Keynes and Econometrics
After the 1920s, the theoretical and methodological approach to economics changed significantly. Based on a criticism of Marshall’s work and legacy, a new generation of American and European economists developed Walras’ and Pareto’s mathematical economics. As a result of this trend, the Econometric Society was founded in 1930.
The constitutional assembly was held in Cleveland, Ohio, during the annual joint meeting of the American Economic Association and the American Statistical Association. The Norwegian economist Ragnar Frisch played an important role in the Econometric Society that was founded to enhance studies based on the theoretical-quantitative and the empirical-quantitative approach to economic problems. In this way, the founding fathers believed that economic thinking could be as rigorous as the one that dominates the natural sciences.
At the 5th European Meeting of the Econometric Society, in 1935, Jan Tinbergen presented a paper on ‘A mathematical theory of business cycle policy’ that followed the Econometric Society’s guidelines. His causal explanation of the business cycle began with a priori economic-theoretical considerations about explanatory variables and then he proceeded to test a model.
In the late 1930s, John Maynard Keynes and other economists objected to this recent “mathematizing” approach. Keynes, as editor of the Economic Journal, wrote a negative review of Tinbergen’s 1939 book A Method and its Application to Investment Activity. This book presented a statistical testing of business cycle theories based on the application of the method of multiple regression and mathematical framing in the form of a specified model. At the core of Keynes’ concern lied the question of methodology. Recalling his own words:
Am I right in thinking that the method of multiple correlation analysis essentially depends on the economist having furnished, not merely a list of the significant causes, which is correct so far as it goes, but a complete list? For example, suppose three factors are taken into account, it is not enough that these should be in fact veræ causæ; there must be no other significant factor. If there is a further factor, not taken account of, then the method is not able to discover the relative quantitative importance of the first three. If so, this means that the method is only applicable where the economist is able to provide beforehand a correct and indubitably complete analysis of the significant factors. The method is one neither of discovery nor of criticism. It is a means of giving quantitative precision to what, in qualitative terms, we know already as the result of a complete theoretical analysis. (Keynes 1939: 560)
In the paragraph above, it is clear that Keynes doubted the use of inductive methods of generalization and statistical inference to build economic theories because of the peculiarity of the economic systems characterized by:
- a low degree of homogeneity,
- a high degree of complexity
- the lack of stability through time.
What was obvious to Keynes is that econometrics is applicable when the theoretical model is already known. In this respect, the problem of the selection of regressors was also highlighted by Keynes in the review of Tinbergen’s book. As econometrics involves regression techniques, researchers must already have furnished a complete list of relevant factors – if the regression is to make sense (this point is indicated by the common reference to “omitted variable bias”). However, Keynes’s concern is still ignored by vast majority of practicing econometricians: missing one relevant factor can certainly lead to misleading results. (Zaman, 2017)
Keynes’s methodological contribution reflects the role of mathematics, statistics and econometrics in economics. In short, on behalf of the peculiarities of the economic systems, Keynes highlighted that econometrics – as a method – can be only applicable where the economist is able to provide beforehand a correct and indubitably complete analysis of the significant factors. Indeed, in Keynes’s words, econometrics is neither “a method of discovery nor of criticism”. And he adds that econometrics
…is a means of giving quantitative precision to what, in qualitative terms, we know already as the result of a complete theoretical analysis – provided always that it is a case where the other considerations to be given below are satisfied (Keynes, p. 560).
At the core of his argument lies the question of methodology and his opposition to the attempt at using induction and statistical inference without any prior effort of building an economic theory. Indeed, Keynes put in question the legitimacy of econometrics as the appropriate method applied to economics.
Garrone, G. and Marchionatti, R. Keynes on econometric method. A reassessment of his debate with Tinbergen and other econometricians, 1938-1943. 2004. Working Paper 012004. Università di Torino.
Keynes, J. M., Professor Tinbergen’s Method, The Economic Journal, Vol. 49, No. 195. Sep., 1939, pp. 558-577. Published by: Blackwell Publishing for the Royal Economic Society. http://www.jstor.org/stable/2224838
Tinbergen, J. A Method and its Application to Investment Activity. Geneva: League of Nations, 1939.
Zaman, A. “Choosing the Right Regressors“. 2017. https://weapedagogy.wordpress.com/?s=Choosing+the+Right+Regressors
From: p.12 of WEA Commentaries 8(1), February 2018