Wednesday, 7 March 2012

What have microfoundations ever done for us?

For those who do not know the reference, which I think is apposite, see here.

In my previous post on microfoundations I said I disagreed with Paul Krugman’s statement that “So as I see it, the whole microfoundations crusade is based on one predictive success some 35 years ago; there have been no significant payoffs since”. I should say why I disagree. Robert Waldmann has also challenged me along similar lines.
I think the two most important microfoundation led innovations in macro have been intertemporal consumption and rational expectations. I have already talked about the former in an earlier post, which focused on a UK specific puzzle in the late 1980s that I find difficult to address without an intertemporal consumption perspective. However I also think too strong an attachment to a very basic intertemporal view has blinded macro to some critical events in the last decade or so. (See John Muellbauer here, for example.) So let me focus on rational expectations. Again I could look at the UK in 1980/81 and talk about Dornbusch overshooting, but let me try and be less parochial.
Between the rapid inflation of the 1970s and the Great Recession, what events might we look to for rational expectations to help explain? It is not an easy question, because the adoption of rational expectations was not the result of some previous empirical failure. Instead it represented, as Lucas said, a consistency axiom. However between the 1970s and the Great Recession what needs explaining is why nothing very dramatic happened – the Great Moderation. In particular, why did the large rise in oil and other commodity prices around 2005 not lead to the kind of stagflation we saw in the mid-70s and early 80s?
I think an important part of the answer was implicit or explicit inflation targeting by independent central banks. That, in turn, reflected an understanding of the importance of rational expectations. If a central bank had a clear inflation objective, and established a reputation in achieving it, that would anchor expectations and reduce the impact of shocks on the macroeconomy. Just as the Friedman’s expectations augmented, accelerationist Phillips curve helped us understand what went wrong in the 1970s, so the New Keynesian Phillips curve led to better policy around the turn of the century.
Now virtually any empirical claim in macro is contestable. (Indeed, for some this is part of the attraction of the microfoundations approach!) There are other explanations of the weak response to oil price increases, although Blanchard and Gali (2007) do argue that the Great Moderation played an important role. Others might suggest that the Great Recession itself proved that the Great Moderation was an illusion. In a crude sense this does not follow. The Great Moderation was all about the stabilising role that monetary policy can play, and that should always (given Japan) have been conditional on not hitting the zero lower bound. A more challenging argument is that the Great Moderation prepared the ground for the financial crisis, but even if this is correct it does not follow that inflation targeting was not an improvement on what went before – we may just need to do better still. Indeed, if as a result of the Great Recession inflation targets are replaced by price level or nominal GDP targets, I believe rational expectations will be central in making that case.
I think macroeconomics today is much better than it was 40 years ago as a result of the microfoundations approach. I also argued in my previous post that a microfoundations purist position – that this is the only valid way to do macro – is a mistake. The interesting questions are in between. Can the microfoundations approach embrace all kinds of heterogeneity, or will such models lose their attractiveness in their complexity? Does sticking with simple, representative agent macro impart some kind of bias? Does a microfoundations approach discourage investigation of the more ‘difficult’ but more important issues? Might both these questions suggest a link between too simple a micro based view and a failure to understand what was going on before the financial crash? Are alternatives to microfoundations modelling methodologically coherent? Is empirical evidence ever going to be strong and clear enough to trump internal consistency? These are difficult and often quite subtle questions that any simplistic for and against microfoundations debate will just obscure. 

9 comments:

  1. I'd argue that there are two other, more convincing reasons for the oil price shocks to not have had as big of an effect as the 70's:

    Our cars are more fuel efficient, so relatively the price of transportation has not gone up the same way it did in the 70's.

    The rise of GPS also leads to more efficient traveling.

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  2. Thanks for the link and especially for putting me in such good company. For noe, I just comment that I share your enthusiasm for that film.

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    1. I was busy as I just taught the Ramsey-Cass-Koopmans model. I add that I tend to agree with Krugman, but "The Life of Brian" is much better than "Hotshots" so, this time, the upper hand is on the other foot.

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  3. Simon, you ask "Can the microfoundations approach embrace all kinds of heterogeneity, or will such models lose their attractiveness in their complexity? Does sticking with simple, representative agent macro impart some kind of bias?"
    I would answer yes two both your questions, and I have a post on my blog where I give the arguments why I think both you and Paul ought to be even more critical of the call for microfoundations of macroeconomics than you are.
    http://larspsyll.wordpress.com/2012/03/07/wren-lewis-noahpinion-and-krugman-on-microfoundations-of-macroeconomics/

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  4. Eduardo Weisz8 March 2012 07:05

    Prof. Wren-Lewis,

    I am following this fascinating debate and have studied both your and Prof. Schlicht papers. What calls my attention is the fact that none of you seem to see micofundamtation of macro models as a work in progress.
    I mean, the whole idea of "go to what works" sounds in my ears as such an idealist epistemologic aproach to the whole issue that cannot be defined by a word different from choking. Why not to say instead that there are amazing results, not yet full established as a unified theoretical body, that definitely demand further studies?
    Why is it impossible to apply to this issue an aproach epistemolicaly more realist? I mean, even the subjectivity in the process microfundamenting models cannot be understood as anything different from the better of our knowledge at present time...
    I mean, it is a relatively new discussion, why can't we say that there is so much we still don't know that our work can only be thought as starting?
    I am realy curious about it...
    Thanks,
    Eduardo

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  5. Prof. Wren-Lewis,

    Can you elaborate on why you think the New Keynesian Phillips Curve led to better policy (as opposed to the traditional expectations-augmented or interia-augmented Phillips curve)? The main difference, as I understand it, is that the former includes expected future inflation, not expected current inflation.

    Thanks.

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  6. As a somewhat tangential historical footnote, Keynes made a point of being concerned with microfoundations. See the discussion in the General Theory of the disconnect between the classical theory of price determination at the level of the firm and the classical views of the aggregate price level and of real wages. In explaining the General Theory he built up from the behaviour of a Marshallian firm, with the warning that, when aggregating from the microfoundations, you couldn't be casual about the cet. par. assumptions you adopted.

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  7. For my money, I'm not sure why you are defending something that you only have half-hearted support for. Sounds to me that you are picking a fight with PK for little or no reason. The problem with micro-economics applied to a macro scale is that microeconomics is a tool box to be applied to looking at specific markets and the economist who employs those tools can err greatly if they don't understand the caveats of those same tools. Taken to a macro-scale is a bit like using a shovel to build a canal over swamps, mountains etc. You can't aggregate any one tool to the Economy as whole. So, things like Demand mean dramatically different things for Macro than Micro.

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  8. Let me see if I have this straight. On the one hand we have a world just past a dramatic (and involuntary) shift in global monetary regime, experiencing heady developed market growth rates, negative output gaps, multiple massive energy supply shocks, and replete with accommodative central banks, powerful labor interests, high energy intensity and de minimis integration of developing markets in the global economy.

    And on the other hand, we have a world at the tail end of three decades of a stable post-Volcker fiat-dollar-based monetary regime, in the midst of an unprecedentedly massive disinflationary shock courtesy of hundreds of millions coming into global labor force, weakened oil cartels and much reduced geopolitical supply risk, ascendant corporatist political power against decimated trade unions, a relatively-less energy intensive economy and a Bretton Woods II system of real exchange rate appreciation for the developed markets.

    And we need, what exactly, microfoundations to detect where the possible differences in the causes and consequences of high real energy prices in these two sets of circumstances? Frankly, it's more difficult to find the similarities in these two sets of circumstances than the differences.

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