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Lectures on First Steps towards Understanding Macroeconomics, on Friday 4th May 2018 in AR Kemal Rm at PIDE, by Dr. Asad Zaman, VC PIDE. 1hr 20m Video Lecture( shorlink: bit.do/azifa)

3100 word summary of lecture:

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The talk linked below explains why the positivist/nominalist methodology used in Econometrics leads to mostly nonesense regressions. It also explains how a realist alternative can be developed.

“The Philosophy and Techniques for Quantitative Research” – Keynote Address by Dr. Asad Zaman, VC PIDE at Workshop on 19-20 April, 2018 Dept of Economics, Fatima Jinnah Women’s University, Rawalpindi, Pakistan.

My message will come as a surprise to students gathered here to learn advanced econometric techniques. Let me begin by stating it baldly: “Econometrics is nothing more than Fraud by Numbers”.

As Joan Robinson famously said, “The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.” A similar statement holds for econometrics. We should learn it not in order to acquire techniques which will teach us how to use data sets to make inferences about reality. Rather, we should learn it to avoid being deceived by econometricians. The techniques described by Perkins in “Confessions of an Economic Hit-Man” are in common use around the world. Fancy econometrics is used to persuade people to adopt policies which harm the public, while fattening corporate coffers.

As a simple illustration of econometric fraud, consider the following regression:

CONS    =              -268.7    +  6.78 SUR – 1.82 CO2 +  error    (R2=0.84)

Std Err:                  (25.9)       (0.73)         (0.65)           (20.0)

Where CONS = Private Consumption Expenditure in Pakistan, SUR =Survival to age 65, female (% of cohort) = SP.DYN.TO65.FE.ZS, C02 =CO2 emissions from gaseous fuel consumption (% of total)= EN.ATM.CO2E.GF.ZS – these are variables taken from the WDI data set.

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Romer writes that macro-economists casually dismiss facts, and the profession as a whole has gone backwards over the past few decades, losing precious and hard-won knowledge. He does not consider WHY this happened. What are the methodological flaws that create the possibility of moving backwards, losing knowledge, affirming theories known to be in conflict with facts. How is it that leading economists can confidently assert theories which border on lunacy, and receive Nobel Prizes instead of psychiatric treatment?

This is due to the famous AS-IF methodology of Friedman, which gave economists a license for lunacy.  Friedman came up with this defense of orthodoxy when numerous emprical investigation revealed clearly that firms did not maximize profits, did not know their marginal costs, typically used mark-up pricing, and did other things which did not square with neo-classical theories. Friedman’s argument has been universally condemned by logicians and philosophers as an instance of the logical fallacy of “Affirming the consequent” – the use of modus ponens in reverse. That is, Friedman says, in effect, that theory T implies observable consequence C. We observe C, and therefore we can affirm that T holds. This is obviously fallacious since many different theories, inconsistent with T, may also imply consequence C. Even more importantly, a false theory T will always imply consequences C* which are not observed — since the theory is false, it will have consequences which are false. Ignoring all of these problems,  Boland uses an instrumentalist interpretation to defend Friedman, just like all economics textbooks. He writes that even though critics universally condemn his logic, Friedman is right, and ALL the critics are wrong.

In my lecture on  AM2L07 (code for Advanced Micro II: Lecture 7) Methodological Mistakes: Prospect Theory and Psychology Protocols, I explain why Friedman is wrong and his critics are right by discussing this methodological debate within the concrete context of trying to understand search theory. Consider a hypothetical problem where a person is searching for the highest wage. He goes from one firm to next. At each point he is offered a job at a certain wage W. He can accept and quit searching, or reject the offer and go on searching. We want to find a theory which explains search behavior that we observe in lab experiments designed to emulate this situation.

In simple models, it is easy to show that optimal search sets a reservation wage W* and the laborer searches until he/she finds the first offer above this value. The Economist is committed to the assumption that humans are hyper-rational, and they maximize. ONLY theories satisfying these assumptions will be examined for validity. This means that there is NO QUESTION of looking at human behavior itself to see whether or not this hypothesis about behavior holds. Rather, the ONLY problem is to find the FUNCTION which is being maximized.  Economists start by using Expected Utility theory. A rather large number of empirical examples show that this theory does not match human behavior. Nonetheless, this continues to be the dominant theory of decision making under uncertainty and continues to be taught in textbooks, even though the theory is KNOWN to be wrong.

An improvement upon this is PROSPECT theory. By making ad-hoc modifications to probabilities, utilities, and FRAMING the problem in a suitable way, this theory can achieve a MUCH BETTER match to observed behavior than Utility theory. This theory preserves MAXIMIZATION – humans maximize something. However it abandons rationality — why should humans treat probabilities INCORRECTLY. Economists cannot stomach this observed failure of rationality and so AFFIRM theories solidly in conflict with observed facts about human behavior.

NEITHER of these approaches is scientific, since both dogmatically assert allegiance to the maximization principle regardless of observation. The articles by John Hey show how one can move beyond this to a genuinely scientific methodology. He explains how many researchers have investigated search behavior, but have only been concerned with whether or not it matched ASSUMED theories of behavior. INSTEAD he proposes to investigate how humans ACTUALLY behave, without imposing any assumptions about behavior in advance. He used psychological protocols, asking subject to think out loud about the process with which they arrive at the decision on whether to accept an offer or to go on to search for the next one. As can be expected, humans cannot make complex calculations that theory requires of them, and instead they use various heuristics and rules of thumb. These heuristic work fairly well, and get them reasonable close to what someone with full information and infinite computational capabilities could achieve. Nonetheless, the use of heuristics gives radically different results about what we could expect to see in markets where these behaviors, rather than the hypothesized AS-IF behavior is used. The full lecture is linked below

For lecture slides and reference materials, links to related articles, as well as the whole sequence of lectures, see the course website: Advanced Micro II (shortlink: bit.do/ee2018)

POSTSCRIPT: The process of lecturing, trying to explain to my students how their fellow students are being duped by economic textbook, always give me greater clarity. In this lecture, I examine three approaches to understanding human behavior in the process of searching for the best wage (or searching for the best price).

1: AXIOMATIC — represented by Expected Utility. Here we know in advance what human behavior is. We do not need to look at human behavior at all. If someone ELSE studies this behavior and finds that our theories do not match actual behavior, we say that the experiment must be wrong.

2: DESCRIPTIVE — represented by Prospect Theory. Unlike economists, experimentalists and behaviorists study actual behavior. When it fails to match Expected Utility, they came up with a new theory — prospect theory — which summarizes and encapsulates a description of how humans behave in decisions under uncertainty. Economists REJECT this picture because it shows how human behavior is IRRATIONAL – and this conflicts with their FUNDAMENTAL assumptions of rationality, which must be maintained regardless of any inconvenient facts or observations or introspection.

3: SCIENTIFIC: An accurate description permits us to proceed to the next stage, which is to try to understand the REASONS for this behavior. For example, we observe that most people are risk-averse. They prefer the certain outcome of $50 to a gamble with offers $0 and $100 with equal probabilty. Now we can ask why — this is with regards to unobservable, hidden motivations, about which we can never be certain. A good explanation for this is REGRET. Because of our psychological makeup, the flatness of the utility function in gains, a win of 100 does not feel vastly superior to a win of 50. But the real kicker is the feat that if I take a gamble and lose, I will feel so stupid. Avoiding the regret that might occur when I say I should have taken that certain $50 might be the explanation for risk aversion.

Actually, even “reverse Modus Ponens” is not a good description of Friedman’s methodology — there is an added F-Twist: If we can FIND some observations C such that theory T implies them, then we affirm theory T, and IGNORE any other implications of T which actually conflict with observations.

The METHODOLOGICAL point is the Friedman, like all nominalists and instrumentalists, GIVES up on the possibility of understanding human behavior. All he wants is a model which provides a SUPERFICIAL match to some observations. However, many many real life situations show that this is NOT ENOUGH — we need to have a deeper understanding, in order to be able to explain economic and social phenomena. See also previous related post on Economists Confuse Greek Methodology with Science

Preliminary Remarks: “The trouble is not so much that macroeconomists say things that are inconsistent with the facts. The real trouble is that other economists do not care that the macroeconomists do not care about the facts. An indifferent tolerance of obvious error is even more corrosive to science than committed advocacy of error.” From The Trouble with Macroeconomics (Paul Romer)

I do not understand why indifference to error is worse than committed advocacy. Tor an illustration of committed advocacy of error, see postscript below on 70 years of economists’ committment to a fallacious theory. Furthermore, the problem is not confined to macro. Microeconomists are also dogmatically committed to utility maximization, when in fact this hypothesis about consumer behavior is solidly rejected by empirical evidence; see: The Empirical Evidence Against Neoclassical Utility Maximization: A Survey of the Literature.

For the followup post, see “Understanding Macro II: Post-War Prosperity”

Understanding Macro: The Great Depression

Published in The Express Tribune, February 21st, 2018.

Due to frequent headlines, there is a substantial public awareness of core macroeconomic issues like unemployment, trade agreements, exchange rates, deficit, taxes, interest rates, etc. However, even professionals are often ignorant of the intellectual battles which have shaped modern macroeconomics, since this is not taught in typical PhD programmes in economics. This article attempts to provide the history of ideas which led to the emergence of macroeconomics, since this is an essential background required for informed analysis of these issues.

Lord John Maynard Keynes invented the entire field of macroeconomics in response to the Great Depression in 1929, which could not be understood according to economic theories dominant until then. According to the classical economic theory, forces of supply and demand in the labour market would ensure full employment. Keynes starts his magnum opus, The General Theory of Employment, Interest, and Money, with the observation that the economic theory cannot explain the long, persistent and deep unemployment that was observed following the Great Depression. Keynes set himself the goal of creating a theory which could explain wide fluctuations in levels of employment that he observed. He discovered that creating such a theory involved rejecting deeply held convictions, central to economic theory.

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This is an outline of the lecture 3 in Advanced Microeconomics — expands somewhat on the slides available from the link. This should be useful to heterodox economists looking for ways to teach an alternative course, radically different from conventional approaches. First two lectures consisted of some preliminary math, and can be skipped without lack of continuity.  Video of the lecture (90m) is available at the bottom of the post.

Supply & Demand is Central to Economics: This is the modern Theory of Value. The market price determines the value – this is in conflict with classical conceptions of value.

BUT, this theory is WRONG!  The central question in theory of Value is: HOW are prices determined? Why are water and tomatoes cheap, and why are diamonds expensive?

Current answer is the Supply and Demand theory of economics. Classical economists’ answers were  Labor Theory of Value.

Modern Answers are seriously deficient. Classical Schools had substantially more insight into these questions. We will be discussing classical thinking (Adam Smith, Ricardo, Marx, Sraffa) later in the course. This lecture deals with: Failure of Supply & Demand in Labor Market. This failure was the Raison-d’etre of Keynesian Economics

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Before proceeding with Re-Reading Keynes, I would like to clarify the issue of exogeneity and endogeneity, which he understands, but most of his followers failed to understand.  This is to clarify a segment of a phrase he uses in describing the four ways in which level of employment can increase within the framework of the classical theory of economics. The fourth factor listed by Keynes appears somewhat mysterious in the original text:
(d) an increase in the price of non-wage-goods compared with the price of wage-goods, associated with a shift in the expenditure of non-wage-earners from wage-goods to non-wage-goods.
== in the previous post (P9: Theory of Employment) I re-stated this as an exogenous increase in real wage, to clarify what Keynes wanted to say. However, (d) above is what Keynes actually wrote, and I want to explain why Keynes wrote in this way. This involves an excursion into the supply and demand model, and the concepts of exogeneity and endogeneity.
What Keynes is saying here is that if there is an increase in demand for luxury goods consumed by aristocrats, and an associate decrease in demand for necessities purchased by laborors, then the real wage will rise and that will increase employment. Keynes is very careful to create a scenario in which the real wage rises due to EXOGENOUS factors shift in demand by non-wage earners — the aristocrats.  What Keynes understood is something basic which is not understood by modern economists like Varian when they discuss the supply and demand model — ONE CANNOT CONTEMPLATE VARIATIONS IN AN ENDOGNEOUS VARIABLE (because endogenous variables are not free to move; they can only change if some of the exogenous variables which affect them change). This means that asking what consumers will demand if the price changes is a WRONG question — prices are endogenous and they cannot change by themselves. An increase in price cause by shortfall in supply would lead different consequencs from an increase in price caused by an upward shift in the demand. If a consumer is asked what he will do when the price changes, he should ask WHY did the price change, because his response to the price change DEPENDS on cause of the price change. He cannot provide a response to the question without learning about the cause, and whether or not this is a temporary or permanent change.

 

Comments on Varian: Intermediate Microeconomics. Chapter 1, which sets up a simple supply and demand model.

Brief Summary of Post:

These comments are about the first few pages of the chapter. Quotes from Varian are in italics. Criticisms are made in this post about the concepts of models, optimization, equilibrium, and the concept of exogeneity, as dealt with by Varian. Models are used without explicit discussion of the relationships between model and reality, which is essential to understanding how models work. For an extended discussion see my lecture on Models Versus Reality. The post explains why optimization, taken is tautological by Varian, is false as a description of consumer behavior. For an extended discussion of the conflict between axiomatic theory of consumer behavior and actual human behavior, see my one hour video: Behavioral Economics Versus Neoclassical Economic Theory.  Similarly, the decision to study only equilibrium behavior handicaps economists, making them blind to disequilibrium events like the Global Financial Crisis.

Detailed Discussion

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keynesgtFifth Post in a sequence on Re-Reading Keynes. 

Chapter 1 of General Theory is just one paragraph, displayed in full HERE

Briefly: Keynes writes that Classical Economics is a special case of his General Theory. Furthermore, the assumptions required for the special case do not hold for contemporary economic societies,”with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience”

The discussion below borrows extensively, without explicit point-by-point acknowledgement, from Brian S. Ferguson, “Lectures on John Maynard Keynes’ General Theory of Employment, Interest and Money (1): Chapter One, Background and Historical Setting” University of Guelph Department of Economics and Finance Discussion Paper No. 2013-06:

1.       RHETORIC: Keynes wishes to persuade fellow economists. Instead of saying that they are all wrong, blinkered idiots, he says that they are studying a special case, which he wishes to generalize. He also acknowledges that he was misled by the same errors, and creates common ground to enable dialog. He is also making a subliminal appeal to the hugely influential General Theory of Relativity published earlier by Einstein.

2.       INVENTION OF MACRO: The revolutionary contribution of Keynes is to study aggregates, instead of micro-level behavior. He is correctly labelled the inventor of macro-economics; prior to him, economists thought that the aggregate behavior would be obtained simply as a sum of the individual behaviors; there is no need to study macroeconomics separately. Parenthetically, it is this same position to which macro-economists retreated in the 70’s and 80’s with the development of DSGE model. Ferguson writes that:

Arguably, prior to the General Theory, most professional economists thought of the macroeconomy in a general equilibrium sense, as an aggregate of a large number of individual markets, and they assumed that the analysis of how individual markets behaved could be carried over pretty much unchanged to the collection of markets which constituted the economy as a whole. There was, it seemed, no need to think of the economy as anything other than the sum of its parts, and an understanding of how those parts worked was sufficient to understand how the economy as a whole worked. After the General Theory, that no longer held. Economists started to think in terms of aggregates.

3.       COMPLEX SYSTEMS: The flaws of this attempt to build macro on micro-foundations are still not well understood by modern economists due to the blinders of methodological individualism. These flaws include the failure to understand “Complexity Theory”, “Emergent Behaviors” and the influence of community and society on individual behavior. Basically, a complex system is one in which the behavior of the system as a whole cannot be inferred or deduced from the study of the individual parts, because it is the inter-relationships and linkages between the parts which create the system.  An extensive discussion of Keynes and complex systems is provided by John Foster, Why is Economics not a Complex Systems Science? Discussion Paper No. 336, December 2004, School of Economics, The University of Queensland. A brief quote from the abstract for the paper:

The macroeconomics of John Maynard Keynes is … an example of … (a) complex systems perspective on the economy. … the reasons why a complex systems perspective did not develop in the mainstream of economics in the 20th Century, despite the massive popularity of an economist like Keynes are discussed …

4.       MISUNDERSTANDING KEYNES: Very few read Keynes, and those who do fail to understand him for several reasons. Conceptual frameworks and background institutional structures (like the gold standard) are taken for granted and implicit in the analysis and discussion, but these have changed radically over time. In addition, “Keynes was inventing a new way of looking at the economy as a whole. He was struggling to develop concepts and invent terms, and many of the terms which he invented are not the ones we use today.” Because of this mis-understanding, revivals of Keynes (Like New Keynesians) often reject principles which Keynes considered central to his analysis, and accept propositions that Keynes firmly rejected.  Another reason for neglect of Keynes is the positivist reduction of scientific knowledge to binaries: true/false. What matters for a statement is whether or not it is relevant and valid for today, not whether or not Keynes said it, or what he meant. As Krugman puts it: Surely we don’t want to do economics via textual analysis of the masters. The questions one should ask about any economic approach are whether it helps us understand what’s going on, and whether it provides useful guidance for decisions. “So I don’t care whether Hicksian IS-LM is Keynesian in the sense that Keynes himself would have approved of it, and neither should you.” If theories have universal, time invariant, validity, then this would be a correct position. However, the basis premise of this re-reading of Keynes is that economic theories must be understood within their historical context.

5.       SAY’s LAW: The crucial issue under debate, tackled in the 2nd chapter of Keynes is: Can unemployment be reduced using fiscal policy and deficit financing? Keynes argues that it can, contrary to the view of classical that “unemployment” is not a problem – Supply and Demand for labor will equilibrate. Say’s Law holds so that the supply of labor will create the demand for it.

6.       CROWDING OUT: A crucial argument against Keynes is the Treasury View: Government investment will crowd out an equal amount of private investment. Government must borrow credit from the same market that private borrowers do. To the extent that Government succeeds in borrowing, private investors will fail in borrowing. This argument fails if the private sector expands the supply of credit in response to increased government demand for borrowing. Therefore the Treasury View is supplemented by two more pragmatic arguments. Second Treasury argument is based on extreme lags and inefficiencies in the governmental bureaucracies selection and launching of major public works projects. Such lags could mean that a intended counter-cyclical investment could be delayed so long as to become pro-cyclical.

7.       PRACTICAL PROBLEMS WITH PUBLIC WORKS: There were other practical, pragmatic aspects to the Treasury View, that governments cannot or should not spend their way out of a recession. To avoid the lags in fiscal policy, one needs “shovel-ready” projects to finance.  One of the most interesting quotes from Ferguson in this regard is:

cash-strapped local governments would cut back on their spending in response to increased central government spending in their areas. … Herbert Hoover, contrary to the image which he has acquired as a consequence of not being FDR, did not cut American federal government spending in response to the Depression, rather he increased it dramatically. … His first policy efforts involved spending federal money on shovel-ready public works projects, meaning projects which were already well into the planning stages and which needed only to have their commencement dates brought forward. In addition to finding that there weren’t anything like as many shovel-ready projects as he had hoped, Hoover found that state governments, whose own revenues were severely stressed by the Depression, responded to inflows of federal money by cutting their own relief spending, and moving to balance their budgets. (Many years later, officials from Franklin Roosevelt’s administration acknowledged that the bits of the New Deal which had actually worked were the bits they had simply taken over from Hoover. By then, though, Hoover’s reputation was pretty much beyond repair.)

8.       GOOD GOVERNANCE: Another very serious pragmatic Treasury concern was that Keynesian policy would lead to irresponsible excessive spending by politicians.

The need to keep the budget balanced had come to be accepted over the years by politicians as a matter of good governance. Treasury officials were concerned that if they accepted Keynes’ argument and gave politicians an excuse to spend in excess of revenue in some circumstances, the floodgates would burst and it would be impossible to prevent politicians from overspending under virtually all circumstances. The concern seems to have been that no matter what the circumstances, politicians would be able to come up for Keynesian reasons for deficit spending. In that fear, the Treasury officials seem to have been vindicated. As for staying on the Gold Standard the concern within the Treasury was similar: adherence to the rules of the Gold Standard was the best safeguard against unrestrained printing of money. (When Britain went off the Gold Standard for good in 1931, Sidney Webb, a member of a previous Labour party government, was reported to have lamented that when they had been in office nobody had told them that they were allowed to do that.)

Among the predecessors of Keynes, Ferguson writes that Keynes views were aligned with those of Malthus and against those of Ricardo on the following key dimensions:

9.       Against Comparative Statics: Keynes objected to Ricardian analysis on the grounds that it analyzed movements from one equilibrium state to another, without considering the disequilibrium transitional paths, and how long the transition would take. This is the context for his famous aphorism that in the long run we are all dead. He believed that studying transitional dynamics was more important than focusing on equilibrium conditions.

10.   Quick Movement to Equilibrium in Labor Markets:  Keynes objected strongly to Ricardian contentions that “labour markets worked efficiently and that wages would adjust quickly to restore equilibrium after a labour market shock.” This belief, widely held, was labeled “classical” by Keynes. Note that this belief is precisely what was resurrected by Lucas and the Chicago School, in their attack on Keynes.

This post covers about half of the Brian Ferguson article, which is about the “theoretical” context in which Keynes was writing. The second half is about the historical context, which we will cover in the next post. The homepage for this project is Keynes.

My author page on LinkedIn Index to my writings: AZPROJECTS. General Posts on Economics: Unlearning Economics. My personal webpage: Transforming Knowledge.