The reductionism stops here

One of the defining features of neoclassical economics is the belief that macroeconomic analysis has to be not merely compatible with, but derivable from, microeconomic analysis. The development of economic theory has been driven far more by this belief than by the desire to make the theory compatible with the observed behaviour of the economy.

This ‘reductionist’ aspect of economics – the attempt to reduce the higher level topic of macroeconomics to an applied version of the lower level topic of microeconomics – is at odds with the last 50 years of genuine sciences, where complexity has ruled the roost, for reasons that were eloquently put by Physics Nobel Laureate Philip Anderson in a highly readable paper entitled “More Is Different”.

In that paper, Anderson asserted that reductionism did not work, because though it is possible to rank sciences in a hierarchy in which “The elementary entities of science X obey the laws of science Y, … this hierarchy does not imply that ‘science X is just applied Y’… At each stage entirely new laws, concepts, and generalisations are necessary, requiring inspiration and creativity to just as great a degree as in the previous one. Psychology is not applied biology, nor is biology applied chemistry.”

Economics violates this by its belief that “macroeconomics is just applied microeconomics”, but recent blogosphere debates have confirmed that there is a limit to how far neoclassical economists will take reductionism: it stops at microeconomics.

Logically, one could argue that if macroeconomics is just applied microeconomics, then economics itself is just applied accounting – since that is the “nuts and bolts” measurement discipline that underlies economics. However, neoclassical economists have responded to this assertion with derision.

The assertion has come about because numerous commentators have tried to persuade neoclassical macroeconomists that their models of central bank behaviour contradict the principles of accounting. The most egregious instance of this was Scott Sumner’s rejoinder to Cullen Roche, when Roche argued that Krugman’s model of banks lending reserves violated basic principles of accounting.

“Cullen, you said: ‘It’s basically double entry bookkeeping, understanding modern banking, flow of funds analysis, sectoral balances, etc. Most of it is just a description of the system we have’” he argued. “I have no interest in banking or bookkeeping. My interest is monetary policy.”

This is instructive on two levels. Firstly, if a Keynesian macroeconomist had given a similar retort to a neoclassical microeconomist asserting that “macro did not have good micro foundations”, the Keynesian would have come off second-best: “of course macro has to be compatible with micro!” would have been the general reaction. The second is that it does raise an important point for economists like me who reject the reductionist approach of neoclassical macroeconomists, and yet at the same time assert that macro has to be compatible with the even lower level discipline of accounting. If reductionism is wrong, then what it the proper relationship between a higher level discipline like macroeconomics and a more fundamental one like accounting?

On the first issue, reductionism fails because of what physicists dubbed “emergent properties”, which was the focus of Anderson’s paper: new phenomena arise from the interaction of fundamental entities – be they atoms in chemistry or individual agents in macroeconomics – that cannot be derived from the properties of the fundamental entities themselves. As Anderson put it in 1972: The behavior of large and complex aggregates of elementary particles, it turns out, is not to be understood in terms of a simple extrapolation of the properties of a few particles. Instead, at each level of complexity entirely new properties appear, and the understanding of the new behaviors requires research which I think is as fundamental in its nature as any other.”

Ironically, neoclassical economics provides one of the best instances of this in what is known as the Sonnenschein-Mantel-Debreu theorem. This theorem posed the question that, if you aggregated the demand curves of a whole lot of individuals who each obeyed the ‘Law of Demand’ (their demand for a good rises as its price falls), would the resulting market demand curve also obey the Law of Demand? The answer was no, it wouldn’t: the market demand curve could have any shape at all. In the jargon-laden words of Hugo Sonnenschein in 1972: “Can an arbitrary continuous function … be an excess demand function for some commodity in a general equilibrium economy?... we prove that every polynomial … is an excess demand function for a specified commodity in some n commodity economy… every continuous real-valued function is approximately an excess demand function.”

Interpreting the jargon, what this means is that a market demand curve derived from adding up the demands of numerous individuals, all of whom have downward-sloping demand curves, doesn’t have to be downward-sloping at all. But that is precisely what economists always draw when they draw a market demand curve, and this fallacious version of microeconomics is what has been imposed on macroeconomics. So microeconomics as taught and practised “doesn’t have good microeconomic foundations”, and nothing should be forced to be either consistent with it or derived from it – least of all macroeconomics.

But at the same time, critics of neoclassical macroeconomics like myself (and Cullen Roach and many others) reproach neoclassical macroeconomics for not being consistent with accounting. Is this a double standard – applying a reductionist vision (“Macroeconomics should be applied accounting”) while all along I’ve rejected reductionism?

No, but it does raise the issue of if not reductionism, what is the relationship between a given discipline like macroeconomics and the lower level entities that constitute it? I would argue that while a higher level discipline – like, for example, biology – can’t be reduced to a lower level one – like organic chemistry – it’s still necessary that biological theories can’t rely upon things that organic chemistry says are impossible.

So a biological model that relied upon something happening that organic chemistry says is impossible – such as for example using cyanide to enhance some cellular process – would be a nonsense model.

It’s in this light that I (and Cullen and many others) criticise the mainstream view that banks can lend from reserves: doing so would violate basic accounting principles. And for that reason, proposals like Nick Rowe’s that the Federal Reserve should just commit to “printing” reserves until such time as nominal GDP rises are nonsense – because those reserves can’t get into circulation in the real economy without violating the basic principles of accounting. I’ll cover why that is so in another post.

Steve Keen is author of Debunking Economics and the blog Debtwatch and developer of the Minsky software program.