A Wealth of Ideas

Competitive history suggest that only the best and most viable economic ideas should become dominant in practice and taught, whereas a cumulative view suggests that we must consider all currently existing theories and studies in order to take a holistic view of economics. In this it is important to establish the subjective nature of economics; we are ultimately privy to pluralism within the subject as there is not always necessarily a right or wrong.

The competitive argument states that unviable concepts be discarded, but what are the criteria for success. We are not entirely sure that our current mainstream economics currently work as they should; the financial crisis is testament to that. Growth figures aside, the term recovery is used too loosely, and we were never too sure how to go about recovery in the first place, should it have been austerity or fiscal expansion?

In this the cumulative view may appear to be stronger, with the inclusion of unorthodox theories, and a greater willingness to compare policy and approaches we may be more able to approach economics as it is: a subjective subject. Through the use of empiricism and statistics we can introduce a mixed approach of both competitive and cumulative, as our understanding changes over time, on the basis of differing economic conditions. Thus a combined view can consider the unorthodox approach while still maintaining a source of strong evidence for it. We have a tendency to flock to mainstream economics as a given way of achieving our economic aims of growth and development. However, if we already appreciate that each nation has different economic conditions, than how can we allow there to be a mainstream approach?

This was already highlighted in the 1990s and early 2000s through the currency liberalisation and lack of debt relief for Sub-Saharan economies, which was being preached by the IMF through the backing of “mainstream” economics. Their disregard for a more personal approach towards the individual economies shows how there is a need for cumulative economic thought; we have a wealth of ideas, all of which have some kind of importance in our approach to the subject and its wider implications.   Moreover, if we can appreciate the existence of a business cycle or any variety of cycle, then we should be far more flexible with the economic policies we pursue such that if the conditions of the economy change so should the policy. Obviously, we are limited by the factor of time, as our response can be too late or too early. However, a response would be sufficient in the first place. The willingness to consider heterodox economics moved use on from mercantilism, I believe that it is once again time to apply it to actual policy rather than leave it in books of theory.

 

I have begun reading a new book: The Wealth of Ideas: A History of Economic Thought
It is not exactly a light read, but some very interesting ideas and concepts all economics related of course.

Advertisements

The Dismal Science?

Whether you have opened The Economist (of October 19th), The Financial Times Weekend Edition (of October 20th), or even The Guardian (online), there seems to be a problem. There has been a quite thorough beating of social science, at least with opinion. The Financial Times Weekend magazine dedicated itself to looking at physics, and while containing the more abstract concepts that have recently been developed, it also looked at the current state of “science”. The foundation of science is our use of empiricism, providing evidence in which to prove a hypothesis, the use of regression to examine the relationships between variables, and questioning our own answers. This is how ‘we do’ science.

The FT notes that at the turn of the 21st century there were claims that the century of breakthrough in physics was over, and now in its place we would see a revolution in biology pertaining to our understanding of biotechnology and genetics. This revolution hasn’t seemed to have happened yet, at least that is my belief. If anything physics has maintained its place as the breakthrough science, just earlier this month Peter Higgs and Francois Englert won the Nobel Prize for their contribution to our understanding of the Higgs Boson – a key step in understanding how mass is created and possibly the absence of it. It is obviously difficult to compare the sciences, and argue for which one is making the most ‘progress’. I am obviously biased because I take physics as a subject, and it has been a personal love of mine. However, maybe a bit of physics in economics would not hurt. By this I mean physicists are often attracted to explaining what seems to just be phenomena, the obvious is given simple and straightforward explanations, but it is the extraordinary that demands their attention.

This consideration of the natural sciences brings me onto the social sciences, and what the underlying theme was behind the FT, Economist, and the Guardian. Are the social sciences really sciences? Or are they just for lack of better wording social studies. Economics has become infamous as a result of the financial crisis, at the time we lacked explanation, our models failed to predict the crisis, and we have not really flourished in resolving it – whatever the growth figures suggest. The economist looked at a behavioural study completed in the early 90s known as the Mere-exposure effect; recent re-trials of the experiment have resulted in data that does not support the original hypothesis. Here lies the issue with social science, us. We have known this since the beginning; it’s not really an original thought: In economics we usually lament that consumers are not always rational, we make decisions on innate emotions which “don’t make sense”. So how can we actually make dependable models?

Moreover, why do we rely upon models that were developed over half a century ago to still attempt to predict, or change our economic situation? Can we allow ourselves to have mainstream economics? Clearly we thought that we need not worry about economic policy or research that would help when in economic crisis at the turn of the century, as that is what defined the 20th century, The Great Depression, The World Wars, etc. The respective crises had led to economists of the calibre of Galbraith, Keynes, Friedman, and Hayek all to consider how economies truly function. Thus we had an age of macroeconomic consideration, and the development of models which we have used up to this day. Aditya Chakrabortty from the Guardian says that those theories which have made up mainstream economics, has led to the current generation of economics to be in denial, and not consider the fact that we may have changed. Clearly this represents a problem, as the models haven’t changed.

The natural sciences are able to prove and disprove hypotheses, on the other hand social sciences especially economics lately only seem to be able to provide an opinion. When looking at economic courses at universities it is clear that maths is essential in part for microeconomics and statistical analysis. Alongside this you have the expected neoclassical and Keynesian theories. To some extent, this teaching of economics has not resulted in the desired results. There is a generation of economists who are making use or at least referring to models which by now possibly don’t actually provide an accurate observation of market, consumer, and supplier behaviour. Charkrabortty in his article states that economics should be a “magpie” subject, being taught with history, politics, and philosophy. I quickly noticed that this is how it was once done, all one has to do is look back to Adam Smith, David Hume, or David Ricardo. They were men of many traits and abilities, notably philosophy and history.

I believe to move economics into the 21st century we must recognise the plurality of the subject. When considering any model we often make note of the assumptions we place, when we apply these models to the real world it is necessary to remove these assumption and this can be achieved with the involvement of philosophy, politics, and history to provide at least a context to our decisions. We still as a society can become baffled with what should be simple, straightforward, “proven” economics by now. One simply has to look at the debate around HS2 in Britain. Keynesian economics suggest that we are stimulating aggregate demand to induce growth in the economy, monetarist theory would suggest that this wouldn’t work in the long run. The truth of the matter is we don’t know, here the monetarist theory is more easily defended as one can consider all the towns that will be passed by, or land that will have to be committed to the transportation. So there is debate, and we struggle to have an authoritative stance, as just yesterday the benefits of HS2 have been “lowered”.

We are at a key point in science and economics. We have the emergence of big data, which may actually enable us to predict current trends, and bring statistical analysis to a whole new scale. To do this, economics in my opinion needs to start behaving like the natural sciences in that we continually question what has been to some extent proven. Up until now we have been too comfortable with theories that ‘seem’ to work, there may be more room now for unorthodox economics, or at least involving more breadth in the base education of the subject. Look at any economics course at university and the stress is placed upon mathematics, for what is ultimately as we have established a behavioural subject, and that the Nobel Prize in economics this year further cemented as a variety of behavioural finance. The question now is how we incorporate effectively all the aspects of an ultimately extremely wide subject? It is time to either introduce more of the scientific method, or accept like history that there is a strong element of a subjective view, and how successful in a sense the subject is depends on how we view it.

For a bit of further reading check out:

http://www.theguardian.com/commentisfree/2013/oct/28/mainstream-economics-denial-world-changed

http://www.economist.com/news/leaders/21588069-scientific-research-has-changed-world-now-it-needs-change-itself-how-science-goes-wrong?fb_ref=activity

If you read anything read this article:

http://www.ft.com/cms/s/2/8461f5e6-35f5-11e3-952b-00144feab7de.html#axzz2jEkVT9iu

Long Run Aggregate Supply

There are two theoretical outlooks on long run aggregate supply; there is the neo-classical/monetarist model and then the Keynesian model.

Neo-classical/Monetarist Model

Picture1

In the short run producers will respond to a change in price, but also higher demand by bringing in more inputs of production and utilising existing means of production. But in the long run in this model it can be note that supply is independent of price.

This makes the assumption that all prices are flexible, and if some prices go up others will go down. Furthermore, this displays that the potential of an economy to grow is based on four central factors land, labour, capital, and enterprise. There can also be an increase in productivity and efficiency which is the better utilisation of already existing factors of production.

An outward shift would be considered an increase in productive potential. This particular model also states that at that given point all resources are being employed and there is a point of full employment.

As a result of this model monetarists would argue that stimulating aggregate demand is artificial manner of promoting growth, and therefore shows that fiscal policy is ineffective.

Equilibrium Neo-classical/Monetarist Model

Picture3

This diagram determines that at the point aggregate demand meets long run aggregate supply that it is at the point of full employment of all resources including labour.  There can only be short term fluctuations as ultimately prices are completely flexible so there are no inflationary or recessionary gaps. The economy should always go back to the point of full employment level of output.

It also shows that increasing aggregate demand only invokes an inflationary response, rather than growth. This shows how supply side policies are extremely effective in regards to the monetarist model as an outward shift of LRAS would mean that there is great output at lower prices if it were to meet the same level of demand.

Keynesian model

Picture2

This model contains an element of the neo-classical model, but otherwise there are two significant differences. These differences are highlighted as this model can be separated into three different sections.

The first section is the horizontal line this is recognition that there are downward inflexible prices (sticky prices). This is because of factors such as labour contracts, unions, minimum wage, etc. At any point of alongside the horizontal line it is the recognition that some resources are not being employed and that there is production capacity which is not utilised.

Then there is the curve section which introduces the concept that there is still some response to price in the long run.  As the output increases so does the employment of resources, this causes prices to rise. To continue output firms must be able to continue increasing prices.

Finally there vertical section where there is the potential of full employment of resources. This is where prices can increase rapidly and GDP can’t increase as all aspects are being utilised.

Similar to the monetarist model, there can be an outward shift in long run aggregate supply. This is where the four main factors land, labour, capital, and enterprise are being utilised in a more efficient or productive manner. There may also be an introduction of new resources, which would cause the expansion. This particular model shows the benefits of using fiscal policy to stimulate aggregate demand as you achieve growth without an inflationary response.

An outward shift would mean an increase in productive potential, as the economy can utilise more resources in order to produce more. In this model however there are inflationary and deflationary gaps, as a result of the price sensitivity.

Equilibrium Keynesian model

Picture4

As shown in the diagram it can be noted that the economy can be at equilibrium at a variety of points where the economy is not at the point of full employment level of output. For AD1 it can be noted that there is not the full utilisation of resources.

Then the following point of AD2 it reaches the beginning of the section which is considered the deflationary gap. In this model the economy can stay at this gap. This is shown at the equilibrium with AD3. The economy can remain at this point because the model argues that without intervention the economy will not tend towards the point of full employment of output.

AD4 in contrast is presiding in the inflationary gap, where any increase in demand results in inflation rather than growth. At the turning point between the curve and the vertical line it can be considered the maximum potential output in the long run as it is the point that coincides with the greatest value of real output.

It is important to look at the point between AD1 and AD2 as this is the justification for the use of fiscal policy to increase aggregate demand. It can be seen that there is only an increase in real output between the two points, and not an inflationary response. This is because while shifting alongside this point the economy is simply using already existing spare capacity. The only point where there is a price increase is the deflationary and inflationary segments.

Evaluation

It is clear that there are strong arguments proposed for both models, the question to apply in the scenario is which one is more relevant to our current economic state. This however leads to a obvious split in decision making in regards to which model is followed, in brief terms Keynes’ model suggest that you must spend to save, whereas the monetarist model argues that there is the cyclical nature and any changes we make are artificial.

The main downfall of the monetarist model in regards to solving recessionary crisis or promoting growth is the extent to which it requires long-term planing. The Keynesian model creates a short-term effect as well as long-term which can make it seem more favorable for economic policy. However to apply the Keynesian model to today’s economic situation in Britain there is a curious result. In regards to aggregate demand there is expansionary monetary policy (low interest rates, increasing money supply i.e. QE) but there is an environment of deficit control which could be counteracting any effects on AD. But in regards to aggregate supply, in the current scenario I would support the Keynesian model as there is currently clear unfulfilled capacity.