, too.

        The key here is the qualifier “for a given pattern of government spending”. Ricardian equivalence is about effects of how government finances given level of G, not about the level of G itself. This has always been the case – Barro in his original 1974 paper defines “expansionary” fiscal policy as “a substitution of debt for tax finance for a given level of government expenditures” (p. 1096) and assumes throughout that:

        Since the focus of the analysis concerns shifts in tax liabilities and government debt for a given level of government expenditure, it is assumed for convenience that the government neither demands commodities nor provides public services. (p. 1099)

        And here’s Barro again, in a later interview at Minneapolis Fed:

        To illustrate the potential pitfalls in what Ricardian equivalence says and does not say, one can consider the famous quote attributed to Vice President Cheney to the effect that President Reagan proved that budget deficits don’t matter. The Cheney quote is often interpreted to mean that the level of government expenditure does not matter, and that surely is not what Ricardian equivalence says. The Ricardian proposition is about the consequences of paying for a given amount of public expenditure in different ways. Specifically, does it matter—or does it matter a lot—whether the government pays for its spending with current taxes or with current borrowing, which entails higher future taxes?

        Protip: before embarking on an Internet troll-slaying quest and/or teaching a university macro course, make sure that you actually know what you’re talking about.

  6. Yan says:

    ” it is assumed for convenience that the government neither demands commodities nor provides public services”…HAHAHAHAHAHAHA.

  7. attitude_check says:

    As a practicing research engineer/scientist this whole post and the comments is very sad. I think the post and comments unintentionally amplifies the position of economic incoherence, not just of mainstream economics but PK as well. For example:

    1. If you are going to debate what Ricard, maybe instead of using Wiki, Google, and economics text books, you should actually go to the source and quote Ricard.
    2. The entire debate if the accounting identity shows causality or not, was hilarious. That the question even had to be asked demonstrates serious cognitive failure, that the response clearly bounces between saying its, then it isn’t, and then denying the logical flip-flopping hardly demonstrates the rigorous logical superiority of PK verses “the other guys”.

    A pox on all your houses. Economics as a discipline needs to be recognized as the laughing stock it is. It is not hard science — and never will be. It is applied complex systems theory to the old school concept of political economy. Physics envy has destroyed economics as a useful study. I hope this period of incoherence enables a deep rethink of the truly fundamental presuppositions of the entire area of study.

    • Ugh… Everyone knows that Ricardo did not think that the argument stood up to scrutiny. It was his bastard child. This is so well-known that I didn’t even bring it up.

      Also, I continuously denied that a salient reading of the above post would give causal significance to the chart. I did not ‘flip-flop’.

      You know how often I go on engineering blogs to critique engineering? All of never. The only thing worse than an economist talking about economics is a non-economist talking about economics.

      • attitude_check says:

        So only economists are welcome to comment? By the way I have studied economics and finance for 5 years, so I know a few things. Any engineer or scientist that cant explain the principles of something to a reasonably intelligent non specialist, doesn’t really understand what they think they do. I have explained relativity and quantum theory principles to young kids. I think economists should be able to engage in reasoned logical discourse with other than practicing economists.

  8. farang says:

    “Solow himself noted this in his Nobel Prize lecture (he won the prize for his flawed work showing that the economy was self-stabilising in the long-run… which shows what passes for Nobel Prize-winning ‘science’ in mainstream economics).”

    After George W. Bush and Barrack Obama recieved the Nobel “Peace” Prize, is the above supposed to be “news?” Nobel is totally corrupted, through and through. Has been for quite a long time.

    Seems to me, the longer the “Hi-Tech Revolution” evolves, the greater and more rapidly the Illusions created.

    Soon? There will be so many illusions and propaganda masquerading as “facts” that nothing will be true. Nothing will operate or act as stated. The Lies will completely crowd out the Real, and battles will be fought over instilling one lie over another.

    Nobody will follow through on any contracts signed, treaties made, promises and vows given, because one thing is completely missing:

    TRUST.

    These “Economists” are not “mistaken.” They are paid-for “experts of the night”, stroking the suckers into forking over the goods. Lacking the ability themselves to actually “produce goods” they scramble for recognition as “experts” to con the masses into willingly accepting serfdom.

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