Theory schmeory

Paul Krugman had a post at the beginning of August riffing on a Noah Smith's reflection on the death of theory in economics. While he says that "death" is an exaggeration, he does see "a measurable decline in the number of papers that offer theoretical innovations as opposed to empirical analysis".

Krugman may well be right, but that would be a shame, because there are some basic economic issues which I think "received theory" hasn't yet really worked out. The two I'm most aware of are:

• the relation between environmental issues and the macroeconomy;
• money.

Regarding the second of those, there's the whole school of "endogenous money," parts of which make a lot more sense to me than what gets passed off in textbooks as "settled theory." The University of Missouri at Kansas City is a center of one particular strain of endogenous money, that calls itself "modern monetary theory." Krugman has traded posts with Randy Wray (the author of the primer at the previous link), and they don't see eye to eye, but there are interesting theoretical investigations going on.

And there are at least a handful of people investigating the macroeconomy-environment link. The ecologist Howard Odum made some thought-provoking inroads into economics in Environment, Power, and Society. His student Charlie Hall, along with some colleagues, advanced Odum's work a ways with Energy and Resource Quality: The ecology of the economic process. Herman Daly came at the question from a more conventional background and collaborated with Josh Farley. I've dabbled in the area as well.

 

But I gather Krugman finds this whole line of investigation unfruitful. It was his own textbook that states concisely on one page why resources don't matter in macro, and thus served me as a foil.

 

These holes in theory make a real difference. For instance, just yesterday Brad DeLong was expressing his bafflement at why the Fed is making noises about tightening up monetary policy. His quite reasonable argument is summed up in this diagram:

 

Potential GDP is an estimate of what the economy "should" be doing. Real GDP is our best measure of what it is doing. Our growth rate in real GDP since the bottom of the recession in 2009 has been reasonable--unspectacular, but roughly keeping up with the growth of potential GDP. But normally after a recession there's a period of really fast growth, which brings you back up to potential GDP, and we clearly haven't had that.

DeLong's point is that, with the economy still about 5% below what it "should" be doing, the Fed shouldn't even be whispering about reducing the support it's been providing to the economy. And from a conventional point of view I'd have to agree.

But what happens when you bring environmental considerations into view? One reasonable line of argument starts from the observation that oil prices are at historically very high levels, even though they're lower than the incredible spike from July, 2008. The second strand of the argument is that high oil prices tend to dampen economic growth. The third piece then observes that U.S. oil use (western oil use in general) has plateaued since 2008, while China and India have continued increasing their consumption; if stimulative policies were successful and the U.S. and Europe returned to their "normal" growth paths, the resulting increased demand for oil would push the price back up to its 2008 levels, if not higher. That in turn would trigger another recession.

Lather, rinse, repeat.

In some analyses, you can even incorporate energy prices into your estimates of potential GDP, in which case we might modify DeLong's diagram more or less like this:

The black dotted line represents a conceptual recalculation of the potential GDP, with "expected" growth slowing down after 2005 as energy prices rise.

DeLong's argument is well summed up in the text he puts below his diagram:

There are no signs in the pace of technological progress, in the level of investment, in the pace at which the American labor force educates itself, in measures of capacity utilization, in signs of upward wage pressure due to labor quality bottlenecks, or in surging commodity prices due to supply bottlenecks to suggest that the path of growth of U.S. sustainable potential GDP is materially lower today than was believed back in 2007.

Sure, but there's the rather obvious and directly observable fact that energy prices are historically high. If our theory includes resources, there is a reason to think that potential GDP is a lot lower than the conventional model estimates.

If a story like this is right, we draw some very different lessons. Simple stimulous is clearly not called for, since the economy isn't necessarily far below what it "should" be doing, given increased energy prices. On the other hand, a continued unemployment rate above 7% is clearly not something to be left alone. A program of investments targeted at reducing energy use becomes not merely a convenient way to spend money, but quite possibly the best macroeconomic policy imaginable.

There's lots of important theoretical economic work to do, and important work being done. If the mainstream is feeling out of steam, it could look around a little.

Postscript: Some gleanings from Krugman's own peanut gallery:

A comment on the drive to use more energy (an idea close to some of my own thinking, though I would no longer use the term "entropy maximization":

Theory ain't dead - I've got a seven part paper completely rewriting economic theory organized around entropy maximization. Truly astounding results and rock-solid analysis.

http://njettpace.wordpress.com/

(Don't let the title of the blog fool ya. Yeah I'm nutz, but that don't mean I'm wrong!)

A comparison to astronomy before Tycho:

Look at what astronomy was before people like Tycho Brahe cared to drastically improve the accuracy of the data on celestial bodies. It was only after he made his measurements that astronomers could devise a sensible theory of celestial mechanics.

The story of science is one of continued life, death and rebirth : you observe, you elaborate a theory that fits your data, you find experimental discrepancies with respect to your theory, then you dump your theory and work on the next one.

That is, when you have a scientific approach.

Economists have the wrong theory of value, and Marxists are the ones who really get it:

Mainstream economic theory has been found wanting because it hasn't been able to explain the crisis. This is because it has the wrong theory of value & so money.

It has been left to Marxists to explain the nature of overproduction, peculiar only to capitalism.

The best exponent is Sam Williams: http://critiqueofcrisistheory.wordpress.com/

(I actually agree with the point about mainstream theory barking up the wrong tree with value, but I don't think Marxists get it, either.)