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What’s Wrong with Paul Krugman’s Philosophy of Economics?

By Alex Rosenberg.

Like most successful economists, Paul Krugman doesn’t have much time for methodology. But ever since the financial crisis of 2007-2008 he’s found it unavoidable. In academic papers and in his blog, Krugman has gone some of the way towards filling out the picture of how he thinks economics should proceed. The trouble is that Krugman’s recipe for how economics at its best is done undermines his substantive economic arguments. It’s just what is needed by those who reject his economic analysis and the policies based on it. Chicago school “extremists,” freshwater ideologues, and other free-market fundamentalists can help themselves to Krugman’s methodology to defend the very views he rejects. This raises the question of whether Krugman should worry more about the right way to do economics?

Models—simple and complex

Krugman tells us that economics is a discipline of models. All of them are incomplete—i.e. leaving out one of more important features of their targets, many of them incompatible—since they illuminate differing features of common targets by making differing simplifications, none of them are accurate, owing to their idealizations. But the good ones among them have some real explanatory power and some predictive content that guide policy.

There are, according to Krugman, two kinds of models: simple and complex [p. 41]. Simpler models are preferred. The more complex model rarely if ever provides better predictions or even explanations about what is going on in the economy. What is the use of the more complex model, then? They provide reassurance about simpler models when they confirm the simpler models conclusions; and where they contradict the simpler models they are warning signs that something is amiss.
Krugman tells us that a model gives “more or less the right answer” when it makes predictions that are borne out by events. When the model does so and is simple, it is particularly useful in guiding policy. Krugman thinks it is enough to sustain his models and undermine ones that give different answers to our questions about where the economy is heading.

That was then, this is now.

In the context of the period from 2008 the questions to be answered were about the consequences of macroeconomic policy, the austerity measures in Europe and the limited stimulus in the US. The right answers about these consequences were given by Krugman’s simple models—Keynesian IS-LM curve. They predicted that austerity wouldn’t work and that the stimulus would only do so in part. Because they rightly predicted the course of events, Krugman is prepared to attach explanatory weight to the models.

By contrast with Krugman’s Keynesian models, those of the New Classical macroeconomists faired very badly in their predictions over the same period, predicting that European austerity would result in growth, that the US stimulus would be ineffective, and that the Fed’s quantitative easing policy would be inflationary.

So, Krugman’s models win, right?

Not so fast, the New Classical Macroeconomists will respond. Wind the clock back about 40 years and the shoe was on the other foot. Back then, the very same IS-LM models that Keynesians had developed and Krugman has recycled, were giving more or less the wrong answers. This was the period of “Stagflation” in the ‘70s when the economy refused to behave the way Keynes’ models told us it would—increasing unemployment together with increasing inflation.

Back then it was the New Classical macrotheory that gave the right answers and explained what the matter with the Keynesian models was.

Whose models are right, Krugman’s or the New Classicals’ “Rational Expectations” models? That depends were we come into the story: 40 years ago it looked like the New Classicals had more or less the right answers to the predictive questions and so the best explanations of economic processes. Today, it looks like the Keynesian models are back in the saddle.

The problem is that “giving more or less the right answer” to questions about prediction is not enough to decide between the usefulness of simple (or complex) models. In economics as in other domains, it’s too easy to be right by accident, to be right for the wrong reasons, to be right for one period and wrong for another.

Improvement in predictive power means getting things more and more right over time, to more decimal places, over a wider range of phenomena, not immediately but eventually. Betting on any economic theory, or its set of models to do this, is to say the least a long shot, given the track record since Adam Smith.

Mr. Krugman and the New Classics

Krugman writes:
‘So how do you do useful economics? In general, what we really do is combine maximization-and-equilibrium as a first cut with a variety of ad hoc modifications reflecting what seem to be empirical regularities about how both individual behavior and markets depart from this idealized case.’

But if you ask the New Classical economists, they’ll say, this is exactly what we do—combine maximizing-and-equilibrium with empirical regularities. And they’d go on to say it’s because Krugman’s Keynesian models don’t do this or don’t do enough of it, they are not “useful” for prediction or explanation.

When he accepts maximizing and equilibrium as the (only?) way useful economics is done Krugman makes a concession so great it threatens to undercut the rest of his arguments against New Classical economics:

‘Specifically: we have a body of economic theory built around the assumptions of perfectly rational behavior and perfectly functioning markets. Any economist with a grain of sense — which is to say, maybe half the profession? — knows that this is very much an abstraction, to be modified whenever the evidence suggests that it’s going wrong. But nobody has come up with general rules for making such modifications.’

The trouble is that the macroeconomic evidence can’t tell us when and where maximization-and-equilibrium goes wrong, and there seems no immediate prospect for improving the assumptions of perfect rationality and perfect markets from behavioral economics, neuroeconomics, experimental economics, evolutionary economics, game theory, etc.

But these concessions are all the New Classical economists need to defend themselves against Krugman. After all, he seems to admit there is no alternative to maximization and equilibrium.

Uncertainty and reflexivity

One thing that’s missing from Krugman’s treatment of economics is the explicit recognition of what Keynes and before him Frank Knight, emphasized: the persistent presence of enormous uncertainty in the economy. Most people most of the time don’t just face quantifiable risks, to be tamed by statistics and probabilistic reasoning. We have to take decisions in the presence of events–big and small–we can’t predict even with probabilities. Keynes famously argued that classical economics had no role for money just because it didn’t allow for uncertainty. Knight similarly noted that for the same reason it could make no room for the entrepreneur. That to this day standard economic theory continues to rules out money and excludes entrepreneurs may strike the noneconomist as odd to say the least. But there it is.

Why is uncertainty so important? Because the more of it there is in the economy the less scope for successful maximizing and the more unstable are the equilibria the economy exhibits, if it exhibits any at all. Uncertainty is just what the New Classical neglected when they endorsed the efficient market hypothesis and the Black-Scholes formulae for pumping returns out of well-behaved risks.

There is a second feature of the economy that Krugman’s useful economics needs to reckon with, one that Keynes and after him George Soros, emphasized. Along with uncertainty, the economy exhibits pervasive reflexivity: expectations about the economic future tend to actually shift that future. In the run up to the financial crisis expectations that real estate values would continue to increase caused real estate values to continue to increase (e.g., by encouraging banks to lend on future values instead of current collateral). Reflexiveness is everywhere in the economy, though it is only easily detectable when it goes to extremes, as in bubbles and busts, or regulatory capture. It was the New Classical vision of the market as efficiently and instantaneously digesting all information that led to the abrogation of the Glass-Steagall Act. That made it possible for the banks to employ the risk-allocation formulae of the hedge-fund managers. But these equations had no variables for uncertainty, only for risk. Neglecting uncertainty brought on the collapse of the subprime mortgage market that reflexivity created.

When combined uncertainty and reflexivity together greatly limit the power of maximizing and equilibrium to do predictively useful economics. Reflexive relations between future expectations and outcomes are constantly breaking down at times and in ways about which there is complete uncertainty. Between them reflexivity and uncertainty about it make the economy a target moving too fast for the New Classical “market fundamentalists.” They make economics into a largely retrospective, historical science, one whose models—simple or complex—are continually made obsolete by events, and so cannot be improved in the direction of greater predictive power, even by more complication. Unlike the New Classical economists, Krugman can make room for both uncertainty and reflexiveness in his philosophy of economics. For he recognizes that economics is at best, and at its best, a historical science, one which offers lessons, but not predictions.

ABOUT THE AUTHOR

Alex Rosenberg is the R. Taylor Cole Professor of Philosophy and chair of the philosophy department at Duke University. He is the author of Economics — Mathematical Politics or Science of Diminishing Returns, most recently, The Atheist’s Guide to Reality.

First published in 3:AM Magazine: Thursday, June 26th, 2014.