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