Its not just Real Business Cycle Models that live in an Unreal World without Businesses

Noah Opinion has a good piece on RBC models , but his target is way too narrow:

 RBC is a glaring example of what I call “Label-the-Residual Economics”, in which the economist assumes that the part of the world that we can’t measure is the Mysterious Force that drives everything, but that we can accurately predict the future behavior of this Mysterious Force.

Now, some work has been done on improving RBC models since their inception – instead of technology, for example, some modelers try to tie business cycles to news about technology. But most of the macro profession has moved on to other types of DSGE models, especially new Keynesian models.

However many of the criticisms apply to the whole class of Arrow-Debreu models and some criticisms to the RBC class of its children – including DGSe and NK. The more fundamental criticism should be to the whole wider class otherwise the ‘we are New Keynesian and we are different’ defence of Mark Thoma can be made.

For example the core assumptions of all A-D models is that ‘firms’ make no profits under constant returns- and that core mathematical assumption is shared by New Keynsian & DGSE models despite attempts to massage it through ex-poste adjustments. David Ellermen demonstrates that this ‘ is a basic modelling flaw (as perhaps Penrose did half a century ago)   Again the core mathematical assumption of all A-D derived models is money neutrality – indeed money, debt and assets which are security against debt are not part of the A-D core.

I and many others argue its the all A-D models that must go

From feedback on that paper two issues have emerged – firstly some of the assumptions that all of neoclassical economics makes about the necessary conditions for equilibrium have been proven wrong.

A good example is the assumption of homogeneity – The spatial impossibility theory shows that in such a world there is no trade – you have to abandon the assumption of spatial homegenity to get trade.

From this modification follows that the neoclassical assumptions of constant returns to scale is flawed, in the real world we see increasing returns without state subsidy. Berliant and Ten Raa have proven that increasing returns is compatible with positive profits if you modify the Alonso land rent model to include production.

The second issue is that living in such a such a real spatial world only gives you fragile islands of partial and temporary equilibrium. I have found no convincing mathematical proof of proof of General Equilibrium in such a realistically modelled world where because of radical homeganiety and constant shifting of people non convexities will be occurring all the time everwhere . All temporary equilibrium does is send information signals to entrepreneurs that there is money to be made and equilibrium points to shift – from their  inevitably often  poor entrepreneurial decisions under uncertainty;  (which is the Hotelling argument generalised) and that shatters the convexity assumption of A-D. You can only get GE in such a world with the deux ex dachina Lucas assumption of ‘rational expectations’ which requires requires perfect foresight and psychic ability of every human being of every other human being till the end of time (and I would argue not even then as who would psycic agents modify their behaviour if they knew everyone elses thoughts). As Buiter writes this Auctioneer at the End of Time assumption is a model of a centrally (god) planned economy not a market one.

We need economics not religion.

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3 thoughts on “Its not just Real Business Cycle Models that live in an Unreal World without Businesses

    • I reckon that the fantasy involved in the EMH is more elementary though. The Godhead is actually the economist themselves. It is they that have been allowed access to the Sacred Knowledge of future price dynamics. They have derived it, like good Platonists, from their practice of the Divine Mathematics.

      But shouldn’t this mean that they can tell everyone what to do? Shouldn’t this mean that they should open up some sort of Gosplan? That’s a bit of a sticky point, alright. But it can be done away with by assuming that everyone — or, at least, people in the aggregate — have access to some sort of Divine Spark that allows them to intuitively perceive the Great Truth that the economists have uncovered on their blackboards. How tidy!

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