Friday, April 22, 2016

The Problem with Macro in one blogpost

Apparently, Nick Rowe slipped up and wrote something about Macro in plain English. David Andalfatto was understandably quite upset and tried to fix things by adding "a bit of formalism".

Then away he goes:

There is a representative agent (this is not necessary, but makes things easy) with additively-separable log preferences defined over consumption sequences {c(t), t = 0,1,...,∞}, with discount factor β. Let R(t) denote the gross real rate of interest (risk-free) earned on a bond held from date t to date t+1. Assume that all individuals can borrow/lend freely at the risk-free rate.

and then this:

Let me consider an endowment economy where each individual is endowed with a deterministic sequence {y(t), t = 0,1,...,∞}.

OK, everybody got that. Representative agent? check. Perfect capital markets? check, lifetime income fixed and known with certainty? check. Time-separable preferences? check.


People, it would be one thing if models like this fit the data, but they don't.

The consumption CAPM is not an accurate predictor of asset prices, The degree of risk aversion required to make the numbers work in the equity premium puzzle is something on the order of 25 or above, the literature is littered with papers rejecting PIH.

So we are being harangued by a model that is unrealistic in the theory and inaccurate to the extreme in its predictions.

And that's pretty much modern macro in a freakin' nutshell.

Mamba out.


Nick Rowe said...

Angus: that is actually (sorta) David's point! Animal spirits can make *anything* happen in his model, despite the Euler equation.

Market Fiscalist said...

+1 to Nick's comment.

I love economics blogs but am terrible at maths (can't even follow Nick Rowe's equations sometimes!) but despite that I like David's blog and find his maths often worth spending time on - they normally clarify points that can be ambiguous when described only in words - plus he is usually ready to leave the maths behind and discuss the underlying intuition in his comments section.

AXEC / E.K-H said...

The problem with macro in two words
Comment on ‘The Problem with Macro in one blogpost’

The two words are: scientific incompetence. Yet, to explain how economics became one of the most embarrassing failures in the history of scientific thought requires some more words.

Standard economics is built upon this set of foundational propositions, a.k.a. axioms: “HC1 economic agents have preferences over outcomes; HC2 agents individually optimize subject to constraints; HC3 agent choice is manifest in interrelated markets; HC4 agents have full relevant knowledge; HC5 observable outcomes are coordinated, and must be discussed with reference to equilibrium states.” (Weintraub 1985)

Methodologically, these premises are forever unacceptable but economists swallowed them hook, line and sinker from Jevons/Walras/Menger onward to DSGE. The failure of methodological individualism is indisputable. The ultimate reason can be stated as an impossibility theorem: NO way leads from the explanation of individual behavior to the explanation of how the economic system works.

Because of this, the microfoundations approach has already been dead in the cradle. This leaves only one option. As Joan Robinson put it: "Scrap the lot and start again."

Keynes started the macrofoundations research program in the General Theory formally as follows: “Income = value of output = consumption + investment. Saving = income - consumption. Therefore saving = investment.” (1973, p. 63)

These formal foundations are conceptually and logically defective because Keynes never came to grips with profit and therefore “discarded the draft chapter dealing with it.” (Tómasson et al., 2010, p. 12).

Keynes’s original blunder kicked off a chain reaction of errors/mistakes:
• All I=S/IS-LM models are are false since Keynes and Hicks (2011).
• Keynes’s profit conundrum has not been solved by After-Keynesians.
• Keynes got the employment equation/Phillips curve wrong (2012).

So, for Keynesianism holds also: "Scrap the lot and start again."

What has to be done is to fully replace the Walrasian and Keynesian axioms with methodologically correct macrofoundations. The paradigm shift is achieved as follows.
(A0) The objectively given and most elementary configuration of the (world-) economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm.
(A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L,
(A2) O=RL output O is equal to productivity R times working hours L,
(A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.

For the graphical representation of the ABSOLUTE formal minimum see link #1. A1 to A3 asserts: At any given level of employment L, the wage income Yw that is generated in the consolidated business sector follows by multiplication with the wage rate W. On the real side, output O follows by multiplication with the productivity R. Finally, the price P follows as the dependent variable under the conditions of (i) budget balancing, i.e. C=Yw and (ii) market clearing, i.e. X=O.

Under the conditions (i)/(ii) the price is derived in each period as P=W/R (1), i.e. the market clearing price is in the most elementary case equal to unit wage costs. This is the elementary form of the Law of Supply and Demand (#2).

The first thing to notice is that the real wage W/P is invariably equal to the productivity R according to (1). So, for the economy as a WHOLE the marginal principle does NOT hold. This explodes the welfare theorems. The second point to notice is that from A1/A3 follows the correct profit equation for the consumption economy as Qm=-Sm and the investment economy as Qm=Yd+I-Sm.

Until this day neither Walrasians, nor Keynesians, nor Marxians, nor Austrians got profit right. No more proof of scientific incompetence is needed. Remains only one question: how do we get rid of these folks?

Egmont Kakarot-Handtke

References see

Anonymous said...

economics an embarrassing failure ? Economics has rarely been more healthy, Egmont.

ps love your overture

gcallah said...

Egmont, I can't see that Menger held a single one of HC1-HC5!

AXEC / E.K-H said...

Gene Callahan

“What we must avoid ... is the bad taste of a finicky scholasticism — getting tied up in little assertions or minor criticism for the sake of criticism.” (Popper, quoted in Redman, 1993, p. 64)

There is a longer version of Weintraub’s set of axioms:

“The [neo-Walrasian] program is organized around the following hard core propositions:
HC1. There exist economic agents.
HC2. Agents have preferences over outcomes.
HC3. Agents independently optimize subject to constraints.
HC4. Choices are made in interrelated markets.
HC5. Agents have full relevant knowledge.
HC6. Observable economic outcomes are coordinated, so they must be discussed with reference to equilibrium states.” (Weintraub, 1985, p. 109)

HC1 contains the explicit commitment to methodological individualism. THIS commitment is shared by the Austrian school in general and Menger in particular: “The Austrian School is a school of economic thought that is based on the concept of methodological individualism – that social phenomena result from the motivations and actions of individuals. It originated in the late-19th and early-20th century Vienna with the work of Carl Menger ... and others.” (Wikipedia,

For ALL variants of methodological individualism holds: NO way leads from the explanation of individual behavior/action to the explanation of how the economic system works. Because of this, methodological individualism (a.k.a. microfoundations) and Austrianism with it and Menger with it have been dead in the cradle in the late-19th century (2013; 2014). Austrians have not realized this until this day.

It is a matter of indifference whether Menger subscribed explicitly to HC2/HC5. It suffices to subscribe to HC1 for vanishing forever in the proto-scientific woods.

Egmont Kakarot-Handtke

Kakarot-Handtke, E. (2013). Confused Confusers: How to Stop Thinking Like an Economist and Start Thinking Like a Scientist. SSRN Working Paper Series, 2207598: 1–16. URL
Kakarot-Handtke, E. (2014). Economics for Economists. SSRN Working Paper Series, 2517242: 1–29. URL
Redman, D. A. (1993). Economics and the Philosophy of Science. New York, NY, Oxford: Oxford University Press.
Weintraub, E. R. (1985). General Equilibrium Analysis. Cambridge, London, New York, NY, etc.: Cambridge University Press.

geoih said...

Egmont, just because you haven't been able to jump from the axioms to an explanation of the whole picture, doesn't make the axioms incorrect (although I'm not sure HC5 or HC6 are correct). The Pythagoreans couldn't explain the square root of 2. Newton couldn't explain relativity. Modern physics can't explain mass. Does that make all geometry and physics a fraud? Or more likely that something else might still be missing?

AXEC / E.K-H said...


The Iron Methodological Rule states ‘garbage in, garbage out’. And this fully explains the failure of economics.

Euclid’s axioms of geometry had REAL content. “In Einstein's words, geometry constituted one of the oldest physical theories. In the preface to his Principia Newton treats geometry as a branch of mechanics, i.e. as a branch of physics: Therefore geometry is founded in mechanical practice and is nothing but that part of universal mechanics which accurately proposes and demonstrates the art of measuring.” (Zahar, 1980, p. 3)

The neo-Walrasian axiom set has NO real content but consists of NONENTITIES. Utility, constrained maximization, equilibrium, angels, and the Easter Bunny are nonentities, in other words, the axiom set HC1/HC6 has NO real content (2014). By consequence, the WHOLE theoretical superstructure (General Equilibrium Theory, DSGE, etc.), too, has no real content.

Economists accepted provably false green cheese behavioral assumptions as axioms. The failure of the microfoundations-of-macro project is just another proof for the Iron Rule ‘garbage in, garbage out’.

Egmont Kakarot-Handtke

Kakarot-Handtke, E. (2014). Objective Principles of Economics. SSRN Working Paper Series, 2418851: 1–19. URL
Zahar, E. (1980). Einstein, Meyerson and the Role of Mathematics in Physical Discovery. The British Journal for the Philosophy of Science, 31(1): 1–43. URL