Ideology in economics

Much as I admire both protagaonists, the debate between Simon and Jo on the role of ideology in economics left me cold. I’m not interested in whether economics is mainstream or heterodox.

To see my point, let’s take an example from outside macro – the capital asset pricing model. This is an elegant, internally consistent and well micro-founded theory.

And it’s wrong. In particular, we’ve known since the first tests of it that low-risk stocks do better than they should. This is weird: theory tells us there should be a trade-off between risk and return, but the facts tell us otherwise.

Herein, for me, lies the essence of economics – the collision between theories and facts.

There’s a parallel here between the CAPM and (some?) RBC models. Both are theoretically elegant. And both fail to survive contact with the real world. Just as the great performance of defensives undermines the CAPM, so the existence of involuntary unemployment rejects RBC theories: the unemployed are significantly less happy than those in work – and in fact unhappier than the divorced or disabled.

But why is the CAPM wrong? There are some nice theories (pdf). But I want to draw your attention to a recent paper by Michael Ungehauer and Martin Weber at the University of Mannheim which I think is a model of good economics.

They show that a key assumption of the CAPM is wrong. The CAPM assumes that investors measure market risk by beta, the covariance of a stock with the market. But Ungehauer and Weber show that people don’t measure risk this way. Instead, they assess correlations by using a simple counting heuristic: how often does a stock co-move with the market? This leads to different measures of risk, because it underweights the importance of large price moves.

They established this first by experiments. Then they applied their theory to US data. And they found that if stocks’ riskiness is measured by the frequency of co-movement with the market, there is indeed a trade-off between risk and return. It’s just that, contrary to the CAPM, risk isn’t measured by beta.

In this sense, there’s another analogy between the CAPM and RBC theory. The CAPM says that agents’ view of risk is determined by beta; RBC theory says their view of the future is determined by rational expectations. For me, both claims must be tested against the facts.

I appreciate that I might just be expressing a personal taste here, but I don’t give a toss whether a theory is elegant or not, or mainstream or not. For me, what matters is: does it fit the facts? And: does it work? My response to elegant theories is often like that of Andrew Tyrie to Boris Johnson: “This is all very interesting, Boris. Except none of it is really true, is it?”

Now, you might find this surprising. We Marxists are supposed to be spittle-flecked ideologues, and yet here I am demanding facts and utility.

But of course, there’s no paradox at all. As a Marxist, I have no skin in the game of whether the CAPM or efficient theory is right or not: such matters are orthogonal to my concerns qua Marxist. And in fact even if Robert Lucas’s main points were right – that business cycles are an optimum response to technology shocks with little welfare cost – a lot of Marxism would survive. Such claims are consistent with the notion that capitalism is exploitative and alienating and leads to unacceptable inequalities of wealth and power.

It’s sometimes said that Marxism brings ideology into economics. For me, though, it takes it out.

Comments

[DP Down South]

Off topic: Could you please give your take on Modern Monitory Theory as espoused (in varying degrees) by Steve Keen, Warren Mosler, Bill Mitchell and Randall Wray (amongst others).

As a non-economist, it's something I find interesting, but am, for obvious reasons, unsure of.

[Carol]

Economics is operating in a capitalistic (hence ideological) paradigm. Models are used to prove the paradigm fits the facts. Due to physics envy and the pseudo-scientific reductionistic paradigm, we also end up with bad models that don't fit the facts very well because we reduce actors to "forces". Of course this is ideological too.

Vicious cycles

[Dave Hansell]

Spot on Carol. At one level they end up knowing more and more about less and less until they know everything about nothing and at another level they make it up as they go along by assuming what they aim to deduce.

On the issue of physics envy there was a very interesting paper published a few years back by a chap named Rothchild (don't know if he was from any branch of that particular well known family or otherwise) which used a number of basic physics equations, substituting economic for physical variables, to demonstrate that fractional reserve banking was parasitic.

[Luis Enrique]

"so the existence of involuntary unemployment rejects RBC theories:"

I think this is wrong! if you omit something from your model by construction, because it is not central to what you are concerned with, the fact that the thing you omitted exists is reality does not mean your model is wrong. Separate question: are you concerned with the right thing.

To convince yourself of this, take any model that you thinks is right, and write down a list of all the things that exist in reality, and which are important in their own right, but which are omitted from the model.

I am probably not best placed to try to explain RBC, not being very sympathetic, but I guess a proponent might say, OK involuntary unemployment exists, but are not going to try to explain that. Rather, we think that business cycles are best explained by something happening which effects the efficiency with which goods and services are produced, and that (alongside the existence of involuntary unemployment we are ignoring) there is a rational reduction in output (and labour supply) and that trying to "correct" that with demand management is an error. Or something like that.

IMO there are lots of ways of critiquing that story, the best known is probably what we ought to see happening to wages if that theory was true. And I also think that it omits far too much that is important, and overall RBC theory is dismal. But I also think the idea that recessions are *sometimes* caused by what might be thought of as shocks to the production technology is not entirely bonkers.

This, though, gets at something Simon WL wrote, about how abstracting away from something is not to deny it, which is that if you abstract away from something and then somehow kid yourself that thing does not exist or is not important, you make whopping errors, such as those dumb papers which use RBC models to try to analyse the welfare costs of recessions (whilst excluding almost everything that matters from a welfare perspective).

[Luis Enrique]

hmm, having written that I am not wondering if RBC believers also believe that involuntary employment does not exist

[Luis Enrique]

now. not not.

[Luis Enrique]

I now wish I could delete the above, which I think is based on a misreading of your word "reject"

I agree that existence of large scale involuntary unemployment in recessions rejects - in the sense of meaning the RBC model is not useful - even if it does not reject RBC in the sense of proving that recessions are not driven by real shocks (and that some reduction in output is optimal).

[Kaleberg]

As a Marxist, you remind me of JBS Haldane, the biologist. He found that Marxism helped him think more clearly.