Why It Matters If You Start From Bad Assumptions

-- Posted by Neil H. Buchanan

To my surprise and disappointment, my post last Thursday on the IRS non-scandal scandal turned out not to be the last thing I would write on that topic.  Perhaps my new Verdict column today will be.  Even if I do end up returning to that subject, however, I will not do so here.

Instead, I will continue my discussion of the orthodox-versus-heterodox debate in economics that erupted again recently, in response to Thomas Piketty's blockbuster book.  My most recent entry on this topic, last Friday, includes links to my previous four posts in this series.  Readers might also want to read (or re-read) Professor Hockett's recent Dorf on Law post in which he questioned the usefulness of the orthodox/heterodox delineation.

In last Friday's post, I concluded that Paul Krugman, the most prominent member of the orthodox left, had unexpectedly come to sound like the conservative icon Milton Friedman, who argued in essence that the assumptions underlying an economic model did not matter, so long as the model successfully predicted the real world.  I concluded that Krugman was, in short, a modernist.

I was surprised to find myself concluding that Krugman was a methodological Friedmanite, because Krugman has otherwise shown himself to care very much about the assumptions in economic models.  He rightly mocks the "new classical" economists from Chicago for making crazy assumptions, and he complains that austerians and sado-monetarists (usually the same people) have abandoned established economic theory in order to make economics a morality play.  In a blog post last week, he wrote: "But is it really too much to demand a model, or at least a carefully spelled-out mechanism?"

Even more to the point, I noted in an after-hours update to my post last Friday: "About a half hour after I published this post, Paul Krugman posted 'Faith-based Freaks' on his blog.  In that post, he explicitly distanced himself from Milton Friedman's extreme positivism.  In the post below, I had criticized Krugman's defense of his own work against the Heterodox Left, likening it to Friedmanian positivism.  Even if I thought that Krugman reads Dorf on Law (which I don't), the timing was too close for his post to have been written in response  to mine.  In any event, I view it as a good thing that Krugman is trying to distinguish his methodology from Friedman's, and I plan to return to this issue soon."

Krugman is certainly right to resist the idea that economic models are mere black boxes, to be assessed only on the basis of their predictive power.  On the other hand, he has defended his own use of extremely unrealistic assumptions, noting that assumptions are by definition "wrong," but that they can still be practical.  (Economists will often analogize to the physical sciences.  For example, they can point to the virtues of assuming, say, that a lever is frictionless.  An unrealistic assumption to be sure, but a harmless one in most contexts.)  As I wrote in the comments section on last Friday's post, in response to some very good comments from readers, it is a struggle to come up with an explanation for Krugman's approach that does not boil down to: "Trust me, I know what I'm doing."

Krugman's rejection of the heterodox left then falls into two categories: (1) Everything useful that they say can be (and has been) brought into good orthodox left models.  (In a sense, this is Professor Hockett's point as well.)  (2) The heterodox guys are obsessed with things that are simply not useful or relevant.  Specifically, they need to get over the Cambridge Controversies, because proving definitively that production functions are incoherent (as the British side did) does not mean that production functions cannot be usefully employed (no pun intended) to improve economic policy.  Frictionless levers are not real either, guys!

To a point, the heterodox guys agree.  Galbraith's review of Piketty's book, as I noted in one of my earlier posts, agrees that one can make Piketty's (actually quite narrow) point about wealth concentration without getting into details about measuring capital correctly, or any of the other points debated in the Cambridge Controversies.  Instead, the heterodox argue that the simplifying assumptions that one makes in one context are harmful in another.  And if those assumptions become a matter of habit, the consequences can potentially be disastrous.

Krugman has argued repeatedly that the economists who supported non-Keynesian policies were simply dishonest.  But maybe some of them got it wrong because they made a mistake.  It is hardly a radical claim to say that one's starting point can increase the likelihood of making mistakes.  And it is not just a matter of making mistakes.  Argumentative power derives from the underlying assumptions as well.  For example, in a comment on one of my earlier posts, Professor Dorf suggested as an example the debate over the minimum wage, where it is possible to start from orthodox foundations and make enough correct analytical moves to "get it right," but by giving ground up front, the likelihood of losing the debate increases.  This obviously carries over to the debate over providing extended unemployment benefits, but with even more powerful macroeconomic consequences.

And this is where the Cambridge Controversies come back into the story.  As I described last week, one of the policy take-aways of that debate is that there is no theoretical connection between interest rates and business investment (and ultimately GDP).  The models that Krugman describes as "harmlessly simplified" generally assume, contra reality, that reducing interest rates increases businesses' desire to own "capital."  If we use the orthodox models, we then are more likely to rely on monetary policy to reduce interest rates; and we are more likely to worry about crowding out of investment from expansionary fiscal policy.

Now, it turns out that the orthodox models can "get it right" in the sense that interest rate cuts can expand the housing sector, which expands the economy, which then feeds back and expands business investment.  So what's the harm?  The harm is that, when one listens to policy discussions among orthodox economists, they talk as if the interest rate cuts directly raise business investment and productivity.  But if the effect is indirect, and if some of the expansionary effect is through the increased production of single-family homes rather than productive capital, then the policy prescription is much more of a mixed bag thatn we generally acknowledge.

Again, this does not mean that one cannot get to the right answer by being careful enough and honest enough.  I admire Krugman's work greatly, in large part because he takes textbook Keynesianism and gets the policy analysis right almost all of the time.  But the suggestion that the concern about the Cambridge Controversies, or other things that the heterodox care about, is somehow an annoying side show is simply not defensible.