Realism, Instrumentalism, and New Classical Macroeconomics

Recently my main concern has been to reread the most important new classical texts. The texts which can be regarded as the most important items from a methodological point of view. Now I am working on a paper in which I will look into the debate between the realist and antirealist camps and, which is more important, I will study whether new classical macroeconomics has really been an instrumentalist movement.

For me, monetarism, under which new classical macroeconomics as a radical wing can also be sorted, has never been a homogenous theoretical system as far as the methodological principles are considered. This is problem is too difficult to solve easily. In the literature, instrumentalism is identified typically with the famous methodological paper of Friedman (F53), but even Milton Friedman himself never seemed to be able to insist consistently on these guidelines. However instrumentalist he is, he seemed to have some other, realist efforts. For me, the main point of F53 is the example of the model set up for estimating the density of leaves on a tree: this is a clear instrumentalist manifesto. However, his theory on the permanent income with its idea of the economic man trying to optimize on longer time horizons is something which was set up in order to grab the very essence of actual (everyday) optimizing behaviour. This is realism. New classicals, however, with their clearly defined idea of the rational agents always and clearly made up a realist movement in my interpretation.

One can find interesting methodological papers which use the new classical models to introduce and describe the instrumentalist methodology of theorizing. This is a serious mistake. So, getting back to the first paragraph, I am making efforts to prove: although new classical macroeconomics and the Friedmanian orthodox monetarism can (and should) be sorted under the same label (‘monetarism’), because their main economic policy recommendations were common and their efforts to place macroeconomics on microfoundations were also shared (following different lines, though), in methodological terms new classical macroeconomics has been a far cry from orthodox monetarism. In order to draw this distinction and to prove that new classical macroeconomics has been a realist program, I am using the well-known realist-instrumentalist opposition. Traditionally, realism, as a rule of thumb, is said to tend to provide theoretically sound, but empirically poor models, while instrumentalism puts emphasis only on the empirical performance. In my opinion, the realist efforts of new classicals were directed at setting this opposition aside. They tried to set up models which were realistic in that they were aimed at grabbing the essence of reality, i.e. the fundamental economic laws (or some of them, at least), while, for new classicals, empirical performance was always a similarly important purpose, supported by the variety of complex mathematical and econometrical methods. In the case of new classical macroeconomics, realism was not accompanied by poor empirical performance, so one was no longer forced to choose between realism and instrumentalism.

Introducing ‘The Theory of New Classical Macroeconomics’

The Theory of New Classical Macroeconomics‘ is a comprehensive assessment of the well-known new classical and monetarist doctrines. By writing this book I tried to answer those challenges which tend to take mainstream economics highly irrelevant and completely useless with regard to everyday economic policy problems and the common efforts to understand reality. In other words, this is all about the positive and negative heuristics suggested by Imre Lakatos: how to find the proper scientific area for new classical macroeconomics where it can be effectively defended and how to find an area where we are not justified to use this theory as an instrument if analysis.

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This assessment is carried out at two levels. First, mainly in Chapter 1, I tried to outline and to comment the ongoing debate between the realist and the anti-realist positions. To be honest, I argue for the realist standpoint throughout the book. In order to do so, I look into the method of building theories in mainstream economics in detail. For me, creating the concepts of new classical macroeconomics consists of two steps: one should abstract from some aspects of everyday life of man, for example norms and values, which make man a social being and then the remaining aspects of human life, i.e. the functioning of the economic man, should be idealized (exaggerated to extremity) in order to make them the only guiding principle of behaviour. This is the way how homo oeconomicus was created–and he is the creature who populates the Lucasian islands. It is asserted that new classical macroeconomics is a realist theory because its concepts and the fundamental economic laws and mechanisms it grabs are all linked to our socio-economic reality. In this respect, mainstream economics is not taken unique and homogenous, since, as it is argued, Milton Friedman in his seminal paper on the method of positive economics (often mentioned as F53) outlined an instrumentalist methodology (which even he himself could not always insist on) which was definitely not followed by the new classical economists.

Second, the monetary and fiscal theory and economic policy recommendations of new classical macroeconomics are reviewed in detail. The greatest emphasis is on the Phillips curve which was somehow the common language of 20th century high theory. A definite distinction is drawn between the Friedmanian and the new classical Phillips curves in order to show how the methodological principles shaped the theories. By studying the equivalence theorem I conclude that the new classical doctrines are all of conditional nature. One should not ignore the presumptions on which these doctrines were built (i.e. from which they were deduced). When analyzing the Ricardian equivalence and the role of unexpected economic policy actions I had to realize that emphasizing a strong opposition between the theory of Keynes and new classical macroeconomics is a huge mistake. New classicals never asserted the complete ineffectiveness of activist economic policies, only pointed out and specified the exact conditions and circumstances which are necessary to this policy ineffectiveness. For example, if expectations are fully rational, prices are flexible, and macroeconomic shocks are white noises, then (and only then) economic policy interventions turn out to be completely useless. But, on the contrary, if any if these presumptions cannot be maintained under the actual conditions of our socio-economic reality, then activist (Keynesian-style) economic policy steps are effective again. And this is my main point: new classicals do not predestine countercyclical economic policies to failure, they just call our attention to the conditions which are needed to establish this ineffectiveness. There are circumstances under which activist economic policy is completely useless, but, necessarily, there circumstances under which it is not so.

In this book I have taken the position that it is time for us to reconsider the relevance of new classical macroeconomics in understanding socio-economic reality and in governing our economic policies. By using the new classical principles, I believe, one will have new methods and new aspects to make economic policy interventions more effective. The Keynesian way of economic policy is not dead, only its conditions got specified further.

A Research Program

Background

The relationship between economic theory and socio-economic reality attracted the increased attention of academics some decades ago. The methodology of economics, as the most important sub-discipline studying this connection, supposes this relationship to be mainly one-sided. In this approach, economic theory is considered as a scheme used to interpret socio-economic reality. In the vast literature of the methodology of economics, researchers use the following question as a starting point: do entities, their features, and their economic behavior exist independently of economics when they are investigated through the lens of economic theory? According to the common standpoint, these entities and the findings regarding them depend on economics and the beliefs entertained by economists. However, in a non-scientific attitude, we may expect this relationship to be a reciprocal connection. Theoretical knowledge and reality reflect upon each other, instead of providing a one-directional connection from theory towards reality.

The constrained view outlined above, according to which our theories shape reality, has some extreme consequences. If reality is formed by our theories, the possibility of relying on our experience as the source for modifying our theories is completely ruled out. However, this connection seems to exist. For instance, the world economic crisis of 1929–33 has significantly contributed to the modification of the accepted economic theory. As a result, this crisis has established the way we consider the functioning of macroeconomic systems even today.

As some recent theoretical works assert, the elements of our socio-economic environment, such as social institutions, social practices, and our social norms and beliefs are all shaped by sciences, from physics to sociology. This must be true for economic theory as well. This view is not surprising at all; rather it strengthens the commonly known characteristics of science, namely, that it is expected to help us to understand and to govern the world. In other words, economic theory has various consequences for the economy and even for everyday business life (for example, recall how mainstream economics guides public policies).

Despite these views, there is a constant effort in economics to describe its own evolution in a context that also takes account of certain milestones in public policy and history in order to find the events that triggered the modifications of the reigning economic theory from time to time. This effort has recently culminated in some monographic works (e.g. Dadkhah, Kamran [2009]: The Evolution of Macroeconomic Theory and Policy), but detailing some individual chapters of the history of economic thought in relation to macroeconomic policies has always been a commonplace in economics (e.g. Hicks, John R. [1974]: The Crisis in Keynesian Economics). These approaches (often implicitly) set the history of mainstream economics in the conception outlined by Thomas Kuhn (in his seminal work The structure of scientific revolutions [1962]) on the notion of scientific progress.

Objectives

However, there are problems in applying the Kuhnian approach in its rough form to economics. Kuhn outlined his concept in order to understand and to explain the evolution of sciences such as physics or chemistry–while human and social sciences definitely make up a different case. These disciplines are all of interpretative nature, so there is no clear basis for evaluating the relationship between economic theory and socio-economic reality. The central problem is the case of paradigm shifts, when this relationship breaks down. Because of the interpretative character of social sciences, we have no definite and ultimate basis to recognize this case. Mainstream economics, as it is often argued, is a pure theory, similar to geometry or Newtonian physics. These disciplines only consider theoretical circumstances which are clearly different from the reality we are directly living in. So, economics is able to generate predictions that cannot be applied to reality in a direct way: these predictions are only loose guidelines to direct macroeconomic policies towards the desired ways or to understand our reality in a comparison to these guidelines. Mainstream economics as a whole is only a collection of broad hypothesis on the nature of the fundamental economic laws, so a careful evaluation is needed.

Michael Polanyi was the first philosopher who has recognized (in his Personal knowledge [1958] and other essays) how significantly this subtle relationship between theories and reality can and should change our understanding of the evolution of a particular discipline. However (similarly to Kuhn), he also  outlined his conception within the realm of natural sciences, so our knowledge on how his work concerns the interpretation of the history of the economic thought is considerably underdeveloped. I strongly believe this interdisciplinary approach is the most justifiable from the perspective of a more complete understanding of the evolution of economics.

So, I would like to broaden Polanyi’s approach to economics. Polanyi succeeded in highlighting the importance of the personal contribution carried out by the understanding and interpreting individual to the creation of knowledge. However, it is not detailed yet how this exactly happens in economics: how can we describe the route from creating the first conceptions of a new theory and the recognition of the inadequacy of the former theoretical framework through interpreting reality with this new theory to the phase when proponents of the new approach try to make other professionals take over the new system of thinking. The philosophy of Michael Polanyi helps us to break open the black box of paradigm shifts in economics. Considering the role of personal commitments and the contributions of the individual to creating knowledge will help us with the deeper understanding of turning points in the history of economic thought. Personal knowledge is the key to evaluate properly how our theories reflect to changes in socio-economic reality.

Applying this new perspective to new classical macroeconomics, which is somehow the culmination of the evolution of mainstream economics, is the theoretical background of my proposed work as a whole. This project has the promise to enhance my previous knowledge on new classical macroeconomics, summarized in a recent monograph. On the practical and operative side, I would like to map macrosocial changes that governed economic theory towards new problems and questions. This line of inquiry could improve our knowledge on the way theories are formed in economics. For example, in monetarism, presuming rational expectations had significant consequences on economic policy. It was a theoretical development that cannot be understand if we leave the concept of personal knowledge outlined by Polanyi out of account. Views on the efficiency of economic policy have radically changed and, as a result, the playing field for activist policies has significantly narrowed. The question naturally arises: What were the social and economic developments that forced representatives of high economic theory to radically curtail the scope of activist economic policy control? Theory both influences our actions and reflects upon the problems of societies. This was the case, for example, when inflation (instead of unemployment) came up as the primary concern of societies or political elites, giving the opportunity for monetarism to crowd out Keynesian theory. In order to better understand the way economists theorize, we need to identify the parallels and inconsistencies between the problems of societies and their economic theories.

Significance

First of all, the greatest benefits of this project shall be realized within the methodology of economics and theoretical economics. There is an old debate on whether economics is a realist or a mere instrumentalist science. If the former, mainstream economics helps us to understand and to govern socio-economic reality, while if the latter, then any interpretative efforts in economics are completely in vain and useless since, in this case, nothing is said about the causal structure of socio-economic reality. This project can contribute to this debate through arguing for the realist position: we will have a clearer understanding of how concepts and theories are formed in economics, creating a pure science which is, notwithstanding, definitely realist. This widely accepted though often debated realist program will be further elaborated through this project resulting a detailed view on the way how economists grab the essence of reality in order to understand it. Moreover, the history of economic thought will be enriched with a special narration which utilizes the recent developments emerged within the methodology of economics.

This line of inquiry seems to be particularly interesting and illuminating in the case of Hungary. Traditionally, public policy in Hungary lacks a solid and well-defined theoretical basis. Economic policies of the succeeding governments in Hungary were characterized by sudden and erratic changes and can only be described only as passive and ungrounded reactions to some unexpected shifts in the world economic environment. During the era of socialism, dominated by the Marxian political economics, all the theoretical advancements of the West were hidden behind the Iron Curtain, so, later, policy makers in Hungary could hardly rely on (mainstream) economics when searching for some adequate answers to the macrosocial and macroeconomic problems. In the 1990s and the early 2000s, this lack of theoretical knowledge was mainly implicit and something to hide, but after 2010, this has been made explicit and sorted under the populist label of ‘unorthodox economic policies’ with the clear intention of crossing any well-known and traditional public policy recommendations. Today, this denial of mainstream economics and any modern economic policy suggestions is extreme, grown to be an apocalyptical opposition of Hungary and the Western world.

In addition, economic policy makers in Hungary are not supported by experienced and open-minded professionals: interpreting this situation as a sociological problem, they are either outsiders to the political elite or they have already abandoned the sound theoretical considerations in order to be insiders. To sum up, economic policy makers in Hungary, first, are not familiar with applying economic theory as a basis for adequate and efficient economic policy actions and, second, do not have considerable experience in starting from actual macrosocial and macroeconomic problems as a ground for directing economic theory towards these new problems. So, this proposed research holds the promises of highlighting the mutual relationship between theory and socio-economic reality even in Hungary.

For me personally, this work holds the promise to elevate my knowledge to a higher level. I have expertise in the subject area, having published some significant and synthesizing works on the methodology of mainstream economics. I also have the ability to apply a new aspect in order to scrutinize the way theoretical economics has been evolving, and this program would enable me to extend my previous knowledge by exploring a territory with the help of a new theoretical background.