Reconstructing Macro

Ricardian Equivalence

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On DSGE and the art of using absolutely ridiculous modeling assumptions

LARS P. SYLL

Reading some of the comments — by Noah Smith, David Andolfatto and others — on my post Why Wall Street shorts economists and their DSGE models, I — as usual — get the feeling that mainstream economists when facing anomalies think that there is always some further “technical fix” that will get them out of the quagmire. But are these elaborations and amendments on something basically wrong really going to solve the problem? I doubt it. Acting like the baker’s apprentice who, having forgotten to add yeast to the dough, throws it into the oven afterwards, simply isn’t enough.

When criticizing the basic workhorse DSGE model for its inability to explain involuntary unemployment, some DSGE defenders maintain that later elaborations — e.g. newer search models — manage to do just that. I strongly disagree. One of the more conspicuous problems with those “solutions,” is that they — as e.g…

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Is Economics a Science?

Light Reading

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Dilemmas of a Neoliberal Democracy

Transitions in Brazil

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Macroeconomic Science and Meaningful Theorems

Greg Hill has a terrific post on his blog, providing the coup de grace to Stephen Williamson’s attempt to show that the way to increase inflation is for the Fed to raise its Federal Funds rate target. Williamson’s problem, Hill points out is that he attempts to derive his results from relationships that exist in equilibrium. But equilibrium relationships in and of themselves are sterile. What we care about is how a system responds to some change that disturbs a pre-existing equilibrium.

Williamson acknowledged that “the stories about convergence to competitive equilibrium – the Walrasian auctioneer, learning – are indeed just stories . . . [they] come from outside the model” (here). And, finally, this: “Telling stories outside of the model we have written down opens up the possibility for cheating. If everything is up front – written down in terms of explicit mathematics – then we have to be honest. We’re not doing critical theory here – we’re doing economics, and we want to be treated seriously by other scientists.”

This self-conscious scientism on Williamson’s part is not just annoyingly self-congratulatory. “Hey, look at me! I can write down mathematical models, so I’m a scientist, just like Richard Feynman.” It’s wildly inaccurate, because the mere statement of equilibrium conditions is theoretically vacuous. Back to Greg:

The most disconcerting thing about Professor Williamson’s justification of “scientific economics” isn’t its uncritical “scientism,” nor is it his defense of mathematical modeling. On the contrary, the most troubling thing is Williamson’s acknowledgement-cum-proclamation that his models, like many others, assume that markets are always in equilibrium.

Why is this assumption a problem? Because, as Arrow, Debreu, and others demonstrated a half-century ago, the conditions required for general equilibrium are unimaginably stringent. And no one who’s not already ensconced within Williamson’s camp is likely to characterize real-world economies as always being in equilibrium or quickly converging upon it. Thus, when Williamson responds to a question about this point with, “Much of economics is competitive equilibrium, so if this is a problem for me, it’s a problem for most of the profession,” I’m inclined to reply, “Yes, Professor, that’s precisely the point!”

Greg proceeds to explain that the Walrasian general equilibrium model involves the critical assumption (implemented by the convenient fiction of an auctioneer who announces prices and computes supply and demand at that prices before allowing trade to take place) that no trading takes place except at the equilibrium price vector (where the number of elements in the vector equals the number of prices in the economy). Without an auctioneer there is no way to ensure that the equilibrium price vector, even if it exists, will ever be found.

Franklin Fisher has shown that decisions made out of equilibrium will only converge to equilibrium under highly restrictive conditions (in particular, “no favorable surprises,” i.e., all “sudden changes in expectations are disappointing”). And since Fisher has, in fact, written down “the explicit mathematics” leading to this conclusion, mustn’t we conclude that the economists who assume that markets are always in equilibrium are really the ones who are “cheating”?

An alternative general equilibrium story is that learning takes place allowing the economy to converge on a general equilibrium time path over time, but Greg easily disposes of that story as well.

[T]he learning narrative also harbors massive problems, which come out clearly when viewed against the background of the Arrow-Debreu idealized general equilibrium construction, which includes a complete set of intertemporal markets in contingent claims. In the world of Arrow-Debreu, every price in every possible state of nature is known at the moment when everyone’s once-and-for-all commitments are made. Nature then unfolds – her succession of states is revealed – and resources are exchanged in accordance with the (contractual) commitments undertaken “at the beginning.”

In real-world economies, these intertemporal markets are woefully incomplete, so there’s trading at every date, and a “sequence economy” takes the place of Arrow and Debreu’s timeless general equilibrium. In a sequence economy, buyers and sellers must act on their expectations of future events and the prices that will prevail in light of these outcomes. In the limiting case of rational expectations, all agents correctly forecast the equilibrium prices associated with every possible state of nature, and no one’s expectations are disappointed.

Unfortunately, the notion that rational expectations about future prices can replace the complete menu of Arrow-Debreu prices is hard to swallow. Frank Hahn, who co-authored “General Competitive Analysis” with Kenneth Arrow (1972), could not begin to swallow it, and, in his disgorgement, proceeded to describe in excruciating detail why the assumption of rational expectations isn’t up to the job (here). And incomplete markets are, of course, but one departure from Arrow-Debreu. In fact, there are so many more that Hahn came to ridicule the approach of sweeping them all aside, and “simply supposing the economy to be in equilibrium at every moment of time.”

Just to pile on, I would also point out that any general equilibrium model assumes that there is a given state of knowledge that is available to all traders collectively, but not necessarily to each trader. In this context, learning means that traders gradually learn what the pre-existing facts are. But in the real world, knowledge increases and evolves through time. As knowledge changes, capital — both human and physical — embodying that knowledge becomes obsolete and has to be replaced or upgraded, at unpredictable moments of time, because it is the nature of new knowledge that it cannot be predicted. The concept of learning incorporated in these sorts of general equilibrium constructs is a travesty of the kind of learning that characterizes the growth of knowledge in the real world. The implications for the existence of a general equilibrium model in a world in which knowledge grows in an unpredictable way are devastating.

Greg aptly sums up the absurdity of using general equilibrium theory (the description of a decentralized economy in which the component parts are in a state of perfect coordination) as the microfoundation for macroeconomics (the study of decentralized economies that are less than perfectly coordinated) as follows:

What’s the use of “general competitive equilibrium” if it can’t furnish a sturdy, albeit “external,” foundation for the kind of modeling done by Professor Williamson, et al? Well, there are lots of other uses, but in the context of this discussion, perhaps the most important insight to be gleaned is this: Every aspect of a real economy that Keynes thought important is missing from Arrow and Debreu’s marvelous construction. Perhaps this is why Axel Leijonhufvud, in reviewing a state-of-the-art New Keynesian DSGE model here, wrote, “It makes me feel transported into a Wonderland of long ago – to a time before macroeconomics was invented.”

To which I would just add that nearly 70 years ago, Paul Samuelson published his magnificent Foundations of Economic Analysis, a work undoubtedly read and mastered by Williamson. But the central contribution of the Foundations was the distinction between equilibrium conditions and what Samuelson (owing to the influence of the still fashionable philosophical school called logical positivism) mislabeled meaningful theorems. A mere equilibrium condition is not the same as a meaningful theorem, but Samuelson showed how a meaningful theorem can be mathematically derived from an equilibrium condition. The link between equilibrium conditions and meaningful theorems was the foundation of economic analysis. Without a mathematical connection between equilibrium conditions and meaningful theorems analogous to the one provided by Samuelson in the Foundations, claims to have provided microfoundations for macroeconomics are, at best, premature.

(Sourced from Uneasy Money)

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HITHER THOU SHALT COME BUT NO FURTHER: An Update

In our previous post “Hither Thou Shalt Come But No Further: a reply to comments” we provided evidence that dismissed the deception that ‘good governance’ as envisioned by the Washington consensus is a prerequisite for growth and development. That analysis had utilized the IRIS property rights index for the periods 1980-1990 and 1990-2003, this data is available for most countries using the World Bank database.

This update utilizes a second data set that has become extremely popular for testing the importance of good governance for material advancement. Kaufmann’s team aggregates a large number of indices into six broad governance indicators:

  1. Voice and accountability: measuring political, civil and human rights
  2. Political instability and Violence: measuring the likelihood of violent threats to, or changes in, government, including terrorism
  3. Government Effectiveness: measuring the competence of the bureaucracy and the quality of public service delivery
  4. Rule of Law: measuring the quality of contract enforcement, the police, and the courts, as well as the likelihood of crime and violence
  5. Control of Corruption: measuring the exercise of public power for private gain, including both petty and grand corruption and state capture
  6. Regulatory Burden: measuring the incidence of market – unfriendly policies.

Similar to our earlier post, all countries listed on the World Bank database are divided into three categories. Advanced countries are rich states using the World Bank’s classification with the exception of Kuwait and the UAE which are considered developing countries. This is primarily because they have undergone little structural change in the direction of industrial development although they have high per capita incomes. The group of developing countries is further divided into converging and diverging states with per capita growth rates higher and lower than the median advanced country rates respectively.

Based on the standard good governance story, we expect that countries with high growth rates and levels of development to score high on these six indices of good governance. The six graphs below corresponds to each index and confirms the fact that advanced countries indeed have better governance indicators when compared to diverging and converging states. However, although converging and diverging states have different growth rates by definition, both groups of countries are plagued by poor governance indicators. This finding confirms our earlier claim using the Knack IRIS property rights index.

The important lesson to learn here is to distinguish between causality and correlation. We all agree that with material and non-material development societies manage to improve their governance structure and style to the betterment of all. But this does not mean that better governance caused material advancement, on the contrary, it is a correlate of development. Those that are hell bent on believing this mistruth must adequately explain the marked difference in economic performance between the converging and diverging states. The governance issues are essentially the same but yet converging countries experience on average, higher growth rates than advanced countries, a performance that is yet to be met by diverging countries. Certainly, this could simply be a coincidence, but the extraordinary similarity in economic agenda and pattern of strategic state intervention by the converging and now developed states offer a different opinion.

FIGURE 1

Voice and Accountability index 1990-2003

Voice and Accountability index 1990-2003

FIGURE 2

Political stability and violence index 1990-2003

Political stability and violence index 1990-2003

FIGURE 3

Government effectiveness index 1990-2003

Government effectiveness index 1990-2003

FIGURE 4

Regulatory quality index 1990-2003

Regulatory quality index 1990-2003

FIGURE 5

Rule of law index 1990-2003

Rule of law index 1990-2003

FIGURE 6

Control of corruption index 1990-2003 (All graphs were sourced from Khan 2009)

Control of corruption index 1990-2003 (All graphs were sourced from Khan 2009)

Why is it that the mainstream can claim that good governance is statistically significant for long run development? The six indices presented in this essay are all weakly positively sloped, but even if these established a strong positive relationship between governance and development, the truth lies in the details. This positive relationship is simply exaggerated within the mainstream view because they fail to differentiate between converging and diverging countries in the World Bank data base. This failure hides the empirical fact that both converging and diverging countries have similar governance characteristics but marked differences in economic performance. When diverging and converging countries are bundled into one group (developing countries) it’s difficult to see this undeniable truth.

Surely the claim that one index is not sufficient to debunk the good governance agenda losses weight since we employ here an alternate measure but yet our findings confirm the results of the IRIS property rights index. But we move beyond this and find support for our results in an analysis of African countries by Sachs et al (2004). This study explains that since we expect higher performing countries to have relatively better governance indicators, the latter should not be used to explain higher incomes. Instead they argue that deviations from the country’s governance indicator (using the Kaufmann-World Bank Index) from the predicted value of the indicator given a country’s per capita income at the beginning of the period is a better way to explain higher incomes. Thus, we would expect countries that had better governance indicators than expected for their per capita income to have superior economic performance than countries that had governance scores below the average for their per capita incomes. No surprise to Cariban’s Reason, the study concludes that good governance has no effect on the growth performance of African countries!

A COLONIAL TALE

Acemoglu et al (2001, 2002 and 2004) contend that strong institutions, which includes good governance and the strong protection of property rights are the fundamental cause of long run growth. They sought to prove their case by highlighting the colonial origins of comparative economic performance between the rich world today and the remaining poor. The argument goes like this: in colonies where mortality rates were low (primarily because white colonists were immune to the diseases) colonists settled and occupied these territories. Additionally, they erected stable property rights, rule of law and generally good governance institutions that significantly reduced the costs and obstacles of doing business. Conversely, in territories where mortality rates were high, the settlement of white colonists proved detrimental. Naturally, few settled in these high mortality territories and utilized them primarily for the extraction of natural resources with the aid of slaves and indentured labor. The absence of good governance in these high mortality colonies is the principal reason why strong and consistent economic growth eluded them as opposed to low mortality territories.

AN ALTERNATE TALE

The colonial tale is fascinating but misleading at best. Essentially it is premised on European settlement and the effective enforcement of inclusive institutions and rights. Two points are crucial to make here:

  1. The colonial tale completely ignores the fact that European settlement represents an influx of relatively advanced human capital. They already knew how to organize production, distribution and exchange, equally important is the fact that they came with technology that was new to the new world. The development literature minces no words about the importance of technology and human capital to the development process. Certainly skills, reverse engineering and technological adaptation played immeasurable roles in the rise of the South East Asians and the now developed western countries.
  2. How do the slave trade and the slaughter of the indigenous peoples fit into the effective enforcement of inclusive institutions and rights? The fact is that they do not! Moreover, political and economic institutions were hardly accommodating to women and labor generally. Welfare programs in all its variations were non-existent and ever present was violent labor struggles. The slaughter of the indigenous peoples is critical because it sought to destroy the pre-existing governance structures and rights that did not serve the interests of the new settlers. According to the colonial tale the white settlers had better governance than the indigenous peoples and all that is required for development is the eradication of these ‘poor governance structures and rights.’ It is clear that the colonial method of genocide to destroy these ‘poor rights’ cannot and should not be employed again. The state is the institution of all institutions as Ha Joon Chang puts it, yet the catalytic role of the state in the development process of these new territories seem to be absent within the analysis of the colonial tale.

It is developmental governance (more on this in future posts) which is strikingly different from good governance as understood within liberal terms that matters most for material advancement. The latter overtime births evolving forms of good governance. These various forms of good governance are ends in themselves and not means to development. This must be remembered and clearly understood when we make policies, otherwise, we miss the moving target of development and a chance to solve distributional conflicts, corruption and other sources of human injustices.

References

Acemoglu, Daron, Simon Johnson and James A. Robinson 2001. The Colonial Origins of Comparative Development: An Empirical Investigation, American Economic Review 91 (5): 1369-401.

Acemoglu, Daron, Simon Johnson and James A. Robinson 2002. Reversal of Fortune: Geography and Institutions in the Making of the Modern World Income Distribution The Quarterly Journal of Economics 117 (4): 1231-94.

Acemoglu, Daron, Simon Johnson and James A. Robinson 2004. Institutions as the Fundamental Cause of Long Run Growth. Working Paper No. 10481. National Bureau of Economic Research: Cambridge Massachusetts.

Kauffman, Daniel, Aart Kraay and Pablo Zoido-Lobaton 1999. Governance Matters. World Bank Policy Working Paper No. 2196. World Bank: Washington.

Khan, Mushtaq 2009. Is ‘Good Governance’ an Appropriate Model for Governance Reforms? The Relevance of East Asia for Developing Countries. In: Springborg, Robert, (ed.), Development Models in Muslim Contexts: Chinese, ‘Islamic’ and Neo-Liberal Alternatives. Edinburgh University Press, pp. 195-230.

Sachs, J.D, McArthur, J.W, Schmidt-Traub, G, Kruk, M, Bahadur, C, Faye, M and McCord, G 2004. Ending Africa’s Poverty Trap. Brookings Papers on Economic Activity pp. 117-240.

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CORRUPTION, INTERESTS AND THE LOGIC OF POLITICAL SURVIVAL

ImageFigure 1 below is a modified version of Khemraj (2013) voting pattern and resource allocations in Guyana. It describes the potential and actual avenues of corruption, the essential pressure groups within Guyana’s political economy and the underlying logic of political survival that confronts all regimes. The block arrows represent the voting pattern of the East Indian Masses (EIM) and African Guyanese Masses (AGM) while all other arrows are indicative of transfers from the state to interest groups, whether it be through legal or illegal (corrupt) means.

It is obvious that the East Indian Elites (EIE) undertake various redistributive schemes to all essential interest groups. The popular contention is that these kickbacks, transfers and side deals are highly skewed in favor of the EIM and the EIE themselves. Not all transfers illustrated are corruption however, some are tax reductions, increase in the income threshold, low interest mortgages and various pension and welfare packages that affect in various ways all interest groups in Guyana. The pervasive nature of corruption is obvious from the diagram and characteristic of undeveloped countries. The block arrow between the EIM and AGM illustrates the conflict and distrust that exists between the two groups and the popular opinion is that this tension is exacerbated by our political leadership.

The biggest fallacy of the development literature is that low corruption is an absolutely necessary prerequisite for material advancement. But the actual evidence dismisses this deception, see here https://caribansreason.wordpress.com/2013/12/24/hither-thou-shalt-come-but-no-further-a-reply-to-comments/. This misdiagnosis is precisely why anti-corruption strategies hardly work in the underdeveloped world. It fails to address the underlying problem of a dormant private sector and ignores the political necessity of many corruption networks which in itself is a compensation for the lack of a dynamic private sector.

Besides the standard anti-corruption strategies of constitutional reforms, empowering civil society is marketed as effective. This understanding of civil society is an aggregation of interests and pressure groups who have a collective stake in the health of the dominant private sector and possess the capacity to monitor and keep the state in check. The solidarity among interest and pressure groups are absent in poor states. They have little collective interests in the private sector since many are unemployed, thus, developing and cementing social networks is the most effective means of acquiring income and employment.

Essentially, civil society in the poor world is a group of competing interests and factions where only the most organized will determine which causes to champion. To effectively use civil society for the advancement of their country, we need to know whose interests are the dominant groups in civil society serving. Are these groups promoting development, or is the nature of their competition for redistribution itself part of the problem?

FIGURE 1

Image

Figure 2 captures a civil society with a collective interest in the health of the private sector. The diagram describes an advanced capitalist society that is governed by the impulses of the private sector rather than political instinct. Interestingly, many forms of corruption disappear and new ones emerge. This dynamic private sector is no respecter of race or political allegiances as it absorbs various political elites, bureaucrats and Guyanese masses generally.

Remarkably, even the political sector is now subservient to the power of the modern private sector. Transfers are no longer done through illegal means or off the budget, as the tax base increases fiscal policy is set to satisfy competing interests within the margins established by the private sector. The private sector’s influence in politics becomes the new form of corruption, and the dominant one. Distributional conflicts still exist, the problem of race and ethnicity is now embedded within the new overarching problem of class conflict.

Meritocracy is essential to the health of a growing private sector, any other form of appointment is within direct conflict to their interest. Hence, we observe in rich capitalist states, a competent and meritocratic state apparatus, high levels of human capital and all the other accompanying elements of development. The sustenance and growth of the private sector is the regulating force of the society in figure 2 as opposed to the political sector in figure 1.

These advanced countries simply need to ensure the general health of the private sector since most of their political constituencies are employed there. This reality reduces the necessity for certain forms of political corruption. The latter is ever present in figure 1 because the majority employer is the political sector. As figure 2 illustrates, growth in the private sector is an effective solution to certain forms of corruption and the catalyst to modernization in all its variations.

FIGURE 2

Image

A crucial part of this analysis is that the governing forces of society remain the same even with a different governing political elite. Consider figure 3. This is primarily the same as figure 1 but with the AGE controlling the resources of the state and appropriating at least a minimum number of swing voters that ensures electoral victory. The distributive pressures remain the same from all interest groups and may even intensify with the new government. The size of the tax base hasn’t changed and the need for off budget transfers is still ever present. The new ruling elites have to please their strong hold support base and the minimum swing voters that got them there.

However, transfers to the EIM are critical to ensure political stability and the political impulse to do this may even intensify. There are good reasons to believe that the AGE would hardly undertake any redistribution to the EIE. The most important question however, is what would be the nature of their relationship with the private sector that they inherit? Arrows of transfers are intentionally left out between the private sector and AGE in figure 3. But this hardly means that corruption of the sort that we now criticize would cease to exist. It is likely that the new ruling elites would effect policy to change the ethnic distribution of the private sector, but this too cannot be done without establishing and cementing new social networks of transfers, both of a legal and illegal nature.

The forms of corruption may change marginally and certain avenues of corruption may move underground to satisfy at least, the minimum swing voters. But this does not change the fact that the society is governed by the need to accumulate political capital through various redistributive schemes, whether legal or illegal. But not all corrupt regimes are created equal. There are great developmental differences between corrupt regimes and this is the contrast between developing countries and stagnant ones.

Any new government in Guyana would have a pressing mandate, but their ultimate priority would always be re-election and this has significant implications for the distribution patterns and the levels and forms of corruptions. The possibility exists that a new government could assume the ‘Mandela role’ and charter a new political culture and nurture a consensual private sector expansion agenda. Whether this is likely is an open question. Essentially, the developmental credentials of governments must remain an integral part of anti-corruption strategies. This is crucial since all governments are pressured by the underlying forces that govern underdeveloped countries. Thus, the logic of political survival dominates and sometimes even at the expense of private sector growth, the one essential for eliminating certain forms of corruption.

FIGURE 3

Image

REFERENCES

Khemraj, Tarron. (2013). Bi-Communalism and Economic Origins of Democracy: A Case Study. Institute of Development Studies, University of Guyana Special Series Working Paper # 4/12 to commemorate the 50th Anniversary (1963-2013) of the University of Guyana

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