Building a science of economics for the real world

22 May, 2017 at 16:51 | Posted in Economics | 1 Comment

Following the greatest economic depression since the 1930s, Robert Solow in 2010 gave a prepared statement on “Building a Science of Economics for the Real World” for this 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 microfounded macromodels 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? Solow surmised 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.”

Conclusion: an economic theory or model that doesn’t pass the real world smell-test is just silly nonsense that doesn’t deserve our attention and therefore belongs in the dustbin.

Rational expectations — not to mention effective market hypotheses, NAIRU, and DSGE models — immediately comes to mind.

Those who want to build macroeconomics on microfoundations usually maintain that the only robust policies and institutions are those based on rational expectations and representative actors. As I tried to show in my paper Rational expectations — a fallacious foundation for macroeconomics in a non-ergodic world there is really no support for this conviction at all. On the contrary. If we want to have anything of interest to say on real economies, financial crisis and the decisions and choices real people make, it is high time to place macroeconomic models building on representative actors and rational expectations-microfoundations where they belong — in the dustbin.

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.

1 Comment

  1. effective market hypotheses”
    I presume you meant to write, “efficient” market hypothesis
    The efficient market hypothesis makes some sense as a technical point in the context of constructing a null hypothesis for research using data on historic financial market prices.
    It makes absolutely no sense as an assertion about a quality supposedly possessed by financial markets.
    How the efficient market hypothesis went from being a perfectly sensible technical point to being a right-wing dogma, with no effective objection being offered within the profession can tell us a great deal about what has gone wrong in economics.
    What in the mechanism design of a financial market contributes to the informational efficiency of a financial market would seem like a reasonable topic for empirical inquiry by economists. Analytic theory would have a part to play, but in a sensible profession, there would be no dispute concerning the need to go and look at institutions in detail and to measure performance, quantitatively. Pontification would never be regarded as sufficient from anyone.
    I do not know what your sneering rhetoric concerning “real world smell-test” is meant to accomplish and I would not be so ready to discard every result from financial economics related to the random-walk of financial market prices. I do think economists should acknowledge the simple epistemic point that analysis is not descriptive; analytic models, no matter how elaborate, can never serve as maps or isomorphic models. There is an institutionalized economy which is never “perfectly” anything; economists need to go out and learn about it, before pronouncing confidently on policy.

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