Demystifying economics

25 Nov, 2018 at 18:10 | Posted in Economics | 7 Comments

The first thing to understand about macroeconomic theory is that it is weirder than you think. The heart of it is the idea that the economy can be thought of as a single infinite-lived individual trading off leisure and consumption over all future time …

reality-header2This approach is formalized in something called the Euler equation … Some version of this equation is the basis of most articles on macroeconomic theory published in a mainstream journal in the past 30 years …

The models may abstract away from features of the world that non-economists might think are rather fundamental to “the economy” — like the existence of businesses, money, and government … But in today’s profession, if you don’t at least start from there, you’re not doing economics.

J W Mason

Yes indeed, mainstream macroeconomics sure is weird. Very weird. And among the weirdest things are those Euler equations Mason mentions in his article.

In a post on his blog, sorta-kinda ‘New Keynesian’ Paul Krugman argues that the problem with the academic profession is that some macroeconomists aren’t “bothered to actually figure out” how the New Keynesian model with its Euler conditions —  “based on the assumption that people have perfect access to capital markets, so that they can borrow and lend at the same rate” — really works. According to Krugman, this shouldn’t  be hard at all — “at least it shouldn’t be for anyone with a graduate training in economics.”

If people (not the representative agent) at least sometimes can’t help being off their labour supply curve — as in the real world — then what are these hordes of Euler equations that you find ad nauseam in ‘New Keynesian’ macromodels gonna help us?

Yours truly’s doubts regarding the macroeconomics modellers’ obsession with Euler equations is basically that, as with so many other assumptions in ‘modern’ macroeconomics, the Euler equations don’t fit reality — and it seems as though I’m not alone holding that view:

fubar1This equation underlies every DSGE model you’ll ever see, and drives much of modern macro’s idea of how the economy works …

[T]he Euler Equation says that if interest rates are high, you put off consumption more. That makes sense, right? Money markets basically pay you not to consume today. The more they pay you, the more you should keep your money in the money market and wait to consume until tomorrow.

But what Canzoneri et al. show is that this is not how people behave. The times when interest rates are high are times when people tend to be consuming more, not less.  No matter what we assume that people want, their behavior is not consistent with the Euler Equation … The consumption Euler Equation is an important part of nearly any such model, and if it’s just wrong, it’s hard to see how those models will work.

Noah Smith

In the standard neoclassical consumption model — used in DSGE macroeconomic modeling — people are basically portrayed as treating time as a dichotomous phenomenon  today and the future — when contemplating making decisions and acting. How much should one consume today and how much in the future? Facing an intertemporal budget constraint of the form

ct + cf/(1+r) = ft + yt + yf/(1+r),

where ct is consumption today, cf is consumption in the future, ft is holdings of financial assets today, yt is labour incomes today, yf is labour incomes in the future, and r is the real interest rate, and having a lifetime utility function of the form

U = u(ct) + au(cf),

where a is the time discounting parameter, the representative agent (consumer) maximizes his utility when

u´(ct) = a(1+r)u´(cf).

This expression – the Euler equation – implies that the representative agent (consumer) is indifferent between consuming one more unit today or instead consuming it tomorrow. Typically using a logarithmic function form – u(c) = log c – which gives u´(c) = 1/c, the Euler equation can be rewritten as

1/ct = a(1+r)(1/cf),


cf/ct = a(1+r).

This importantly implies that according to the neoclassical consumption model that changes in the (real) interest rate and the ratio between future and present consumption move in the same direction.

So good, so far. But how about the real world? Is the neoclassical consumption as described in this kind of models in tune with the empirical facts? Hardly — the data and models are as a rule inconsistent!

In the Euler equation, we only have one interest rate,  equated to the money market rate as set by the central bank. The crux is that — given almost any specification of the utility function  – the two rates are actually often found to be strongly negatively correlated in the empirical literature.

Well, that more or less says it all, doesn’t it? Modern mainstream macroeconomics is indeed “weirder than you think.” If an economic model is found to be inappropriately used in research, then it is the model that has to be revised. Economic processes and structures are not about to change just to make the model relevant. Using scientific models is fine, but it has to be done within the limits set by the nature of the beast!


  1. When really smart people go down a rabbit hole together into a wonderland of pointless math, it seems almost futile to point to any particular discrepancy with reality, when it is all discrepancies all the time. I clicked thru to Noah Smith’s blogpost of four years ago and all I could do is marvel at the unfounded faith that still more papers about Wonderland could get the field of macroeconomics out of Wonderland.
    At the most fundamental level, economics struggled with Euler long before Lucas came along. Euler was and is famous for mastering a particular analytic method: bootstrapping a kind of “equilibrium” analysis from using a conservation law as a constraint. Euler’s was not the homeostatic equilibrium adopted by the neoclassical economists; his idea was that Newton’s conservation laws always had to be satisfied, and consequently, one could derive an analysis of forces that balanced out, satisfying the conservation law as absolute constraint. Aerodynamics exemplifies such an analysis: there’s an equilibrium of forces on an airfoil in motion thru a fluid, even if the airplane is on track to crash to earth.
    Adam Smith, in the Wealth of Nations, was using his Labour Theory of Value to imitate Euler, using the productive effort of a nation’s workforce as an implicit constraint in much the same way Keynes would later use Aggregate Demand. Many less celebrated thinkers almost unconsciously lapse into thinking that depends on the assumption that a hard and fast constraint on production can be identified or observed: that there is only so much money, say, or so much capacity.
    What is wrong with the application of the Euler equation in DSGE is not simply the behavioral contradiction with the observed relation of central bank interest rates to rates of consumption. The problem is conceptual: the implicit notion that there is a hard-and-fast constraint imposing a calculable trade-off between current and future consumption.
    In an uncertain world, whatever constraint there may be is much too fuzzy to use as Euler used Newton’s conservation laws.
    It is because of uncertainty, that we have money and money finance. In an uncertain world, money and money finance are analytically “necessary”. And, many, many interest rates are also “necessary”. That the DSGE tradition has only be bolting on finance to its kitchen sink models in the last decade is a fair indication that macroeconomists are still lost in an analytic wonderland, as is the use of “stylized” notions of “one” interest rate in this silly test.
    Analytic models are never descriptive. You cannot test an analytic model against data. To work with data, an operational model is necessary and operational models will have to deal with pervasive uncertainty as the most important fact shaping the design, management and performance of actual economic institutions. That means leaving Wonderland for the real world. Just the way it is.

    • “operational models will have to deal with pervasive uncertainty as the most important fact shaping the design, management and performance of actual economic institutions.”
      Right, but finance has evolved tools to hedge every uncertainty. Thus the external finance premium (see a screenshot from a 2018 Bernanke paper) is countercyclical and someone (the Fed?) can sell a derivative index based on the EFP. Banks could thus hedge against the only real uncertainty they face: a panic where labile traders emotionally sell off everything in a groupthink panic …
      The rest of your post about the constraint assumption is spot-on.

  2. The main thing Mason got wrong in that blog is the cause of the 2008 panic: mortgage debt alone was not enough to cause the crisis. Traders lost it and devalued everything, arbitrarily and emotionally. But the government acted to refinance mortgages and pay out insurance on defaulting loans so investors got paid the promised premiums on Mortgage-Backed Securities. The problem was that MBS had been arbitrarily valued at many multiples of the underlying mortgages’ combined value. Then rumors that everything would default spread and traders no longer accepted MBS as collateral for funding anymore. The traded MBS value which was much higher than the underlying mortgage value collapsed to below the face value. That was because of panic, not because of the real losses caused by defaults. The system was designed to handle defaults, but the immature insurance piece broke in 2008. The Fed printed money to fix it. I fear Mason still believes the story that the defaults alone were so weighty that they caused the crisis. Rather it was arbitrary trader panic that caused a mild slowdown to become a much bigger deal …
    See Bernanke’s “Real Effects of the Financial Crisis” for more. Mason cited Mian and Sufi, but Bernanke uses sophisticated math models to show that the household balance sheet is less of a predictor of real variables than the credit factors that make up the External Finance Premium.
    The EFP, or the Excess Bond Premium, appears to be a market interest rate that is set independently of the Fed. When it spikes, the Fed can do what it can to bring it down: lower interest rates, print money to buy bonds, etc.

    • are Bernanke’s “sophisticated math models” any good? If there’s one thing economists have shown again and again, it’s that they don’t do modeling very well at all. After all he starts with the statement that essentially macroeconomics isn’t really a problem and equates, through analogy, macroeconomics to basic physics. Not really a promising start

      • The Fed should put its ability to create liquidity on demand where its mouth is. Bernanke claims the External Finance Premium predicts real economy stress, so let the Fed sell panic insurance in the form of an EFP index. If the EFP-containing model is wrong, we’ll find out.

        • Whenever any one says “sophisticated maths models” in either finance or economics, run for cover.

          In the end you have to work like a good historian. Much of what amounts to proper investigation is not suited to any type of maths.

          • Finance uses math to strip bonds into principle, interest rate, and default risk, and sells each to different people. The insurers themselves sell bonds that strip out their risk. The only real risk is a panic where everyone sells because of emotional groupthink.
            The Fed is going to end a panic by supplying liquidity to put a floor on prices, anyway.
            If Bernanke’s External Finance Premium (which appears to be a private interest rate that moves independently of Fed policy rates) really is countercyclical, as his math models claim, then it would provide a natural hedge for panics.
            If the Fed sold EFP shares as panic insurance, banks could buy them and sell them back to the Fed at high rates in a panic, thus replacing funding lost due to the panic.
            If the Fed doesn’t sell panic insurance, we will continue with business-as-usual where regulators are way behind bankers and panics will occur and the Fed will respond with a “put” because otherwise, ATMs will stop working.
            We can stop the madness by making an EFP index derivative. The Fed is the natural market-maker in an EFP index because it is the Fed’s job to end panics anyway.
            If we don’t create panic insurance, we will prove we simply are addicted to panics for the emotional thrill, and though we know a way out of panics we won’t take it because we actually like panics.

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