Microfoundations and Macro Wars

There have been two strands of reaction to my last post. One has been to interpret it as yet another salvo in the macro wars. The second has been to deny there is an issue here: to quote Tony Yates: “The pragmatic microfounders and empirical macro people have won out entirely”. If people are confused, perhaps some remarks by way of clarification might be helpful.

There are potentially three different debates going on here. The first is the familiar Keynesian/anti-Keynesian debate. The second is whether ‘proper’ policy analysis has to be done with microfounded models, or whether there is also an important role for more eclectic (and data-based) aggregate models in policy analysis, like IS-LM. The third is about how far microfoundation modellers should be allowed to go in incorporating non-microfounded (or maybe behavioural) relationships in their models.

Although all three debates are important in their own right, in this post I want to explore the extent to which they are linked. But I want to say at the outset what, in my view, is not up for debate among mainstream macroeconomists: microfounded macromodels are likely to remain the mainstay of academic macro analysis for the foreseeable future. Many macroeconomists outside the mainstream, and some other economists, might wish it otherwise, but I think they are wrong to do so. DSGE models really do tell us a lot of interesting and important things.

For those who are not economists, let’s be clear what the microfoundations project in macro is all about. The idea is that a macro model should be built up from a formal analysis of the behaviour of individual agents in a consistent way. There may be just a single representative agent, or increasingly heterogeneous agents. So a typical journal paper in macro nowadays will involve lots of optimisation by individual agents as a way of deriving aggregate relationships.

Compare this to two alternative ways of ‘doing macro’. The first goes to the other extreme: choose a bunch of macro variables, and just look at the historic relationship between them (a VAR). This uses minimal theory, and the focus is all about the past empirical interaction between macro aggregates. The second would sit in between the two. It might start off with aggregate macro relationships, and justify them with some eclectic mix of theory and empirics. You can think of IS/LM as an example of this third way. In reality there is probably a spectrum of alternatives here, with different mixes between theoretical consistency and consistency with the data (see this post).

In the 1960s and 1970s, a good deal of macro analysis in journals was of this third type. The trouble with this approach, as New Classical economists demonstrated, was that the theoretical rationale behind equations often turned out to be inadequate and inconsistent. The Lucas critique is the most widely quoted example where this happens. So the microfoundations project said let’s do the theory properly and rigorously, so we do not make these kind of errors. In fact, let’s make theoretical (‘internal’) consistency the overriding aim, such that anything which fails on these grounds is rejected. There were two practical costs of this approach. First, doing this was hard, so for a time many real world complexities had to be set aside (like the importance of banks in rationing credit, for example, or the reluctance of firms to cut nominal wages). This led to a second cost, which was that less notice was taken of how each aggregate macro relationship tracked the data (‘external’ consistency). To use a jargon phrase that sums it up quite well: internal rather than external consistency became the test of admissibility for these models.

The microfoundations project was extremely successful, such that it became generally accepted among most academics that all policy analysis should be done with microfounded models. However I think macroeconomists are divided about how strict to be about microfoundations: this is the distinction between purists and pragmatists that I made here. Should every part of a model be microfounded, or are we allowed a bit of discretion occasionally? Plenty of ‘pragmatic’ papers exist, so just referencing a few tells us very little. Tony Yates thinks the pragmatists have won, and I think David Andolfatto in a comment on my post agrees. I would like to think they are right, but my own experience talking to other macroeconomists suggests they are not.

But let’s just explore what it might mean if they were right. Macroeconomists would be quite happy incorporating non-microfounded elements into their models, when strong empirical evidence appeared to warrant this. Referees would not be concerned. But there is no logical reason to only include one non-microfounded element at a time: why not allow more than one aggregate equation to be data rather than theory based? In that case, ‘very pragmatic’ microfoundation models could begin to look like the aggregate models of the past, which used a combination of theory and empirical evidence to justify particular equations.

I would have no problem with this, as I have argued that these more eclectic aggregate models have an important role to play alongside more traditional DSGE models in policy analysis, particularly in policy making institutions that require flexible and robust tools. Paul Krugman is fond of suggesting that IS-LM type models are more useful than microfounded models, with the latter being a check on the former, so I guess he wouldn’t worry about this either. But others do seem to want to argue that IS-LM type models should have no place in ‘proper’ policy analysis, at least in the pages of academic journals. If you take this view but want to be a microfoundations pragmatist, just where do you draw the line on pragmatism?

I have deliberately avoided mentioning the K word so far. This is because I think it is possible to imagine a world where Keynesian economics had not been invented, but where debates over microfoundations would still take place. For example, Heathcote et al talk about modelling ‘what you can microfound’ versus ‘modelling what you can see’ in relation to the incompleteness of asset markets, and I think this is a very similar purist/pragmatist microfoundations debate, but there is no direct connection to sticky prices.

However in the real world where thankfully Keynesian economics does exist, I think it becomes problematic to be both a New Keynesian and a microfoundations purist. First, there is Paul Krugman’s basic point. Before New Keynesian theory, New Classical economists argued that because sticky wages and prices were not microfounded, they should not be in our models. (Some who are unconvinced by New Keynesian ideas still make that case.) Were they right at the time? I think a microfoundations purist would have to say yes, which is problematic because it seems an absurd position for a Keynesian to take. Second, in this paper I argued that the microfoundations project, in embracing sticky prices, actually had to make an important methodological compromise which a microfoundations purist should worry about. I think Chari, Kehoe and McGrattan are making similar kinds of points. Yet my own paper arose out of talking to New Keynesian economists who appeared to take a purist position, which was why I wrote it.

It is clear what the attraction of microfoundations purity was to those who wanted to banish Keynesian theory in the 1970s and 1980s. The argument of those who championed rational expectations and intertemporal consumption theory should have been: your existing [Keynesian] theory is full of holes, and you really need to do better – here are some ideas that might help, and let’s see how you get on. Instead for many it was: your theory is irredeemable, and the problems you are trying to explain (and alleviate) are not really problems at all. In taking that kind of position it is quite helpful to follow a methodology where you get rather a lot of choice over what empirical facts you try and be consistent with.

So it is clear why the microfoundations debate is mixed up with the debate over Keynesian economics. It also seems clear to me that the microfoundations approach did reveal serious problems with the Keynesian analysis that had gone before, and that the New Keynesian analysis that has emerged as a result of the microfoundations project is a lot better for it. We now understand more about the dynamics of inflation and business cycles and so monetary policy is better. This shows that the microfoundations project is progressive.

But just because a methodology is progressive does not imply that it is the only proper way to proceed. When I wrote that focusing on microfoundations can distort the way macroeconomists think, I was talking about myself as much as anyone else. I feel I spend too much time thinking about microfoundations tricks, and give insufficient attention to empirical evidence that should have much more influence on modelling choices. I don’t think I can just blame anti-Keynesians for this: I would argue New Keynesians also need to be more pragmatic about what they do, and more tolerant of other ways of building macromodels.