Let's not assume that

I accidentally set off several threads when I tweeted that maybe empirical evidence should guide what we think about the economy rather than pronouncements about what money is. One of the shorter sub-threads (and pretty much the only one I understood what people were talking about — j/k) included Nick Rowe and his old post on (the lack of) evidence favoring of fiscal or monetary policy. He's great because regardless of what you think about the ideas behind the toy models he builds or parables he tells, they're remarkably clear illustrations of the ideas. I'd recommend even the most hardened heterodox MMTer read his blog (here's a good one on stock-flow consistency).

The summary of Rowe's post is that if you have a fiscal or monetary authority (government, central bank) that targets some some variable it can affect — possibly imperfectly — under the assumption of rational expectations, then there'd be little evidence that the instrument used to target that variable had any effect. The fluctuations in the instrument or target variable are going to be the authority's uncorrelated forecast errors. It's "Milton Friedman's thermostat" (also well-explained by Nick Rowe in another post using an analogy with a driver on hilly terrain). The conclusion is that you should expect little evidence that fiscal and/or monetary policy works even if it does.

But as Dan Davies has written:

I’m pretty sure that it was JK Galbraith (with an outside chance that it was Bhagwati) who noted that there is one and only one successful tactic to use, should you happen to get into an argument with Milton Friedman about economics. That is, you listen out for the words “Let us assume” or “Let’s suppose” and immediately jump in and say “No, let’s not assume that”.

If assuming that a central bank with rational expectations stabilizes the economy will produce no evidence that a central bank with rational expectations stabilizes the economy, then what we have is effectively unfalsifiable (in the useful sense of Popper).

Let's not assume that, then.

What use is it to make these assumptions? They essentially prevent learning things about the economy. In fact, the most useful thing to do in this case — even if those assumptions are true — is to assume the opposite: that central banks (or fiscal policy) has no effect on the macroeconomy. Incidentally, this would produce exactly the same observation of a lack of correlation between the authority's inputs and the target variable output. In the worst case, at least you'd learn that you were wrong if the assumptions were actually true. And if you discovered robust empirical regularities about e.g. fiscal policy mitigating unemployment, then you'd learn that those assumptions of rational expectations and policy effectiveness are wrong in some way. It's a win-win.

You as the theorist should endeavor to maximize the ways in which you can be wrong through observations because that's how we learn [1]. If your preferred framework makes it impossible for data to shed light on it, then the best evidence you can provide is to assume the opposite and show how it fails to capture the data. These frameworks run the gamut from specific mathematical assumptions to more philosophical ones, but they have a single purpose: protecting beliefs from data. If this isn't your aim, the best course of action still would be to lean over backward against this bias [2] and seek out how you might be proven wrong.

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Footnotes:

[1] High energy physics (the particles and string theory stuff that people often think of as "physics" in a similar way to the way people think of macroeconomics as "economics") has been thought to be in a kind of existential crisis because it is too good at explaining observations — there's no place high energy physics is wrong, so we can't learn anything new.

[2] It might just perceived as bias by others, but that's the breaks. If we think you're biased to adopt a framework that lets you keep your beliefs by escaping comparison with the data then it's unfortunately on you to disavow us of this belief.