Gods and idiots may share Wren-Lewis model, but it certainly isn’t my model!

17 Jul, 2012 at 17:55 | Posted in Economics, Theory of Science & Methodology | 22 Comments

In his latest piece on the “The Great Divide” debate, Oxford professor Simon Wren-Lewis today writes:

There is a lot that I have read which is challenging, and which has made me think about things in different (for me) ways, which is good. But there is also lots of stuff that seems less helpful …

Stuff like we cannot possibly take microfounded macro seriously, because it is based on an all-embracing representative actor equipped with superhuman knowledge and forecasting abilities. To which I feel like shouting – where else do you start? I always say to PhD students, start simple, understand the simple model, and then complicate. So we start with a representative agent …

What about superhuman knowledge and forecasting abilities? That seems like an extreme position. But the alternative is to assume we know what kind of mistakes agents will make (sic!). Where does this knowledge come from? … To keep things simple, I therefore assume I do not know what mistakes they will make, which implies (sic!) rational expectations.

Being one of those annoying heterodox economists forcing Wren-Lewis and other neoclassical economists to “think about things in different ways,” yours truly comes to think about a laboratory experiment run by James Andreoni and Tymofiy Mylovanov – presented here – where the researchers induced common probability priors, and then told all participants of the actions taken by the others. Their findings is very interesting, and says something rather profound on the value of the rational expectations hypothesis in the kind of models used by Wren-Lewis and other macroeconomists of the same ilk:

We look at choices in round 1, when individuals should still maintain common priors, being indifferent about the true state. Nonetheless, we see that about 20% of the sample erroneously disagrees and favors one point of view. Moreover, while other errors tend to diminish as the experiment progresses, the fraction making this type of error is nearly constant. One may interpret disagreement in this case as evidence of erroneous or nonrational choices.

Next, we look at the final round where information about disagreement is made public and, under common knowledge of rationality, should be sufficient to eliminate disagreement. Here we find that individuals weigh their own information more than twice that of the five others in their group. When we look separately at those who err by disagreeing in round 1, we find that these people weigh their own information more than 10 times that of others, putting virtually no stock in public information. This indicates a different type of error, that is, a failure of some individuals to learn from each other. This error is quite large and for a nontrivial minority of the population.

Setting aside the subjects who make systematic errors, we find that individuals still put 50% more weight on their own information than they do on the information revealed through the actions of others, although this difference is not statistically significant.

So in this experiment there seems to be some irrational idiots who don’t understand that that is exactly what they are. When told that the earth is flat they still adhere to their own beliefs of a circular earth. It is as if people thought that the probability that all others are idiots with irrational beliefs is higher than the probability that the earth is circular.

Now compare these experimental results with rational expectations models, where the world evolves in accordance with fully predetermined models where uncertainty has been reduced to stochastic risk describable by some probabilistic distribution.

The tiny little problem that there is no hard empirical evidence that verifies these models doesn’t seem to bother its protagonists too much. When asked in an interview by George Evans and Seppo Honkapohja (Macroeconomic Dynamics (2005, vol.9, 561-583) if he thought “that differences among people’s models are important aspects of macroeconomic policy debates”, Nobel laureate Thomas Sargent replied:

The fact is you simply cannot talk about their differences within the typical rational expectations model. There is a communism of models. All agents within the model, the econometricians, and God share the same model.

One might perhaps find it odd to juxtapose God and people, but I think Leonard Rapping – himself a former rational expectationist – was on the right track (Arjo Klamer, The New Classical Macroeconomics 1984, p 234):

Frankly, I do not think that the rational expectations theorists are in the real world. Their approach is much to abstract.

Building models on rational expectations either means we are Gods or Idiots. Most of us know we are neither. So, God may share Sargent’s and Wren-Lewis’s model, but it certainly isn’t my model.

22 Comments

  1. That is very interesting and I share your doubts about rationality and representative actors. But how would you analyze the particular policy question that Simon proposed?

  2. It is a hopeless cause. Check out Sargent’s nonsensical statement:

    “The criticism of real business cycle models and their close cousins, the so-called New Keynesian models, is misdirected and reflects a misunderstanding of the purpose for which those models were devised. These models were designed to describe aggregate economic fluctuations during normal times when markets can bring borrowers and lenders together in orderly ways, not during financial crises and market breakdowns.”

    After all, the crisis arose out of “normal times.”

    • I fine case of ad hocery, isn’t it?

  3. “To which I feel like shouting – where else do you start?”

    Well for one they could try dropping the obsession with pure mathematics and use some of the simulation and modelling techniques we use in information science all the time.

    I’d create a few classes of actors and a message bus to allow them to interact. Then I’d create a few thousand instances on a computer and see how they worked together.

    Haven’t these people ever played Sim City?

  4. Barack Obama had “The Audacity of Hope”, Thomas Sargent has “The Audacity of Certainty”. Your citing of Arjo Klamer reminded me of the excerpt from his blog, where, (upon learning of Sargent winning the 2011 version of The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, he wrote:

    Esther Mirjam Sent tells the story that when she had class from him, he walked in, wrote three equations on the blackboard and announced that this is the economy. Economic questions were not welcome but if you wanted to question the math, please go ahead. It is the math that counts.

    Source: http://www.klamer.nl/wordpress/?p=785

    While I care about the mathematics; I don’t care for the abstractions imposed by Sargent, Wren-Lewis, and the like. That sort of mathematics does not count. I do, however, always care about the economy and all the social interactions that underpin it and the societal implications that stem from it.

    • “While I care about the mathematics; I don’t care for the abstractions imposed by Sargent, Wren-Lewis, and the like. That sort of mathematics does not count.” I couldn’t have put that better myself, Arijit!

  5. Interestingly, Sargent might argue he and others are engaged in a form of abstract theoretical simulations. He has a long winded interview from 2005 that goes in this direction. See Macro Dynamics that Lars quotes from.

  6. Deidre McCloskey has a great piece on the problem of math in economics. It is a “gem.”

  7. Hold on! How did you obtain the “export license” for that experiment to your “target system”?

  8. If you have anything that mildly resembles a model, you also know its predictions. And if your agents expectations diverge from these prediction, you have also specified their mistakes. But you still don’t address Wren-Lewis’ challenge how to specify what these mistakes are.

    What are they?

    In an old videoclip you posted on your blog, Skidelsky said that even Keynes (even Keynes!) said that “as practical men” we must evaluate the future in some way. And one principle of doing so is to say that the future will be “much the same as the present”.

    Is that even a consistent statement? So if GDP is Y today, does that mean that GDP will be Y also in 50 years? But if growth of Y is x% today, does that mean that growth in 50 years will be x%? Both these statements are inconsistent with each other, so what on earth did the man – and you perhaps? – mean?

    (btw. Skidelsky also suggest that it is reasonable to assume that current stock prices reflect all knowledge of future event … a statement that sounds very similar to the EMH to me!)

  9. Here’s some tounge in cheek editing of Mr Lewis (a slight exaggeration for comic effect.)

    Next, we look at the final round where information about disagreement is made public and, under common knowledge of rationality, should be sufficient to eliminate disagreement. Here we find that WREN LEWIS weighs HIS own information more than 10 times that of others, putting virtually no stock in public information. This indicates a different type of error, that is, a failure of some individuals to learn from others. This error is quite large for a supposedly clever economist.

  10. Damn, Matthew Yglesias came late to the debate but he nailed it!

    “This is about a million years late in blog time, but last week there were a range of interesting blog posts about the quest to provide “microfoundations” for macroeconomic theory. As someone who took more philosophy of science classes than economics courses as an undergrad, I have to say that I’ve always found this particular tick to be a bit puzzling.

    In philosophy there’s an idea called “reduction.” We might start with a bunch of observed psychological regularities about human behavior (“when people go a while without drinking they get thirsty”) and then ask if we can reduce this psychological insight into some kind of neurological phenomenon. And perhaps some day we’ll be able to go down from neurology to chemistry and particle physics and understand the quantum mechanical underpinnings of thirst. But while reduction is something scientists inquire into, it’s never been the case that reduction is the sine qua non of useful scientific inquiry. To the best of my understanding, Newton’s account of gravity didn’t have any microfoundations at all. It was a mathematical formalization of observations about how the world functions. And while modern physicists aspire to come up with a “theory of everything” that will explain relativistic gravity in quantum mechanical terms they haven’t yet succeeded. But this hardly means that the whole history of human inquiry into how gravity works is some kind of silly parlor game that lacks rigor.

    And crucially the key test a purported effort to provide microfoundations for gravity must pass is that it has to explain gravity well. The trend in economics since the Lucas Critique seems to be the reverse. If a theory lacks adequate microfoundations, it’s rejected out of hand while you get a lot of wriggle room in terms of accounting for the data properly.

    People who seem very bothered by the fact that the observed reality of nominal wage stickiness is not well microfounded don’t appear to have the same difficulty relying on the observed reality of gravity. This is particularly strange since microeconomics itself is not particularly microfounded in psychology or neurology. Non-economists often level this as a somewhat misguided purportedly devastating critique of microeconomics, noting that abstractions about welfare-maximizing agents are not justified by scientific understanding of actual decision-making procedures. The right answer is that productive inquiry can happen at many different levels of understanding and the appropriate test of a theory is whether it gives some kind of useful account of the thing it’s supposed to explain. But if microeconomics doesn’t require a psychological or neurological foundation to offer insight, then there’s no reason to think macroeconomics requires a microeconomic foundation. A theory of everything would be nice, but general relativity is a very impressive achievement.”

    • Matthew’s piece – http://www.slate.com/blogs/moneybox.html – is absolutely terrific! As a critical realist I can’t but see the similarity between his argumentation about “reduction” and what science philosophers Rom Harré, Roy Bhaskar and Margret Archer have called “emergence”.

      • Hold on. I thought you didn’t believe in nominal wage rigidity! Are you betraying your own intellectual foundations just not to clinch with big shot bloggers? I certainly hope not.

        • What on earth made you think that? But maybe you confuse this undeniable empirical fact with another issue and a totally different standpoint of mine (and Keynes and Krugman) – namely that even IF nominal wages weren’t rigid, it still wouldn’t in most situations solve the unemployment problem to lower wages, but rather make it worse.

          • So in “most situations” wage rigidity actually helps the economy in a recession! Is there any – any! – empirical evidence to support that point? And does wage rigidity have any merit in explaining recessions (apart from that they help the recovery)?

            And no, I do not believe there is a single statement of Krugman where he has supported this point. Why don’t you provide us with a link?

            • Don’t lecturers in economics in Cambridge ever read anything nowadays? You could e.g. start with pages 53 and 163-64 in Krugman’s latest book, End this depression now!

          • Oh, as opposed to professors in social science at Malmö University College we’re expected to write stuff on our own. Reading what other people have said and reciting it is just not considered good enough. It’s weird, I know, but universities tend to work that way.

            But the strange thing is that Krugman has on multiple occasions singled out nominal wage rigidity as the key reason why unemployment is high. The last time must have been a few weeks ago. But you are claiming that he disagrees with this idea in his book?

  11. I’ve heard the argument from Keynesians here and there about how the “stubborn” libertarians just cannot admit they’re wrong or see the evidence and are blind to new information. Well the truth is that us libertarians have the exact same opinions about Keynesians. The evidence is on the libertarian side, the logic is on the libertarian side, with every generation the libertarians are the ones who see what’s coming while the Keynesians miss. When libertarians argue with Keynesians, libertarians always win if they can hold their salt in terms of knowledge. Logic is on the side of the libertarians, it’s the “complex theories” and “this is what the textbook says, read Keynes!” that holds up the Keynesians.


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