## Where modern macroeconomics went wrong

9 January, 2018 at 13:16 | Posted in Economics | 6 CommentsIn the latest issue of *Oxford Review of Economic Policy* (Volume 34, Issue 1-2, 2018) the editors have invited some well-known contemporary mainstream macroeconomists (including e.g. Simon Wren-Lewis, Randall Wright, Olivier Blanchard, Ricardo Reis, Joseph Stiglitz) to give their views on how to rebuild macroeconomic theory for the future.

Some of the contributions are interesting to read. Others — like Wren-Lewis and Blanchard — seem to think that we can basically just go on with our microfounded DSGE models and *complement* them with one or other structural econometric model (SEM). Two bads, however, do not add up to one good.

Joseph Stiglitz article on Where Modern Macroeconomics Went Wrong acknowledges that his approach “and that of DSGE models begins with the same starting point: the competitive equilibrium model of Arrow and Debreu.” That is, however, probably also the reason why Stiglitz’ suggestions for rebuilding macroeconomics don’t go far enough.

It’s strange that mainstream macroeconomists still stick to a general equilibrium paradigm more than forty years after the Sonnenschein-Mantel-Debreu theorem — SMD — devastatingly showed that it is an absolute non-starter for building realist and relevant macroeconomics:

SMD theory means that assumptions guaranteeing good behavior at the microeconomic level do not carry over to the aggregate level or to qualitative features of the equilibrium …

Given how sweeping the changes wrought by SMD theory seem to be, it is understandable that some very broad statements about the character of general equilibrium theory were made. Fifteen years after General Competitive Analysis, Arrow (1986) stated that the hypothesis of rationality had few implications at the aggregate level. Kirman (1989) held that general equilibrium theory could not generate falsifiable propositions, given that almost any set of data seemed consistent with the theory …

New Classical-Real Business Cycles-DSGE-New Keynesian microfounded macromodels try to describe and analyze complex and heterogeneous real economies with a single rational-expectations-robot-imitation-representative-agent. That is, with something that has absolutely nothing to do with reality. And — worse still — something that is not even amenable to the kind of general equilibrium analysis that they are thought to give a foundation for since SMD *unequivocally *showed that there did not exist any condition by which assumptions on individuals would guarantee either stability or uniqueness of the equilibrium solution.

Opting for cloned representative agents that are all identical is of course not a *real solution* to the fallacy of composition that SMD points to. Representative agent models are — as I have argued at length here — rather an *evasion* whereby issues of distribution, coordination, heterogeneity — everything that really defines macroeconomics — are swept under the rug.

Of course, most macroeconomists know that to use a representative agent is a flagrantly illegitimate method of ignoring real aggregation issues. They keep on with their business, nevertheless, just because it significantly simplifies what they are doing. It reminds — not so little — of the drunkard who has lost his keys in some dark place and deliberately chooses to look for them under a neighbouring street light just because it is easier to see there.

General equilibrium is fundamental to economics on a more normative level as well. A story about Adam Smith, the invisible hand, and the merits of markets pervades introductory textbooks, classroom teaching, and contemporary political discourse. The intellectual foundation of this story rests on general equilibrium, not on the latest mathematical excursions. If the foundation of everyone’s favourite economics story is now known to be unsound — and according to some, uninteresting as well — then the profession owes the world a bit of an explanation.

Almost a century and a half after Léon Walras founded general equilibrium theory, economists still have not been able to show that markets lead economies to equilibria. We do know that — under very restrictive assumptions — equilibria do exist, are unique and are Pareto-efficient. But — what good does that do? As long as we cannot show that there are convincing reasons to suppose there are forces which lead economies to equilibria — the value of general equilibrium theory is nil. As long as we cannot really demonstrate that there are forces operating — under reasonable, relevant and at least mildly realistic conditions — at moving markets to equilibria, there cannot really be any sustainable reason for anyone to pay any interest or attention to this theory.

A stability that can only be proved by assuming Santa Claus conditions is of no avail. Most people do not believe in Santa Claus anymore. And for good reasons — Santa Claus is for kids.

Continuing to model a world full of agents behaving as economists — ‘often wrong, but never uncertain’ — and still not being able to show that the system under reasonable assumptions converges to equilibrium (or simply assume the problem away), is a gross misallocation of intellectual resources and time.

The full force of the Sonnenschein, Mantel, and Debreu (SMD) result is often not appreciated. Without stability or uniqueness, the intrinsic interest of economic analysis based on the general equilibrium model is extremely limited …

The usual way out of this problem is to assume a “representative agent,” and this obviously generates a unique equilibrium. However, the assumption of such an individual is open to familiar criticisms (Kirman 1992; Stoker 1995), and recourse to this creature raises one of the basic problems encountered on the route to the place where general equilibrium has found itself: the problem of aggregation. In fact, we know that, in general, there is no simple relation between individual and aggregate behavior, and to assume that behavior at one level can be assimilated to that at the other is simply erroneous …

The very fact that we observe, in reality, increasing amounts of resources being devoted to informational acquisition and processing implies that the standard general equilibrium model and the standard models of financial markets are failing to capture important aspects of reality.

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The endurance of wrong macroeconomics is inductive evidence that the critics share the same fundamental problems as the orthodox.

Krugman sometimes says, “When an agent-based model does x better than my method, I’ll adopt an agent based model.”

The music of the spheres model of the universe critiqued Newton thusly: “When universal gravity can explain the ratio of the orbits the way our theory does (harmonious ratios being favored just as they are in music), we will adopt universal gravity.”

Comment by Thornton Hall— 9 January, 2018 #

Jonathan Barzilai (who is a mathematician, not an economist) has, in various papers e.g. http://scientificmetrics.com/downloads/publications/Barzilai_2009_MCDM.pdf, argued that the basic mathematical assumption of Arrow-Debreu is incorrect. If Barzilai is correct, and I strongly believe he is, then General Equilibrium theory is fundamentally wrong. The incorrect assumption is that if utility is ordinal it is differentiable.

Comment by Philip George— 9 January, 2018 #

If General Equilibrium is wrong, aren’t prices arbitrary? Which is everyday experience, when different prices are quoted simultaneously? Since the no arbitrage assumption is violated in the very large currency swap markets, can’t prices go negative and free lunches abound? Linear algebra allows relaxation of traditional economic constraints on budgets and hedging, allowing quants to write programs that guarantee a minimum desired payout no matter what the market does …

Comment by Robert Mitchell— 10 January, 2018 #

There is a fundamental problem with applying general equilibrium theory to macroeconomics (apart from those mentioned above). GET is about microeconomic equilibrium, that is, simultaneous equilibrium in all and individual goods and factor markets. It does not deal with macroeconomic equilibrium. GE defines an equilibrium at the (narrowly defined) level of full employment and assumes a given level of income. The means by which equilibrium is obtained is by the adjustment of relative prices. GET cannot characterize an equilibrium below full employment. Macroeconomic equilibrium can occur at levels of employment below full employment. Adjustment of macroeconomic equilibrium is effected by changes in the level of income.

Comment by Henry Rech— 11 January, 2018 #

Henry, from what I know and have discovered on the subject of general equilibrium in economics, your claims are completely wrong. I suspect you are trying to find out what the true situation really is.

Comment by David Harold Chester— 11 January, 2018 #

David I think Henry is right. Prices do not equilibrate an economy (and this has nothing to do with frictions and sticky prices). Microeconomic prices and macroeconomic price levels are not the same thing. General equilibrium theory is the wrong framework from which to look at macroeconomics.

Comment by Nanikore— 12 January, 2018 #