The state of microfoundations and macroeconomics – Robert Solow says it all

16 Mar, 2012 at 15:15 | Posted in Economics, Theory of Science & Methodology | 3 Comments

The purported strength of new-classical and new-Keynesian macroeconomics is that they have firm anchorage in preference-based microeconomics, and especially the decisions taken by inter-temporal utility maximizing “forward-loooking” individuals.

To some of us, however, this has come at too high a price. The almost quasi-religious insistence that macroeconomics has to have microfoundations – without ever presenting neither ontological nor epistemological justifications for this claim – has put a blind eye to the weakness of the whole enterprise of trying to depict a complex economy based on an all-embracing representative actor equipped with superhuman knowledge, forecasting abilities and forward-looking rational expectations. It is as if – after having swallowed the sour grapes of the Sonnenschein-Mantel-Debreu-theorem – these economists want to resurrect the omniscient walrasian auctioneer in the form of all-knowing representative actors equipped with rational expectations and assumed to somehow know the true structure of our model of the world (how that could even be conceivable is beyond my imagination, given that the ongoing debate on microfoundations, if anything, shows that not even we, the economists, can come to agreement on a common model).

Following the greatest economic depression since the 1930s, the grand old man of modern economic growth theory, Nobel laureate Robert Solow, on July 20, 2010, gave a prepared statement on “Building a Science of Economics for the Real World” for a hearing in the U. S. Congress. According to Solow modern macroeconomics has not only failed at solving present economic and financial problems, but is “bound” to fail. Building dynamically stochastic general equilibrium models (DSGE) on “assuming the economy populated by a representative agent” – consisting of “one single combination worker-owner-consumer-everything-else who plans ahead carefully and lives forever” – do not pass “the smell test: does this really make sense?” One cannot but concur in Solow’s surmise that a thoughtful person “faced with the thought that economic policy was being pursued on this basis, might reasonably wonder what planet he or she is on.”

Already in 2008 Solow had – in “The State of Macroeconomics” (Journal of Economic Perspectives 2008:243-249) – told us of what he thought of microfounded “modern macro”:

[When modern macroeconomists] speak of macroeconomics as being firmly grounded in economic theory, we know what they mean … They mean a macroeconomics that is deduced from a model in which a single immortal consumer-worker-owner maximizes a perfectly conventional time-additive utility function over an infinite horizon, under perfect foresight or rational expectations, and in an institutional and technological environment that favors universal price-taking behavior …

No one would be driven to accept this story because of its obvious “rightness”. After all, a modern economy is populated by consumers, workers, pensioners, owners, managers, investors, entrepreneurs, bankers, and others, with different and sometimes conflicting desires, information, expectations, capacities, beliefs, and rules of behavior … To ignore all this in principle does not seem to qualify as mere abstraction – that is setting aside inessential details. It seems more like the arbitrary suppression of clues merely because they are inconvenient for cherished preconceptions …

Friends have reminded me that much effort of ‘modern macro’ goes into the incorporation of important deviations from the Panglossian assumptions … [But] a story loses legitimacy and credibility when it is spliced to a simple, extreme, and on the face of it, irrelevant special case. This is the core of my objection: adding some realistic frictions does not make it any more plausible than an observed economy is acting out the desires of a single, consistent, forward-looking intelligence …

It seems to me, therefore, that the claim that ‘modern macro’ somehow has the special virtue of following the principles of economic theory is tendentious and misleading … The other possible defense of modern macro is that, however special it may seem, it is justified empirically. This strikes me as a delusion …

So I am left with a puzzle, or even a challenge. What accounts for the ability of ‘modern macro’ to win hearts and minds among bright and enterprising academic economists? … There has always been a purist streak in economics that wants everything to follow neatly from greed, rationality, and equilibrium, with no ifs, ands, or buts … The theory is neat, learnable, not terribly difficult, but just technical enough to feel like ‘science’. Moreover it is practically guaranteed to give laissez-faire-type advice, which happens to fit nicely with the general turn to the political right that began in the 1970s and may or may not be coming to an end.

Earlier this week, new-Keynesian macroeconomist Simon Wren-Lewis asked me to explain why other ways of doing macro have (purportedly) died out and the microfoundations approach has become so dominant. In my admittedly tentative answer I wrote.

(1) One could of course say that one reason why the microfundations approach is so dominant is – as Krugman has it on his blog today – “trying to embed your ideas in a microfounded model can be a very useful exercise — not because the microfounded model is right, or even better than an ad hoc model, but because it forces you to think harder about your assumptions, and sometimes leads to clearer thinking”.But I don’t really believe that is an especially important reason on the whole. I mean, if people put that enormous amount of time and energy that they do into constructing macroeconomic models, then they really have to be substantially contributing to our understanding and ability to explain and grasp real macroeconomic processes. If not, they should – after somehow perhaps being able to sharpen our thoughts – be thrown into the waste-paper-basket (something the father of macroeconomics, Keynes, used to do), and not as today, being allowed to overrun our economics journals and giving their authors lots of academic prestige.

(2) A more plausible reason is that microfoundations is in line with the reductionism inherent in the metohodological individaulism that almost all neoclassical economists subscribe to. And as e.g. argued by Johan Åkerman and Ekkehart Schlicht this is deeeply problematic for a macroeconomics trying to solve the “summation problem” without nullifying the possibility of emergence.

(3)It is thought to give macroeconomists the means to fully predetermine their models and come up with definitive, robust, stable, answers. In reality we know that the forecasts and expectations of individuals often differ systematically from what materialize in the aggregate, since knowledge is imperfect and uncertainty – rather than risk – rules the roost.

(4) Microfoundations allegedly goes around the Lucas critique by focussing on “deep” structural, invariant parameters of optimizing individuals’ preferences and tastes. As I have argued, this is an empty hope without solid empirical or methodological foundation.

The kind of microfoundations that “new-Keynesian” and new-classical general equilibrium macroeconomists are basing their models on, are not – at least from a realist point of view – plausible.

As all students of economics know, time is limited. Given that, there has to be better ways to optimize its utilization than spending hours and hours working through or constructing irrelevant macroeconomic models founded on microfoundations more chosen from considerations of mathematical tractability than applying to reality. I would rather recommend my students allocating their time into constructing better, real and relevant macroeconomic models – models that really help us to explain and understand reality.

Of course, I could just as well have directed Wren-Lewis to Robert Solow’s article. There the answer to his question was given already four years ago.