Solow on the limited value of microfounded macroeconomics

8 June, 2015 at 20:59 | Posted in Economics | 2 Comments

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

To some of us, however, this has come at too high a price.

In 2008, the always eminently quotable Nobel Laureate Robert Solow told us in “The State of Macro-economics” (Journal of Economic Perspectives) what he thought of microfounded ‘modern macro’:

[When modern macro-economists] speak of macro-economics 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.

Solow more or less says it all.

One reason why the microfundations approach is so dominant is — as Krugman has it on his blog — “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.

A more plausible reason is that microfoundations is in line with the reductionism inherent in the methodological individaulism that almost all neoclassical economists subscribe to. This is deeeply problematic for a macroeconomics trying to solve the “summation problem” without nullifying the possibility of emergence.

Microfoundations 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.

Microfoundations allegedly goes around the Lucas critique by focussing on “deep” structural, invariant parameters of optimizing individuals’ preferences and tastes. This is actually nothing but an empty hope without solid empirical or methodological foundation.

The kind of microfoundations that ‘New Keynesian’ and New Classical macroeconomists are basing their models on, are not — at least from a realist point of view – plausible.

Instead of 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 rather recommend my students allocating their time into constructing relevant macroeconomic models that really help us to explain and understand what is happening in the real world in which we happen to live.

2 Comments »

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  1. Macroeconomic models based on the aggregate have a tendency towards curve fitting a preconceived belief and models based upon individual understanding come up with a reasonable aggregation function (often falling back on simple summation despite that being provably false).
    .
    So there is a problem operating in both directions.

  2. “I rather recommend my students allocating their time into constructing relevant macroeconomic models that really help us to explain and understand what is happening in the real world in which we happen to live.”

    I don’t think that is possible. Or maybe it depends on what you mean by “model” (very likely an abused term in the profession).

    The priority at the moment is for people to engage with historians and others to make sure they have a more complete understanding of the facts. For example, people go straight into ‘modelling’ the Japanese lost decade without really knowing about the historical events that led up to it. They see some of it and immediately see their ‘model’. For explain they do not explain how the country got into a liquidity trap (eg the link with financial restructuring). If you do not know the specifics of the causes you do not really know how to deal with it. (And the Japanese did deal with it, largely without the help of these models.)

    Before models, you need a thorough ground up investigation of the historical record and an understanding of how the institutions work in the system you are examining.


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