Over the last couple of days two of the big beasts of the economics blogosphere have offered views on a question of considerable significance for the field of macroeconomics.

On Friday Simon Wren-Lewis discussed whether New Keynesians made a Faustian pact when they decided to engage new classical economists on their own modelling territory. He concludes that New Keynesians were not compelled against their will to adopt modelling devices such as rational expectations and inter-temporal optimisation at the individual level. These modelling techniques were perceived as an improvement on existing practice. But it may nonetheless have turned out in retrospect to have been a strategy that carried significant costs. New Keynesians may be less able to shed light on fast moving events in the real world than they might otherwise have been.

On Saturday, Simon’s post elicited a response from Paul Krugman. Krugman takes a slightly different position.

He agrees that New Keynesians weren’t coerced. But he then argues:

The Faustian bargain, however, was the willingness to accept the proposition that only models that were microfounded in that particular sense would be considered acceptable. It’s one thing to accept that models with an Euler condition at their core can sometimes be useful; it’s quite different to restrict your discourse to models with that characteristic, while ruling out everything else.

Krugman argues that this resulted in earlier ideas that had potential – here he cites Tobin’s work on financial markets during the 1960s – being written out of the canon because they didn’t conform to a particular vision of the ‘correct’ way to do macroeconomics. And that vision has arguably narrowed over time, excluding a whole range of possible approaches.

Why is this discussion significant?

The fact that it is happening at all is notable. The argument that macroeconomics may have taken a wrong turn somewhere along the line and could have benefitted from a more pluralist approach is one that doesn’t go down well at the heart of the orthodox economics community. But it feels like an argument that is increasingly being made. And not just by the irredeemably heterodox. It appears that closer to the core of the discipline there is some momentum gathering behind the idea that a bit of a rethink and a reappraisal is needed.

I encountered this exchange of blogfire just as I was finishing Matthew Watson’s new book Uneconomic economics and the crisis of the model world. This is the first output from Watson’s three year ESRC- funded project Rethinking the market.

Watson is addressing pretty much the same issue as Wren-Lewis and Krugman but, as befits a Professor of Political Economy, he is framing the analysis much more broadly.

I must start by saying that I have a lot of sympathy for objective of Watson’s overall project, even though I don’t think the book quite hits the spot. I’ll try to explain why a bit later.

Watson begins with an observation that bears incessant reiteration so that it is not lost or forgotten. The crisis of 2007-08 was a private sector crisis originating in the banking system. It has been translated by the political system into a public sector crisis of welfare. By focusing policy action on cutting public services and public assistance – claiming that this will deliver a solution to the problem – the causes of the crisis go largely unaddressed.

Watson’s primary interest is not, however, the analysis of the political strategies that have effected this sleight of hand. Rather, he is interested in the role of economic models in both shaping the nature of the crisis and in constraining the range of responses to the crisis that have been contemplated.

His starting point is the distinction between “economic economics” and “uneconomic economics”, and the correspondence or otherwise of theoretical models to the social phenomena they seek to represent. “Economic economics” is interested in getting its hands dirty: it is interested in real markets, competitive processes and what is happening in the economy outside the classroom window. There is a hefty dose of empirical observation and induction. Uneconomic economics, in contrast, focuses on ‘markets’, ‘competition’ and ‘the economy’ that exist primarily in theory and on the page. Resemblance to any real economy is incidental and most likely accidental. Watson argues that macroeconomics has not only come to be dominated by uneconomic economics, but economic economics is frowned upon as distinctly inferior.

This is a version of McCloskey’s complaint from twenty years ago about “blackboard economics” – the dominance of the values of the maths department within economics.

Watson sees the dominance of uneconomic economics as more than simply an intellectual cul-de-sac for macroeconomics. It has had real world consequences that have significant negative impacts upon the lives of millions of people.

He conducts an abbreviated analysis of the CDO market of the type which Mackenzie had earlier undertaken for options markets. Where Mackenzie focused on Black-Scholes-Merton, Watson concentrates on Li’s Gaussian cupola formula. The focus is the performativity of the economic models – the models don’t just describe the world, their articulation induces actions that bring that world into being. A key point is that while B-S-M at least implied a trading strategy, Li’s approach was largely untethered from anything in the real economy. This meant that prices for synthetic financial instruments were sustained by little more than collective belief.

But Watson’s main target is not the exotica of the financial markets. It is the deficiencies of general equilibrium theorizing and, to a lesser extent, the efficient market hypothesis. He sees the 4^th edition of Walras’ masterpiece Elements of Pure Economics as a turning point in the history of economic thought. With the 4^th edition Walras gave up on economic economics – trying to explain how the vagaries of markets in the real world might co-ordinate behaviour – and retreated into uneconomic economics by postulating the mythical auctioneer to resolve the co-ordination problem. That was a failure of Walras’ intellectual project. Yet it was hailed as a great achievement by those who came later.

The second key milestone is, of course, Arrow-Debreu. It may be a mighty mathematical achievement, but Watson argues that this is where macroeconomics fully embraces uneconomic economics. The models cease to be rooted in anything distinctively economic and the ‘economic’ content is merely a case of applying ‘economic’ labels to generic variables. The gain in mathematical precision comes as a cost of being emptied of real content.

Watson then goes on to note that this is not a problem that is unknown in the field. Since the S-M-D critique of the 1970s it has been known that general equilibrium theory is, at its heart, highly problematic in theory, let alone as an account of any sort of actually existing economy.

The core of the problem with macroeconomic theorising, for Watson, would appear to be two-fold.

The first, more fundamental problem is the reliance upon the assumption of probabilistic risk that conforms to a normal distribution and the assumption that the economy is an ergodic process. Watson favours the recognition that economic processes are non-ergodic, do not conform neatly to normal distributions, and are subject to genuine uncertainty (of the Keynesian/Knightian type, although he doesn’t label it as such).

The second problem is the location of the concept of equilibrium at the heart of macroeconomic theorising. The point here is not so much that the real-world economy can never be in equilibrium. Rather the problem is starting the analysis from the modelling assumption that it is in equilibrium.

The field may now be operating with Dynamic Stochastic General Equilibrium models. But DSGE models are afflicted just as badly as earlier generations of models with these problems.

Watson argues that these assumptions discipline the analysis in ways that exclude all sorts of possibilities. Economists working from within this framework simply cannot see certain characteristics of real-world economy, and nor are some types of action thinkable. In particular, the assumption of equilibrium, coupled with rational expectations, lies at the heart of the new classical critique of policy intervention. Even though the empirical support for the policy ineffectiveness thesis is, at the very least, contestable.

Watson frames his analysis of the status of equilibrium in terms of the Kuhnian idea of an exemplar. It is welcome to see an analysis of economic thought reforging the connection with ideas from the literature on the history and philosophy of science. That’s the sort of thing that used to happen in economics departments, but does so much less frequently these days. Indeed, another strand of Watson’s argument is about the way the institutional structures of the economics discipline – in the UK at least – have acted to narrow the range of voices and approaches seen as acceptable. Rather than pluralism being celebrated, the incentive structures mean heterodoxy has been marginalised or eradicated. He is acutely aware, unlike some other critics of the discipline, that simply calling for greater pluralism is unlikely to have much effect when we may well be locked-in to a path that leads to an equilibrium sustaining an “intellectual monoculture”.

Here the sort of distinctions that Wren-Lewis and Krugman would draw between New Keynesian and new classical approaches – saltwater or freshwater – do not register in Watson’s analysis. The differences between the two schools are pretty insignificant when viewed from a perspective that queries many of the foundational assumptions that the approaches share. It is all ‘orthodox equilibrium economics’, with or without sticky prices. Watson’s aspirations are for something rather different – a more clearly historically and institutionally-embedded “economic economics”. But the totemic status of formalism stands in the way of that aspiration being realized.

As I said above, I have a lot of sympathy for the overall objective of Watson’s project. But ultimately I came away from Uneconomic economics wondering what its target was.

Many of his arguments against general equilibrium theory, for example, are relatively well-trodden ground, among those who have studied the methodology of economics at least. I am pretty sure that the ‘dirty secret’ at the heart of general equilibrium analysis could do with being exposed more widely. But Watson’s treatment of the arguments is relatively concise and, quite possibly, only comprehensible to those who already know the story. If the aim is to recruit new converts to the cause then I’m not entirely sure it will succeed.

And if Watson wanted to take that sort of modelling approach apart then there is much more to be said. For example, we could argue that the main reason that DSGE models failed to see the global financial crisis coming was not so much a commitment to equilibrium but that prior to 2007 few thought it essential to explicitly model the financial sector. So the models were incapable of generating the sort of crisis dynamics subsequently observed. And he doesn’t really explore the use of the fiction of the representative agent to “overcome” aggregation problems. These aspects of the approach are, arguably, just as problematic. The rational expectations assumption itself is, of course, equally debatable. These assumptions are just as likely to be driven by modellers prioritizing formal analysis that can deliver precise results, even if those results have limited resonance with events in the real world.

The target of Watson’s critique could also have been sharpened up a little. Much – indeed most – of economics is not macroeconomics. And much of what goes on is seeking to build beyond the models of perfect competition that Watson, quite rightly, questions. Models of imperfect competition have been popular for quite a while. Much contemporary analysis is taking the insights of behavioural economics seriously. Applied economics that grapples with the data and seeks policy relevance is very much in vogue. Economists are seriously interested in institutions, altruism, reciprocity and all sorts of other things that non-economists assume they ignore. Those who focus on public economics typically have market failures coming out of their ears.

It is undoubtedly a very important point that a lot of this activity has not (yet) been folded back into a reworking of the sort of analysis that delivered the fundamental theorems of welfare economics. Indeed, it may not be possible to do so because it all becomes too messy. But that isn’t quite the point that Watson is making. Or at least not in so many words.

I wouldn’t for a moment argue that contemporary economic analysis has dealt satisfactorily with the problems Watson identifies. But I’m not sure it is all quite as benighted as he implies with his somewhat undifferentiated critique of  “simple demand-and-supply” orthodoxy.

Watson’s preoccupation is with the economic ideas that have allowed new markets to be created or governments to deny themselves the power to act. The analysis therefore, almost inevitably, has a strong idealist flavour. MacKenzie’s work has been criticised for ignoring the broader social forces and material interests in play in acting on economic ideas. Watson refers to those who seek to make the link to the interests served by promoting particular ideas, but a similar accusation of idealism might be levelled at his argument.

The analysis could do with a stronger institutional embedding. How do the economic ideas find their way into policy? Indeed, is it the economic ideas that you find in the academic journals that have leverage over policy? It may well be that specific high profile economists have acted as policy entrepreneurs for particular ideas. But that is not quite the same point. Are they always speaking qua “scientists”? Clearly not. For if they were committed to maintaining a scientific persona then, equipped with models that can offer no guidance, they should remain mute in the face of a crisis they cannot explain.

Of course, it may be that Watson will be seeking to develop these connections during the remainder of his project.

Finally, one thing I missed in Watson’s analysis is the recognition that he is one of a number of fellow travellers. There has been quite a lot of recent interest, in the UK and elsewhere, in student movements agitating for changes in the economics curriculum. A number of student societies are now offering opportunities to non-orthodox thinkers to articulate their ideas, sometimes in direct opposition to the orthodoxy. There are moves to develop new, more rounded and pluralist curricula for economics undergraduate degrees. There are initiatives to try to reintroduce history of economic thought, philosophy, methodology, and economic history – possibly even to teach the subject in an explicitly pluralist fashion.

Some would condemn these moves as inadequate. No one would doubt that considerable barriers stand in the way of their progress. The intellectual capital invested in the orthodoxy is immense.

Watson’s analysis can draw strength from the fact that it is one among an increasing number of voices, coming from very different points on the analytical spectrum, calling for change. They would all like to believe the centre cannot hold.

I enjoyed Watson’s book. I have a few reservations about parts of the argument. And it felt to me like it could have been left to simmer for a little while longer before publishing – a bit more crafting to make sure the story is being told as clearly as possible. But leaving that to one side, I thought it was trying to do something important.

The book deals with an arcane topic. But it is a topic of the utmost practical significance. These are ideas that shape the lives of every one of us, whether we know it or not. They require greater scrutiny and a reality check from beyond the ranks of the initiated. This book should perhaps best be thought of as valuable as a propaedeutic. And it will hopefully encourage some readers to probe more deeply.

Update (20/02/14)

This post was reblogged to Pieria on 18/02/14, and the Pieria version featured as one of the links for 19/02/14 at Naked Capitalism.