The Third Nordic Post-Keynesian Conference 22-23 May 2014 Finn Olesen Aalborg University – Department of Business and Management 1.

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The Making of a Revolution –how important are economic crises?

The Third Nordic Post-Keynesian Conference 22-23 May 2014

Finn OlesenAalborg University – Department of Business and

Management

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A scientific revolution – how and why?

Thomas Kuhn: a scientific revolution should be explained by the existence of anomalies

→ theoretical anomalies→ empirical anomalies

→ conceptual anomalies

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The 1930sThe era of the Great Depression:

mainstream under attack – time to change the macroeconomic understanding!

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The 1930s

Kuhn's theory can easily explain how and why we talk about The Keynesian Revolution:

→ lack of optimality: Yt is less than full employment

→ what is involuntary unemployment all about (theoretically, empirically and conceptually)?

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The 1930s

With Keynes’s General Theory the scene was set for a revolution in economics

Research (normal science activities) followed with inspiration from Keynes’s macroeconomic model:

’the principle of effective demand’

Still today we are using the 45o-diagram, the IS/LM model and the AD/AS model when we teach

basic macroeconomics

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1930sEconomics did undergo many changes as a

result of The General Theory(theoretical as well as methodological – as any

Post Keynesian would tell you)

Just to mention six important aspects

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1930sFirstly, macroeconomists acknowledged the

necessity of having focus on how the level of aggregated output was determined and how

it could be manipulated e.g. by economic policy

(focus on the processes of income determination by use of a macroeconomic

model)

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1930sSecondly, macroeconomists got a new view on

the importance of aggregated demand

Aggregated demand now came to play a much more active role in the economic analysis

(at the same time within basic Keynesianism aggregate supply took over the more passive

role that demand effects had hitherto played in the economic analysis)

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1930sThirdly, macroeconomists got a new view on

how to conduct monetary policy

Away with the classical view that monetary policy had to do with price stability and

nothing else. From now on, fluctuations in aggregate production was very important and

also a concern of bankers: monetary policy should be coordinated with other aspect of the

general economic policy (especially fiscal policy)

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1930sFourthly, macroeconomists got a new view on

how to conduct fiscal policy

Away with the classical view on fiscal policy stating, that the budget should always be

balanced. Potential crowding out effects were no longer that important if the economy

functioned at a level less than full employment. Budget deficits (and a public debt) could be

acceptable(functional fiscal policy)

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1930sFifthly, macroeconomists got a new view on

international affairs – countries should operate internationally in coordination not in

conflict with each other(the Bretton Woods System)

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1930sSixthly, macroeconomists began doing

econometrics and thereby gave the politicians a vital instrument, that they could use when

deciding what to do economic policy wise when they tried to minimise the fluctuations

in aggregated demand and output

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The 2010s2008: from an international financial crisis to

the present Great Recession of many countries:

mainstream under attack once again – time to change the macroeconomic understanding???

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The 2010smainstream under attack:

1. Bye-bye to the representative agent and rational expectations?

2. And what about financial matters?3. And still DSGE modelling?

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The 2010sWell:

1. Yes, probably2. Yes, it seems so

3. No, TINA governs

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The 2010sYes, probably because:

The assumption of rational expectations is:”a strong one, and one may wonder if it should

be relaxed, especially when considering relatively short-run responses to disturbances, or the consequences of newly adopted policies

that have not been followed in the past – both of which are precisely the types of situations which

macroeconomic analysis frequently seeks to address”

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2010sAnd furthermore:

”the assumption that an economy’s dynamics must necessarily correspond to an RE

equilibrium may seem unjustifiably strong … It makes sense to assume that expectations

should not be completely arbitrary, and have no relation to the kind of world in which the

agents live; indeed, it is appealing to assume that people’s beliefs should be rational, in the

ordinary-language sense, though there is a large step from this to the RE hypothesis”

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The 2010sAnd that is why:

”We should like, therefore, to replace the RE hypothesis by some weaker restriction, that nonetheless implies a substantial degree of

conformity between people’s beliefs and reality – that implies, at the least, that people do not

make obvious mistakes”

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The 2010sAnd this is a view on rational expectations that

is given by a mainstreamer:

Michael Woodford (2013:304): Macroeconomic Analysis Without the Rational Expectations Hypothesis, Annual Review of Economics,

2013, Vol. 5, pp. 303-46

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The 2020sYes, it seems that financial aspects matters more than

expected hitherto by mainstreamers

As stated by e.g. Romer (2011:358):

”The crisis of 2008-2009 has made it clear that non-Walrasian features of credit markets have important macroeconomic consequences. Disruptions in credit markets can cause large swings in economic activity,

and credit-market imperfections can have large effects on how other shocks affect the macroeconomy”

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The 2010sAn alternative to DSGE modelling? No, apparently TINA

still rules the game:

”While the problems of the field have hardly all been resolved, there are no longer such fundamental

disagreements among leading macroeconomists about what kind of questions one might reasonably seek to

answer or what kinds theoretical analyses or empirical studies should even be admitted as contributions to

knowledge … [and this is done by using DSGE models] … there are really no longer alternative approaches to the resolution of macroeconomic issues”.; Woodford

(2008:2 & 13)

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The 2010sHowever, some mainstreamers express themselves a little

less fundamentalist (perhaps due to empirical facts of resent years):

“First, despite the models’ complications, there is a great deal they leave out. For example, until the resent crisis, the models’ treatment of credit-market imperfections

was generally minimal. Second, the microeconomic case for some important features of the models is

questionable. Most notably, the models include assumptions that generate inertia in decision making …

[which] … is mainly motivated not by microeconomic evidence, but by a desire to match macroeconomic

facts”; Romer (2011:361)

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The 2010sAnd actually, the DSGE modelling has been

empirical falsified as:Although the DSGE models can cope with random

exogenous events; events or shocks need not be random nor exogenous – often disturbances are

endogenous in nature rather than exogenous

Stiglitz (2012:32): “In most models, the disturbances to the tranquillity of the economy were exogenous, but historically – as now – the

important shocks are endogenous”

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The 2010sMacroeconomic patterns in real life are not only patterns of unique steady-states paths –

real life phenomena is seldom ergodic

DSGE try to include aspects of uncertainty; however, only of an epistemological nature – there is no room for an uncertainty that is

ontological

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The 2010sOf course, economic behaviour is dependent on expectations; however in real life, households and

firms do not act economically based on perfect rational expectations. They make mistakes

(stochastically but much more important also of a systematically kind).

Likewise, of course, households and firms make decisions of an intertemporal kind; however, these intertemporal decisions are not characterised by

perfect optimality, rather decisions are often (always) of a 2. best kind

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The 2010sAnd methodologically, the ‘hypothetical-

deductive method’ used by the DSGE modelling is not the most relevant method

when you acknowledge that:

”unlike atoms or cells, individuals are free and, so, unpredictable, because they learn and

change their behavior; because institutions also change their behavior; and because a general uncertainty permeates individual behavior and economic analysis”; Bresser-

Pereira (2012:9)

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The 2010sSo apparently, it seems, the modern

macroeconomic understanding is currently undergoing some revisions

However, seen from a Post Keynesian

perspective, it is more than questionable if these revisions would be sufficient to make

mainstreamers to be able to perform a macroeconomic analysis that really, in a

relevant way, copes with the essential concepts of: time, money, expectations & uncertainty.

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The 2010sUnfortunately, it seems that mainstreamers are

still bound to do analyses that are ergodic in nature

The non-ergodic view on economics is regrettable only accepted by the Post

Keynesian understanding, as non-mainstreamers have had no influence at all on the modern macroeconomic New Neoclassical

Synthesis

We might be right but hardly no one seems to listen

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The 2010sNo hope for the future then?

Well, that depends on the students of economics today

Perhaps we are able to tell them a story about the

interplay between economic theory and the facts of real life that is interesting and convincing to them

At least, we have to try. As we actually do at The University of Aalborg

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The Making of a Revolution

Thank you very much