Saturday, January 11, 2014

Neo-Paleo-Keynesianism: A suggested definition

There has been a lot written on the blogosphere in recent weeks about the microfoundations of macroeconomics. Tony Yates argues in favour of micro-founded structural models. Adam Posen is sceptical of micro-foundations and Simon-Wren Lewis, Noah Smith and Nick Rowe call for a more eclectic approach. For those looking for a neat summary of these debates, Paul Krugman traces the history of macroeconomic ideas.  Responding to a  piece by Brad Delong, he argues that there has been a recent resurgence of what he calls “neo-paleo-Keynesianism”.  This is very useful concept and I have much in common with the ideas expressed in Paul's piece. This essay offers a novel definition of the term that Paul coined and an invitation to fellow academics to join me in pursuing an agenda based on this definition.


I agree with Paul Krugman: macroeconomics has taken the wrong path.  I disagree with Paul’s reading of when that happened.  The error has nothing to do with new-classical versus new-Keynesian approaches; it is a more fundamental error that pervades both new-classical and new-Keynesian schools of thought. Macroeconomics took a wrong turn in Cambridge Massachusetts in 1955 when Paul Samuelson, in the third edition of his textbook, introduced the idea of the “neoclassical synthesis” (see Pearce and Hoover for a discussion of the influence of Samuelson’s textbook). Everything since then has been the economic equivalent of the scientific theory of phlogiston.

Many economists are exposed to the philosophy of science through Milton Friedman’s book, Essays in Positive Economics. Friedman promoted the views of Karl Popper who argued (here) that science progresses when theorists make bold conjectures that are confronted by facts. Those conjectures stand until they are refuted by the evidence.  Occasionally, economics students are exposed to the ideas of Thomas Kuhn who talks (here ) of paradigm shifts and scientific revolutions. Rarely does the economics curriculum of a Ph.D. program have time to push much further into the methodology of science.   That’s a pity since there is much to be learned from alternative philosophies.

Axel Leijonhufvud has argued persuasively (here) that we have much to learn from Imré Lakatos, a philosopher of science who spent much of his career at the London School of Economics. Lakatos, (here) in contrast to Popper and Kuhn, sees science as a set of competing scientific research programs.  His approach is a useful one for understanding the current debate amongst practicing macroeconomists who are facing a series of natural experiments that provide serious challenges to both new-classical and new-Keynesian agendas.

According to Lakatos, all tests of scientific theories are necessarily tests of joint hypotheses.  The sciences, both physical and social, are best characterized as interacting communities of scholars.  Those scholars adhere to research programs that interpret the evidence through different lenses.

Each research program has a ‘hard core’ and a ‘protective belt’. When an event in nature appears to refute a theory, the scientist must decide which of the possible components of his theory should be rejected in order to reconcile his worldview with the outcome he observed.  Assumptions that make up the hard core of a research program will never be rejected; instead, the scientist will amend one of the assumptions in its protective belt.

The new-Keynesian research program is the descendent of Samuelson’s ‘neoclassical synthesis’.  According to that synthesis, the economy is ‘Keynesian’ in the short-run when not all markets have had time to clear:  it is ‘classical’ in the long run when all price adjustment has run its course.  It is these twin propositions that form the hard core of the new-Keynesian program. According to that program, market economies are self-correcting, and although the adjustment to the long-run equilibrium may take time, that adjustment will, eventually, occur.

Despite its name, the new-Keynesian research program is neither new, nor Keynesian. The idea, that real economic activity may be different from its long run steady state as a consequence of sticky prices, is firmly rooted in monetarist tradition.   It originated in the eighteenth century and is summarised by David Hume in his delightful essay, Of Money. Keynes argued, in contrast, in the opening chapters of The General Theory, that high unemployment of the kind that persisted in the Great Depression is one of many possible steady state equilibria.

How can we recover this idea, without discarding three hundred years of microeconomic principles? I will refer to a research agenda that maintains the notion of unemployment as a steady-state equilibrium as paleo-Keynesianism. When combined with general equilibrium theory in a way that provides a micro-foundation to this key idea, I will refer to the resulting synthesis as neo-paleo-Keynesianism.

In contrast to new-Keynesian ideas, neo-paleo-Keynesianism does not assume that ‘frictions’ prevent wages or prices from clearing markets.  It does not deny that wages and prices move slowly, relative to quantities. But that observation does not mean that we must assume that there are menu-costs, contracting costs or any other artificial barrier to price adjustment. As I explain (here), sticky prices may simply be part of a rational expectations equilibrium.  Robert Lucas was exactly right when he argued (here) that markets are always in equilibrium. But accepting that proposition does not require us to accept that equilibrium is unique; nor must we accept that equilibrium is optimal, or that unemployment is voluntary.

The neo-paleo-Keynesian (NPK) research program is unashamedly neo-classical. It seeks to reconcile Keynesian ideas with the microeconomics of general equilibrium theory; and it does so in a new way.  As with new-classical and new-Keynesian economics, neo-paleo-Keynesianism constructs models of rational actors who interact in markets.  In contrast to new classical and new-Keynesian programs, neo-paleo-Keynesianism contains two propositions that are absent from the hard core of these agendas: 1) there is a continuum of possible equilibrium unemployment rates and 2) the unemployment rate that prevails is determined by the ‘animal spirits’ of investors.

How might one accomplish this agenda? One approach that I describe (here) combines a search theory of unemployment with an asset-pricing model and (here) I develop a model driven by animal spirits that returns to paleo-Keynesian ideas without invoking sticky prices or wages.  My survey paper (here) explains what is different about neo-paleo-Keynesianism, from the new-Keynesian alternative.[1]

What is wrong with new-Keynesian economics and why should we prefer the NPK approach? Lakatos provides us with an answer. Research programs are not refuted, as in Popper, nor are they dramatically overturned, as in Kuhn. They simply attract more new adherents than their competitors. In the language of Lakatos, research programs are progressive or degenerative.

In the normal course of events, a successful research program meets challenges to its hegemony by modifying hypotheses in its protective belt.  A progressive research program is one that occasionally makes a prediction that is confirmed by experiment or, in the case of macroeconomics, by history. A degenerative research program is one that struggles with continued refutations by continually modifying its protective belt in ever more inelegant ways.

The new-Keynesian research program, like the new-classical program before it, is degenerative. Like Ptolemaician astronomy, it explains new data by adding ever increasing layers of complexity. And like that theory; new-Keynesian economics has not succeeded in making a single prediction that has been confirmed by fresh evidence that was unavailable when the theory was constructed.

So where does that leave the neo-paleo-Keynesian? What event is explained by this approach? First and foremost, there is the persistence of long-term unemployment in the wake of a financial crisis. For a new-Keynesian, it is hard to explain why wages and prices have been so sticky that employment still has not recovered more than five years after the onset of the stock market crash. For a neo-paleo-Keynesian it is an expected outcome for a theory in which high involuntary unemployment is an equilibrium state.

There are those who claim that we should return to the Keynes of the General Theory while rejecting the attempt to build microfoundations. That is the message, for example, of post-Keynesians like Paul Davidson. While there are attractive elements to that path, I do not believe that we should abandon all of classical economics.  There is much to like in the ideas of demand and supply and several branches of economics have had notable successes by following the idea that actors are rational and goal oriented. Examples that come to mind are auction theory that was used successfully to sell the rights to the electromagnetic spectrum in the UK and matching theory that was used to develop kidney exchanges.

The path of combining multiple equilibria with ‘animal-spirits’ has the potential to explain many of the puzzles thrown out by recent experience. I showed (here) that it offers an alternative explanation of the monetary transmission  mechanism, one that outperforms the new-Keynesian alternative, and I argue (here) that active stabilization of financial markets offers an alternative approach to traditional fiscal policy as a means of maintaining full employment.

If Keynes were alive today, one thing is certain; he would not be a Keynesian in the sense in which that term is used today. Keynes was notorious for changing his views on a daily basis and was said to be capable of holding several conflicting opinions at the same time. Would he be a neo-paleo-Keynesian? Who knows?  What seems certain, to me, is that existing ideas have failed us.  For me, that’s enough to try something new.





[1] I am not the only one that is seeking a return to paleo-Keynesian ideas. Others I would place in this category include Stephanie Schmitt Grohé and Martín Uribe (here) who drop classical principles of market clearing and return to the Keynesian concept of involuntary unemployment.  Narayana Kocherlakota constructs (here) a model of incomplete factor markets, Greg Kaplan and Guido Menzio (here) combine search in the labor market with search in the product markets and Pascal Michaillat and Emmanuel Saez (here) takes prices as parametric. All of these papers are examples of multiple steady state equilibria.

25 comments:

  1. Great to see your blog Roger!

    Start with a standard model with perfectly flexible prices and wages. Delete one equation, for example the labour market clearing condition. We are now one equation short of a solution, so we have multiple equilibria. Does that mean we are now free to add any additional equation we feel like? Mathematically, we can do that, of course. But one would like some sort of intuition for that extra equation. Why, for example, should it be an equation for stock prices? Why not a different equation for wages?

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    1. Hi Nick. That's a great point. I will answer it in a new post. :)

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    2. Thanks Roger. I've been thinking about that point, in relation to your work, for some time. I can't really explain why I feel uneasy, but I do. My instinct is to talk about Schelling focal points to determine nominal wages. Which ends up with some sort of sticky wage, or sticky wage inflation, story instead. But I can't justify my instinct.

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  2. This is an impressive consolidation of neoclassical ideas and Keynesian ideas. Sounds at first glance like a potentially more fruitful approach than the fudge of sticky wages.

    Keynes actually hinted at this in a sense with the notion of a "depressed equilibrium". I guess the logical conclusion of this is that there are many different equilibria that an economy is tending toward, and once you get into one the only way to start tending toward another is some kind of shock that drastically shifts expectations and-or material conditions...

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    1. Thanks John... I will try to explain WHY I thinks its better than assuming sticky wages when I answer Nick's comment.

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  3. I will only react to the last para.
    I think keynes strongly believed the economic problem was no problem at all and it was an entirely man made constrict.

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    1. There is certainly a sense in which that is true... the same with famines and "natural disasters" as Amartya Sen argues: http://www.amazon.com/Development-as-Freedom-Amartya-Sen/dp/0385720270

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  4. Very interesting post, insofar as I understood it (not a criticism - I've only had a couple econ classes).

    I do wonder about your reference to Paul Davidson. My understanding is that at one point Davidson tried to place Post-Keynesianism on a foundation of "Marshallian microfoundations." According to Steve Keen, Davidson saw Post-Keynesianism and Neo-Classical macroeconomics as having common axiomatic foundations. Keen went on to say that Davidsons's view won't win him many converts among Post-Keynesians. The paper can be found here - http://keenomics.s3.amazonaws.com/debtdeflation_media/papers/Amfpk.pdf

    You seem to contradict this when you write "there are those who claim that we should return to the Keynes of the General Theory while rejecting the attempt to build microfoundations. That is the message, for example, of post-Keynesians like Paul Davidson. While there are attractive elements to that path, I do not believe that we should abandon all of classical economics. There is much to like in the ideas of demand and supply and several branches of economics have had notable successes by following the idea that actors are rational and goal oriented."

    What I'm wondering is if this means Davidson has changed his mind about this somewhere along the way, as I think it was the early 90s when he proposed it. Or, perhaps supply and demand is something more robust than mere "Marshallian" micro? I thought supply and demand was strongly implied by Marginalism. Any help would be greatly appreciated.

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    1. @J.Jeffers Thanks for pointing me to Steve Keens' paper.

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    2. No problem. The portion most relevant to Paul Davidson's flirtations with micro is near the bottom of page 2 and top of page 3. It's just a paragraph or two worth, really. Heck, I'll post it here:

      "One consistent champion of the proposition that there is an axiomatic foundation to Post Keynesian economics is Davidson, who argues that Post Keynesian and neoclassical macroeconomics have common axiomatic foundations, and that neoclassical results are the consequence of three additional, special axioms that neoclassical macroeconomics adds to this common core: '(a) the axiom of the neutrality of money; (b) the gross substitution axiom; and (c) the ergodic axiom." (Davidson, 1994, p. 11; see also 1981, p. 168; 1984, p. 562). Since Post Keynesian economics is based upon less axioms, Davidson asserts that it is the more general and thus the superior theory.

      Davidson maintains that the common foundations of the two schools are the macroeconomics of the General Theory, together with Marshallian microeconomics (Davidson 1994, pp. 24, 55, 66, et alia). However, this acceptance of Marshallian microfoundations puts Davidson at odds with many other Post Keynesian and heterodox economists, who have made developing alternatives to the Marshallian concepts of marginal cost pricing and the representative firm a major part of the non-neoclassical agenda (Sraffa 1926; Kalecki 1943, pp. 43-61; Eichner 1985, pp. 44-47,
      151-152; Kriesler 1987, pp. 17-20; Reynolds 1987, pp. 53-82). Thus, though Davidson does show that fundamental Post Keynesian results--such as the possibility of an unemployment equilibrium--can be derived from these foundations, his "Keynes-Marshall synthesis" cannot be
      accepted as a methodological basis for Post Keynesian economics."

      I can't speak to the economics, but the rest of the paper struck me as a highly speculative, tentative, and forward looking attempt to ground post-Keynesianism on terms different than the ones being ascribed to Davidson. Not especially rigorous, but maybe that's a reflection of the stage of the process Keen imagines himself to be in.

      I haven't kept up with Davidson or the development of post-Keynesianism so I can't do much more than pass the information along. If however you ever get a hankering to post any thoughts on whether this means Davidson changed his mind, or if he hasn't been then must see "Marshallian" microeconomics as not committing him to anything very constraining to his "post-Keynesian" leanings, or what, I would be interested.

      Thank for your post.

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  5. Question: how do the various econ schools view the market for borrowing/savings?

    Due to the intermediation of banking and the supply of flexible reserves by the Fed, this market can sustain infinite number of states, none of which require an equilibrium. For example if borrowing exceeds savings, banks will simply expand the supply of money to meet loan demand by substituting their liabilities for those of the borrowers. The Fed stands ready to provide any additional reserves, otherwise the fed funds rate will exceed its target rate. The reverse is true as well. If savings exceed borrowing, such excess balances will simply show up as excess reserves on the Fed balance sheet. The fed will begin to lower rates as to to bring savings and borrowing back in balance. However, the Fed can only go down to zero and if the equilibrium rate is negative, this will result in a steady state of excess savings, depressed growth and low inflation. What I am describing here is obviously the lower zero bound - a perfectly steady state that can persists in the long run.

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    1. @H.Publius The situation you describe was debated in 1950's when economists were worried that the Hicks-Hansen IS/LM model might be inconsistent with the existence of equilibrium in a liquidity trap. The perceived problem was that the excess supply of saving would spill over to the labor market and there might be NO constellation of wages, prices and interest rates at which all markets clear. That issue was resolved by <a href="http://www.amazon.com/Money-Interest-Prices-Integration-Monetary/dp/0262161141>Patinkin </a> who showed that, if demand depends on wealth, then prices would fall, and increase the value of nominal assets in real terms, thereby generating sufficient demand to sustain full employment.

      That whole debate has been revived by the new-Keynesians by introducing rational expectations into a version of the same model. The problem with that literature, is that it has not fully grappled with the problem of how an excess supply of labor can be consistent with the absence of profit opportunities by firms. It is precisely that problem that is solved by a theory of labor market search.

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    3. Thank you for pointing me in this direction. Labor search theory is quite brilliant. Two more questions - how does labor search theory explain significantly longer recoveries after a recession triggered by a banking crisis? Specifically, I am curious if someone has made a comparison between the job market recovery after the 1982 recession and current. In 1982 the unemployment rate spiked to 10.8%; however, within 2 years it was down to 7.3%. In 2009 unemployment reached 10%, and it took 4 years to go back down to 7.3%. Somehow the search friction (as measured by recovery period) associated with similar levels of unemployment is different, which would suggest that there may be another factor at play.

      Second question. In the presence of an active Fed, which does not allow prices to fall, it seems the clearing mechanism you are suggesting works differently. Rather than relying on the nominal effects of price deflation, the Fed relies on the wealth effect of asset inflation. However, there are limitations to this approach, namely money balances supplied by the Fed are concentrated with large corporations and the wealthy who have a lower propensity to invest and spend. Accordingly, new money balances originally churn in an asset bubble and only later trickle down to the real economy. I describe this effect at length and provide historical evidence here: http://tinyurl.com/q8pmmb2

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    4. There are different causes of recessions. Search theory provides an explanation why very high unemployment persists following a shock. But it is only half of the story. Persistence of the current crisis has a lot to do with persistence of shocks in the financial markets. Thats a story for another post.

      Thanks for the link to your post on bubbles.

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  6. I think when you assume a relation between prices and demand you are moving away from Keynes and into the classic world. Actually we can argue that AD is downward slope because of wage stickiness, but my comment goes beyond that.

    What is set on the market isn’t the value of a good but the surplus that is cleared. I.e. we are talking second order curves where marginal demand and offer is compensated. When we go to the market we don’t take all our needs and we don’t take all our asset’s.

    What puzzles me in economic literature is the different treatment you give to resources, we say wages are sticky, no matter if we have evidence that people are hired with lower wages in a depression, just like the interest rates on new contracts go down or new rents go down even if the old rents are the same.

    First order equilibria must assume that all prices are sticky, because trading surplus doesn’t impact the value of the stock, if it did on n+1 after rising prices all buyers at n would become sellers.


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  7. Just another remark, when you say "Keynes argued, in contrast, in the opening chapters of The General Theory, that high unemployment of the kind that persisted in the Great Depression is one of many possible steady state equilibria."

    From my recollection Keynes says that he's General Theory was named General because he considered full employment to be a special case of his General Equilibrium, not unemployment.

    The empirical evidence for Keynes was overwhelming in the sense that economies were not in full employment, just in special cases.

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  8. Just a final remark, IMHO, we can only progress in economic science if we abandon the concept of Demand and Supply and search for a different model to explain reality.

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  9. http://alephblog.com/2014/02/04/differences-in-us-states-unemployment-over-the-last-36-years/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+TheAlephBlog+%28The+Aleph+Blog%29

    Take a look, high volatility in unemployment mostly a coordination failure in government, is my conclusion.

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  11. Across all the variations upon Keynes’s themes, the core notion is that markets, in particular financial markets, cannot be trusted to deliver; and that state-sponsored initiatives and regulation can be trusted to secure remedial action. Accepting that for the sake of continuing the argument, where is the companion volume; i.e., the General Theory of Sovereign Debt Management?

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  12. It is very helpful that you mention Davidson and Post Keynesians. Despite the all-important notion of liquidity-preference and their emphasis on fundamental uncertainty it is true that they they have not developed behavioural micro-foundations. On the other hand, there are some Post Keynesians who are currently open to behavioural economics. Davidson himself has claimed that Keynes was the first behavioural economist. In addition, adding animal spirits as a fourth datum is similar to adding fundamental uncertainty to the standard data of technology, tastes and wealth. Thus, there is perhaps scope for exploring similar themes with certain strands in Post Keynesian economics. On the other hand,, for mainstream Keynesian economics of different persuasions, your approach provides a fresh framework to rethink of important issues that somehow are dealt in a shallow way and hastily.

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  13. Multiple equilibria plus animal spirits sounds like no equilibrium at all. Shit happens and can keep on happening indefinitely. Which I don't necessarily doubt, but it seems to add up to huge indeterminacy.

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    1. Good to see my very first post is still getting hits! General equilibrium models (generically) have multiple equilibria. Monetary general equilibrium model always have multiple equilibria (no qualification). The way to deal with this is to model the way people form beliefs here.

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  14. Neo-Paleo-Stupidicism
    Comment on Roger Farmer on ‘Neo-Paleo-Keynesianism: A suggested definition’

    Science was there before economics was there. Economists either conform to well-defined scientific standards or they are out of science: they are in NO position to redefine scientific criteria. This, though, is what they regularly attempt to do. Roger Farmer’s featured post is a case in point.

    Because economics — as represented by the four failed sects Walrasians, Keynesians, Marxians, Austrians — has never risen above the level of a proto-science it has become popular among economists to question the standards, to lower them or, as Blaug put it, ‘to play tennis with the net down’. Hence, economists are very receptive to methodological soft-pedaling like anything-goes (Feyerabend), economics is not a Science with a capital S (Solow), economics is an inexact and separate science (Hausman/J. S. Mill), pluralism of false theories or nobody-knows-anything (Heterodoxy), or Lakatosian replacement of scientific true/false by opportunistic like/dislike.

    The scientific method is well-defined by formal and material consistency (Klant, 1994, p. 31). Logical consistency is secured by applying the axiomatic-deductive method and empirical consistency is secured by applying state-of-the-art testing. To secure both consistencies is a tough job and it is in no way predetermined how the general methodological principle applies at the cutting edge of research. To figure this out is exactly the creative scientific achievement.

    Economics fails on both counts: the axiomatic foundations are provably false and, as a consequence, testing is regularly inconclusive. So, the four economic sects have happily established themselves in the swamp between true and false where ‘nothing is clear and everything is possible’ (Keynes).

    Standard economics is built upon this set of foundational propositions, a.k.a. axioms: “HC1 economic agents have preferences over outcomes; HC2 agents individually optimize subject to constraints; HC3 agent choice is manifest in interrelated markets; HC4 agents have full relevant knowledge; HC5 observable outcomes are coordinated, and must be discussed with reference to equilibrium states.” (Weintraub, 1985, p. 147)

    Methodologically, these premises are forever unacceptable but economists swallowed them hook, line and sinker from Jevons/Walras/Menger onward to DSGE. The failure of methodological individualism as embodied in HC1|HC5 is indisputable. NOT ONE axiom is acceptable.

    Because of this, the microfoundations approach has already been dead in the cradle more than 140 years ago. Have economists realized this? Forget it! Krugman put it thus: “most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point”.

    Get this: ALL models that contain maximization-and-equilibrium in any shape or form are a priori unacceptable. Post Keynesianism is different but in no way better.* This leaves only one option. As Joan Robinson put it: “Scrap the lot and start again.”

    Roger Farmer asks: “How can we recover this idea, without discarding three hundred years of microeconomic principles?“ Wrong question. Sticking to these principles is as good as sticking to the flat-earth principle, that is, it is a reliable indicator of scientific incompetence.

    The failure of economics requires a paradigm shift. Nothing less will do. Roger Farmer instead teams up with a zombie: “The neo-paleo-Keynesian research program is unashamedly neo-classical.” But it gets worse. Who is Roger Farmer’s ideal economist? “Keynes was notorious for changing his views on a daily basis and was said to be capable of holding several conflicting opinions at the same time.” Allais called this “insuffisance logique” (1993, p. 70) which unceremoniously translates into stupidity (see also 2013).

    Egmont Kakarot-Handtke

    References see
    http://axecorg.blogspot.de/2016/05/neo-paleo-stupidicism.html

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