Home > Uncategorized > The Compartmentalization of Economics

The Compartmentalization of Economics

Alright, before I begin I want to acknowledge that the field has been working on these issues for a while and has made significant progress.  So to some extent I’m arguing with a historical phenomenon here.  But I think this is still important for a couple of reasons.  First, we still teach econ majors the version of economics that suffers from this deficiency, and our policy makers seem to rely largely on the same models.  Second, from a historical perspective I think it is important to ponder how things like this happen.

As you may know by now, I have been trying to develop the idea on this blog that our monetary system is of such a nature that lowering the interest rate causes inflation in the “medium run” and then deflation in the long run.  The argument for this is amazingly straight forward.  All you have to do is look at the Fisher equation and believe that in the long run, the real interest rate is determined by real factors (which I suspect most economists would concede).  And yet I have never heard another economist make this observation (of course that doesn’t mean it has never happened, but if it was common it seems like I would have noticed).  How can this be?

My opinion that Keynesianism marked a radical departure from sound economic reasoning is well documented but how was this able to happen and persist for all these years?  There are several reasons I think.  Part of it is that it has enjoyed some degree of empirical success (though with much help from progressives manipulating the economy into something that doesn’t make much sense).  This brings up the old rationalism vs. empiricism debate which I don’t intend to have here.  Another (big) reason is that the theory is convenient to politicians and other “powers that be” who enjoy having an intellectual justification for a lot of interventionist policies and Keynesian economics suits that purpose nicely (see the above parenthetical comment).  But I think another important component in this formula is the compartmentalization of the discipline.

What I mean by that is dividing the subject into multiple “schools” which peacefully coexist and yet are logically incompatible.  I am talking of course, about the neoclassical synthesis in which  economics was divided into microeconomics and macroeconomics.  This allowed the sound reasoning which had come to dominate all of economics up to the time of Keynesianism to be cordoned off and kept away from the Keynesian paradigm which was to become the accepted mainstream approach to macro.  Before this, economists were not macroeconomists or microeconomists they were just economists.  Their theories had various implications and often these extended to both of what we now call micro and macro. 

The problem with this is that if you really understand classical micro concepts, you can’t really understand Keynesian economics.  This is because Keynesian economics is hopelessly flawed.  It in fact takes a drastic step back in the area of economic understanding in the sense that it revives the old confusion between a supply relationship and a demand relationship as I pointed out in this post.  If you let capable microeconomists think about this long enough, certainly they would notice.  But certainly they couldn’t hope to overturn a century and a half of progress in the field.  They would have to find a way to let them keep that knowledge but also accept the new incompatible model.  The answer is natural.  Just create a new field. 

This has two important implications.  The first, and most obvious, is that most people don’t carefully study both micro and macro now.  You can ask an accomplished microeconomist about Keynesian economics and they will just shrug and say “I don’t know. I don’t think about that stuff.” and macroeconomists will say the same thing if you ask them about industrial organization.  But the second, and I think even more significant issue, is that the two fields, by their different natures, select certain kinds of people into them.  Specifically, people who have a strong intuition regarding things like market equilibrium and Pareto efficiency find micro fascinating.  Alternatively, people who like the idea of empirical knowledge and a giant machine called the economy that we can control by pulling the right levers at the right time gravitate toward macro.  These people (macroeconomists) tend to be the last people who want to discover that the economy can’t be controlled in a way that is good for society.  So can we be surprised when they don’t notice that a model which says all the things that get them excited is contradicted by the basic principles of another field which doesn’t really turn them on that much?

But it doesn’t stop there.  Macroeconomists know about the Fisher equation.  But they have actually further compartmentalized macroeconomics.  They did this by dividing it up into the short, medium, and long-run.  Again, newer models don’t do this but this is what we still teach in intermediate macro.  To see the importance of this, you must notice that what Keynesian economics says about the effect of increasing the money supply (lowering the interest rate) on the price level.  It says that in the short run, prices are fixed (again see previous parenthetical comment) so prices don’t change (or don’t change much) and then in the medium run expectations adjust and prices go up, and then in the long run blank out.  “Wait, what happens in the long run” you ask?  Well when we analyze the long run we use the Solow growth model.  It deals with saving and capital accumulation.  You: “but what happens in the long run when the money supply increases?” Smart professor: well, in the long run model there is no money supply, it’s all real variables…  You: hmph [rolling eyes] ok, so what’s going to be on the test….

Is it possible that the things we’re doing to save ourselves in the short run actually have long run implications?  Maybe a better question is: is it possible to answer the first question with this approach to economics?  And furthermore, is it surprising that we haven’t managed to stumble onto the answer to a question which doesn’t even exist in the framework on which we have built our knowledge? 

Ok, so in physics they had a theory of gravity that didn’t really work the same near earth as in space for a while but they fixed it.  Ok, so now they have a different theory for quantum physics than for astrophysics but at least they have the decency to be uneasy about that and realize that one or both must be wrong.  And when they find something that is logically consistent, they will stop teaching the one (or both) that’s wrong!

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