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The Post-crisis Critique of the NCM: Theoretical Aspects

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Critique of the New Consensus Macroeconomics and Implications for India

Part of the book series: India Studies in Business and Economics ((ISBE))

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Abstract

Turbulent economic events in the past have often triggered substantial changes in ruling economic paradigms. It was expected by many that the Global Crisis would provoke a similar outcome. We show in this chapter that by and large, this expectation was belied, and the NCM emerged almost unscathed through the various criticisms levelled both on its theoretical and policy aspects. This chapter is devoted to a detailed review of the theoretical criticisms levelled against the main tenets of the NCM particularly the hypotheses of rational expectations, representative agent, efficient markets, etc. There is also a detailed critique of DSGE models as these forms an integral component of the NCM.

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Notes

  1. 1.

    Actually philosophers distinguish between three types of reductionism viz. theory reductionism, methodological reductionism and ontological reductionism. Economists usually have the last in mind which Murphy (op. cit) p. 82 defines as denial “that wholes are anything more than their parts”.

  2. 2.

    Simon was awarded the Nobel for Economics in 1978.

  3. 3.

    There are several interesting applications of “satisficing” models in management science, operations research, marketing, behavioural psychology etc.

  4. 4.

    The fallacy of composition is best described in Keynes’ own words “I argue that important mistakes have been made through extending to the system as a whole, conclusions which have been correctly arrived at in respect of a part of it taken in isolation” Keynes (1939, p. xxxii).

  5. 5.

    Following Kirman (1992), the DSM theorem may be explained as follows. The foundations of neoclassical economics rest on the assumption that if individual demand functions satisfy Wald’s (1936) WARP (weak axiom of revealed preference) (implying individual demand curves are downward sloping) then a unique stable market equilibrium exists. The DSM theorem asserts that whereas the WARP is sufficient to ensure the existence and local uniqueness (of a market equilibrium), global uniqueness and stability are not ensured by WARP (or by even stronger restrictions on individual demand functions). In this connection, it is interesting to observe that Wald (1936) had correctly observed that “there is a statistical probability that from the assumption that [WARP] holds for every household, the validity of [WARP] for the market follows”. In other words WARP at the micro level can lead to WARP at the macro level. The later neoclassicals conveniently interpreted this possibility as a nomic necessity.

  6. 6.

    Their main findings were that (i) individuals exaggerate the importance of vivid over pallid evidence (TV montage over reports in newspapers/scientific journals) (ii) there is exaggeration of probabilities of recent events over those occurring earlier (iii) individuals’ errors are systematic rather than random (they are reluctant to give up pre-conceived notions, more favourably disposed towards accepting evidence confirming initial beliefs than contra-evidence etc.) and (iv) individuals react sluggishly to new information, preferring very often to rely on heuristic decision rules in such cases.

  7. 7.

    There seems to be some evidence of Hicks having revised his position on this (see Hicks 1979).

  8. 8.

    For an introduction to copulas and their uses in finance, kindly refer Brigo et al. (2010).

  9. 9.

    We recognize, of course, that securitization was one among several factors leading up to the crisis. Nevertheless, securitization will continue to be a key element in any narrative of the crisis.

  10. 10.

    Shiller’s work has spawned a phenomenal literature (see e.g. Cochrane 1991; Cooper 1999; Dumas et al. 2009; Wang and Ma 2014 etc.).

  11. 11.

    Basel III tries to pay some attention to the fat tails problem.

  12. 12.

    Charles Munger (an American investor, businessman, and philanthropist), who is Vice Chairman of Berkshire Hathaway, the conglomerate controlled by Warren Buffett, once said in a speech “Efficient market theory is a wonderful economic doctrine that had a long vogue in spite of the experience of Berkshire Hathaway. In fact one of the economists who won — he shared a Nobel Prize — and as he looked at Berkshire Hathaway year after year, which people would throw in his face as saying maybe the market isn’t quite as efficient as you think, he said, “Well, it’s a two-sigma event.” And then he said we were a three-sigma event. And then he said we were a four-sigma event. And he finally got up to six sigmas — better to add a sigma than change a theory, just because the evidence comes in differently. [Laughter] And, of course, when this share of a Nobel Prize went into money management himself, he sank like a stone.” (http://thereformedbroker.com/2014/01/03/that-time-buffett-smashed-the-efficient-market-hypothesis/).

  13. 13.

    This point seems to have been made earlier by Sims (1980) and as a matter of fact was a recurrent theme in the identification debates of the 1950s (see Marschak 1950; Hurwicz 1950 etc.)—a point noted by Kocherlakota (op. cit.).

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Nachane, D.M. (2018). The Post-crisis Critique of the NCM: Theoretical Aspects. In: Critique of the New Consensus Macroeconomics and Implications for India. India Studies in Business and Economics. Springer, New Delhi. https://doi.org/10.1007/978-81-322-3920-8_11

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