Good bad theories

In 1945 George Orwell wrote an essay on good bad books – “the kind of book that has no literary pretensions but which remains readable when more serious productions have perished.” He gave as examples the Sherlock Holmes stories. Uncle Tom’s Cabin and Dracula. These are in contrast to bad good books, works of alleged literary merit which aren’t much cop: Orwell cited George Meredith but you can add other examples. We might add to this that there are good good books (Dostoyevsky) and bad bad ones (Dan Brown?)

I suspect that the same distinctions apply to economic theories.

A good bad theory is one that lacks solid microfoundations but which works (roughly) in an ad hoc way. This might be true of the better type of structural economic model and of those lead indicators which predict but don’t explain, such as the tendency for inverted yield curves to predict recessions.

A bad good theory is one that doesn’t necessarily have predictive power but whose failure actually helps to illuminate the real world, often by alerting us to the fact that particular assumptions behind the theory do not in fact hold. In this category I’d put the Miller-Modigliani theorem, the Coase theorem (hat tip Derida derider), the Mehra and Prescott equity premium puzzle (pdf) and the CAPM (pdf).  

Then we have good good theories – ones that work in practice as well as theory. The bog-standard supply and demand framework, transactions cost economics and theories of irreversible investment are all in this set, among others.

Bringing up the rear we have bad bad theories – ones that are wrong in practice but which, unlike bad good theories don’t much help us understand why. Marginal productivity theory (at least for higher-paid workers) belongs in this category. So too does the money multiplier, the LM (pdf) curve, and at least the simpler DSGE models (pdf).

Of course, you might disagree with my examples. And I’ve certainly left a lot out here. Where does Hecksher-Ohlin-Samuelson international trade theory fit? Or representative agent models (bad bad or bad good, I suspect) Or Marx’s tendency for the rate of profit to fall? Or emergence? Etc, etc, etc.

Even so, I suspect this schema might be more illuminating than the standard mainstream vs heterodox one. Debates about this too often consist of: “the mainstream’s rubbish”: “you’re attacking a straw man”: “no he isn’t.” Can we move on?

Comments

[Calgacus]

In general, good ideas and sentiments. But the way they are expressed ....

"A good bad theory is one that lacks solid microfoundations but which works (roughly) in an ad hoc way.":
The implicit idea in this - that micro "founds" macro, that micro(foundations) are clear and well understood and unproblematic and solid and truer and more fundamental, less ad hoc than macro . . . is a bad, bad theory.

[Cacrisalves]

"We might add to this that there are good good books (Dostoyevsky) and bad bad ones (Dan Brown?)"...yes, we can!

[Ralph Musgrave]

Re Modigliani Miller, I'm almost certain that Anat Admati said in one of her works that Google was 90% funded by equity, which she said, indicated that high capital ratios did not add to the costs of funding a corporation - bank or non-bank.

Anyone know of some sort of chart which shows the capital ratio of US or UK corporations? That might confirm or disprove my point.

[Cacrisalves]

Can't Marx’s tendency for the rate of profit to fall be a bad good good theory? It works in theory and sometimes in practice; it has a solid microfoundations and predicts a tendency, but the explanation is not clear; and, finally, its failure helps to illuminate the real world by alerting us to the fact that we still don’t know how value is created and how it can be measured; by showing us the neither LTV nor marginal utility value is correct; and by posing us the question: what would happen if technology manages to lead marginal costs close to zero?

[Marteen]

"bog-standard supply and demand"

What does "bog" stand for?

[Chris Auld]

I'd offer Malthus' as the best bad good theory.

[Blissex]

«I’d put the Miller-Modigliani theorem, the Coase theorem (hat tip Derida derider), the Mehra and Prescott equity premium puzzle (pdf) and the CAPM (pdf).»

I blame myself for not having had time yet to objec to "derrida derider"'s comment...

There is unfortunately the "Theorem of Second Best".

More explicitly: Economics theorems that apply 100% when assumptions are 100% valid don't necessarily apply 90% when they are 90% validar , they might apply not at all, or whatever.

That is, the when the assumptions are not valid, the only thing we can say that the theorem is not necessarily valid; it does not mean that one can achieve 10% of the result when the assumptions are mostly false, or 90% when they are mostly true.

So if the Modigliani-Miller (or Coase or "comparative advantage") are violated we know only that the funding structure of the firm does matter, but maybe it matters very little, or maybe it matters a lot, the theorem does not tell us anything.

Most "theorems" of Ecoonomics are uselessly moronic like that: they have amazingly narrow assumptions that deliver amazingly narrow qualitative "results", They don't as a rule give quantitative laws, like "for every doubling of the quantity of catalyst the reactions is 50% faster" or "for every doubling of the distance the force is four times weaker".

And this is *by design*: Economists find the cheapest way to get a paper published is not a general law that applies, even if approximately, to something interesting like quantities, oh no! The cheapest way to get a paper published is to define in weasel words a politically acceptable or desirable cool-sounding statement, and then look for a while for assumptions that are substantially equivalent or obviously imply that statement, so that a proof follows without much effort.
A very large part of macro is like that, and a lot of theoretical micro, as many if not most Economics are aware, and dare not confess too openly.

[Blissex]

«They don't as a rule give quantitative laws»

Actually not just that: as the "Theorem of the Second Best" says, they are very fragile to their assumptions, they cannot be used approximately.

Which is amazingly surprisingly, because actual political economies are surprisingly stable, surprisingly resilient, with long term quantitative relationships that oscillate around pretty stable values.
Sure the oscillations are very painful or unlucky to those to those mostly impacted, but they are still small: a recession does not mean that GDP reduces to 1/10th, or even half. There is a lot of ballast in political economies, for example as JM Keynes said to general indifference, most capital is long lived.
Given that, theories that give quantitatively approximate relationships should be easy (some have tried), but Economists want "internal consistency" (with JB Clarks's 3 "fables").

[Blissex]

«So if the Modigliani-Miller (or Coase or "comparative advantage") are violated we know only that the funding structure of the firm does matter»

Oops, not even that: if any of the assumptions of Modigliani-Miller is violated by any mount, we know only that the funding structure of the firm *may* matter, but maybe not at all.

Because there may be another set of assumption under which the funding structure does not matter, and perhaps Modigliani-Miller just grabbed the first one that they found.

[Lidl Janus]

As an utter non-economist, I've heard the gravity model of trade being cited as a good bad theory.

@ Marteen: it's mostly referring to the supply/demand models from when Ireland's currency was tied to the value of peat; not relevant now they've got the Euro.

[Blissex]

«Malthus' as the best bad good theory.»

That was not quite his theory, it was copied from earlier authors, among them the venetian early political economist G Ortes.

And it was not a "bad" theory: what happened is simply that extraordinarily fertile new lands (the deserts of Texas and Arabia) were discovered after Ortes and Malthus which enormously raised, as long as they stay fertile, the production of calories of the world, lifting considerably the "malthusian" ceiling.

[Ralph Musgrave]

The assumptions that Modigliani Miller makes are very reasonable and common sense ones. In contrast, the alleged defects in those assumptions are mainly an exercise in nit picking. I’ve set out reasons on p.24 onwards here:

https://www.yumpu.com/en/document/view/57025889/fulresbk179senttocrspto