The intellectual regress of macroeconomics

21 Jan, 2020 at 17:45 | Posted in Economics | 1 Comment

Real business cycle theory — RBC — is one of the theories that has put macroeconomics on a path of intellectual regress for three decades now. And although there are many kinds of useless ‘post-real’ economics held in high regard within mainstream economics establishment today, few — if any — are less deserved than real business cycle theory.

The future is not reducible to a known set of prospects. It is not like sitting at the roulette table and calculating what the future outcomes of spinning the wheel will be. So instead of — as RBC economists do — assuming calibration and rational expectations to be right, one ought to confront the hypothesis with the available evidence. It is not enough to construct models. Anyone can construct models. To be seriously interesting, models have to come with an aim. They have to have an intended use. If the intention of calibration and rational expectations is to help us explain real economies, it has to be evaluated from that perspective. A model or hypothesis without specific applicability is not really deserving of our interest.

Without strong evidence, all kinds of absurd claims and nonsense may pretend to be science. We have to demand more of a justification than rather watered-down versions of ‘anything goes’ when it comes to rationality postulates. If one proposes rational expectations one also has to support its underlying assumptions. None is given by RBC economists, which makes it rather puzzling how rational expectations has become the standard modelling assumption made in much of modern macroeconomics. Perhaps the reason is that economists often mistake mathematical beauty for truth.

In the hands of Lucas, Prescott and Sargent, rational expectations have been transformed from an — in-principle — testable hypothesis to an irrefutable proposition. Believing in a set of irrefutable propositions may be comfortable – like religious convictions or ideological dogmas – but it is not science.

So where does this all lead us? What is the trouble ahead for economics? Putting a sticky-price DSGE lipstick on the RBC pig sure won’t do. Neither will — as Paul Romer noticed  — just looking the other way and pretend it’s raining:

The trouble is not so much that macroeconomists say things that are inconsistent with the facts. The real trouble is that other economists do not care that the macroeconomists do not care about the facts. An indifferent tolerance of obvious error is even more corrosive to science than committed advocacy of error.

1 Comment

  1. “The future is not reducible to a known set of prospects.”
    However, finance is trying, and one should at least be aware of what is going on in private firms.
    Coursera’s Financial Engineering and Risk Management MOOC contains background material on how you can represent all possible future market states in a matrix A. Then you can set a minimum desired payoff as a vector, b, and use linear optimization to solve Ax = b for the optimal portfolio x.
    Also, you can combine several derivatives to create “butterfly” trades where you know beforehand your maximum possible loss and gain. Future price action has been reduced to known ranges over which your profit and loss is fully defined. If you have other investments that make money in the ranges where you lose your ante, you can rig it so you profit in all possible states.
    The only real risk is whether the Fed will print money to backstop payoffs that default. If you are too big to fail, that risk has proven negligible. And the money-printing has not led to inflation as expected by the Fed itself.

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