Where modern macroeconomics went wrong

23 Jul, 2018 at 16:09 | Posted in Economics | 19 Comments

In issue 1-2 (2018) of Oxford Review of Economic Policy, 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.

economist_cover_oh_fuck_september_2008Some 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 …

24958274Given 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 …

S. Abu Turab Rizvi

New Classical-Real Business Cycles-DSGE-New Keynesian microfounded macro models 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.

Frank Ackerman

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.

19 Comments

  1. Lars,

    I don’t know why you perpetually take the argument against GET as a macro theory onto the GET playing field – representative agents, stability, uniqueness of equilibrium and all the rest of it. While these are valid criticisms – the point is you are playing by the rules of the neoclassical game.
    .
    I would argue that all this is unnecessary.
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    GET is founded on optimization and optimal use of resources.
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    What has this to do with the level of the utilization of resources?
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    This is the true playing field of macroeconomics.
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    The attack on neoclassical economics qua macroeconomic theory should begin there.

    • GET is founded on optimization and optimal use of resources.
      .
      What has this to do with the level of the utilization of resources?

      .
      The great stumbling block is that leaving resources idle is prima facie inefficiency in their allocation. Resources which are available but remain unused are being wasted as the time during which they remain idle can not be recovered. This basic insight was Keynes’ trump card. However badly he played his hand in The General Theory, the then undeniable experience of widespread involuntary unemployment was proof of market failure.
      .
      All of mainstream macroeconomics ever since Keynes has been a series of attempts to repair the breach, to show that the allegedly self-regulating Market System tended toward stable levels of activity and was seeking thru adjustment of prices and wages an efficient allocation of resources. Efficient operation of each individual market would add-up to an efficient general system, without a need for public, purposeful interventions in opposition to private exercises of power.

  2. “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”.
    .
    I second Henry’s comment above regarding the irrelevance of SMD to macroeconomics.
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    In addition there is a further puzzle as to why anti-economic iconclasts are so besotted with SMD.
    OK, let us accept the maths that SMD shows that there is no GUARANTEE of stability or uniqueness.
    But the lack of guarantee does not rule out the POSSIBILITY of stability or uniqueness.
    Even more so, SMD does not rule out the possibility or the likelihood of TENDENCIES TOWARD a unique equilibrium point (such as that in Keynes’ General Theory), or TENDENCIES TOWARD a local equilibrium.

    Whether such situations exist is an emprical matter which cannot be determined by armchair philosophising.

    Many of Prof. Syll’s criticisms of DSGE may well be valid, but SMD seems to be irrelevant.

    • Kingsley,
      .
      To be clear, I am saying GET is not relevant to macroeconomics and to the extent that SMD is about GET then it is irrelevant to macroeconomics. GET is the fundamental theory of microeconomics and optimal resource utilization under constraint.

      • I guess what Lars is getting at is that he opposes macro-economics being seen within a general equilibrium framework – which is flawed on both logical and empirical grounds. The overriding objective of macro-economics over the last 2 or three decades has basically been to unite micro and macro under a mathematical general equilibrium framework. This seems to have been more important than understanding how economies actually work. Absurd, especially given the pressing problems we face, but miserably true.

        However I agree with comments here that if something is proven factually incorrect then that should be enough. A discussion about its mathematical validity shouldn’t even be necessary.

        • “I guess what Lars is getting at is that he opposes macro-economics being seen within a general equilibrium framework ”
          .
          I not so sure he’s saying this. To me he’s playing the neoclassical game of pick the conditions/assumptions under which a constrained equilibrium will occur. If your argument relies on invalidating the assumptions of GET, you are still talking about GET.

          As far as I can see, macroeconomics has nothing to do with GET.

  3. The kind of equilibrium described by GET is given by changes in relative prices. This is an equilibrium which assumes full employment of resources and an optimum utilization of resources against an assumed income constraint. It is the only viable equilibrium under the theory. If resource utilization is below the PPF then the constraint is irrelevant and there can be no optimal utilization of resources defined.
    .
    The kind of equilibrium given by Keynesian analysis is set by the level of spending (i.e. there is no assumed level of income), does not assume full employment of resources and can be stable. There can be a multitude of stable equilibrium points depending on the level of spending.
    .
    These are entirely two different modes of economic thinking.

    • Keynes, as you must know, claimed one was a special case of the other. I am not so sure that the system outlined by Keynes can be stable, but leave that aside. It is true that established methods can derive an equilibrium analysis from a conservation law — Euler was very good at doing so in physical contexts; it is not at all clear to me that neoclassical economists are committed to that mode of thinking at all. It seems to me that the marginal revolution threw out the search for a conservation law in favor of treating a market equilibrium as given from the operation of a market process and therefore an outcome of a social process of discovery and dare I say, feedback, a homeostasis. The market is conceived of as an adaptive process. It is unnecessary to specify a conservation law — a singularly problematic notion to apply to social relations as the classical economists discovered. The market process will discover an equilibrium — think Walras and tatonnement — and then in a sleight of hand, that homeostasis can be treated as if it is mathematically equivalent to an equilibrium derived by logical necessity from a conservation law; the advantage to doing so is that the math of hydraulics say can be imported and economics becomes pseudo-physics.
      .
      The actual base mode of thought though isn’t Euler’s derivation, it is Walras and tatonnement. The market process has to discover the appropriate relative price. Can a system of markets discover all the right relative prices at once?
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      And, getting all prices right implies drawing all resources into the system of production, allocating those resources efficiently. Hence, the central importance of Say’s Law.
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      GET has to prove (or disprove) that it is possible for a system of markets to work out all the relative prices necessary for an efficient allocation of resources. SMD is one of several arguments tending to prove that a system of markets can NOT work out all the right relative prices for a presumably unique efficient allocation of resources. Of course, mainstream macroeconomics does not want to accept that result from whatever line of argument — it would mean involuntary unemployment for Dr Pangloss after three centuries.

      • “Keynes, as you must know, claimed one was a special case of the other.”
        .
        Yes I do. But Keynes saying this doesn’t mean that he believed full employment was attained via a process of optimization or some such. He believed full employment was attained by maintaining a given level of spending.
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        And I believed that he argued that an economy could be stable at any level of employment if nothing was done to shift effective demand, i.e. by changing the level of spending.

        • I do not have a clear sense of how deeply inertial Keynes thought the circular flow of income, but he argued forcefully for the idea that simply letting prices and wages fall in the presence of large-scale unemployment would not achieve full employment of resources in a suitably finite period of time.
          .
          If you look in textbooks today, you will find Aggregate Demand meeting Aggregate Supply at a Price Level, surely one of the dumbest ideas uncritically presented to college students in the late 20th century. Still, it does get across the unsteady notion that prices have something to do with it.

          • “it does get across the unsteady notion that prices have something to do with it.”

            Do you mean relative prices or the general level of prices?

      • “the math of hydraulics say can be imported and economics becomes pseudo-physics.”
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        The funny thing is that water doesn’t have an equation of state, because one of the most important natural substances has triple points and supercooling and other equilibrium states that are not predetermined. Math cannot derive an equation of state for water because water’s states are not always transitive and several equilibria can exist at once.

        • hydraulics is about the way fluids flow and transmit pressure. The critical connection to a property of water is that liquid water does not compress much in response to pressure, with implications for the velocity of flow, levels in a closed system and so on. The mathematical analysis of hydraulics was important as a model in the early history of neoclassical economics. The great Irving Fisher, earned the first PhD in economics at Yale, under the tutelage of the absolutely brilliant Willard Gibbs, himself the first man to earn a PhD in engineering from Yale and an accomplished theoretical physicist. Fisher was an early advocate of the Quantity Theory of Money under a gold standard and explorer of general equilibrium theory. He borrowed the mathematics of his analysis from the physics he learned from Gibbs. Wikipedia says, “to complement the arguments in his doctoral thesis, he built an elaborate hydraulic machine with pumps and levers, allowing him to demonstrate visually how the equilibrium prices in the market adjusted in response to changes in supply or demand.”

          • Yes, I learned of Gibbs in a Thermodynamics class. The point is that not even Gibbs could make water obey logical rules, which is why they use a look-up table to predict states of water under different conditions. In a look-up table you can represent intransitive state sequences. Math can’t supply a simple equation that predicts states of water, because water, like important factors in economics, does not follow mathematical assumptions of transitivity, additivity, the law of non-contradiction, etc. Math doesn’t work well on water or economics.

  4. Bruce,
    .
    You said: “Exactly.”
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    I presume you mean by this either one or the other or both?
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    Let’s say you’re a businessman with a $100M burning a hole in your pocket. You’ve been eying two investment opportunities A and B. You’ve noticed that the returns for A have been edging higher for some time so A looks good relative to B. However, you see general economic storm clouds on the horizon. Your expectations/confidence are dulled and negative. Do you proceed with the investment and why/why not?
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    This is the way I would look at it.
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    The microeconomic factors (relative returns) say go with A but the macroeconomic factors (expectations/confidence) say keep your money in your pocket.
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    I would keep the money in my pocket and bide my time.
    .
    The relative returns cause investment to be directed in certain directions (micro). They do not impact on the level of investment (macro).

    • I personally would not think it can be sensible to do macroeconomic theory without a money. In that sense, you could certainly convince me that GET with money as only a numéraire, is not a proper foundation for macroeconomics. But, that’s just me, unfortunately; that’s not a distinction that impresses itself on much of the profession.
      .
      Once you introduce a money and money-contingencies — banking, money-debt, money-taxes, bankruptcy, financial markets, leverage in the structured ownership of fictitious persons (corporations), etc — you have pretty much shredded any hope of finding an “income constraint” to use as a conservation law suitable for deriving an equilibrium analysis.
      .
      What economics has in hand is a vague concept of a market system as a nearly organic, loosely-coupled social system deeply adaptive to circumstance. If it worked perfectly, so goes the wave of the hand, it would discover market prices that would in turn allocate resources efficiently and completely. Elaborate financial markets would serve to aggregate and disclose distributed information anticipating the future while insuring against risks, allowing the smooth taking up of all investment projects with a positive net present value (given an implicit aggregate social discount rate revealed in [financial] markets) as those projects emerged with the invention or discovery of new information, technology, resources, etc.
      .
      Speaking realistically, I am not sure that “relative returns” can ever explain much, as simple prices are not involved — this is not comparing bottles of ketchup at the supermarket. The process of investment is a matter of assembling and motivating resources in a political structure of ownership and control, in which political power — some but not all of it derived from pre-existing property rights — is exercised to extract an economic rent from the stream of residual income associated with the control regime placed over a process of production and distribution with fixed-cost commitments and sunk-cost investment in dedicated organization and equipment at its core, which in turn creates a cost-structure that precludes market prices or market equilibrium in principle from the most common conditions of economic exchange. Actual investments are structured with leverage as contingent, incomplete contracts, to differentially motivate the behavior of various contracting parties and, as I noted, the political power to extract an economic rent is critical to realizing a return on sunk-cost investments, which by logic ought to be ‘free’ not a cost after the fact of their creation.

      At a micro-economic level, bargaining and strategic behavior are importantly constrained and even suppressed in the interests of efficiency (and mostly that’s a good thing; sometimes, it results in a big cheat). To even admit that that is what goes on, economists would have to concede that allocative efficiency is subordinate in importance to the management of technical issues and political costs. At a macro-economic level the problem is managing the aggregate fall-out from expectations that are realized as mistakes and a struggle over the distribution of income that gets out of hand, resulting in a promised division of the pie that exceeds the size of the pie.

      • “the distribution of income that gets out of hand, resulting in a promised division of the pie that exceeds the size of the pie.”
        .
        The rest of your post is pretty brilliant. I just want to say that the promised division is easily backstopped by the Fed, linked to other central banks via unlimited currency swap lines. The financiers know how to keep their slice growing, using public backstops as necessary.

        • Thank you for the high praise. I was worried that my very brief essay was too densely worded to be comprehensible.
          .
          You are right about over-promising on the pie.


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