Paul Romer is a top mainstream economist. Romer has just been appointed chief economist at the World Bank. World Bank President Jim Yong Kim described Romer’s appointment with acclaim: “We’re thrilled to have an economist as accomplished as Paul Romer join us,” said Kim.“We’re most excited about his deep commitment to tackling poverty and inequality and finding innovative solutions that we can take to scale.” For a critical review of Romer’s’ ideas and his likely influence at the World Bank, see this piece from the graduate blog, the New School Economic Review.
So it is big news among professional mainstream economics that Romer should publish just this month a working paper in which he trashes the whole basis of macroeconomics (i.e. looking at an economy as a whole), both neoclassical and Keynesian versions, in what appears to be a parting farewell to his colleagues in economic academia (leo16_romer). This is what he says in his intro to the paper, The trouble with macroeconomics, “For more than three decades, macroeconomics has gone backwards. …Macroeconomic theorists dismiss mere facts by feigning an obtuse ignorance… Their models attribute fluctuations in aggregate variables to imaginary causal forces that are not influenced by the action that any person takes… a general failure mode of science that is triggered when respect for highly regarded leaders evolves into a deference to authority that displaces objective fact from its position as the ultimate determinant of scientific truth.”
Romer’s critique mirrors the criticisms that have been expressed by heterodox and Marxist economists for decades. For example, see Steve Keen’s excellent book, Debunking economics, which exposes the fallacious assumptions and approach of mainstream economics; or more recently, Ben Fine’s critique of both micro and macroeconomics. But now we have top mainstream economist Paul Romer dismissing the approach and methods that he and others have taught in all the economics departments of universities across the world.
Romer starts by an attack on the explanation of crises under capitalism as just being the result of ‘exogenous shocks’ to an inherently harmonious process of economic growth. “Macroeconomists got comfortable with the idea that fluctuations in macroeconomic aggregates are caused by imaginary shocks, instead of actions that people take.” The great economist of models based on shock was Nobel prize winner Edward Prescott. In 1986, he calculated that 84% of output variability (crises) is due to technology ‘shocks’, even though others came up with estimates that “fill the entire range from Prescott estimate of about 80% down to 0:003%, 0:002% and 0%”! (Romer).
By ‘imaginary’ is the idea that mainstream economics just invents possible exogenous causes for crises because it does not want to admit that crises could be endogenous. These imaginary shocks become increasingly unrealistic. As Romer says, the “standard defense invokes Milton Friedman’s (1953) methodological assertion from unnamed authority that “the more significant the theory, the more unrealistic the assumptions (p.14).” Romer adds, “More recently, “all models are false” seems to have become the universal hand-wave for dismissing any fact that does not conform to the model that is the current favorite.”
What this approach leads to is that we cannot make a proper identification of what causes a change economically. If you just keep adding possible ‘imaginary shocks’ to explain sharp changes in an economy, “more variables makes the identification problem worse.” As Romer points out, “solving the identification problem means feeding facts with truth values that can be assessed, yet math cannot establish the truth value of a fact. Never has. Never will.”
Looking at the facts has given way to the purity of mathematical models and seeking the truth has given way to deference to authority. “Because guidance from authority can align the efforts of many researchers, conformity to the facts is no longer needed as a coordinating device. As a result, if facts disconfirm the officially sanctioned theoretical vision, they are subordinated. Progress in the field is judged by the purity of its mathematical theories, as determined by the authorities.”
Romer concludes that “the disregard for facts has to be understood as a choice.” In other words, mainstream economics is stuck in an ideological defence of the status quo and of the ‘conventional wisdom’, to use the term of Keynes and JK Galbraith. The defence of capitalism and the ruling order is more important than seeking the truth.
Romer agrees that leading neoclassical economist Robert Lucas had a point when he reckoned that Keynesian economic models “relied on identifying assumptions that were not credible.” And that the “predictions of those Keynesian models, the prediction that an increase in the inflation rate would cause a reduction in the unemployment rate, have proved to be wrong”. But Romer also takes to task Lucas himself with his now (infamous) quote in 2003 that “macroeconomics in this original sense has succeeded: Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades.” As Romer puts it “Using the worldwide loss of output as a metric, the financial crisis of 2008-9 shows that Lucas’s prediction is far more serious failure than the prediction that the Keynesian models got wrong.”
The trouble with Romer’s critique is that he actually accepts the idea of ‘shocks’ external to the endogenous growth of capital accumulation as the cause of ‘fluctuations’ or crises under capitalism. He just has different ones. Romer’s main complaint is that mainstream macro models, because they must be tied to neoclassical models of rational expectations and unrealistic assumptions like ‘perfect competition’, cannot account for ‘shocks’ caused by monetary policy. And it is those changes that cause ‘fluctuations’. He cites as an example that if a central bank raised its policy rate dramatically, by say 5% points, as Fed chair Paul Volcker did in the early 1980s, that will cause a slump. So monetary policy matters. This is his litmus test for the role of money and central banks.
No heterodox or Marxist economist would deny the role of money and credit in the circuit of capital accumulation, but that does not mean that monetary policy action is the main cause of crises. Did Paul Volcker cause the ‘double-dip’ recession of 1980-2 by his attempt to drive down late 1970s high inflation? Or were there ‘endogenous’ causes to do with the very low level of corporate profitability by the late 1970s that led to an investment collapse?
Brad Setser, a right-wing economist, points out Romer seems to accept that the mainstream view that there is some natural equilibrium rate of interest that determines when an economy is growing ‘just right’, with full employment and no inflation. But this ‘Wicksellian’ rate is just as much ‘imaginary’ as the neoclassical ‘shocks’ that Romer criticises. “Romer… claims that the real interest rate is a useful measure of the stance of monetary policy, and it isn’t—not even close. All of the traditional indicators are unreliable. After all, the Wicksellian equilibrium rate cannot be directly observed. You need to look at outcomes”.
As Setser points out, in criticising the ludicrous position of Robert Shiller, the behavioural economist of the mainstream, “Shiller seems unaware that it’s normal for the economy to be weak during periods of low interest rates, and strong during periods of high interest rates. He seems to assume the opposite. In fact, interest rates are usually low precisely during those periods when the investment schedule has shifted to the left (ie DOWN). Shiller’s mistake would be like someone being puzzled that oil consumption was low during 2009 “despite” low oil prices.” The cause of crises lies in the fall in investment which induces lower interest rates, not vice versa.
Nevertheless, Romer has ruffled the feathers of traditional mainstream Keynesian economists like Simon Wren-Lewis. Having spent most of the last month or so writing posts on his blog arguing that the new leftist leader of the British Labour party, Jeremy Corbyn, was a loser and did not have any hope of winning an election (and leaving Corbyn’s advisory council accordingly), he has now tried to defend mainstream economic models from Romer’s critique.
Wren-Lewis argued that Romer was out of date in his critique and the latest (DSGE) models did try to incorporate money and imperfections in an economy: “macroeconomics needs to use all the hard information it can get to parameterise its models. “respected macroeconomists (would) argue that because of these problematic microfoundations it is best to ignore something like sticky prices (wages) (a key Keynesian argument for an economy stuck in a recession – MR) when doing policy work: an argument that would be laughed out of court in any other science. In no other discipline could you have a debate about whether it was better to model what you can microfound rather than model what you can see. Other economists understand this, but many macroeconomists still think this is all quite normal.” In other words, there are good and bad macroeconomists and macroeconomics and we should not throw the baby out with the bath water.
Romer has been quick to retort in an update on his paper that “If we know that the RBC (Lucas) model makes no sense, why was it left as the core of the DSGE (Keynesian) model? Those phlogiston (imaginary) shocks are still there. Now they are mixed together with a bunch of other made-up shocks. Moreover, I see no reason to be confident about what we will learn if some econometrician adds ‘sticky prices’ and then runs a horse to see if the shocks are more or less important than the sticky prices. The essence of the identification problem is that the data do not tell you who wins this kind of race. The econometrician picks the winner.” In other words, Keynesian type DSGE models are just as full of econometric tricks and unrealistic assumptions as neoclassical, non-monetary models.
Leftist journalist Paul Mason wrote a piece on Romer’s critique, highlighting that “Romer’s huge mea culpa on behalf of mainstream economics is a sign that, after a decade-long hunt for trolls and gremlins as the cause of crisis, academia now has to begin the search for the cause of instability inside the system, not outside it.” Maybe, although I am not as optimistic as he is that the mainstream will look at the economic world realistically from now on rather than ideologically. Marx thought that after the end of classical economists, political economy became ‘vulgar’ economics, namely an apologia for capitalism and the rule of capital. I don’t expect that to change because it is still the task of the mainstream.
Mason notes that Marx too tried to develop mathematical models that would help explain an economy but he did not succeed. That does not mean it is impossible to use mathematical models as long as they are based on realistic assumptions and tested empirically. But I’m not sure that Mason is right that such models will be based on “large, agent-based simulations, in which millions of virtual people take random decisions driven by irrational urges – such as sex and altruism – not just the pursuit of wealth.” – whatever that might mean.
In my book, The Long Depression, I argue that Marxist economics is based on scientific method. You start with a hypothesis that has realistic assumptions that have been ‘abstracted’ from reality and then construct a model or set of laws that can be tested against the evidence. The model can use mathematics to refine its precision, but eventually the evidence decides. Moreover, macro-economics is the world of the aggregate, not individual behaviour. That delivers measurable data to test a theory.
Romer ends with an appeal to return to the scientific method. “Scientists commit to the pursuit of truth even though they realize that absolute truth is never revealed. All they can hope for is a consensus that establishes the truth of an assertion in the same loose sense that the stock market establishes the value of a firm. It can go astray, perhaps for long stretches of time. But eventually, it is yanked back to reality by insurgents who are free to challenge the consensus and supporters of the consensus who still think that getting the facts right matters. Despite its evident flaws, science has been remarkably good at producing useful knowledge. It is also a uniquely benign way to coordinate the beliefs of large numbers of people, the only one that has ever established a consensus that extends to millions or billions without the use of coercion.”
True, but I don’t expect mainstream economics ever to be “yanked back to reality”.