Contemporary “political economics”

1. Contemporary “political economics”

2. Roadmap • What is a “causal theory” and does economics have any? • How do economists theorize? • The multiplicity of economic theories and the role of empirical contingency • How does economics advance? When does it fail? • The (sorry) state of modern macroeconomics

3. What is a theory? “in modern science the term "theory", or "scientific theory" is generally understood to refer to a proposed explanation of empirical phenomena, made in a way consistent with scientific method.” -- Wikipedia

4. Causal theories in economics: examples • A theory of economic development: poor countries are poor because they joined the world economy with a comparative advantage in primary products • factor endowments theory, institutional development and growth • A theory of growth: high inequality reduces economic growth • median voter theorem, incentives to accumulate, endogenous growth • A theory of the size of the government: high degrees of exposure to international trade leads to a large public sector • volatility, exposure to risk, social insurance • A theory of employment: public expenditure increases employment when the economy suffers from unemployment and excess capacity • nominal wage rigidity, coordination failure

5. Characteristics of causal economic theories • They are based on models that are necessarily “wrong,” by construction • each theory is advanced by an abstract model that excludes many other aspects of reality, so as to focus on role of causal mechanism • They are not exclusive • they admit exceptions, as well as additional explanations • Some countries may be poor for reasons other than comparative advantage pattern • Some countries with comparative advantage in primary products may still end up rich

6. Characteristics of causal economic theories • They are empirically contingent • they apply only under specific conditions, specified in the theory • Wages are determined by marginal products or by bargaining depending on… • Prices are determined by competition or by monopolistic behavior which comes in different variants depending on… • Employment levels are determined by supply side or demand side, depending on… • They are empirically testable • a theory receives empirical support if there is close correspondence between actual outcomes and those predicted by theory • falsification is possible, in principle…

7. Economic theory and empirical contingency • Example: a theory of price controls • What is the effect of a price ceiling imposed by the government on the supply of the commodity or service in question?

8. Effects of price ceiling under two different kinds of market structure p S D q A competitive market

9. Effects of price ceiling under two different kinds of market structure p S D q A competitive market

10. Effects of price ceiling under two different kinds of market structure p p S MC D D MR q q A competitive market A monopolized market

11. Effects of price ceiling under two different kinds of market structure p p S MC D D MR q q A competitive market A monopolized market

12. Economic theory and empirical contingency • Example: a theory of price controls • What is the effect of a price ceiling imposed by the government on the supply of the commodity or service in question? • Answer: it depends • In a model of competitive equilibrium, market supply falls • In a model of monopolistic equilibrium, market supply increases • Neither is a universal model, but both are important, insightful, and relevant in different settings • Key is to figure out which model is the more relevant one • Check entry, size of firms, technology, etc…

13. Advances in economics • Theoretical advance rarely occurs by one theory succeeding the other • not like physics • It occurs through a richer set of theories • a larger range of models on what is feasible and possible in economic life • Better understanding of the conditions under which they apply • discriminating among competing theories • Better testing of theories • from anecdotes to econometrics to randomized evaluations

14. Failings… • Mistaking a model for reality • Over-confidence, hubris • Mistaking a model for the model • Overlooking alternative models with different implications • Categorical preference for certain axioms • assumption of rational, forward-looking individuals operating in perfectly competitive markets • Preference for questions that are amenable to available tools of analysis • neglect of issues involving scale economies until analytical tools were developed • Implicit political-economy theorizing in policy discussions • economists’ training endows them with no way to evaluate alternative social states other than through lens of allocative efficiency

15. How modern macroeconomics made itself irrelevant • Two key post-Keynesian ideas • Lucas critique: behavioral “regularities” depend on policy (e.g., MPC), so only models based on “deep parameters” are reliable • “Rational expectations”: cannot assume expectations are arbitrary (e.g. static or backward-looking) • Not unreasonable as refinements • In practice, were linked with a particular model of the economy, taken to be the only reasonable approximation • Long list of additional assumptions, see next slide • And generated policy conclusions of limited relevance: • Before crisis, futility of identifying central banker or regulator who could have predicted it because asset prices reflect all available information (EMH) • But admitting possibility of bubbles, financial panic, “fat tails”, etc. would have called for more cautious deregulation • After crisis, futility of stimulus to offset decline in private demand (RE) • But Ricardian Equivalence follows from rational expectations only under many additional assumptions

16. Example: Ricardian equivalence • “Because consumers recognize that debt-financed government expenditure will require higher taxes in the future, they respond to higher public spending by increasing their saving. Therefore Keynesian stimulus policy is of doubtful, if any, efficacy.” • Assumptions • Rational expectations, competitive markets, no liquidity constraints, infinite lifetimes,… • How can we tell whether it applies • By checking whether assumptions do gross injustice to prevailing reality • By empirical testing of model under conditions similar to those that obtain at present • So, is this done? • Yes and with some success • Most empirical studies do find expansionary effect of fiscal spending in times of recession • Does this process change everyone’s mind? • No, because every empirical validation exercise has some loose ends

17. Program evaluation in microeconomics: an entirely different strand • Because macro phenomena do not seem susceptible to conclusive empirical validation/refutation • Some have given up on large-scale explanations for demonstrating causal empirical relationships in specific settings: • Examples from randomized field experiments: • Do school vouchers increase educational attainment? • Do conditional cash transfers improve health outcomes? • Do free bed nets reduce malaria? • … • Internal versus external validity in empirical economics • Is the causal effect well-demonstrated in the specified setting? • Is the demonstrated effect likely to operate in other settings as well?

18. Final words • The economics of the seminar room is very different from the economics used in policy discussion • Many economists simply stay away from policy discussions because they understand they have limited to contribute • Others too often carry their own political and normative judgments into policy discussions • along with considerable hubris and self-assurance • In this economists are no different than other social scientists • But their fancy techniques sometimes gives others the illusion of scientific objectivity and certainty