This post is prompted by this post by Robert Waldmann, and this by Noah Smith, commenting on an earlier post by Wieland and Wolters.
1) Forecasting and policy analysis
Noah repeats what is a standard line, which is that microfounded models are for policy analysis and not forecasting, and for forecasting “we don't need the structural [microfounded] models, and might as well toss them out”. The reason he gives is policy invariance: microfounded models address the Lucas critique.
While the Lucas critique is important, it is not in my view the reason we have microfounded models. The need for internal consistency drives the microfoundations project. Often internal consistency and addressing the Lucas critique go together, but not always. The clearest example is Woodford’s derivation of a quadratic social welfare function from agents’ utility. This is not needed to address the Lucas critique, but it is required for an internally consistent analysis of what a benevolent policy maker should do.
Why is internal consistency important? Because we think that agents in the real world are internally consistent, so models that are not can make mistakes. They can make mistakes in forecasting as well as policy analysis.
However, in an effort to achieve internal consistency, we may well ignore important features of the real world. ‘Ad hoc’ models that capture these features may be better models, and give better policy advice, even though they are potentially internally inconsistent.
So microfounded models could be better at forecasting, and ‘ad hoc’ models could give better policy advice. In that sense I think Noah is repeating a common misperception.
2) On a pedantic point, there is a long tradition of comparing different macromodels, both for forecasting and policy analysis, so Wieland and Wolters is hardly a first step. In the UK for 16 years we had an excellent research centre that did just that, run by Ken Wallis. There is a wealth of expertise there, which anyone doing this kind of comparative analysis needs to tap.
3) Just in case anyone reading Robert’s post gets the wrong impression, the idea of the core/periphery structure for the Bank of England’s model came from economists at the Bank (strongly influenced by the antecedents from other central banks that I mentioned in my post), and not me. My role was mainly to give advice on theoretical aspects of the model to a very competent team who needed little of it. However Robert and Noah are wrong to suggest that because the Bank uses the core/periphery structure for forecasting, there is no point in having the microfounded core. For example, you can do policy analysis with both the complete model and just the core.
4) This final comment is just for those who read Robert’s post, and is very pedantic. Robert starts off by saying “As far as I can tell, Simon Wren-Lewis has been convinced by Paul Krugman”. The first point is that all my posts on this issue have come from a consistent view. I think microfoundations modelling is an important thing to do, but I do not think it is the only valid way of modelling the economy and doing policy analysis. I think Paul Krugman and I are on absolutely the same page here, and always have been. Robert is however right that my aim has been to convince those doing microfounded modelling of this point.
I’ve disagreed with Paul Krugman (and Robert) on the empirical success of the microfoundations approach, and I still disagree. But given that we agree that analysing microfounded models is useful, I don’t think this is terribly important. I picked up on the ‘mistaking beauty for truth’ phrase, because – taken literally – I don’t think that this is a problematic force behind the way the microfoundations project progresses. All scientists like simplicity, and they also get complicated when they need to, and DSGE models do the same. What I think is problematic is the weak role played by external consistency that I illustrated here, and the role of ideology. On the latter I think I’m once again on the same page as Paul Krugman.