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The messy methods of macroeconomics
December 2017 / January 2018

(Illustration by Michael Daley)

Acrobats come together in troupes, churchgoers in congregations and witches in covens, but what about economists? What is the right collective noun for practitioners of the dismal science?

The question is not as trivial as it seems. The way in which groups of people characterise themselves can help others understand their methods and motives. For over 30 years I have been a loyal and appreciative member of the Society of Business Economists. But the powers that be have proposed that its name be changed to the Society of Professional Economists. I am therefore faced with an unexpected and urgent intellectual challenge. Do I belong to a profession?

Dictionaries see the term “profession” as applying to a paid occupation, where qualification involves prolonged training and a formal testing of skills. The testing of skills implies that a profession shares a body of expertise and that this body of expertise is objective. It is unacceptable if the member of a profession, when asked for advice, lapses into “in my opinion” or “in our view”. Artists and writers can be as subjective as they please, but economists must never use phrases like “on the one hand . . . on the other hand . . . on balance, I think . . .” Language of that kind is unsound and irresponsible, and — above all — unprofessional.

Dear reader, you may chuckle. Are not groups of economists defined by the jokes that non-economists tell about them? And are not many of these jokes concerned with economists’ inability to agree among themselves about anything?

My argument here will be that the humour is largely, although far from entirely, misguided. I will suggest that much of economics is (fairly) uncontroversial. With goodwill and common sense, certain ideas and principles could be brought together in a professional code. The trouble arises because these parts of economics are of less interest to non-economists than other parts that are riven by contention and faction-fighting. Because non-economists particularly want answers in the disputed areas of the subject, they have an exaggerated impression of disunity. All the same, economists have failed to resolve such fundamental issues and are engaged in so much squabbling that they do not constitute a profession.

The (fairly) uncontroversial parts of economics relate to the determination of the prices and quantities of individual products, and of the factors of production (of labour, capital, land and raw materials) that are needed to make them. In a word, they relate to “microeconomics”. In the late 19th century, leading thinkers — such as William Jevons and Alfred Marshall in England, and Carl Menger in Vienna — proposed that the conditions of demand and supply could be analysed separately. Their technical expositions invariably appealed to a geometry of curves on a plane, with quantity on one axis and price on the other. An equilibrium could be defined when the curves intersected, at which point demand and supply would be equal, and quantity and price determined. 

The underlying insight was that, at the equilibrium point, a marginal change in any direction would make someone worse off, so that market forces would come into play to restore the prices and quantities found at the equilibrium. The resulting “marginal revolution” in economic ideas swept away a clutter of nonsense, from medieval notions of “the just price” to specious distinctions between “exchange value” and “use value”. If someone claims to be an economist and cannot explain why price and quantity are determined when supply equals demand, he or she is an impostor. Of course, a range of market contexts need to be analysed, and a competitive market (with many suppliers, none of which can control the price) has different outcomes from one that is oligopolistic (with a few suppliers) or monopolistic (with only one). But the same analytical tools, of supply and demand functions represented by curves in diagrams, can be harnessed in a multiplicity of situations. The versatility of the tools reflects the power and robustness of the intellectual framework.

It gets better. Microeconomics generates not just descriptions of the world as it is, but public policy prescriptions that are grounded in logic and fact. Again, the core principle is simple and appeals to calculation at the margin: society is worse off if the additional costs (or “marginal costs”) of a particular course of action exceed the extra benefits (or “marginal benefits”) that can be shown to accrue to citizens at large. This may seem so obvious as hardly to need statement. Unfortunately, much of public policy is driven by rhetoric, ideology, custom, habit and so on, and is even further mangled in practice by the political process. The key principles of welfare economics derive from microeconomics and price theory, while welfare economics lies behind “social cost-benefit analysis”.

Non-economists — even non-economists in occupations that are undoubtedly professions, like accountants, engineers or actuaries — do not have the skill set that allows them to conduct cost-benefit analysis in the same way as economists; they are sometimes surprised by the rigour, consistency and distinctiveness of the work that economists do.

I said that microeconomics with price theory, and welfare economics, plus its associate social cost-benefit analysis, are fairly uncontroversial. I have no objection to the suggestion that economists involved in these branches of the subject should be able to claim a status comparable with that of more established professions. But I have inserted the adverb “fairly” to weaken the adjective “uncontroversial”. While it is my view that an economist who cannot manipulate supply and demand curves is an impostor, a minority of economists (or perhaps of so-called “economists”) protest that price theory suffers from false assumptions and latent prejudice.

This minority alleges that the validity of microeconomics depends on a tacit premise, that the only economy of analytical interest includes the categories (firms, consumers, and — crucially — property rights) found in modern capitalism. In their judgment, wages and profits are determined not by equilibration at a margin, but by bargaining and power. As they see the matter, property rights are political in origin and enforced by the threat of state violence. In the extreme they want to junk marginalism, and instead to uphold Marx’s labour theory of value and sometimes a great deal more of the Marxist box of tricks.

I appreciate that this minority exists and is a nuisance; I also admit that every self-styled “social scientist” (including myself) has hidden political commitments. But, if the labour theory of value had to be accommodated in standard instruction and thinking, much of microeconomics and welfare economics would become moot. The overwhelming majority of economists — in the universities as well as in the worlds of government, finance and business — have rejected old-style Marxism, and accept the same body of microeconomic theory and the consequent doctrines of welfare economics. There is enough agreement here that — if economics were comprised only of microeconomics — its votaries could aspire to the status of a profession. They could do so, despite the Left’s far from silly attempts to intrude politics into subjects that purport to be technical and value-free.

Economists’ assertion of professional status is spurious not because of the relatively minor intellectual tensions in microeconomics, but because of the utter shambles that is macroeconomics. Macroeconomics is often seen as beginning with Keynes’s 1936 book The General Theory of Employment, Interest and Money. Whereas microeconomics looks to determine the prices and quantities of individual products in particular marketplaces, macroeconomics is about the determination of aggregates of demand, output and employment for an entire economy. While Keynes’s book was certainly a classic that pointed in new directions, it was also so badly written and abstruse that it was unintelligible except to experts. Most students have learned macroeconomics not from The General Theory, but from Paul Samuelson’s textbook Economics, which first came out in 1948. The Samuelson textbook has had 15 or so editions, as well as many imitators, and is by far the best-selling economics book of all time.

Samuelson avoided the harder parts of The General Theory, distilling its essence in a handful of equations that present “the Keynesian theory of national income determination”. To elaborate, output depends on aggregate expenditure, and aggregate expenditure is equal to the sum of consumption, investment and government spending. These identities are vacuous by themselves, but behaviour and meaning are introduced by making a sweeping claim. According to Samuelson interpreting Keynes, investment and government spending do not depend on national income, and in that sense are “autonomous”. Their autonomous character allows them to have a causative role in the determination of aggregate demand. (They are unlike consumption, which is said to depend on income.) A few lines of algebra are sufficient to show that national income is a multiple of autonomous expenditure, where the multiplier is the inverse of one minus the marginal propensity to consume.

If you want better to understand the notions of “the multiplier” and “the marginal propensity to consume”, you need to attend a first-year university economics course. At any rate, it should be obvious — even from the brief account in the last two paragraphs — that Samuelson’s interpretation of Keynes blesses government spending because of its supposed ability to regulate aggregate demand. Assume that omniscient, forward-looking economists know the value of the multiplier. Then they can tell politicians how much to change government spending in order to achieve particular levels of aggregate demand, national output and employment. All being well, the dials of fiscal policy can be set so perfectly that full employment becomes permanent and unquestioned.

I have of course simplified Samuelson’s message, but I have not caricatured it. The first edition of his textbook was upbeat about fiscal policy and the therapeutic powers of government spending, while also remarking that “few economists regard Federal Reserve monetary policy as a panacea for controlling the business cycle”. Unfortunately, over the decades in which Samuelson dominated classroom instruction in macroeconomics, experience showed that money and banking had a profound bearing on the business cycle, and that the conduct of monetary policy mattered hugely. The 1985 edition of the textbook opined, “money is the most powerful and useful tool that macroeconomic policymakers have” and recognised the Fed’s centrality in decision-taking.

Moreover, in several key policy-making episodes it became clear that Samuelson’s interpretation of Keynes, focused on the multiplier theory of national income, was unsatisfactory. In Britain the intellectual watershed was the 1981 Budget, where a tightening of fiscal policy was followed by an improvement in demand, which ought to have been impossible if the textbook theory were correct: 364 economists — including a majority of Chief Economic Advisers to the government in the post-war period — signed a letter of protest to The Times, but are subsequently seen as having been wrong in their pessimism about the economic outlook. In the United States large cuts in government spending under President Clinton from 1992 were associated with healthy growth and strong employment, again an outcome that contradicted naïve Keynesianism. Even more damning was the sequel to the “fiscal cliff” of five years ago. Numerous forecasts appeared in late 2012 that looming big tax increases would plunge the US into a recession in 2013. In the event most of the tax increases went ahead, but the American economy saw higher demand growth in 2013 than in 2012.

My point is that the most familiar theory of national income determination among economists — the core of macroeconomics — is useless. Not only is there something wrong with it, but the problem is so deep-seated that it cannot be sorted out by minor addenda and corrigenda within the same paradigm. The last few years have seen statements from Robert Barro, a Harvard professor, that the multiplier has a value of zero and from Paul Krugman, a Princeton professor and the world’s most influential economic columnist, that it has a value of two. Both of them must be aware that Chapter Ten of The General Theory judged that in the 1930s it took a value of five. Other economists can be found who believe that a tightening of fiscal policy is often expansionary, opening up the possibility that reductions in government spending boost demand and that the multiplier is negative. So reputable sources can be found for estimates of the multiplier which vary between minus a half and plus five!

Economists should be proud of microeconomics, and of the important and valuable insights that price theory and welfare economics have generated in a range of public policy contexts. But macroeconomics is a mess. Contrary to a myth propagated by mostly left-leaning university economists in the English-speaking world in the late 1940s and 1950s, Keynes’s General Theory was not definitive. His theory of national income determination has not enabled policymakers to forecast how the economy will respond to their actions. As it is forecasts that non-economists really want from economists, this failure is all the more upsetting and tiresome.

While the debates in macroeconomics are raging with such intensity, it would be impudent for economists to claim that they form a profession. The muddles over the determination of aggregate demand and output are serious and unresolved. Economists are far from having a shared, objective body of expertise in exactly those areas of decision-taking where non-economists are most interested to hear what they have to say. If the Society of Business Economists decides to hold a vote on the proposed name change, I will be against it. And what is the best collective noun for our vocation? If pressed, I would say that a babble of macroeconomists is a good way to label believers in the multiplier approach to national income determination. 
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