Microfounded DSGE models — spectacularly useless and positively harmful

18 December, 2013 at 19:23 | Posted in Economics | 3 Comments

Economists — yours truly included — working within the Post Keynesian tradition, have always maintained that there is  a strong risk that people may find themselves unemployed in a market economy.

And, of course, unemployment is also something that can take place in microfounded  DSGE models — but the mechanism in these models is of a fundamentally different kind.

In the basic DSGE models the labour market is always clearedresponding to a changing interest rate, expected life time incomes, or real wages, the representative agent maximizes the utility function by varying her labour supply, money holding and consumption over time. Most importantly — if the real wage somehow deviates from its “equilibrium value,” the representative agent adjust her labour supply, so that when the real wage is higher than its “equilibrium value,”  labour supply is increased, and when the real wage is below its “equilibrium value,”  labour supply is decreased.

In this model world, unemployment is always an optimal choice to changes in the labour market conditions.  Hence, unemployment is totally voluntary. To be unemployed is something one optimally chooses to be. 

Although this picture of unemployment as a kind of  self-chosen optimality, strikes most people as utterly ridiculous, there are also, unfortunately, a lot of neoclassical economists out there who still think that price and wage rigidities are the prime movers behind unemployment. What is even worse — I’m totally gobsmacked every time I come across this utterly ridiculous misapprehension — is that some of them even think that these rigidities are the reason John Maynard Keynes gave for the high unemployment of the Great Depression. This is of course pure nonsense. For although Keynes in General Theory devoted substantial attention to the subject of wage and price rigidities, he certainly did not hold this view. That’s rather the view of microfounded DSGE modelers, explaining variations in employment (and a fortiori output) with assuming nominal wages being more flexible than prices —  happily disregarding the total lack of empirical evidence for this rather counterintuitive assumption.

Since unions/workers, contrary to classical assumptions, make wage-bargains in nominal terms, they will – according to Keynes – accept lower real wages caused by higher prices, but resist lower real wages caused by lower nominal wages. However, Keynes held it incorrect to attribute “cyclical” unemployment to this diversified agent behaviour. During the depression money wages fell significantly and – as Keynes noted – unemployment still grew. Thus, even when nominal wages are lowered, they do not generally lower unemployment.

In any specific labour market, lower wages could, of course, raise the demand for labour. But a general reduction in money wages would leave real wages more or less unchanged. The reasoning of the classical economists was, according to Keynes, a flagrant example of the “fallacy of composition.” Assuming that since unions/workers in a specific labour market could negotiate real wage reductions via lowering nominal wages, unions/workers in general could do the same, the classics confused micro with macro.

Lowering nominal wages could not – according to Keynes – clear the labour market. Lowering wages – and possibly prices – could, perhaps, lower interest rates and increase investment. But to Keynes it would be much easier to achieve that effect by increasing the money supply. In any case, wage reductions was not seen by Keynes as a general substitute for an expansionary monetary or fiscal policy.

Even if potentially positive impacts of lowering wages exist, there are also more heavily weighing negative impacts – management-union relations deteriorating, expectations of on-going lowering of wages causing delay of investments, debt deflation et cetera.

So, what Keynes actually did argue in General Theory, was that the classical proposition that lowering wages would lower unemployment and ultimately take economies out of depressions, was ill-founded and basically wrong.

To Keynes, flexible wages would only make things worse by leading to erratic price-fluctuations. The basic explanation for unemployment is insufficient aggregate demand, and that is mostly determined outside the labor market.

The classical school [maintains that] while the demand for labour at the existing money-wage may be satisfied before everyone willing to work at this wage is employed, this situation is due to an open or tacit agreement amongst workers not to work for less, and that if labour as a whole would agree to a reduction of money-wages more employment would be forthcoming. If this is the case, such unemployment, though apparently involuntary, is not strictly so, and ought to be included under the above category of ‘voluntary’ unemployment due to the effects of collective bargaining, etc …
The classical theory … is best regarded as a theory of distribution in conditions of full employment. So long as the classical postulates hold good, unemploy-ment, which is in the above sense involuntary, cannot occur. Apparent unemployment must, therefore, be the result either of temporary loss of work of the ‘between jobs’ type or of intermittent demand for highly specialised resources or of the effect of a trade union ‘closed shop’ on the employment of free labour. Thus writers in the classical tradition, overlooking the special assumption underlying their theory, have been driven inevitably to the conclusion, perfectly logical on their assumption, that apparent unemployment (apart from the admitted exceptions) must be due at bottom to a refusal by the unemployed factors to accept a reward which corresponds to their marginal productivity …

Obviously, however, if the classical theory is only applicable to the case of full employment, it is fallacious to apply it to the problems of involuntary unemployment – if there be such a thing (and who will deny it?). The classical theorists resemble Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight – as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry. Something similar is required to-day in economics. We need to throw over the second postulate of the classical doctrine and to work out the behaviour of a system in which involuntary unemployment in the strict sense is possible.

J M Keynes General Theory

People — like Simon Wren-Lewis — calling themselves “New Keynesians” ought to be rather embarrassed by the fact that the kind of microfounded DSGE models they use, cannot incorporate such a basic fact of reality as involuntary unemployment!

Of course, working with representative agent models, this should come as no surprise. The kind of unemployment that occurs is voluntary, since it is only adjustments of the hours of work that these optimizing agents make to maximize their utility.

The final court of appeal for macroeconomic models is the real world, and as long as no convincing justification is put forward for how the inferential bridging de facto is made, macroeconomic modelbuilding is little more than “hand waving” that give us rather little warrant for making inductive inferences from models to real world target systems. If substantive questions about the real world are being posed, it is the formalistic-mathematical representations utilized to analyze them that have to match reality, not the other way around.

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3 Comments »

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  1. Very nice post, indeed.

  2. on the part about unemployment, I agree. And I find Blanchard’s effort to claim that some progress has been made in NK models on this score laughable. He notes that

    “The first question is then how to think about and introduce unemployment in a macro model. Here, fortunately, we can build—and are building—on a parallel effort, developed over the past twenty years by, in particular, Peter Diamond, Chris Pissarides, and Dale Mortensen (thus, the name “DMP model”. In this approach, unemployment arises from the fact that the labor market is a decentralized market, where, at any time, some workers are looking for jobs, while some jobs are looking for workers. This has two implications. The first is that, by necessity, there is always some unemployment—and, symmetrically, some vacancies. The second is that, as it takes time for a worker to find another job, and for a firm to find another worker, both the worker and the firm have some bargaining power. This implies that the wage—and by implication, the cost of labor, employment, and unemployment—depends on the nature of bargaining.”

    Still doesn’t explain large-scale and long-term unemployment. …

  3. “The final court of appeal for macroeconomic models is the real world, and as long as no convincing justification is put forward for how the inferential bridging de facto is made, macroeconomic modelbuilding is little more than “hand waving” that give us rather little warrant for making inductive inferences from models to real world target systems.”

    Nice post. Actually most of economics is abductive, not inductive or deductive. Abduction is (nearly) inference to the best explanation.

    Given that an increasingly larger part of the population is being thrown out of the workforce because of automation and robotics, traditional economics no longer works because the meaning of labor and capital have changed and I am surprised why some economists do not understand this. This is the new digital world: http://bit.ly/1cbHLji


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