Implications for theory

This section discusses the implications for theory. The thesis is an experiment comparing AIE with REH, but more importantly the experiment allows a comparison between the neoclassical and

‘science of complexity’ frameworks.

The results of the thesis show that AIE provides better predictive performance and describes reality far more accurately. Additionally, it was found that REH assumptions relegate its applicability to an extremely narrow domain but despite this, REH may retain a useful function as a normative or heuristic theory used with the caution that the assumptions of the neoclassical framework and of REH are logically inconsistent, see section 2.1.4.5. Section 5.4 discusses REH and AIE taking on complementary roles where REH takes on a normative role while AIE takes on a descriptive/predictive role.

In the bigger picture, the comparison between AIE and REH is also a comparison between the complexity and neoclassical frameworks, respectively. The predictive performance of a theory is more important than the ability of a theory to describe reality in the view of neoclassical economics whose underlying philosophy is instrumentalism, where ideas are instruments and realism is unnecessary and the only measure of the success of an idea is its ability to predict. Therefore from a neoclassical perspective the ideas and assumptions in the complexity framework are more valuable than those in the neoclassical framework because AIE makes more accurate predictions than REH.

Furthermore, Friedman (1953, p. 15), a major proponent of instrumentalism, states that assumptions only need to be judged by their ability to provide sufficiently accurate predictions, not whether the assumptions are realistic. However, Musgrave (1981) discusses the flaws in instrumentalism, when he notes three types of assumption, negligibility, domain and heuristic. Musgrave (1981) discusses Friedman’s example of assuming no air resistance when he applies Newton’s Universal Law of Gravity in the earth’s atmosphere, which is a negligibility assumption when applied within the domain of objects of high mass and low air resistance, but outside this domain the theory of gravity fails to provide an adequate model for, by way of example, the terminal velocity of a skydiver. Musgrave (1981) notes that Friedman and neoclassical economics fail to acknowledge or to clearly specify their domain assumptions and when operating outside of this domain theory may well be misleading or incorrect. Colander (2000, p. 3) equates neoclassical economics ‘to the celestial mechanics of a nonexistent universe’ for using theory outside its domain assumptions. The gap

between the real economy and the domain assumptions of neoclassical economics makes it inappropriate for policy development unless used with great caution, see section 5.3.2.

Friedman (1953, p. 14) continues his advocacy of instrumentalism ‘Truly important and significant hypotheses will be found to have “assumptions” that are wildly inaccurate descriptive representations of reality, and, in general, the more significant the theory, the more unrealistic the assumptions (in this sense)’. Musgrave (1981) notes that this approach may be suitable for heuristic assumptions, for example he cites Newton’s solar system consisting of just the sun and the earth, an unrealistic assumption, but the model made reasonably accurate predictions and introducing more realistic assumptions lead to an increase in predictive performance, which eventually lead to the many bodies’ problem and Poincare’s solution, with this inturn ushering in chaos theory and complexity theory. Keen (2001, p. 153) summarises, in contradiction to Friedman (1953, p. 14), that abandoning the factually false heuristic assumptions normally leads to better theory – not worse theory. The parallel in neoclassical economics is its three underlying assumptions discussed in section 2.1.1.1, methodological instrumentalism, methodological individualism, and methodological equilibration. Abandoning these three unrealistic assumptions for more realistic ones includes. First, agents are rule following. Second, agents interact directly not just via uniformly known market prices. Third, assume the economy is dynamic. These realistic assumptions describe the

‘science of complexity’ framework and AIE, which describes and predicts more accurately than REH.

Section 2.1.4.5(5) discusses the need for neoclassical economists to focus on the variables more easily modelled, given the mathematical techniques and computing power available in the 1950s. Additionally, Musgrave (1981) notes Newton simplifying the many body problem with a two body problem as a heuristic assumption to allow calculation. All the neoclassical assumptions can be seen in this light, which allows simple, mostly linear, theory to approximate the economy that is in fact a complex system. For instance, Keen (2001, pp. 175-6) quotes Jevons (1911), Clark (1898), Marshall (1920, p. xiv) and Keynes (1923) who recognise the economy as a dynamic process that is better modelled dynamically but static analysis provides a stop–gap measure until adequate technical ability arrives to model the economy dynamically.

The static and dynamic divide between REH and AIE and between neoclassical and complexity economics is an important dimension to discuss for two reasons. First, there is a need to reconcile the inconsistency between the SMD Theorem and Smith’s experimental economics. Second, there

is a need to explain why DSGE and CGE, even though using the word ‘dynamic’, are still part of the ‘static’ stop–gap measure.

There is an inconsistency between the SMD Theorem that finds GE unstable, and Smith’s (2007) experimental economics that finds stability in market prices. The static/dynamic divide provides a simple explanation for the inconsistency. The SMD Theorem is a static theory by assuming that all the buyers and sellers agree on a price at one point in time and then swap the goods. Smith’s (2007) markets are dynamic in that buyers and sellers continually trade. In summary, the examples show

static-instability and dynamic-stability. Keen (2001) illustrates the difference between dynamic and static economic analysis with the analogy of learning to ride a bike, where learning how to balance on a stationary bike tell us very little about riding a moving bike. Furthermore, it is easy to balance on a moving bike but nearly impossible on a stationary bike, hence why waste time learning to balance on a stationary bike when you want the bike to move. Static economics has failed to find a stable GE and modelling the dynamic economy as a static entity may well be misleading and time– wasting.

The DSGE and CGE models use the word ‘dynamic’ but they are still part of the stop–gap static regime because their claim to being dynamic is at the level that a number of pictures of a stationary bike can be combined to produce a moving film, however, each of these still pictures or GE is actually unstable. In contrast to the CGE and DSGE models that produce dynamic instability, Smith’s experimental economics produces dynamic-stability. Making the CGE and DSGE dynamically stable requires relaxing the methodological equilibration assumption. Section 5.6.3 and 5.6.4, in further research, further discuss this relaxation.

Farmer and Geanakoplos (2008, p. 54) discusses neoclassical theory as ‘an elegant attempt to find a parsimonious model of human behaviour in economic settings. It can be criticized, though, as a quick and dirty method, a heroic attempt to simplify a complex problem. Now that we have begun to understand its limitations, we must begin the hard work of laying new foundations that can potentially go beyond it.’ The computing power is available and the ‘science of complexity’

provides a suitable framework. Additionally, the ‘science of complexity’ uses scientific realism that provides a much sounder philosophical basis than the instrumentalism of neoclassical economics.

While Farmer and Geanakoplos (2008, p. 54) call neoclassical economics ‘an heroic attempt to simplify a complex system’, Blaug (1992, pp. 238-39) criticises neoclassical economics for its ‘reluctance to produce theories that yield unambiguous refutable implications, followed by a

general unwillingness to confront those implications with fact.’ Given that neoclassical economics is based upon instrumentalism whose only claim to the validity of a theory is its ability to predict, this begs the question what is neoclassical theory? Neuman (2003, p. 43) discusses the difference between social theory and ideology, noting that ideologies avoid tests and discrepant findings.

Blaug’s criticisms are confirmed in the discussion of REH, the Efficient Market Hypothesis (EMH),

General Equilibrium Theory (GET) and Dynamic Stochastic General Equilibrium (DSGE) in sections 2.1.2, 2.1.3, 2.1.4 and 2.1.5 respectively. On REH, Prescott (1977, p. 30) claims, ‘Like utility, expectations are not observed, and surveys cannot be used to test the rational expectations hypothesis. One can only test if some theory, whether it incorporates rational expectations or, for that matter, irrational expectations, is or is not consistent with observations.’ Following his advice, REH is examined within the larger theories of DSGE, EMH and GET. Regarding DSGE, Mäki (2002, p. 42) discusses how Kydland and Prescott (1982) create a new method for testing their model rather than use standard econometric testing, where parameters of their model are quantified from calibration and they claim that these calibrated parameters yield empirical content for testing. However, Prescott (1988, p. 84) acknowledges that their models are ‘necessarily false and statistical hypothesis testing will reject them.’ Regarding EMH, Barberis and Thaler (2002, p. 8) note that any test of the EMH jointly tests the discounted future cash flow model that makes it difficult to provide evidence of market inefficiency, which is known as the ‘joint hypothesis problem’. Regarding GET, the Sonnenschein–Mantel–Debreu (SMD) Theorem finds that the aggregate excess demand curve is shapeless, that proves the neoclassical assumptions are inconsistent, when an attempt is made to fix the shapeless curve by specifying that all goods have neutral Engel curve, which results in the domain assumptions of GET becoming even more unrealistic because in practice there are few, if any, goods with neutral Engel curves (Keen 2001, pp. 38-42).

The ‘science of complexity’ offers a number of approaches that can allow economics to become a science and resolve many of the current impasses. Section 2.1.3.4 discusses Lo’s (2004) Adaptive Market Hypothesis (AMH) to reconcile the EMH and behavioural economics within an evolutionary framework. Sections 5.6.3 and 5.6.4 discuss how agents within a network structure based on an ‘input-output table’ be implemented in CGE, GET and DSGE to improve shock transmission and the realism of the models to make them more suitable for policy development, which in effect makes CGE, GET and DSGE into ABMs.

In summary, the neoclassical framework was a computationally expedient stop-gap. However, logically, philosophically and empirically the AIE and ‘science of complexity’ are an improvement over REH and neoclassical framework, respectively.