Internal consistency rather than external consistency is the admissibility criteria for microfounded models. Which means in ordinary English that academic papers presenting macroeconomic models will be rejected if some parts are theoretically inconsistent with other parts, but not if some model property is inconsistent with the data. However the motivation for a paper will often be a ‘puzzle’, which is an empirical fact that cannot as yet by explained by a model. However the paper is not required to be consistent will all other relevant facts, so external consistency is not as important as internal consistency.
In a previous post I expressed a concern that researchers might tend to choose puzzles that were relatively easy to solve, rather than puzzles that were really important. In this post I want to raise another problem, which is that some researchers might select facts on the basis of ideology. The example that I find most telling here is unemployment and Real Business Cycle models.
Why is a large part of macroeconomics all about understanding the booms and busts of the business cycle? The answer is obvious: the consequences of booms – rising inflation – and busts – rising unemployment – are large macroeconomic ‘bads’. No one disagrees about rising inflation being a serious problem. Almost no one disagrees about rising unemployment. Except, it would appear, the large number of macroeconomists who use Real Business Cycle (RBC) models to study the business cycle.
In RBC models, all changes in unemployment are voluntary. If unemployment is rising, it is because more workers are choosing leisure rather than work. As a result, high unemployment in a recession is not a problem at all. It just so happens that (because of a temporary absence of new discoveries) real wages are relatively low, so workers choose to work less and enjoy more free time. As RBC models do not say much about inflation, then according to this theory the business cycle is not a problem at all.
If anyone is reading this who is not familiar with macroeconomics, you might guess that this rather counterintuitive theory is some very marginal and long forgotten macroeconomic idea. You would be very wrong. RBC models were dominant in the 1980s, and many macroeconomists still model business cycles this way. I have even seen textbooks where the only account of the business cycle is a basic RBC model.
But perhaps common sense here is wrong, and the RBC approach is right. Perhaps, despite appearances, high levels of unemployment in a recession are just people choosing to enjoy more leisure. Unfortunately not. One of the really robust findings revealed by happiness data (see here for a recent comprehensive survey) is that unemployment increases unhappiness. As Chris Dillow notes from some recent research, unemployment appears worse than divorce or widowhood, in the sense that the happiness of the unemployed does not adapt over time to their state. Given the future earnings loss implied by spells of unemployment documented here, this is not that surprising. It is also not surprising that quits (voluntary exits) from employment are negatively correlated with unemployment, which is also difficult to rationalise with the RBC approach.
Now the RBC literature is very empirically orientated. It is all about trying to get closer to the observed patterns of cyclical variation in key macro variables. Yet what seems like a rather important fact about business cycles, which is that changes in unemployment are involuntary, is largely ignored. (By involuntary I mean the unemployed are looking for work at the current real wage, which they would not be under RBC theory.) There would seem to be only one defence of this approach (apart from denying the fact), and that is that these models could be easily adapted to explain involuntary unemployment, without the rest of the model changing in any important way. If this was the case, you might expect papers that present RBC theory to say so, but they generally do not. New Keynesian models are RBC models plus sticky prices, but that plus bit is crucial. Not only does it allow involuntary unemployment, and therefore a role for policy to smooth the cycle, but it also changes other properties of the model.
What could account for this particular selective use of evidence? One explanation is ideological. The commonsense view of the business cycle, and the need to in some sense smooth this cycle, is that it involves a market failure that requires the intervention of a state institution in some form. If your ideological view is to deny market failure where possible, and therefore minimise a role for the state, then it is natural enough (although hardly scientific) to ignore inconvenient facts. For the record I think those on the left are as capable of ignoring inconvenient facts: however there is not a left wing equivalent of RBC theory which plays a central role in mainstream macroeconomics.
In this and a previous post I have looked at two biases that can arise in the puzzle selection that drives microfoundation model development. There may well be others. Do these biases matter? I think they do for two reasons. First from a purely academic point of view they distort the development of the discipline. As I keep stressing, I do think the microfoundations project is important and useful, but that means anything that distorts in energies is a problem. Second, policy does rely on academic macroeconomics, and both the examples of bias that I use in this post and the last could have been the source of important policy errors.
One way of reading these two posts is a way of exploring Krugman’s Mistaking Beauty for Truth essay. I know the reactions of colleagues, and bloggers, to this piece have been quite extreme: some endorsing it totally, while others taking strong exception to its perceived targets. My own reaction is very similar to Karl Smith here. I regard what has happened as a result of the scramble for austerity in 2010 to be in part a failure of academic macroeconomics. It would be easy to suggest that this was only the result of unfortunate technical errors, or political interference, and that otherwise the way we do macro is basically fine. I think Krugman was right to suggest otherwise. Given the conservative tendency in any group, an essay that said maybe there might just be an underlying problem here would have been ignored. The discipline needed a wake-up call from someone with authority who knew what they were talking about. Identifying exactly what those problems are, and what to do about them, seems to me an important endeavour that has only just begun.