Nothing New in Macroeconomic Methodology?

Simon Wren Lewis who is a professor of economics at Oxford University has an interesting piece (hat tip: Mark Thoma) on the distinction and choice between micro founded macroeconomic models and top-down models such as the IS/LM (Keynesian) or other variants such as Modern Monetary Theory (MMT).

I think this is an interesting discussion and I have penned my own thoughts on microfoundations in macroeconomics here. Mr Lewis is balanced but seems to be on Paul Krugman’s side (by and large) who has been devastating in his critique of modern macroeconomics especially in the wake of the financial crisis.

For good order, my own views are summarized in the following snippet.

Two obvious questions impose themselves at this point. One is whether the use of representative agents in macroeconomics has something, in general, to do with the recent soul searching among macroeconomists and the critique against the profession. And the second is whether the study of macroeconomics and demographics in particular calls for the non-use of representative agent modelling.

On the first I don’t necessarily think that it exists to the detriment of macroeconomics as a discipline, but I do think that a couple of points need mention. First of all I will echo the point made in Hartley (1997) that given the widespread use of representative agent modelling in almost all corners of macroeconomics and the almost religious devotion to it in graduate and PhD economics I think it is highly problematic that we have not had a more serious debate of its methodological merits. I would emphasize this in particular in the context of the fact that the use of representative agents leads to very inflexible (although rigorous) mathematical models and the blind faith in these models tend to steer macroeconomics onto a very narrow methodological path. During my research and initial ground work for the thesis I actually did write my own representative agent model to suit my specific agenda, but found in the end that I was paying more tribute to the laws of calculus than the connection between ageing and capital flows/open economy dynamics and as I set up the problem I ended up very close to the original benchmark problem.

It is interesting in this respect that Mr. Lewis spends quite a bit of time to come up with a name for what he calls the alternative to traditionally micro founded general equilibrium models (in either dynamic or static form). It seems that despite the fact that such “ad-hoc” models have been around for a long time, we have been able to come up with a name for them. Here is Mr Lewis.

The issue I want to discuss now is very specific. What is the role of the ‘useful models’ that Blanchard and Fischer discuss in chapter 10? Can Krugman’s claim that they can be more useful than micro founded models ever be true? I will try to suggest that it could be, even if we accept the proposition (which I would not) that the micro foundations approach is the only valid way of doing macroeconomics. If you think this sounds like a contradiction in terms, read on. The justification I propose for useful models is not the only (and may not be the best) justification for them, but it is perhaps the one that is most easily seen from a micro foundations perspective.

For those un-initiated in the taxonomy of modern economic teaching this will seem odd. But it isn’t.

I would venture the claim then that the general Keynesian framework of IS/LM (or “curve shifting” models in general) is still seen as an undergraduate tool or a tool for business students with little or no foundation in mathematics. If this is the informed view of the economics profession as a whole (which I think it is) then there is certainly no need to elevate such models to the honour of being alternatives to conducting real and serious micro founded macroeconomics. At this point, the sarcasm is obvious I hope.

The general equilibrium framework in its dynamic form with dynamic programming problems and sophisticated econometric methodology to estimate the optimized equations is largely outside the scope for most people. As a result, the ivory tower in which many (if not most) academic economists do their research serves as an incubator for skepticism (even pity) towards those who might have the audacity to argue that what they are doing is wrong. Indeed, I would argue that despite signs that a genuine critique towards micro- and pure mathematical founded economics has emerged, the general trend is still one of “physics envy” in economics.

Hence, the debate for and against micro founded models very quickly turns into a discussion between those who do not understand the language of modern macroeconomics and those who do. Obviously, in Mr Lewis’ case this is not the case. Indeed, the financial crisis seems to have given birth to a growing critique from within the macroeconomic research community towards blind reliance on the micro founded framework. Krugman’s piece from 2009 (linked above) is already a classic example of the anti-thesis, but there have been others.

Buiter had a go in relation to monetary economics back in 2009;

Charles Goodhart, who was fortunate enough not to encounter complete markets macroeconomics and monetary economics during his impressionable, formative years, but only after he had acquired some intellectual immunity, once said of the Dynamic Stochastic General Equilibrium approach which for a while was the staple of central banks’ internal modelling: “It excludes everything I am interested in”. He was right.; It excludes everything relevant to the pursuit of financial stability.

Menzie Chinn from Econbrowser did a useful overview of the initial flurry (see also the Economist) as well and ended up arguing that the “modern macroeconomic apparatus” should not be jettisoned. Indeed, Mr Chinn points out (using his own experience) that his own PhD experience was not doctrinate. I believe him of course, but I would still argue that right from the early steps as an undergraduate those who do not devote considerable time and effort into making their research proposals on the basis mathematically rigorous micro founded models may find their chance of proceeding as academics diminished.

In my own work as an economist which centers on demographics and economics the issue on micro foundations is acute. The life cycle framework (or even the Permanent Income Hypothesis) are both micro founded models which have been widely used to form aggregate models. But we also know that many of the most obvious conclusions from such exercises are untrue (e.g. the extent of dissaving as a population ages). Perhaps these inconsistencies with economic realities can be explained on the micro level (and I certainly think we should try to address them there), but there is also a need for a pure macroeconomic theory of how population dynamics affect complex macroeconomic processes.

On the state of macroeconomics itself, an colleague once told me that economics was fine mainly because it stuck to doing what it did best. I only conditionally agree. Learning economics is a brilliant way to cultivate a sharp mind and it is also offers a reasonably good framework to make sense of the processes which govern society and human behavior. However, the way economics is often narrated as sub-discipline of math and physics is unfortunate. I am all for quantitative analysis and use it every day in my own work (mainly empirical work), but I would think that the reason Mr Lewis finds it difficult to come up with a name of the alternative to mainstream macroeconomics is precisely because such an alternative does not currently exist. That is a pity.

This post originally appeared at Claus Vistesen’s Blog and is posted with permission.