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Friday 3 April 2015

Do not underestimate the power of microfoundations

Mainly for economists

Brad DeLong asks why the New Keynesian (NK) model, which was originally put forth as simply a means of demonstrating how sticky prices within an RBC framework could produce Keynesian effects, has managed to become the workhorse of modern macro, despite its many empirical deficiencies. (Recently Stephen Williamson asked the same question, but I suspect from a different perspective!) Brad says his question is closely related to the “question of why models that are microfounded in ways we know to be wrong are preferable in the discourse to models that try to get the aggregate emergent properties right.”

I would guess the two questions are in fact exactly the same. The NK model is the microfounded way of doing Keynesian economics, and microfounded (DSGE) models are de rigueur in academic macro, so any mainstream academic wanting to analyse business cycle issues from a Keynesian perspective will use a variant of the NK model. Why are microfounded models so dominant? From my perspective this is a methodological question, about the relative importance of ‘internal’ (theoretical) versus ‘external’ (empirical) consistency.

As macro 50 years ago was very different, it is an interesting methodological question to ask why things changed, even if you think the change has greatly improved how macro is done (as I do). I would argue that the New Classical (counter) revolution was essentially a methodological revolution. However there are two problems with having such a discussion. First, economists are usually not comfortable talking about methodology. Second, it will be a struggle to get macroeconomists below a certain age to admit this is a methodological issue. Instead they view microfoundations as just putting right inadequacies with what went before.

So, for example, you will be told that internal consistency is clearly an essential feature of any model, even if it is achieved by abandoning external consistency. You will hear how the Lucas critique proved that any non-microfounded model is inadequate for doing policy analysis, rather than it simply being one aspect of a complex trade-off between internal and external consistency. In essence, many macroeconomists today are blind to the fact that adopting microfoundations is a methodological choice, rather than simply a means of correcting the errors of the past.

I think this has two implications for those who want to question the microfoundations hegemony. The first is that the discussion needs to be about methodology, rather than individual models. Deficiencies with particular microfounded models, like the NK model, are generally well understood, and from a microfoundations point of view simply provide an agenda for more research. Second, lack of familiarity with methodology means that this discussion cannot presume knowledge that is not there. (And arguing that it should be there is a relevant point for economics teaching, but is pointless if you are trying to change current discourse.) That makes discussion difficult, but I’m not sure it makes it impossible.


  1. I agree that 'many macroeconomists today are blind to the fact that adopting microfoundations is a methodological choice'. Why not go further though? Adopting a very specific type of microfoundations - equilibria derived from a particular type of optimising decision - is an even more restrictive methodological decision. It is also one which is not strongly supported by empirical evidence - to put it mildly. There are other, more empirically plausible, ways to specify microfoundations - why are they not even discussed?

    1. Here's the thing about utility optimization: it is so general an idea that it can't be tested -- that is, unless you make it case specific. What is testable is a specific utility function with a specific set of constraints and a specific environment... No one has the information require to dismiss this approach -- and, for a good reason, it's a definition and, as such, it's made to be bent so it fits what you see. The interesting part isn't that agents maximize utility, it's what sort of constraint will matter and how behqvior changes when you mosify them -- that is, it's ultimately about being able to say something meaningful about empirical reality.

      It doesn't -- and, I'd argue shouldn't -- stop people from trying other approaches. I don't yell at sociologists when they prefer holist social theories more akin to Durkheim's work instead of picking something closer to indivisuals as did Weber. Pick the right fight -- and that fight is with nuts who just work out tips from theories without bothering to see how they fit into reality -- and that is not the case of most economists.

    2. «Adopting a very specific type of microfoundations - equilibria derived from a particular type of optimising decision - is an even more restrictive methodological decision. It is also one which is not strongly supported by empirical evidence - to put it mildly.»

      Those particular micro-foundations were also comprehensively demolished during the Cambridges Capital Controversy (familiar to our blogger) decades ago, and delusions about their applicability to realistic modeling were completely destroyed by the Theorem of the Second Best, again decades old.

      Even more ironically the one guy who developed an internally consistent micro-founded model which was actually rigorous instead of containing some gross internal inconsistencies and mathematical errors (listed in detail by Steve Keene in a relatively recent booked) demonstrated that in that rigorous model there can be multiple equilibria with multiple possible income distributions determined by the exogenous (aka "government determined") interest rate, even in pretty simple scenarios.

      But the overriding concern is "consistency" with the Central Truthiness of Economics.

  2. "The NK model is the microfounded way of doing Keynesian economics..."

    This is where you lose me. Even if I accept that the best way must be a microfounded way, why does the NK model deserve to be called "the" microfounded way? People like BĂ©nassy use OLG models with sticky prices to get results which look every bit as Keynesian as the NK model. I'm not saying they're better, but are they so much worse that the NK model deserves pride of place?

  3. My understanding is that NK models have become the workhorse of modern *academic* macro. Business economists (investors, banks, private firms) use the older models with fewer empirical deficiencies. My impression is central banks look at both, but rely more on the older models.

    The usual reason I see for the rise of the new models is a certain political slant combined with a love of complex math.

  4. Sorry, but the models optimize 'social utility'. As far as I'm concerned social utility lacks a proper concept, definition and operationalization, let alone measurement. The National Accounts have their SNA, which spells out in detail what the national accounts measure (concepts, definitions, operationalization, measurement).Comparable books can be found in other science, from psychology and geology to law (on a national basis) or chemistry. For neoclassical macro anything even remotely comparable is as far as I know totally lacking: what is this think called utility!? The very fact that all these DSGE models are different (and therewith have different implicit definitions of rational expectations!) shows the lack of rigor of the models. The task for DSGE economists is to come up with independent estimates of expectations which square with independent estimates of utility.They don't even try.

    Aside from this we have the problems with (involuntary) unemployment, money (loanable funds), government consumption (teaching is assumed to add to utility when the teacher is paid by a private body or a person, but not when she or he is paid by the government, you migh like most DSGE economists not know it but government consumption is consumption by households financed by the govenrment, look also at Eurostat and their AIC concept of consumption), when you introduce more than 2 consumers the Arrow paradox (how do these consumers decide about public goods and services), the concept of capital (statisticians do not estimate fixed capital by discounting future streams of income, as this leads to totally fickle estimates), the mirage of the 'natural' rates of interest and unemployment, the absence of unproduced fixed capital and therewith rent incomes (John Bates Clark, the first (to my knowledge) to introduce something like a representative consumer, conspicously purged 'land' from his models to disable people to think about rents, though DSGE economists of course do state that 'mark-up's' on wages are a rent), the idea that our economies tend to equilibrium (explain Italy, explain Greece) and so on, and so on. A waste of time.

    1. Thanks Merijn Knibbe, this comment was help to me.

  5. I would like to add my voice to the below-the-line comments that fail to understand just WHY the micro-founded models have achieved a monopoly of academic discourse.

    I admit that I learnt my academic economics in the 70's when people struggled to relate their results to the real world (as opposed to declaring that the real world is evidently mistaken which seems to be the modern way) but I don't think you've answered Brad's second question. So let me put it another way.

    Why does the academic macroeconomic universe impose a methodological approach which demonstrably limits the scope of observed reality and leads to a limited range of predictions which are very rarely confirmed by evidence?

    I have remarked before that if everything is 'microfounded' to suppose a rational consumer or market agent you have already drastically limited the range of possible outcomes of your analysis. Just when behavioural economics, with all its limitations, has started showing ways of getting beyond the 'marginal man' concept it seems, to an outside observer, that macro-economists are putting their hands over their ears shouting "Ra-Rah we can't hear you"!

    No doubt this is grossly unfair, particularly as I very much endorse the political conclusions that you normally come to on this blog, but there is still more work to do to convince people sympathetic to an economic perspective that microfoundations are solid enough to support the macro world.

  6. Is it really choice? Don't microfounded models get published more than non-microfounded? It seems to me that if you want to go where the money/fame is you have to go down this route, it's just too bad that this is poorly correlated with empirical validity. Academia for you.

    As a side note: Its quite funny that you have the experimental micro guys on one side trying to figure out how people behave in specific scenarios and you have the macro guys in a dark basement trying to figure out what values on what parameters look pretty(but don't work when applied to data). Until the time when we have internally and externally coherent micro models its probably best to not rely too much on microfoundations.

    1. Isn't this something Krugman has been saying? If IS-LM doesn't have the right microfoundations yet, but predictions from the model hold, then continue with the model and we'll figure out the microfoundations later. (This doesn't mean IS-LM is "right." Ptolemy's model of how and why celestial bodies moved as they did really seemed to work, until it didn't.)

  7. How did the Lucas critique prove anything? What's the proof?

    1. I believe the Lucas critique was just taken as eminently reasonable advice -- a skeptical take on empirically observed macroeconomic relationships. Here is the original paper [pdf]:

  8. Lucas: So the microfoundations are stronger?

    Master Yoda: No, no, no. Quicker, easier, more seductive...

  9. The microfoundations program seems like as if on discovering quantum effects, physicists decided that everything must be described in terms of Newtonian gravity. I still can't wrap my head around it except as a political shift ...

  10. Well, there is something to be said for this. The microfoundations open up mechanisms that aggregate to "macro" (if there is a "macro"--that's another discussion). Think of it this way. Chemists could do chemistry without knowing quantum mechanics, but when this became possible, it opened up new vistas about how reaction mechanisms operate, and so expanded our understanding of organic chemistry and what we could do. Quantum mechanics are the "microfoundations" of organic chemistry, and no chemist would be considered competent if they didn't know the basics of QM.

    So I'd have to disagree with the way you frame it. There is value in microfoundations. It just seems that economics has royally screwed up how one should do this.

  11. Consistency sounds so good, Oh, of course we want consistency, who wouldn’t?! But consistent in what way? What exactly do you mean? Consistent with reality, or consistent with people all being superhumans? Which concept is usually more useful, or more useful for the task at hand?

    Essentially, they want models that are consistent with only certain things, and often because this makes their preferred ideology look far better. They want models, typically, that are consistent with everyone in the world having perfect expertise in every subject there is, from finance to medicine to engineering, perfect public information, and perfect self-discipline, and usually on top, frictionless and perfectly complete markets, often perfectly competitive too.

    But a big thing to note is that perfectly consistent people means a level of perfection in expertise, public information, self-discipline, and “rationality”, that’s extremely at odds with how people actually are. And as a result, this can make the model extremely misleading if it’s interpreted very literally (as so often it is, especially by freshwater economists), or taken as The Truth, as Paul Krugman puts it.

    You get things like the equity premium “puzzle”, which involves why people don’t invest more in stocks when the risk-adjusted return appears to usually be so abnormally good, and this “puzzle” can only be answered with “consistency”, that people are all perfectly expert in finance, with perfect information, so they must have some mysterious hidden good reason. It can’t be at all that it's because 65% of people answered incorrectly when asked how many reindeer would remain if Santa had to lay off 25% of his eight reindeer ( ).

    Yes, these perfect optimizer consistency models can give useful insights, and help to see what is best, what we can do better, and they can, in some cases, be good as approximations. But to say they should be used only, and interpreted literally, is, well, inconsistent with optimal, rational behavior -- of the economist using them.

    1. Of course, unless the economist using them is doing so to mislead people into supporting his libertarian/plutocratic ideology.

    2. FWIW, the equity premium turns out not to exist if you look at the 19th century and analyze it correctly (accounting for bankruptcies properly). I read the paper proving this a few years back and unfortunately did not keep the reference.

      People have longer cultural memory than economists might expect. Changing the norms is slower than you might think. The equity premium is only about 100 years old -- why would people assume that it will persist?

      Of course, this is the sort of phenomenon which can't even be described in DSGE.

  12. In Michael Rothschild's Consumption Theory class in 1985 I learned about the aggregation problem: The restrictions you required on individual demand curves in order for them to add up to an aggregate demand curve that behaves like the individual curves do are unlikely to be satisfied in reality. For production functions it's even worse. So there really is no hope that microfoundations are going to give us macroeconomic models that actually fit the data. Not ever.

    Given that, what good are they? Do they give us better predictions about the effects of policies than, say, the partial equilibrium theories of people like Milton Friedman? No one's ever shown that they do. You might expect that after some 40 years of development, there would be at least a few triumphs of micro-founded DSGE models, but there aren't.

    The only thing they are really good for is telling internally consistent stories. But since those stories are stories about economies that behave nothing like the one we live in and never will, why should we care?

    Perhaps the real value is keeping the riff raff out of the journals.

    1. «|earned about the aggregation problem: The restrictions you required on individual demand curves in order for them to add up to an aggregate demand curve that behaves like the individual curves do are unlikely to be satisfied in reality. For production functions it's even worse. So there really is no hope that microfoundations are going to give us macroeconomic models that actually fit the data. Not ever.»

      There go your chances of a generously remunerated career in Economics, as true Economists never mention that.

      «The only thing they are really good for is telling internally consistent stories.»

      Those stories all center around "proving" the Central Truthiness of Economics: that income distribution by "the markets" is perfectly fair in that it corresponds exactly to personal productivity. That if a CEO makes $200m a year it is only because they have personally produced more than $200m a year of value, and that taxation and any other form of intervention is unfair and value destroying.

      That Central Truthiness of Economics is the hallmark of "internal consistency". Any theory of Economics that cannot "prove" it thus cannot be "consistent". Consistency with the data is insignificant compared to that.

      Every aspect of the "microfoundations" that looks strange to "unsponsored" political economists has been devised by true Economists to make it possible to "prove" the Cnetral Truthiness of Economics, and "proving" it is the key to securing lavish remuneration from generous "sponsors".

  13. I should also note that there's a problem in economics, at least finance economics, where I have the bulk of my PhD experience, with this, what is thee explanation (cause, factor). And this extends to what is thee model. It's just terrible. What is thee reason for the equity premium puzzle, for high trading volume,..., when almost always there is more than one substantial explanation, or factor. There's a debate about what is thee explanation, when duh, it's so obvious that both "explanations" are important factors. (I have been told that economists keep this more than one factor thing in the back of their minds, even though what they say and write is different, but I'm not so sure at all with many economists.)

    So, there's this same kind of thing in the field with many economists with regard to models. What kind of models are good and should be used, and what kind are bad? Which is thee model that is best and should be the only one we look at? I mean, it should be obvious that models serve different purposes and illuminate different things, so often to understand a situation better, and come up with a better policy response, it's optimal to look at what a number of models can teach you.

    So, really, the answer, which again I don't think should be so hard to see, and clearly Simon understands, is that it's not internally consistent models versus externally consistent models. Often to get the best understanding and policy you should look at both, and then make intelligent interpretations to reality from them (not necessarily literal interpretations).

  14. Microfoundations are important to avoid another Philipps Curve/stagflation debacle. Observing trends without understanding them can lead to apparently accurate empirical laws that turn out to make predictions that are wrong, because those applying them did not understand their range of validity.

    Microfounded models are never completely accurate, because completely accurate models are intractable, but at least their limitations are admitted and can be studied.

  15. Methodology as Force Majeure
    Comment on ‘Do not underestimate the power of microfoundations’

    Wren-Lewis writes: “First, economists are usually not comfortable talking about methodology.” (See intro)

    As a matter of fact, there is not much to talk. All that is necessary to know about methodology is this.

    “Research is in fact a continuous discussion of the consistency of theories: formal consistency insofar as the discussion relates to the logical cohesion of what is asserted in joint theories; material consistency insofar as the agreement of observations with theories is concerned.” (Klant, 1994, p. 31)

    Now, everybody who looks at economics can convince himself that over more than 200 years economists have failed to produce a formally and materially consistent theory.

    Worse, economists do not even understand that science always has to satisfy TWO criteria. What are they told instead?

    “So, for example, you will be told that internal consistency is clearly an essential feature of any model, even if it is achieved by abandoning external consistency. You will hear how the Lucas critique proved that any non-microfounded model is inadequate for doing policy analysis, rather than it simply being one aspect of a complex trade-off between internal and external consistency.” (See intro)

    Methodology says there is NO trade-off. You always have to deliver BOTH.

    Wren-Lewis writes: “In essence, many macroeconomists today are blind to the fact that adopting microfoundations is a methodological choice, rather than simply a means of correcting the errors of the past.” (See intro)

    True, but unfortunately economists have made the wrong choice. They second-guess the behavior of agents and do not come to grips with the behavior of the economy. This is the consequence of the self-imposed imperative that all explanations must run in terms of the actions and reactions of individuals (Arrow, 1994, p. 1).

    The decisive point is that NO way leads from the understanding of the actions and interactions of individuals to the understanding of the working of the economy as a whole. The economic system has its own logic which is different from the behavioral logic of humans. The systemic logic is what Adam Smith called the invisible hand.

    Methodology demands a paradigm shift which consists in abandoning the obsolete subjective-behavioral axioms of standard economics and in adopting objective-structural axioms (2014).

    Until now, the majority of economists has been unfit for a paradigm shift and this neatly explains why proto-scientific NK, NC, and RBC modelling is still around. This has nothing to do with explanatory power but much with intellectual inertia.

    Egmont Kakarot-Handtke

    Arrow, K. J. (1994). Methodological Individualism and Social Knowledge.
    American Economic Review, Papers and Proceedings, 84(2): 1–9. URL http:
    Kakarot-Handtke, E. (2014). Objective Principles of Economics. SSRN Working
    Paper Series, 2418851: 1–19. URL
    Klant, J. J. (1994). The Nature of Economic Thought. Aldershot, Brookfield, VT:
    Edward Elgar.

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  17. Arrived rather late to this discussion. I quite like the way PK put it recently:

    "A foolish insistence on microfoundations at all times and no matter what the issue is the hobgoblin of little minds."

    1. Maybe, but that kind of rhetoric is not going to convince a DSGE modeller to be more tolerant, and that is the only game worth playing I'm afraid.

  18. I've mentioned this before, but microfoundations are worthless if the microfoundations are blatantly false. "Rational agents"? Suuuure.

    Everything in psychology, sociology, and anthropology, not to mention marketing and advertisting -- actually, everything in *every single social science ever developed* -- tells us that people are, on the whole, and particularly in matters of money, NOT rational agents. So nobody in their right mind would develop a model based on "rational agent" microfoundations -- unless they were attempting to run some kind of fraud.

    Microfoundations sound great. But you can't "microfound" biology on the theory of the four humours, and you can't microfound chemistry on alchemical principles, and you can't microfound physics on Aristotle. Economics has been using the same kind of phony microfoundations for decades.

    And it's not just "rational agents". Microeconomics is mostly a rotten stinking mess. The standard "theory of the firm" is obviously wrong. The standard "theory of the consumer" is not much better. There simply *aren't* any decent microfoundations to work with. You'd have to do years of research just to develop some.

    Biology faced the same problem. Biology developed the theory of evolution -- while having no microfoundations for it. Eventually, we figured out the microfoundations (DNA, RNA, etc.) but it happened decades later.

    The theory of evolution is one of the great triumphs of holistic (big picture) rather than reductive (microfounded) analysis. Furthermore, it describes emergent behavior of the system, which is not remotely obvious from the microfoundations of DNA.

    Keynes's theories of the economy are another of those great triumphs of holistic analysis.

    Do not overestimate the power of microfoundations.

    Perhaps the best reaction to DSGE modellers is to make fun of them. They're not doing scientific work. They shouldn't get paid.


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