More on the illusion of superiority

For economists, and those interested in methodology

Tony Yates responds to my comment on his post on microfoundations, but really just restates the microfoundations purist position. (Others have joined in - see links below.) As Noah Smith confirms, this is the position that many macroeconomists believe in, and many are taught, so it’s really important to see why it is mistaken. There are three elements I want to focus on here: the Lucas critique, what we mean by theory and time.

My argument can be put as follows: an ad hoc but data inspired modification to a microfounded model (what I call an eclectic model) can produce a better model than a fully microfounded model. Tony responds “If the objective is to describe the data better, perhaps also to forecast the data better, then what is wrong with this is that you can do better still, and estimate a VAR.” This idea of “describing the data better”, or forecasting, is a distraction, so let’s say I want a model that provides a better guide for policy actions. So I do not want to estimate a VAR. My argument still stands.

But what about the Lucas critique? Surely that says that only a microfounded model can avoid the Lucas critique. Tony says we might not need to worry about the Lucas critique if policy changes are consistent with what policy has done in the past. I do not need this, so let’s make our policy changes radical. My argument still stands. The reason is very simple. A misspecified model can produce bad policy. These misspecification errors may far outweigh any errors due to the Lucas critique. Robert Waldmann is I think making the same point here. (According to Stephen Williamson, even Lucas thinks that the Lucas critique is used as a bludgeon to do away with ideas one doesn't like.)

Stephen thinks that I think the data speaks directly to us. What I think is that the way a good deal of research is actually done involves a constant interaction between data and theory. We observe some correlation in the data and think why that might be. We get some ideas. These ideas are what we might call informal theory. Now the trouble with informal theory is that it may be inconsistent with the rest of the theory in the model - that is why we build microfounded models. But this takes time, and in the meantime, because it is also possible that the informal theory may be roughly OK, I can incorporate it in my eclectic model.[1] In fact we could have a complete model that uses informal theory - what Blanchard and Fischer call useful models. The defining characteristic of microfounded models is not that they use theory, but that the theory they use can be shown to be internally consistent.

Now Tony does end by saying “ad-hoc modifications seem attractive if they are a guess at what a microfounded model would look like, and you are a policymaker who can’t wait, and you find a way to assess the Lucas-Critique errors you might be making.” I have dealt with the last point – it’s perfectly OK to say the Lucas critique may apply to my model, but that is a price worth paying to use more evidence than a microfounded model does to better guide policy. For the sake of argument let’s also assume that one day we will be able to build a microfounded model that is consistent with this evidence. (As Noah says, I’m far too deferential, but I want to persuade rather than win arguments.) [2] In that case, if I’m a policy maker who cannot wait for this to happen, Tony will allow me my eclectic model.

This is where time comes in. Tony’s position is that policymakers in a hurry can do this eclectic stuff, but we academics should just focus on building better microfoundations. There are two problems with this. First, building better microfoundations can take a very long time. Second, there is a great deal that academics can say using eclectic, or useful, models.

The most obvious example of this is Keynesian business cycle theory. Go back to the 1970s. The majority of microfoundations modellers at that time, New Classical economists, said price rigidity should not be in macromodels because it was not microfounded. I think Tony, if he had been writing then, would have been a little more charitable: policymakers could put ad hoc price rigidities into models if they must, but academics should just use models without such rigidities until those rigidities could be microfounded.

This example shows us clearly why eclectic models (in this case with ad hoc price rigidities) can be a far superior guide for policy than the best microfounded models available at the time. Suppose policymakers in the 1970s, working within a fixed exchange rate regime, wanted to devalue their currency because they felt it had become overvalued after a temporary burst of domestic inflation. Those using microfounded models would have said there was no point - any change in the nominal exchange rate would be immediately offset by a change in domestic prices. (Actually they would probably have asked how the exchange rate can be overvalued in the first place.) Those using eclectic models with ad hoc price rigidities would have known better. Would those eclectic models have got things exactly right? Almost certainly not, but they would have said something useful, and pointed policy in the right direction.

Should academic macroeconomists in the 1970s have left these policymakers to their own devices, and instead got on with developing New Keynesian theory? In my view some should have worked away at New Keynesian theory, because it has improved our understanding a lot, but this took a decade or two to become accepted. (Acceptance that, alas, remains incomplete.) But in the meantime they could also have done lots of useful work with the eclectic models that incorporated price stickiness, such as working out what policies should accompany the devaluation. Which of course in reality they did: microfoundations hegemony was less complete in those days.

Today I think the situation is rather different. Nearly all the young academic macroeconomists I know want to work with DSGE models, because that is what gets published. They are very reluctant to add what might be regarded as ad hoc elements to these models; however strong the evidence and informal theory might be that could support any modification. They are also understandably unclear about what counts as ad hoc and what does not. The situation in central banks is not so very different.

This is a shame. The idea that the only proper way to do macro that involves theory is to work with fully microfounded DSGE models is simply wrong. I think it can distort policy, and can hold back innovation. If our DSGE models were pretty good descriptions of the world then this misconception might not matter too much, but the real world keeps reminding us that they are not. We really should be more broad minded. 

[1] Suppose there is some correlation in the past that appears to have no plausible informal theory that might explain it. Including that in our eclectic model would be more problematic, for reasons Nick Rowe gives.

[2] I suggest why this might not be the case here. Nick Rowe discusses one key problem, while comments on my earlier post discuss others.