Dumb and dumber in modern macroeconomics

15 Jul, 2012 at 14:15 | Posted in Economics | 8 Comments

Oxford professor Simon Wren-Lewis has a new post up today on the elevated gadgets of modern macroeconomics:

So while I think I was right to define modern macro by its methodology, I also agree that this methodology can assume an importance that can be dangerous. I think this is a danger that economics is particularly prone to, because its methodology is essentially deductive in character, and economists are very attached to their rationality axioms. The microfoundation of macroeconomic theory means that macro is subject to that same danger. 

If he had ended his post there, I wouldn’t have had to write any comment at all, but rather silently infer that after all we weren’t thinking importantly different on the issue. But recognising the danger of this “misinterpretation” of his standpoint, Wren-Lewis quickly adds:                 

That would be a nice way to end this post from a rhetorical point of view, but I suspect if I did, some would misinterpret what I say as implying that the majority of mainstream macroeconomists routinely make mistakes of this kind, or worse still that the microfoundation of macro was a mistake. I believe neither of those things, and I have been rather more positive than Professor Krugman in the past on what modern macro has achieved.

So – here we go!

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 macroeconomics:

[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.

So, of course, I could just as well have directed Wren-Lewis to Robert Solow’s article. There the answer to what’s wrong with the modern microfounded macroeconomics of Wren-Lewis et consortes was given already four years ago.

And in case you’re still not convinced – here’s another masterpiece that essentially says it all:

So how did macroeconomics arrive at its current state?

The original impulse to look for better or more explicit micro foundations was probably reasonable. What emerged was not a good idea. The preferred model has a single representative consumer optimizing over infinite time with perfect foresight or rational expectations, in an environment that realizes the resulting plans more or less flawlessly through perfectly competitive forward-looking markets for goods and labor, and perfectly flexible prices and wages.

How could anyone expect a sensible short-to-medium-run macroeconomics to come out of that set-up? My impression is that this approach (which seems now to be the mainstream, and certainly dominates the journals, if not the workaday world of macroeconomics) has had no empirical success; but that is not the point here. I start from the presumption that we want macroeconomics to account for the occasional aggregative pathologies that beset modern capitalist economies, like recessions, intervals of stagnation, inflation, “stagflation,” not to mention negative pathologies like unusually good times. A model that rules out pathologies by definition is unlikely to help. It is always possible to claim that those “pathologies” are delusions, and the economy is merely adjusting optimally to some exogenous shock. But why should reasonable people accept this? …

What is needed for a better macroeconomics? [S]ome of the gross implausibilities … need to be eliminated. The clearest candidate is the representative agent. Heterogeneity is the essence of a modern economy. In real life we worry about the relations between managers and shareowners, between banks and their borrowers, between workers and employers, between venture capitalists and entrepreneurs, you name it. We worry about those interfaces because they can and do go wrong, with likely macroeconomic consequences. We know for a fact that heterogeneous agents have different and sometimes conflicting goals, different information, different capacities to process it, different expectations, different beliefs about how the economy works. Representative-agent models exclude all this landscape, though it needs to be abstracted and included in macro-models.

I also doubt that universal rational expectations provide a useful framework for macroeconomics …

Now here is a peculiar thing. When I was in advanced middle age, I suddenly woke up to the fact that my colleagues in macroeconomics, the ones I most admired, thought that the fundamental problem of macro theory was to understand how nominal events could have real consequences. This is just a way of stating some puzzle or puzzles about the sources for sticky wages and prices. This struck me as peculiar in two ways.

First of all, when I was even younger, nobody thought this was a puzzle. You only had to look around you to stumble on a hundred different reasons why various prices and factor prices should be much less than perfectly flexible. I once wrote, archly I admit, that the world has its reasons for not being Walrasian. Of course I soon realized that what macroeconomists wanted was a formal account of price stickiness that would fit comfortably into rational, optimizing models. OK, that is a harmless enough activity, especially if it is not taken too seriously. But price and wage stickiness themselves are not a major intellectual puzzle unless you insist on making them one.

Robert Solow, “Dumb and dumber in macroeconomics”

8 Comments

  1. Is Modern Macro or 1978‐era Macro More Relevant to the Understanding of the Current Economic Crisis?
    Robert J. Gordon Northwestern University, NBER, and CEPR
    September 12, 2009, revision of a paper first presented to International Colloquium on the History of Economic Thought
    Sao Paulo, Brazil, August 3, 2009

    • Looks interesting. Will have a look at it. Thanks Dwayne.

  2. Krugman just posted a response to your previous post on gadgets. He has now added scratchpad to the mix.

  3. […] an Economics for the Real World Via Lars Syll, a group of distinguished economists recently testified before a Congressional hearing on […]

  4. […] Dumb and dumber in modern macroeconomics – Lars P Syll's Blog […]

  5. Impressive! Thanks for sharing that article of Solow (too bad he isn’t blogging…)

    Note that posts of Prof Wren-Lewis seem to trigger comments with similar titles (but don’t expect anything as profound as Solow)
    http://www.98economics.com/2012/07/you-always-need-someone-dumber-than-you.html

  6. You are wrong to say that there are no ontological or epistemological reasons put forward for microfoundations. This whole debate played out well before my time, thats for sure, but it never the less does exist in the literature. In short, the reason for microfoundations is to improve our ability to inform policy–with non-founded models, we can never be sure how a particular policy change, especially if it is a proposal that has not been tried before, will influence the parameters of the model. Microfoundation is simply the process of reducing the model down to a level of clarity where we can be reasonably confident that the parameters specified in the model are exogenous and won’t shift in response to the policy change. It is worth noting that as soon as anyone publishes a useful model that is not microfounded, the very next publication on the topic will be from some clever theorist showing how that model can be microfounded as a special case of a DSGE model. In that respect, your critique of microfoundations seems a lot more like laziness, wanting to skip to the interesting parts without doing the homework to show that the result is robust to policy changes.

    The rest of your critique just boils down to arguing for more and better microfoundations. You reject the representative agent framework. Fine, but there are tons of microfounded macro papers with heterogeneous agents. The reason why they aren’t all heterogeneous agents models is because most of the time the heterogeneity doesn’t affect our particular research question. You criticize the use of infinitely-lived agents. Fine, but there is extensive use of overlapping generations models in all branches of macro. Again, most of the time the finite life-span of agents doesn’t affect the particular research question. You criticize models of perfect competition. Fine, but nearly all New Keynesian models actually assume imperfect competition.

    Finally, a word about rational expectations. At a fundamental level, all that economists are assuming when they rely on rational expectations is that firms and households in the private sector are no stupider than the government–that is, that their forecasts are no worse than the ones used by policy makers. And when you compare private sector forecasts to those released by, for example, the federal reserve governors, you find that in fact this assumption is absolutely true.

  7. […] people occasionally take the trouble to debunk neoclassical macro-models. Look for instance here, here, here, here, here, here, here, here, here, and […]


Sorry, the comment form is closed at this time.

Blog at WordPress.com.
Entries and comments feeds.