Where modern macroeconomics went wrong

7 Nov, 2020 at 09:19 | Posted in Economics | 8 Comments

DSGE models seem to take it as a religious tenet that consumption should be explained by a model of a representative agent maximizing his utility over an infinite lifetime without borrowing constraints. Doing so is called micro-founding the model. But economics is a behavioral science. If Keynes was right that individuals saved a constant fraction of their income, an aggregate model based on that assumption is micro-founded.Of course, the economy consists of individuals who are different, but all of whom have a finite life and most of whom are credit constrained, and who do adjust their consumption behavior, if slowly, in response to changes in their economic environment. Thus, we also know that individuals do not save a constant fraction of their income, come what may. So both stories, the DSGE and the old-fashioned Keynesian, are simplifications. When they are incorporated into a simple macro-model, one is saying the economy acts as if… And then the question is, which provides a better description; a better set of prescriptions; and a better basis for future elaboration of the model. The answer is not obvious. The criticism of DSGE is thus not that it involves simplification: all models do. It is that it has made the wrong modelling choices, choosing complexity in areas where the core story of macroeconomic fluctuations could be told using simpler hypotheses, but simplifying in areas where much of the macroeconomic action takes place.

Joseph Stiglitz

Stiglitz is, of course, absolutely right.

DSGE models are worse than useless — and still, mainstream economists seem to be impressed by the ‘rigour’ brought to macroeconomics by New-Classical-New-Keynesian DSGE models and its rational expectations and microfoundations!

It is difficult to see why.

Take the rational expectations assumption. Rational expectations in the mainstream economists’ world imply that relevant distributions have to be time independent. This amounts to assuming that an economy is like a closed system with known stochastic probability distributions for all different events. In reality, it is straining one’s beliefs to try to represent economies as outcomes of stochastic processes. An existing economy is a single realization tout court, and hardly conceivable as one realization out of an ensemble of economy-worlds since an economy can hardly be conceived as being completely replicated over time. It is — to say the least — very difficult to see any similarity between these modelling assumptions and the expectations of real persons. In the world of the rational expectations hypothesis, we are never disappointed in any other way than as when we lose at the roulette wheels. But real life is not an urn or a roulette wheel. And that’s also the reason why allowing for cases where agents make ‘predictable errors’ in DSGE models doesn’t take us any closer to a relevant and realist depiction of actual economic decisions and behaviours. If we really want to have anything of interest to say on real economies, financial crisis and the decisions and choices real people make we have to replace the rational expectations hypothesis with more relevant and realistic assumptions concerning economic agents and their expectations than childish roulette and urn analogies.

Or take the consumption model built into the DSGE models that Stiglitz criticises. There, 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),

or

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. The data on returns and aggregate consumption simply are inconsistent with the DSGE models.

Although yours truly shares a lot of Stiglitz’ critique of DSGE modelling — “the standard DSGE model provides a poor basis for policy, and tweaks to it are unlikely to be helpful” —  it has to be said that his more general description of the history and state of modern macroeconomics is less convincing.  Stiglitz notices that some of the greatest deficiencies in DSGE models “relates to the treatment of uncertainty,” but doesn’t really follow up on that core difference between Keynesian ‘genuine uncertainty’ economics and neoclassical ‘stochastic risk’ economics. DSGE models are only the latest outgrow of neoclassical general equilibrium (Arrow-Debreu) economics. And that theory has never, and will never, be a good starting point for constructing good macroeconomic theory and models. When the foundation of the house you build is weak, it will never be somewhere you want to live, no matter how many new — and in Stiglitz’ view better — varieties of ‘micro-foundations’ you add.