'Economics is a set of problems in need of solution'

A highly recommended column from John Kay;

The two branches of economics most relevant to the recent crisis are macroeconomics and financial economics. Macroeconomics deals with growth and business cycles. Its dominant paradigm is known as “dynamic stochastic general equilibrium” (thankfully abbreviated to DSGE) – a complex model structure that seeks to incorporate, in a single framework, time, risk and the need to take account of the behaviour of many different companies and households...

As late as 2007, the International Monetary Fund would justify its optimism about the macroeconomic outlook with the claim that “developments in the global financial system have played an important role, including the ability of the United States to generate assets with attractive liquidity and risk management features”...

In his presidential lecture to the American Economic Association in 2003, Robert Lucas of the University of Chicago, the Nobel prizewinning doyen of modern macroeconomics, claimed that “macroeconomics has succeeded: its central problem of depression prevention has been solved”. Prof Lucas based his assertion on the institutional innovations noted by Mr Greenspan and the IMF authors, and the deeper theoretical insights that he and his colleagues claimed to have derived from models based on DSGE and the capital asset pricing model....

Subsequent policy decisions have been pragmatic and owe little to any economic theory. The recent economic policy debate strikingly replays that after 1929. The central issue is budgetary austerity versus fiscal stimulus, and – as in the 1930s – the positions of the protagonists are entirely predictable from their political allegiances.

Why did the theories put forward to deal with these issues prove so misleading? The academic debate on austerity versus stimulus centres around a property observed in models based on the DSGE programme. If government engages in fiscal stimulus by spending more or by reducing taxes, people will recognise that such a policy means higher taxes or lower spending in the future. Even if they seem to be better off today, they will later be poorer, and by a similar amount. Anticipating this, they will cut back and government spending will crowd out private spending. This property – sometimes called Ricardian equivalence – implies that fiscal policy is ineffective as a means of responding to economic dislocation...

Consistency and rigour are features of a deductive approach, which draws conclusions from a group of axioms – and whose empirical relevance depends entirely on the universal validity of the axioms. The only descriptions that fully meet the requirements of consistency and rigour are completely artificial worlds, such as the “plug-and-play” environments of DSGE – or the Grand Theft Auto computer game...

What is absurd is not the use of the deductive method but the claim to exclusivity made for it. This debate is not simply about mathematics versus poetry. Deductive reasoning necessarily draws on mathematics and formal logic: inductive reasoning, based on experience and above all careful observation, will often make use of statistics and mathematics...

Economics is not a technique in search of problems but a set of problems in need of solution. Such problems are varied and the solutions will inevitably be eclectic. Such pragmatic thinking requires not just deductive logic but an understanding of the processes of belief formation, of anthropology, psychology and organisational behaviour, and meticulous observation of what people, businesses and governments do.

Related:
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Lucas- Noble Prize Lecture

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