Macroeconomics’s “Faustian Bargain”?: Thursday Focus: February 20, 2014

Let me start with Chris Dillow:

Chris Dillow: The Macroeconomic Challenge: “In discussing macroeconomics’ Faustian bargain, Simon [Wren-Lewis] asks:

By putting all our macroeconomic model building eggs in one microfounded basket, have we significantly slowed down the pace at which macroeconomists can say something helpful about the rapidly changing real world?

Let me deepen this question… facts… which any good, useful macro theory should be compatible with:

1. The unemployed are significantly less happy than those in work….
2. Price and wage stickiness is over-rated. One Bank of England study has found that: “Nearly half of firms changed their prices within three months of an increase in costs or a fall in demand”….
3. The failure of a handful of organizations can have massive macroeconomic consequences. The great recession originated in the collapse of a few banks. This tells us that we need models in which micro failures generate macro ones….
4. Supply shocks do happen. It’s improbable that all productivity fluctuations are due merely to labour hoarding in the face of demand shocks….
5. Interactions between agents can magnify fluctuations. We know there are expenditure cascades… it’s likely that animal spirits can spread in much the same way as diseases do… because optimism and pessimism are infectious. We can talk ourselves poorer.

These facts are a challenge to both RBC and New Keynesian models. But they have something in common. They stress… heterogeneity…. Now, you’ll object that any model that tries to embed these five facts will very quickly become very complex. But that’s my point…. It could be that the best way to understand… lies in agent-based models rather than conventional DSGE ones. However, such models are–for now–beyond the understanding of most economics students (and me!). Which poses the question: what should students be taught?

And Paul Krugman:

Paul Krugman Fighting the Last Macro War?: “Noah Smith… argues that macroeconomic theorists have been like French generals, always preparing to fight the last war–in the 80s they were working on finding solutions for the problems of the 70s, in the 90s they were working on the problems of the 80s, and so on….

I think it gives economists both too much and too little credit. First of all, a large part of academic macroeconomics is dominated by real business cycle theorists–and to the extent that their work is motivated by any real economic problems, it’s still about the stagflation of the 1970s, which is at least two wars back. Those guys aren’t like French generals getting ready to fight World War I in 1939; they’re still working out how to repel cavalry charges…. Second… what were the macro wars? First there was stagflation… the freshwater guys… stopped there… forever living in 1979…. They never reacted at all to the second macro war, the disinflation of the 1980s. The point there was that disinflation was very costly…. This reality, as much as clever new models, drove the Keynesian revival; the RBC guys paid no attention, and learned nothing.

It is, I think, somewhat fair to say that Keynesians spent a lot of time thereafter focused on price stickiness and momentum, on one side, and on monetary policy as the be-all and end-all, on the other. Did this leave them unprepared for the next war? A bit, but actually not so much…. Bank runs have been pretty well understood for a long time…. And policy responded pretty effectively, too: the financial crisis may have come as a shock, but it was more or less contained by the spring of 2009. No, the real war involved dealing with a persistently depressed economy, with monetary policy constrained by the zero lower bound. And I just don’t see an intellectual failure there. A number of Keynesians… had studied the issue. The models rolled out… didn’t fundamentally change the approaches… the predictions those models made, about interest rates, inflation, the output effects of fiscal policy, were both counterintuitive to many people and reasonably on target. I just don’t see this as a story of economists unprepared to deal with new events….

Now, you might ask why, in that case, we haven’t solved the problem. But the answer there has nothing to do with lack of economic understanding; it has to do with ideologues who made up new doctrines on the fly (like expansionary austerity or doom by 90 percent debt) to justify policies that made no sense in the standard models. If politicians turn to climate deniers, that’s not a reflection on climate science; if they turn to crank macroeconomics, that’s not a reflection on Keynesianism.

Paul is responding to Noah Smith:

Noah Smith: Noahpinion: Is macro doomed to always fight the last war?: “It seems obvious to most people that the Great Recession was caused by stuff that happened in the financial sector; the only alternative hypothesis that anyone has put forth is the idea that fear of Obama’s future socialist policies caused the recession, and that’s just plain silly.

Before 2009 there was very little finance in mainstream macro models (the biggest exception being these models by Ben Bernanke and coauthors). In 2009 and after, lots of people outside the field noticed this fact and got angry at macro. But macro, to its credit, was not nearly as tone-deaf as its critics made it out to be… as far as I can tell, “financial friction macro” is almost the only game in town…. But of course it would have been even nicer if macro had picked up on the finance thing more strongly before 2009…. Are macroeconomists doomed to always “fight the last war”?

Let me note that I find myself with Robert Waldmann:

Robert Waldmann: Commenting Before Reading: “The eternally simmering blog debate over ‘microfoundations’ has reached a sort of balance….

I haven’t gotten a one-tenth of the way convincing answer to the question “what have microfoundations ever done for us.”… One would think that [Simon Wren-Lewis’s] being accused of offering “very thin gruel” by Krugman would stimulate some further effort. I do think that. I am confident that Wren-Lewis has devoted considerable effort to the search for payoffs from the micro-foundations approach. I think he hasn’t found any, because there aren’t any to find…. New Keynesian economics does not fit data from the Volcker deflation except to the extent that it is identical to old Keynesian economics…. Over here (in Europe)… the huge unemployment problem of the late 70s, 80s, and 90s… is radically inconsistent with new Keynesian models…. Macroeconomists are totally unprepared to fight the last war or the war before that…. Not only have macroeconomists not gained the ability to predict the future but they have lost ability to fit past data.

That by Robert is in response to:

Simon Wren-Lewis: Are New Keynesian DSGE models a Faustian bargain?: “It is true that New Keynesian models are essentially RBC models plus sticky prices.

But is this because New Keynesian economists were forced to accept the RBC structure, or did they voluntarily do?… The RBC model is just the classical macromodel with… rational expectations… [and] intertemporal optimisation…. Both ideas were readily adopted because they appeared to be a distinct improvement on previous methods…. I can see little that most modellers would love to junk if it wasn’t for those nasty New Classicals…. Has [this] turned out to be a Faustian pact between macroeconomics and microfoundations… have we significantly slowed down the pace at which macroeconomists can say something helpful about the rapidly changing real world?… If there was a Faustian bargain… most Keynesian economists agreed to it for good reasons, and… were not forced into it by others.

But consider:

• Calvo pricing: In order to introduce sticky prices into a DSGE model, NK models almost always–for analytical convenience–assume that firms have a constant random and equal chance of having an opportunity to change the prices they charge at every moment. These are fake micro foundations: That is not how firms are constrained in their ability to flex their prices. But these produce clean and analytically convenient expressions for the evolution of the overall price level. The problem is of those clean and analytically convenient expressions force the current rate of inflation to be the present value, for some discount factor related to the frequency of price changes, Of expected future deviations of output from its natural rate. That means that the inflation jumps before a boom, rather than during and after a boom. And so this insistence on microfoundations has already forced the model into a configuration in which it cannot fit empirical time series.

• The consumption “Euler equation”: it simply does not work. Any model that requires it is not going to manage to fit the time series

• The neglect of financial frictions–because people were trying to nail down (false) microfoundations.

And let me temporarily turn the microphone on this over to Paul Krugman yet again:

Paul Krugman: Microfoundations and Mephistopheles: “Let me offer an example of how this ended up impoverishing macroeconomic analysis: the strange disappearance of James Tobin.

In the 1960s Tobin developed and elaborated a sophisticated view (pdf) of financial markets that offered insights into things like the role of intermediaries, the effects of endogenous inside money, and more…. But Tobin, as far as I can tell, disappeared from graduate macro over the course of the 80s, because his models, while loosely grounded in some notion of rational behavior, weren’t explicitly and rigorously derived from microfoundations. And for good reason, by the way: it’s pretty hard to derive portfolio preferences rigorously in that sense. But even so, Tobin-type models conveyed important insights — which were effectively lost.

Then came the financial crisis, and many economists apologetically admitted that they had erred by not incorporating finance into their models, and announced plans to try to do that in the future. But why wasn’t finance in the models? Because a promising, once-influential approach to doing that, an approach that was in important ways much more sophisticated than what came later, was driven out because it didn’t conform to a particular, highly restrictive definition of what was considered valid theory…

Is it too much to ask of anyone building a model with “microfoundations” that the microfoundations be “true”? I mean, climatologists have models with microfoundations, but their assumptions about heat transfer actually work…

As I wrote some time ago: Yes, New Keynesian models were built to study post-industrial North Atlantic economies undergoing small fluctuations in nominal demand and small supply shocks in a context in which inflation expectations were at least potentially unanchored and in which the financial system was stable. But New Keynesian models were also built to accomplish a different task. They were built to rebut a current of thought lamented by Robert Solow:

Robert Solow: Dumb and Dumber in Macroeconomics: The original impulse to look for better or more explicit microfoundations was probably reasonable. It overlooked the fact that macroeconomics as practiced by Keynes and Pigou was full of… generalizations about aggregative consumption-saving patterns, investment patterns, money-holding patterns [that] were always rationalized by plausible statements about individual–and, to some extent, market–behavior. But some formalization… was a good idea. What emerged was not… a single representative consumer optimizing over infinite time with perfect foresight or rational expectations, in an environment that realizes the resulting plans more or less flawlessly through perfectly competitive forward-looking markets for goods and labor, and perfectly flexible prices and wages. How could anyone expect a sensible short-to-medium-run macroeconomics to come out of that set-up?… We want macroeconomics to account for the occasional aggregative pathologies that beset modern capitalist economies…. A model that rules out pathologies by definition is unlikely to help. It is always possible to claim that those “pathologies” are delusions, and the economy is merely adjusting optimally to some exogenous shock. But why should reasonable people accept this?… Why should the burden of proof fall on those who see an ordinary standard pathology here?

And they rebutted this current of thought by demonstrating that all you needed was very small market frictions–very small deviations from the Ramsey setup at the level of the individual agent–to produce large and macroeconomically-significant pathologies: to show that large business cycles could emerge from small menu costs, and thus the assumption that market failures were small at the level of individual economic actors should not be taken to imply that any macroeconomy was approximating the solution to any optimal central planning problem.

But then Mike Woodford and company lost sight of the goal. Yes, New Keynesian models with more or less arbitrary micro foundations are useful for rebutting claims that all is for the best macro economically in this best of all possible macroeconomic worlds. But models with micro foundations are not of use in understanding the real economy unless you have the micro foundations right. And if you have the micro foundations wrong, all you have done is impose restrictions on yourself that prevent you from accurately fitting reality.

Thus your standard New Keynesian model will use Calvo pricing and model the current inflation rate as tightly coupled to the present value of expected future output gaps. Is this a requirement anyone really wants to put on the model intended to help us understand the world that actually exists out there? Thus your standard New Keynesian model will calculate The expected path of consumption as the solution to some Euler equation plus an intertemporal budget constraint, with current wealth and the projected real interest rate path as the only factors that matter. This is fine if you want to demonstrate that remodel can produce macroeconomic pathologies. But is it a not-stupid thing to do if you want your model to fit reality?

I remember attending the first lecture in Tom Sargent’s evening macroeconomics class back when I was in undergraduate: very smart man from whom I have learned the enormous amount, and well deserving his Nobel Prize. But…

He said that in this class we were not going to make the mistake of simply putting money in the utility function: that would be ad-hoc. We were not allowed to wave our hands and say that people had a demand for money because holding money allowed them to take advantage of unexpected market parking is an so increase their utility. Instead, we had to explicitly model just what transactions holding money allowed you to undertake that you could not undertake otherwise. Hence, he said, we were going to build a rigorous, micro founded model of the demand for money: We would assume that everyone lived for two periods, worked in the first period when they were young and sold what they produced to the old, held money as they aged, and then when they were old use their money to buy the goods newly produced by the new generation of young. Tom called this “microfoundations” and thought it gave powerful insights into the demand for money that you could not get from money-in-the-utility-function models.

I thought that it was a just-so story, and that whatever insights it purchased for you were probably not things you really wanted to buy. I thought it was dangerous to presume that you understood something because you had “microfoundations” when those microfoundations were wrong. After all, Ptolemaic astronomy had microfoundations: Mercury moved more rapidly than Saturn because the Angel of Mercury left his wings more rapidly than the Angel of Saturn and because Mercury was lighter than Saturn…