progress in economics as elusive as soap in the bath?
TRANSCRIPT
Progress in Economics
As elusive as soap in the bath?
The issue of social science
• Pure science includes subjects such as Physics and Chemistry
• They have the ability to use laboratory experiments to test theories and examine the world
• Social sciences have no laboratory, there can be no experiments, just observation.
No lab, so what do you do?
• There are two ways to approach a problem when you can’t experiment
• 1. Observe the world and see if you can see a pattern
• 2. Think about the world and form a theory which you then test against reality
No lab, so what do you do?
• The first is called Induction or the inductive method
• The second Deduction or the deductive method
• The problem is the first is logical nonsense and the second may never work!
Induction
• The process of induction
• Observe the data – an empirical study
• Form a theory (hypothesis) from those observations
• Usually works in the hard sciences. Repeat experiments, get the same results time and time again and you are probably on safe ground
Induction
• Social sciences have a problem
• No matter how many observations are made there is no inevitability that future observations will support the same theory.
Induction
• I observe only white swans
• I induce that all swans are white
• But a black one might be out there
Deduction
• Start with axioms which are taken to be true
• Apply deductive logic and form a theory
• Then test against reality (the data)
Deduction
• Axiom: Consumers try to maximise their satisfaction through rational decisions
• Logic: Consumers will try to get the best value for money from their income when deciding what to buy
• Theory: If the price of a good rises Consumers will buy less of it
Deduction
• Problems for Economics
• Consumers may not be rational
• More than just price may change at the same time
• So price may rise and people buy more of a good – maybe incomes changed, people judge quality by price, a good consumed with it got cheaper
Deduction
• So economics must make the assumption of Ceteris Paribus – All other things stay the same – for the theory to make sense
• Also the assumptions may be wrong.
Hypothetico-Deductive Method
• Science requires a theory to produce a set of predictions which have the potential to be falsified by the evidence.
• So Economists favour the hypothetico-deductive method of reasoning as induction and deduction seem inadequate
Hypothetico-Deductive Method
Hypothesis
Deduction
Proposition
Empirical testing
Induction
Revised hypothesis
Hypothetico-Deductive Method
HypothesisThere is a relationship between theLevel of unemployment and wage rises
DeductionWhen unemployment is low Unions can ask for higher wages
PropositionInflation is caused by ‘wage-push’ factors
Empirical testing
Induction
Revised hypothesis
The Phillips Curve
Hypothetico-Deductive Method
Hypothesis
Deduction
Proposition
Empirical testing
InductionThere is a trade-off between Unemployment and inflation
Revised hypothesisInflation is caused by cost factors and highest duringlow unemployment
Phillips curve
It turned out to be wrong!
The Reality
• Economists debate – argue with each other to make progress
• The problem is that when forming the hypothesis they will rely on selecting axioms
• And the economists core belief will guide that choice
Progress through debate
• Since the start of Economics as a distinct subject (1776) economists have argued their point
• One of the oldest debates in economics is the one about the cause of recessions.
Progress through debate
• There are two fundamental schools of thought:
• Those who believe that the economy is essentially self regulating
• Those who believe that the economy can fail to employ everyone and growth is not assured
What causes recessions?
• This debate has been an active one since the 18th Century
• We will concentrate on its latest incarnation the Keynesian – Monetarist debate
How debates proceed
• One side lays out their theory. They state their assumptions and put forward their predictions
• They appeal to the data to support their theory
• The other side put forward their objections and may state a theory of their own
Keynesian thinking• Keynes reignited this old debate in his
‘General Theory’ in 1936. His aim was to explain the ‘Great Depression’ of 1930 to 33.
• His axiom is that the economy is not self-regulating
• His hypothesis is that it is possible for expenditure in the economy to be less than the total level of output
Keynesian thinking
HypothesisIt is possible for effective demand to beless than total output
DeductionThis will lead to a ‘surplus’ level ofoutput and so workers will bereleased by firms
PropositionWithout government actionto boost demand the situationpersists
Empirical testing
Induction
Revised hypothesis
Keynesian thinking
Hypothesis
Deduction
Proposition
Empirical testingThe Great Depression 1930To 1933
InductionIf effective demand risesthe recession will end
Revised HypothesisGovernments shouldManage the economy
Keynesian thinking• The Keynesian view was very
persuasive in the wake of the experience of the 1930s
• Governments after 1945 followed a policy of managing the level of economic activity by manipulating the level of demand.
• They did this by varying their own spending and taxation levels
Monetarist thinking• Monetarists represent the type of
thinking that dominated economics prior to the Great Depression
• There axiom was that the economy is essentially self-regulating, but cyclical
• Their hypothesis was that prolonged recessions must be caused by some sort of intervention in the normal process
Monetarist thinking• For the Monetarists, led by Milton
Friedman and the Chicago School the problem was the quantity of money in circulation
Monetarist thinking
HypothesisEffective demand is determined by thequantity of money in circulation
DeductionA fall in the money supply will leadto a fall in demand and so output
PropositionThe Central Bank shouldmaintain a stable money supply
Empirical testing
Induction
Revised hypothesis
Monetarist thinking
Hypothesis
Deduction
Proposition
Empirical testingDuring Great Depression the FederalReserve allowed the US money supplyto fall by a third
InductionThe Great Depressionwas caused by theFederal Reserve Bank
Revised HypothesisCentral Banks should adopt a ‘Money Supply Rule’
Monetarist thinking• After the failure of Keynesian policy in
the 1970s the Monetarist view became the norm
• This developed into the ‘New Classical’ approach as Monetarism is essentially a ‘one problem’ theory.
The debate• In the 1970s Keynesians and
Monetarists debated how the economy worked with passion
• The debate was often difficult as each side talked at cross-purposes
• This was because their axioms – which were based on their core beliefs - conflicted
The debate• But as time wore on progress was
made.
• Keynesians (now called Post-Keynesians and New-Keynesians) accepted that ‘money does matter’
• Milton Friedman discussed the Monetarist case in the format of the Keynesian IS/LM model
The debate• By the 1990s a consensus was
reached.
• Inflation stability was prioritised but not by manipulating the money supply. Instead interest rates were used
• Aggregate demand was monitored to smooth out the business cycle while not threatening the inflation target
The latest• The Global Financial Crisis was met by
a massive Keynesian style stimulus to boost demand in the economy
• No serious objections to this was raised by market economists recognising this was a major and unusual demand side shock
• Monetary policy was changed to support an economic recovery
The latest• Sadly the debate now reignites
• There is still disagreement on
• 1. What caused the GFC
• 2. How to design policy to recover from it after the initial shock
The latest
• But that’s why economics is so interesting – it’s always changing