Mistaking beauty for truth – Real Business Cycle models and the quest for external validity

23 April, 2012 at 15:30 | Posted in Economics, Theory of Science & Methodology | 2 Comments

Most models in science are representations of something else. Models “stand for” or “depict” specific parts of a “target system” (usually the real world). A model that has neither surface nor deep resemblance to important characteristics of real economies ought to be treated with prima facie suspicion. How could we possibly learn about the real world if there are no parts or aspects of the model that have relevant and important counterparts in the real world target system? The burden of proof lays on the theoretical economists thinking they have contributed anything of scientific relevance without even hinting at any bridge enabling us to traverse from model to reality. All theories and models have to use sign vehicles to convey some kind of content that may be used for saying something of the target system. But purpose-built assumptions, like invariance, made solely to secure a way of reaching deductively validated results in mathematical models, are of little value if they cannot be validated outside of the model.

All empirical sciences use simplifying or unrealistic assumptions in their modeling activities. That is (no longer) the issue – as long as the assumptions made are not unrealistic in the wrong way or for the wrong reasons.

Theories are difficult to directly confront with reality. Economists therefore build models of their theories. Those models are representations that are directly examined and manipulated to indirectly say something about the target systems.

There are economic methodologists and philosophers that argue for a less demanding view on modeling and theorizing in economics. And to some theoretical economists it is deemed quite enough to consider economics as a mere “conceptual activity” where the model is not so much seen as an abstraction from reality, but rather a kind of “parallel reality”. By considering models as such constructions, the economist distances the model from the intended target, only demanding the models to be credible, thereby enabling him to make inductive inferences to the target systems.
But what gives license to this leap of faith, this “inductive inference”? Within-model inferences in formal-axiomatic models are usually deductive, but that does not come with a warrant of reliability for inferring conclusions about specific target systems. Since all models in a strict sense are false (necessarily building in part on false assumptions) deductive validity cannot guarantee epistemic truth about the target system. To argue otherwise would surely be an untenable overestimation of the epistemic reach of “surrogate models”.

Models do not only face theory. They also have to look to the world. But being able to model a credible world, a world that somehow could be considered real or similar to the real world, is not the same as investigating the real world. Even though all theories are false, since they simplify, they may still possibly serve our pursuit of truth. But then they cannot be unrealistic or false in any way. The falsehood or unrealisticness has to be qualified (in terms of resemblance, relevance etc). At the very least, the minimalist demand on models in terms of credibility has to give away to a stronger epistemic demand of “appropriate similarity and plausibility” (Pålsson Syll 2001:60). One could of course also ask for a sensitivity or robustness analysis, but the credible world, even after having tested it for sensitivity and robustness, can still be a far way from reality – and unfortunately often in ways we know are important. Robustness of claims in a model does not per se give a warrant for exporting the claims to real world target systems.

Questions of external validity are important more specifically also when it comes to microfounded macromodels. It can never be enough that these models somehow are regarded as internally consistent. One always also has to pose questions of consistency with the data. Internal consistency without external validity is worth nothing.

“New Keynesian” macroeconomist Simon Wren-Lewis has an interesting post on his blog on these topics and how they may be related to ideology:

I want to raise [the] problem that some researchers might select facts on the basis of ideology. The example that I find most telling here is unemployment and Real Business Cycle models.

Why is a large part of macroeconomics all about understanding the booms and busts of the business cycle? The answer is obvious: the consequences of booms – rising inflation – and busts – rising unemployment – are large macroeconomic ‘bads’. No one disagrees about rising inflation being a serious problem. Almost no one disagrees about rising unemployment. Except, it would appear, the large number of macroeconomists who use Real Business Cycle (RBC) models to study the business cycle.

In RBC models, all changes in unemployment are voluntary. If unemployment is rising, it is because more workers are choosing leisure rather than work. As a result, high unemployment in a recession is not a problem at all. It just so happens that (because of a temporary absence of new discoveries) real wages are relatively low, so workers choose to work less and enjoy more free time. As RBC models do not say much about inflation, then according to this theory the business cycle is not a problem at all …

Now the RBC literature is very empirically orientated. It is all about trying to get closer to the observed patterns of cyclical variation in key macro variables. Yet what seems like a rather important fact about business cycles, which is that changes in unemployment are involuntary, is largely ignored. (By involuntary I mean the unemployed are looking for work at the current real wage, which they would not be under RBC theory.) There would seem to be only one defence of this approach (apart from denying the fact), and that is that these models could be easily adapted to explain involuntary unemployment, without the rest of the model changing in any important way. If this was the case, you might expect papers that present RBC theory to say so, but they generally do not …

What could account for this particular selective use of evidence? One explanation is ideological. The commonsense view of the business cycle, and the need to in some sense smooth this cycle, is that it involves a market failure that requires the intervention of a state institution in some form. If your ideological view is to deny market failure where possible, and therefore minimise a role for the state, then it is natural enough (although hardly scientific) to ignore inconvenient facts …

Do these biases matter? I think they do for two reasons. First from a purely academic point of view they distort the development of the discipline. As I keep stressing, I do think the microfoundations project is important and useful, but that means anything that distorts in energies is a problem. Second, policy does rely on academic macroeconomics, and both the examples of bias that I use in this post … could have been the source of important policy errors.

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  1. I agree with Simon Wren-Lewis’ view on RBC. But when you say “At the very least, the minimalist demand on models in terms of credibility has to give away to a stronger epistemic demand of ‘appropriate similarity and plausibility’ “, I wonder who should be the czar of “appropriateness” and “plausibility”. It’s easy to throw around open ended, and to be honest quite trivial, questions and statements. But it’s much much harder to answer them. And in all frankness, you consistently avoid these more difficult questions and instead pooh-pooh simplifications that may or may not serve us well. And it’s easy to tell everyone how bad they are doing things. But much harder to show how to do it right. I’m still waiting for the day when you will turn to actually doing economics, instead of just telling the rest of us how wrong we are. But let me just say that I doubt that day will ever happen. What a waste of energy and time.

    • Happy we can agree on RBC (although I have to say, when it comes to “New Keynesianism”, that it is nothing but wishful thinking to say, as Wren-Lewis, that “New Keynesian models are RBC models plus sticky prices, but that plus bit is crucial. Not only does it allow involuntary unemployment, and therefore a role for policy to smooth the cycle, but it also changes other properties of the model.” I don’t concur. Garbage in – garbage out.)
      Re allocation of time, I would say telling the emperor he is naked, can never be as waste of time, as long as he has devoted followers that consciously choose to look the other way.
      In economics we usually look favourably on division of labour, so macroeconomists build models, and science theorists and methodologists evaluate them and see if they are relevant.


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