Archive for May, 2017

Hayek and Intertemporal Equilibrium

I am starting to write a paper on Hayek and intertemporal equilibrium, and as I write it over the next couple of weeks, I am going to post sections of it on this blog. Comments from readers will be even more welcome than usual, and I will do my utmost to reply to comments, a goal that, I am sorry to say, I have not been living up to in my recent posts.

The idea of equilibrium is an essential concept in economics. It is an essential concept in other sciences as well, its meaning in economics is not the same as in other disciplines. The concept having originally been borrowed from physics, the meaning originally attached to it by economists corresponded to the notion of a system at rest, and it took a long time for economists to see that viewing an economy as a system at rest was not the only, or even the most useful, way of applying the equilibrium concept to economic phenomena.

What would it mean for an economic system to be at rest? The obvious answer was to say that prices and quantities would not change. If supply equals demand in every market, and if there no exogenous change introduced into the system, e.g., in population, technology, tastes, etc., it would seem that would be no reason for the prices paid and quantities produced to change in that system. But that view of an economic system was a very restrictive one, because such a large share of economic activity – savings and investment — is predicated on the assumption and expectation of change.

The model of a stationary economy at rest in which all economic activity simply repeats what has already happened before did not seem very satisfying or informative, but that was the view of equilibrium that originally took hold in economics. The idea of a stationary timeless equilibrium can be traced back to the classical economists, especially Ricardo and Mill who wrote about the long-run tendency of an economic system toward a stationary state. But it was the introduction by Jevons, Menger, Walras and their followers of the idea of optimizing decisions by rational consumers and producers that provided the key insight for a more robust and fruitful version of the equilibrium concept.

If each economic agent (household or business firm) is viewed as making optimal choices based on some scale of preferences subject to limitations or constraints imposed by their capacities, endowments, technology and the legal system, then the equilibrium of an economy must describe a state in which each agent, given his own subjective ranking of the feasible alternatives, is making a optimal decision, and those optimal decisions are consistent with those of all other agents. The optimal decisions of each agent must simultaneously be optimal from the point of view of that agent while also being consistent, or compatible, with the optimal decisions of every other agent. In other words, the decisions of all buyers of how much to purchase must be consistent with the decisions of all sellers of how much to sell.

The idea of an equilibrium as a set of independently conceived, mutually consistent optimal plans was latent in the earlier notions of equilibrium, but it could not be articulated until a concept of optimality had been defined. That concept was utility maximization and it was further extended to include the ideas of cost minimization and profit maximization. Once the idea of an optimal plan was worked out, the necessary conditions for the mutual consistency of optimal plans could be articulated as the necessary conditions for a general economic equilibrium. Once equilibrium was defined as the consistency of optimal plans, the path was clear to define an intertemporal equilibrium as the consistency of optimal plans extending over time. Because current goods and services and otherwise identical goods and services in the future could be treated as economically distinct goods and services, defining the conditions for an intertemporal equilibrium was formally almost equivalent to defining the conditions for a static, stationary equilibrium. Just as the conditions for a static equilibrium could be stated in terms of equalities between marginal rates of substitution of goods in consumption and in production to their corresponding price ratios, an intertemporal equilibrium could be stated in terms of equalities between the marginal rates of intertemporal substitution in consumption and in production and their corresponding intertemporal price ratios.

The only formal adjustment required in the necessary conditions for static equilibrium to be extended to intertemporal equilibrium was to recognize that, inasmuch as future prices (typically) are unobservable, and hence unknown to economic agents, the intertemporal price ratios cannot be ratios between actual current prices and actual future prices, but, instead, ratios between current prices and expected future prices. From this it followed that for optimal plans to be mutually consistent, all economic agents must have the same expectations of the future prices in terms of which their plans were optimized.

The concept of an intertemporal equilibrium was first presented in English by F. A. Hayek in his 1937 article “Economics and Knowledge.” But it was through J. R. Hicks’s Value and Capital published two years later in 1939 that the concept became more widely known and understood. In explaining and applying the concept of intertemporal equilibrium and introducing the derivative concept of a temporary equilibrium in which current markets clear, but individual expectations of future prices are not the same, Hicks did not claim originality, but instead of crediting Hayek for the concept, or even mentioning Hayek’s 1937 paper, Hicks credited the Swedish economist Erik Lindahl, who had published articles in the early 1930s in which he had articulated the concept. But although Lindahl had published his important work on intertemporal equilibrium before Hayek’s 1937 article, Hayek had already explained the concept in a 1928 article “Das intertemporale Gleichgewichtasystem der Priese und die Bewegungen des ‘Geltwertes.'” (English translation: “Intertemporal price equilibrium and movements in the value of money.“)

Having been a junior colleague of Hayek’s in the early 1930s when Hayek arrived at the London School of Economics, and having come very much under Hayek’s influence for a few years before moving in a different theoretical direction in the mid-1930s, Hicks was certainly aware of Hayek’s work on intertemporal equilibrium, so it has long been a puzzle to me why Hicks did not credit Hayek along with Lindahl for having developed the concept of intertemporal equilibrium. It might be worth pursuing that question, but I mention it now only as an aside, in the hope that someone else might find it interesting and worthwhile to try to find a solution to that puzzle. As a further aside, I will mention that Murray Milgate in a 1979 article “On the Origin of the Notion of ‘Intertemporal Equilibrium’” has previously tried to redress the failure to credit Hayek’s role in introducing the concept of intertemporal equilibrium into economic theory.

What I am going to discuss in here and in future posts are three distinct ways in which the concept of intertemporal equilibrium has been developed since Hayek’s early work – his 1928 and 1937 articles but also his 1941 discussion of intertemporal equilibrium in The Pure Theory of Capital. Of course, the best known development of the concept of intertemporal equilibrium is the Arrow-Debreu-McKenzie (ADM) general-equilibrium model. But although it can be thought of as a model of intertemporal equilibrium, the ADM model is set up in such a way that all economic decisions are taken before the clock even starts ticking; the transactions that are executed once the clock does start simply follow a pre-determined script. In the ADM model, the passage of time is a triviality, merely a way of recording the sequential order of the predetermined production and consumption activities. This feat is accomplished by assuming that all agents are present at time zero with their property endowments in hand and capable of transacting – but conditional on the determination of an equilibrium price vector that allows all optimal plans to be simultaneously executed over the entire duration of the model — in a complete set of markets (including state-contingent markets covering the entire range of contingent events that will unfold in the course of time whose outcomes could affect the wealth or well-being of any agent with the probabilities associated with every contingent event known in advance).

Just as identical goods in different physical locations or different time periods can be distinguished as different commodities that cn be purchased at different prices for delivery at specific times and places, identical goods can be distinguished under different states of the world (ice cream on July 4, 2017 in Washington DC at 2pm only if the temperature is greater than 90 degrees). Given the complete set of state-contingent markets and the known probabilities of the contingent events, an equilibrium price vector for the complete set of markets would give rise to optimal trades reallocating the risks associated with future contingent events and to an optimal allocation of resources over time. Although the ADM model is an intertemporal model only in a limited sense, it does provide an ideal benchmark describing the characteristics of a set of mutually consistent optimal plans.

The seminal work of Roy Radner in relaxing some of the extreme assumptions of the ADM model puts Hayek’s contribution to the understanding of the necessary conditions for an intertemporal equilibrium into proper perspective. At an informal level, Hayek was addressing the same kinds of problems that Radner analyzed with far more powerful analytical tools than were available to Hayek. But the were both concerned with a common problem: under what conditions could an economy with an incomplete set of markets be said to be in a state of intertemporal equilibrium? In an economy lacking the full set of forward and state contingent markets describing the ADM model, intertemporal equilibrium cannot predetermined before trading even begins, but must, if such an equilibrium obtains, unfold through the passage of time. Outcomes might be expected, but they would not be predetermined in advance. Echoing Hayek, though to my knowledge he does not refer to Hayek in his work, Radner describes his intertemporal equilibrium under uncertainty as an equilibrium of plans, prices, and price expectations. Even if it exists, the Radner equilibrium is not the same as the ADM equilibrium, because without a full set of markets, agents can’t fully hedge against, or insure, all the risks to which they are exposed. The distinction between ex ante and ex post is not eliminated in the Radner equilibrium, though it is eliminated in the ADM equilibrium.

Additionally, because all trades in the ADM model have been executed before “time” begins, it seems impossible to rationalize holding any asset whose only use is to serve as a medium of exchange. In his early writings on business cycles, e.g., Monetary Theory and the Trade Cycle, Hayek questioned whether it would be possible to rationalize the holding of money in the context of a model of full equilibrium, suggesting that monetary exchange, by severing the link between aggregate supply and aggregate demand characteristic of a barter economy as described by Say’s Law, was the source of systematic deviations from the intertemporal equilibrium corresponding to the solution of a system of Walrasian equations. Hayek suggested that progress in analyzing economic fluctuations would be possible only if the Walrasian equilibrium method could be somehow be extended to accommodate the existence of money, uncertainty, and other characteristics of the real world while maintaining the analytical discipline imposed by the equilibrium method and the optimization principle. It proved to be a task requiring resources that were beyond those at Hayek’s, or probably anyone else’s, disposal at the time. But it would be wrong to fault Hayek for having had to insight to perceive and frame a problem that was beyond his capacity to solve. What he may be criticized for is mistakenly believing that he he had in fact grasped the general outlines of a solution when in fact he had only perceived some aspects of the solution and offering seriously inappropriate policy recommendations based on that seriously incomplete understanding.

In Value and Capital, Hicks also expressed doubts whether it would be possible to analyze the economic fluctuations characterizing the business cycle using a model of pure intertemporal equilibrium. He proposed an alternative approach for analyzing fluctuations which he called the method of temporary equilibrium. The essence of the temporary-equilibrium method is to analyze the behavior of an economy under the assumption that all markets for current delivery clear (in some not entirely clear sense of the term “clear”) while understanding that demand and supply in current markets depend not only on current prices but also upon expected future prices, and that the failure of current prices to equal what they had been expected to be is a potential cause for the plans that economic agents are trying to execute to be modified and possibly abandoned. In the Pure Theory of Capital, Hayek discussed Hicks’s temporary-equilibrium method a possible method of achieving the modification in the Walrasian method that he himself had proposed in Monetary Theory and the Trade Cycle. But after a brief critical discussion of the method, he dismissed it for reasons that remain obscure. Hayek’s rejection of the temporary-equilibrium method seems in retrospect to have been one of Hayek’s worst theoretical — or perhaps, meta-theoretical — blunders.

Decades later, C. J. Bliss developed the concept of temporary equilibrium to show that temporary equilibrium method can rationalize both holding an asset purely for its services as a medium of exchange and the existence of financial intermediaries (private banks) that supply financial assets held exclusively to serve as a medium of exchange. In such a temporary-equilibrium model with financial intermediaries, it seems possible to model not only the existence of private suppliers of a medium of exchange, but also the conditions – in a very general sense — under which the system of financial intermediaries breaks down. The key variable of course is vectors of expected prices subject to which the plans of individual households, business firms, and financial intermediaries are optimized. The critical point that emerges from Bliss’s analysis is that there are sets of expected prices, which if held by agents, are inconsistent with the existence of even a temporary equilibrium. Thus price flexibility in current market cannot, in principle, result in even a temporary equilibrium, because there is no price vector of current price in markets for present delivery that solves the temporary-equilibrium system. Even perfect price flexibility doesn’t lead to equilibrium if the equilibrium does not exist. And the equilibrium cannot exist if price expectations are in some sense “too far out of whack.”

Expected prices are thus, necessarily, equilibrating variables. But there is no economic mechanism that tends to cause the adjustment of expected prices so that they are consistent with the existence of even a temporary equilibrium, much less a full equilibrium.

Unfortunately, modern macroeconomics continues to neglect the temporary-equilibrium method; instead macroeconomists have for the most part insisted on the adoption of the rational-expectations hypothesis, a hypothesis that elevates question-begging to the status of a fundamental axiom of rationality. The crucial error in the rational-expectations hypothesis was to misunderstand the role of the comparative-statics method developed by Samuelson in The Foundations of Economic Analysis. The role of the comparative-statics method is to isolate the pure theoretical effect of a parameter change under a ceteris-paribus assumption. Such an effect could be derived only by comparing two equilibria under the assumption of a locally unique and stable equilibrium before and after the parameter change. But the method of comparative statics is completely inappropriate to most macroeconomic problems which are precisely concerned with the failure of the economy to achieve, or even to approximate, the unique and stable equilibrium state posited by the comparative-statics method.

Moreover, the original empirical application of the rational-expectations hypothesis by Muth was in the context of the behavior of a single market in which the market was dominated by well-informed specialists who could be presumed to have well-founded expectations of future prices conditional on a relatively stable economic environment. Under conditions of macroeconomic instability, there is good reason to doubt that the accumulated knowledge and experience of market participants would enable agents to form accurate expectations of the future course of prices even in those markets about which they expert knowledge. Insofar as the rational expectations hypothesis has any claim to empirical relevance it is only in the context of stable market situations that can be assumed to be already operating in the neighborhood of an equilibrium. For the kinds of problems that macroeconomists are really trying to answer that assumption is neither relevant nor appropriate.

What’s so Great about Science? or, How I Learned to Stop Worrying and Love Metaphysics

A couple of weeks ago, a lot people in a lot of places marched for science. What struck me about those marches is that there is almost nobody out there that is openly and explicitly campaigning against science. There are, of course, a few flat-earthers who, if one looks for them very diligently, can be found. But does anyone — including the flat-earthers themselves – think that they are serious? There are also Creationists who believe that the earth was created and designed by a Supreme Being – usually along the lines of the Biblical account in the Book of Genesis. But Creationists don’t reject science in general, they reject a particular scientific theory, because they believe it to be untrue, and try to defend their beliefs with a variety of arguments couched in scientific terms. I don’t defend Creationist arguments, but just because someone makes a bad scientific argument, it doesn’t mean that the person making the argument is an opponent of science. To be sure, the reason that Creationists make bad arguments is that they hold a set of beliefs about how the world came to exist that aren’t based on science but on some religious or ideological belief system. But people come up with arguments all the time to justify beliefs for which they have no evidentiary or “scientific” basis.

I mean one of the two greatest scientists that ever lived criticized quantum mechanics, because he couldn’t accept that the world was not fully determined by the laws of nature, or, as he put it so pithily: “God does not play dice with the universe.” I understand that Einstein was not religious, and wasn’t making a religious argument, but he was basing his scientific view of what an acceptable theory should be on certain metaphysical predispositions that he held, and he was expressing his disinclination to accept a theory inconsistent with those predispositions. A scientific argument is judged on its merits, not on the motivations for advancing the argument. And I won’t even discuss the voluminous writings of the other one of the two greatest scientists who ever lived on alchemy and other occult topics.

Similarly, there are climate-change deniers who question the scientific basis for asserting that temperatures have been rising around the world, and that the increase in temperatures results from human activity that discharges greenhouse gasses into the atmosphere. Deniers of global warming may be biased and may be making bad scientific arguments, but the mere fact – and for purposes of this discussion I don’t dispute that it is a fact – that global warming is real and caused by human activity does not mean that to dispute those facts unmasks that person as an opponent of science. R. A. Fisher, the greatest mathematical statistician of the first half of the twentieth century, who developed most of the statistical techniques now used in experimental research, severely damaged his reputation by rejecting or dismissing evidence that smoking tobacco is a primary cause of cancer. Some critics accused Fisher of having been compromised by financial inducements from the tobacco industry, while others attribute his positions to his own smoking habits or anti-puritanical tendencies. In any event, Fisher’s arguments against a causal link between smoking tobacco and lung cancer are now viewed as an embarrassing stain on an otherwise illustrious career. But Fisher’s lapse of judgment, and perhaps of ethics, don’t justify accusing him of opposition to science. Climate-change deniers don’t reject science; they reject or disagree with the conclusions of most climate scientists. They may have lousy reasons for their views – either that the climate is not changing or that whatever change has occurred is unrelated to the human production of greenhouse gasses – but holding wrong or biased views doesn’t make someone an opponent of science.

I don’t say that there are no people who dislike science – I mean don’t like it because of what it stands for, not because they find it difficult or boring. Such people may be opposed to teaching science and to funding scientific research and don’t want scientific knowledge to influence public policy or the way people live. But, as far as I can tell, they have little influence. There is just no one out there that wants to outlaw scientific research, or trying to criminalize the teaching of science. They may not want to fund science, but they aren’t trying to ban it. In fact, I doubt that the prestige and authority of science has ever been higher than it is now. Certainly religion, especially organized religion, to which science was once subordinate if not subservient, no longer exercises anything near the authority that science now does.

The reason for this extended introduction into the topic that I really want to discuss is to provide some context for my belief that economists worry too much about whether economics is really a science. It was such a validation for economists when the Swedish Central Bank piggy-backed on the storied Nobel Prize to create its ersatz “Nobel Memorial Prize” for economic science. (I note with regret the recent passing of William Baumol, whose failure to receive the Nobel Prize in economics, like that of Armen Alchian, was in fact a deplorable failure of good judgment on the part of the Nobel Committee.) And the self-consciousness of economists about the possibly dubious status of economics as a science is a reflection of the exalted status of science in society. So naturally, if one is seeking to increase the prestige of his own occupation and of the intellectual discipline in which one does research, it helps enormously to be able to say: “oh, yes, I am an economist, and economics is a science, which means that I really am a scientist, just like those guys that win Nobel Prizes.” It also helps to be able to show that your scientific research involves a lot of mathematics, because scientists use math in their theories, sometimes a lot of math, which makes it hard for non-scientists to understand what scientists are doing. We economists also use math in our theories, sometimes a lot math, and that’s why it’s just as hard for non-economists to understand what we economists are doing as it is to understand what real scientists are doing. So we really are scientists, aren’t we?”

Where did this obsession with science come from? I think it’s fairly recent, but my sketchy knowledge of the history of science prevents me from getting too deeply into that discussion. But until relatively modern times, science was subsumed under the heading of philosophy — Greek for the love of wisdom. But philosophy is a very broad subject, so eventually that part of philosophy that was concerned with the world as it actually exists was called natural philosophy as opposed to say, ethical and moral philosophy. After the stunning achievements of Newton and his successors, and after Francis Bacon outlined an inductive method for achieving knowledge of the world, the disjunction between mere speculative thought and empirically based research, which was what science supposedly exemplifies, became increasingly sharp. And the inductive method seemed to be the right way to do science.

David Hume and Immanuel Kant struggled with limited success to make sense of induction, because a general proposition cannot be logically deduced from a set of observations, however numerous. Despite the logical problem of induction, early in the early twentieth century a philosophical movement based in Vienna called logical positivism arrived at the conclusion that not only is all scientific knowledge acquired inductively through sensory experience and observation, but no meaning can be attached to any statement unless the statement makes reference to something about which we have or could have sensory experience; to be meaningful a statement must be verified or at least verifiable, so that its truth could be either verified or refuted. Any reference to concepts that have no basis in sensory experience is simply meaningless, i.e., a form of nonsense. Thus, science became not just the epitome of valid, certain, reliable, verified knowledge, which is what people were led to believe by the stunning success of Newton’s theory, it became the exemplar of meaningful discourse. Unless our statements refer to some observable, verifiable object, we are talking nonsense. And in the first half of the twentieth century, logical positivism dominated academic philosophy, at least in the English speaking world, thereby exercising great influence over how economists thought about their own discipline and its scientific status.

Logical positivism was subjected to rigorous criticism by Karl Popper in his early work Logik der Forschung (English translation The Logic of Scientific Discovery). His central point was that scientific theories are less about what is or has been observed, but about what cannot be observed. The empirical content of a scientific proposition consists in the range of observations that the theory says are not possible. The more observations excluded by the theory the greater its empirical content. A theory that is consistent with any observation, has no empirical content. Thus, paradoxically, scientific theories, under the logical positivist doctrine, would have to be considered nonsensical, because they tell us what can’t be observed. And because it is always possible that an excluded observation – the black swan – which our scientific theory tells us can’t be observed, will be observed, scientific theories can never be definitively verified. If a scientific theory can’t verified, then according to the positivists’ own criterion, the theory is nonsense. Of course, this just shows that the positivist criterion of meaning was nonsensical, because obviously scientific theories are completely meaningful despite being unverifiable.

Popper therefore concluded that verification or verifiability can’t be a criterion of meaning. In its place he proposed the criterion of falsification (i.e., refutation, not misrepresentation), but falsification became a criterion not for distinguishing between what is meaningful and what is meaningless, but between science and metaphysics. There is no reason why metaphysical statements (statements lacking empirical content) cannot be perfectly meaningful; they just aren’t scientific. Popper was misinterpreted by many to have simply substituted falsifiability for verifiability as a criterion of meaning; that was a mistaken interpretation, which Popper explicitly rejected.

So, in using the term “meaningful theorems” to refer to potentially refutable propositions that can be derived from economic theory using the method of comparative statics, Paul Samuelson in his Foundations of Economic Analysis adopted the interpretation of Popper’s demarcation criterion between science and metaphysics as if it were a demarcation criterion between meaning and nonsense. I conjecture that Samuelson’s unfortunate lapse into the discredited verbal usage of logical positivism may have reinforced the unhealthy inclination of economists to feel the need to prove their scientific credentials in order to even engage in meaningful discourse.

While Popper certainly performed a valuable service in clearing up the positivist confusion about meaning, he adopted a very prescriptive methodology aimed at making scientific practice more scientific in the sense of exposing theories to, rather than immunizing them against, attempts at refutation, because, according to Popper, it is only if after our theories survive powerful attempts to show that they are false that we can have confidence that those theories may be truthful or at least come close to being truthful. In principle, Popper was not wrong in encouraging scientists to formulate theories that are empirically testable by specifying what kinds of observations would be inconsistent with their theories. But in practice, that advice has been difficult to follow, and not only because researchers try to avoid subjecting their pet theories to tests that might prove them wrong.

Although Popper often cited historical examples to support his view that science progresses through an ongoing process of theoretical conjecture and empirical refutation, historians of science have had no trouble finding instances in which scientists did not follow Popper’s methodological rules and continued to maintain theories even after they had been refuted by evidence or after other theories had been shown to generate more accurate predictions than their own theories. Popper parried this objection by saying that his methodological rules were not positive (i.e., descriptive of science), but normative (i.e., prescriptive of how to do good science). In other words, Popper’s scientific methodology was itself not empirically refutable and scientific, but empirically irrefutable and metaphysical. I point out the unscientific character of Popper’s methodology of science, not to criticize Popper, but to point out that Popper himself did not believe that science is itself the final authority and ultimate arbiter of scientific practice.

But the more important lesson from the critical discussions of Popper’s methodological rules seems to me to be that they are too rigid to accommodate all the considerations that are relevant to assessing scientific theories and deciding whether those theories should be discarded or, at least tentatively, maintained. And Popper’s methodological rules are especially ill-suited for economics and other disciplines in which the empirical implications of theories depend on a large number of jointly-maintained hypotheses, so that it is hard to identify which of several maintained hypotheses is responsible for the failure of a predicted outcome to match the observed outcome. That of course is the well-known ceteris paribus problem, and it requires a very capable practitioner to know when to apply the ceteris paribus condition and which variables to hold constants and which to allow to vary. Popper’s methodological rules tell us to reject a theory when its predictions are mistaken, and Popper regarded the ceteris paribus quite skeptically as an illegitimate immunizing stratagem. That describes a profound dilemma for economics. On the one hand, it is hard to imagine how economic theory could be applied without using the ceteris paribus qualification, on the other hand, the qualification diminishes empirical content of economic theory.

Empirical problems are amplified by the infirmities of the data that economists typically use to derive quantitative predictions from their models. The accuracy of the data is often questionable, and the relationships between the data and the theoretical concepts they are supposed to measure are often dubious. Moreover, the assumptions about the data-generating process (e.g., independent and identically distributed random variables, randomly selected observations, omitted explanatory variables are uncorrelated with the dependent variable) necessary for the classical statistical techniques to generate unbiased estimates of the theoretical coefficients are almost impossibly stringent. Econometricians are certainly well aware of these issues, and they have discovered methods of mitigating them, but the problems with the data routinely used by economists and the complicated issues involved in developing and applying techniques to cope with those problems make it very difficult to use statistical techniques to reach definitive conclusions about empirical questions.

Jeff Biddle, one of the leading contemporary historians of economics, has a wonderful paper (“Statistical Inference in Economics 1920-1965: Changes in Meaning and Practice”)– his 2016 presidential address to the History of Economics Society – discussing how the modern statistical techniques based on concepts and methods derived from probability theory gradually became the standard empirical and statistical techniques used by economists, even though many distinguished earlier researchers who were neither unaware of, nor unschooled in, the newer techniques believed them to be inappropriate for analyzing economic data. Here is the abstract of Biddle’s paper.

This paper reviews changes over time in the meaning that economists in the US attributed to the phrase “statistical inference”, as well as changes in how inference was conducted. Prior to WWII, leading statistical economists rejected probability theory as a source of measures and procedures to be used in statistical inference. Haavelmo and the econometricians associated with the early Cowles Commission developed an approach to statistical inference based on concepts and measures derived from probability theory, but the arguments they offered in defense of this approach were not always responsive to the concerns of earlier empirical economists that the data available to economists did not satisfy the assumptions required for such an approach. Despite this, after a period of about 25 years, a consensus developed that methods of inference derived from probability theory were an almost essential part of empirical research in economics. I close the paper with some speculation on possible reasons for this transformation in thinking about statistical inference.

I quote one passage from Biddle’s paper:

As I have noted, the leading statistical economists of the 1920s and 1930s were also unwilling to assume that any sample they might have was representative of the universe they cared about. This was particularly true of time series, and Haavelmo’s proposal to think of time series as a random selection of the output of a stable mechanism did not really address one of their concerns – that the structure of the “mechanism” could not be expected to remain stable for long periods of time. As Schultz pithily put it, “‘the universe’ of our time series does not ‘stay put’” (Schultz 1938, p. 215). Working commented that there was nothing in the theory of sampling that warranted our saying that “the conditions of covariance obtaining in the sample (would) hold true at any time in the future” (Advisory Committee 1928, p. 275). As I have already noted, Persons went further, arguing that treating a time series as a sample from which a future observation would be a random draw was not only inaccurate but ignored useful information about unusual circumstances surrounding various observations in the series, and the unusual circumstances likely to surround the future observations about which one wished to draw conclusions (Persons 1924, p. 7). And, the belief that samples were unlikely to be representative of the universe in which the economists had an interest applied to cross section data as well. The Cowles econometricians offered to little assuage these concerns except the hope that it would be possible to specify the equations describing the systematic part of the mechanism of interest in a way that captured the impact of factors that made for structural change in the case of time series, or factors that led cross section samples to be systematically different from the universe of interest.

It is not my purpose to argue that the economists who rejected the classical theory of inference had better arguments than the Cowles econometricians, or had a better approach to analyzing economic data given the nature of those data, the analytical tools available, and the potential for further development of those tools. I only wish to offer this account of the differences between the Cowles econometricians and the previously dominant professional opinion on appropriate methods of statistical inference as an example of a phenomenon that is not uncommon in the history of economics. Revolutions in economics, or “turns”, to use a currently more popular term, typically involve new concepts and analytical methods. But they also often involve a willingness to employ assumptions considered by most economists at the time to be too unrealistic, a willingness that arises because the assumptions allow progress to be made with the new concepts and methods. Obviously, in the decades after Haavelmo’s essay on the probability approach, there was a significant change in the list of assumptions about economic data that empirical economists were routinely willing to make in order to facilitate empirical research.

Let me now quote from a recent book (To Explain the World) by Steven Weinberg, perhaps – even though a movie about his life has not (yet) been made — the greatest living physicist:

Newton’s theory of gravitation made successful predictions for simple phenomena like planetary motion, but it could not give a quantitative account of more complicated phenomena, like the tides. We are in a similar position today with regard to the strong forces that hold quarks together inside the protons and neutrons inside the atomic nucleus, a theory known as quantum chromodynamics. This theory has been successful in accounting for certain processes at high energy, such as the production of various strongly interacting particles in the annihilation of energetic electrons and their antiparticles, and its successes convince us that the theory is correct. We cannot use the theory to calculate precise values for other things that we would like to explain, like the masses of the proton and neutron, because the calculations is too complicated. Here, as for Newton’s theory of the tides, the proper attitude is patience. Physical theories are validated when they give us the ability to calculate enough things that are sufficiently simple to allow reliable calculations, even if we can’t calculate everything that we might want to calculate.

So Weinberg is very much aware of the limits that even physics faces in making accurate predictions. Only a small subset (relative to the universe of physical phenomena) of simple effects can be calculated, but the capacity of physics to make very accurate predictions of simple phenomena gives us a measure of confidence that the theory would be reliable in making more complicated predictions if only we had the computing capacity to make those more complicated predictions. But in economics the set of simple predictions that can be accurately made is almost nil, because economics is inherently a theory a complex social phenomena, and simplifying the real world problems to which we apply the theory to allow testable predictions to be made is extremely difficult and hardly ever possible. Experimental economists try to create conditions in which this can be done in controlled settings, but whether these experimental results have much relevance for real-world applications is open to question.

The problematic relationship between economic theory and empirical evidence is deeply rooted in the nature of economic theory and the very complex nature of the phenomena that economic theory seek to explain. It is very difficult to isolate simple real-world events in which economic theories can be put to decisive empirical tests that allow us to put competing theories to decisive tests based on unambiguous observations that are either consistent with or contrary to the predictions generated by those theories. Under those circumstances, if we apply the Popperian criterion for demarcation between science and metaphysics to economics, it is not at all clear to me whether economics is more on the science side of the line than on the metaphysics side.

Certainly, there are refutable implications of economic theory that can be deduced, but these implications are often subject to qualification, so the refutable implications are often refutable only n principle, but not in practice. Many fastidious economic methodologists, notably Mark Blaug, voiced unhappiness about this state of affairs and blamed economists for not being more ruthless in applying Popperian test of empirical refutation to their theories. Surely Blaug had a point, but the infrequency of empirical refutation of theories in economics is, I think, less attributable to bad methodological practice on the part of economists than to the nature of the theories that economists work with and the inherent ambiguities of the empirical evidence with which those theories can be tested. We might as well just face up to the fact that, to a large extent, empirical evidence is simply not clear cut enough to force us to discard well-entrenched economic theories, because well-entrenched economic theories can be adjusted and reformulated in response to apparently contrary evidence in ways that allow those theories to live on to fight another day, theories typically having enough moving parts to allow them to be adjusted as needed to accommodate anomalous or inconvenient empirical evidence.

Popper’s somewhat disloyal disciple, Imre Lakatos, talked about scientific theories in the context of scientific research programs, a research program being an amalgam of related theories which share a common inner core of theoretical principles or axioms which are not subject to refutation. Lakatos called these deep axiomatic core of principles the hard core of the research program. The hard core defines the program so it is fundamentally fixed and not open to refutation. The empirical content of the research program is provided by a protective belt of specific theories that are subject to refutation and, when refuted, can be replaced as needed with alternative theories that are consistent with both the theoretical hard core and the empirical evidence. What determines the success of a scientific research program is whether it is progressive or degenerating. A progressive research program accumulates an increasingly dense, but evolving, protective belt of theories in response to new theoretical and empirical problems or puzzles that are generated within the research program to keep researchers busy and to attract into the program new researchers seeking problems to solve. In contrast, a degenerating research program is unable to find enough interesting new problems or puzzles to keep researchers busy much less attract new ones.

Despite its Popperian origins, the largely sociological Lakatosian account of how science evolves and progresses was hardly congenial to Popper’s sensibilities, because the success of a research program is not strictly determined by the process of conjecture and refutation envisioned by Popper. But the important point for me is that a Lakatosian research program can be progressive even if it is metaphysical and not scientific. What matters is that it offer opportunities for researchers to find and to solve or even just to talk about solving new problems, thereby attracting new researchers into the program.

It does appear that economics has for at least two centuries been a progressive research program. But it is not clear that is a really scientific research program, because the nature of economic theory is so flexible that it can be adapted as needed to explain almost any set of observations. Almost any observation can be set up and solved in terms of some sort of constrained optimization problem. What the task requires is sufficient ingenuity on the part of the theorist to formulate the problem in such a way that the desired outcome can be derived as the solution of a constrained optimization problem. The hard core of the research program is therefore never at risk, and the protective belt can always be modified as needed to generate the sort of solution that is compatible with the theoretical hard core. The scope for true refutation has thus been effectively narrowed to eliminate any real scope for refutation, leaving us with a progressive metaphysical research program.

I am not denying that it would be preferable if economics could be a truly scientific research program, but it is not clear to me how much can be done about it. The complexity of the phenomena, the multiplicity of the hypotheses required to explain the data, and the ambiguous and not fully reliable nature of most of the data that economists have available devilishly conspire to render Popperian falsificationism an illusory ideal in economics. That is not an excuse for cynicism, just a warning against unrealistic expectations about what economics can accomplish. And the last thing that I am suggesting is that we stop paying attention to the data that we have or stop trying to improve the quality of the data that we have to work with.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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