Contemporary “political economics”

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

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

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

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

• 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…

Characteristics of causal economic theories

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?

Effects of price ceiling under two different kinds of market structure

q

p

D

S

A competitive market

Effects of price ceiling under two different kinds of market structure

q

p

D

S

A competitive market

Effects of price ceiling under two different kinds of market structure

q

p

D

S

q

p

D

MC

MR

A competitive market A monopolized market

Effects of price ceiling under two different kinds of market structure

q

p

D

S

q

p

D

MC

MR

A competitive market A monopolized market

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…

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

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

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

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

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?

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