Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 20 January 2018

Microfoundations and the values of policymakers

For economists

This post started an interesting discussion, directed largely by Beatrice Cherrier‏ (@Undercoverhist), about how economists are increasingly tending to hide the value judgements they make. By value judgement I do not mean the trivial, like why did you get interested in this area rather than others, but more serious issues like what values are assumed as part of their analysis. (The distinction between the two was the point of my original post.)

It occurred to me that microfounded macro has an issue that is related to that discussion. It is in fact discussed in my OXREP paper, but used there as an example of where microfoundations had gone one step backwards, with only the prospect of going forwards in the future. The example is the derivation of a benevolent policy maker’s preferences from the utility function of the representative consumer assumed as part of the model, a line of research initiated by Michael Woodford.

Before getting on to the values point, let me note that it is a good example of the primacy of internal consistency in microfoundations rather than the Lucas critique. Before Woodford’s work, microfoundations macroeconomists were embarrassed that they typically assumed an ad hoc objective function for the policy maker choosing between the bads of deviations in inflation from target or deviations of output from its natural rate. Typically, results were presented with alternative values for the policy maker’s preferences between the two. But if the policy maker was benevolent and the model is internally consistent, shouldn’t this objective function reflect the utility function of the representative consumer in the model? What Woodford showed was how this could be done, and better still how it implied the form of objective function, quadratic, that had previously been used on an ad hoc basis. The preference between output and inflation deviations was now an implication of the model.

It was, it is important to admit, an exciting breakthrough. We could now tell policymakers that, if this is the utility function of the representative consumer, and the model was a good representation of reality (yes, I know), this is how you should be trading off output and inflation losses. It was a literature I participated in with colleagues. The derivations were hard and tedious to do, and could take pages of algebra, but within a year every macro paper of this kind had switched from ad hoc objective functions to derived objective functions. If you were doing macro and wanted the paper published in a good journal, this is what you had to do. 

There was only one problem. The simple version of a New Keynesian model that most researchers used implied that inflation deviations were much more important than output deviations. This was very different from the adhoc objective functions that had been used before, where equal weights were commonly used. It also appeared unrealistic: not only did policy makers not act as if inflation was all important in reality, but consumers in happiness studies tended to rate unemployment as more important than inflation. That was the step backwards that I mentioned earlier.

But what it also did, I think, was to make less transparent the value judgements that the researcher was implicitly making. Everyone, including policymakers, know that macro models are huge simplifications, but to get interpretable results that is what you have to do. Yet they also have some idea of their preferences between excess output and inflation. But if the policymaker’s preferences were now endogenised, they would generally get welfare results presented to them with no choice to make involving their own preferences.

Researchers were not hiding anything. The utility function of the representative agent was there to see, and most papers would show the derived objective function with a low relative weight on output deviations. But what was often not shown was how the results would differ under alternative objective functions: why would you as a modeller committed to microfoundations, as to use any other weights than those implied by the model was internally inconsistent. Thus internal consistency took a value judgement away from policy makers.   


  1. Time to retire political economists
    Comment on Simon Wren-Lewis on ‘Microfoundations and the values of policymakers’

    Economics started as Political Economy. Adam Smith and Karl Marx where agenda pushers who used theoretical economics (= science) not so much for enlightenment about how the actual economy works but as the appropriate format of political communication. After the breathtaking successes of science and the debunking of all variants of religious/moral/mythical world interpretation there was simply no other format left.

    The dilemma of the soapbox economist is this: the overwhelming majority in any population likes storytelling, gossip, and moralizing and dislikes the insistence on objectivity, consistency, and proof which defines science. In other words, science does not yield emotional approval, likes on Facebook, votes, and all the other social goodies that have top priority for the agenda pusher. Yet on the other hand, religions have convincingly demonstrated that it is very effective to speak in the name of some higher authority and/or eternal truth.

    From Adam Smith/Karl Marx to the “Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel” economists claim to do science and exploit the prestige of science but economics never rose above the level of a proto-scientific sitcom. The four main approaches ― Walrasianism, Keynesianism, Marxianism, Austrianism ― are mutually contradictory, axiomatically false, materially/formally inconsistent and all got the foundational concept of the subject matter ― profit ― wrong.

    When economists are taken to task for the indefensible pluralism of false theories or ask themselves occasionally ‘Why economists disagree’ they argue that most of the disagreement is only apparent. Friedman and Machlup argued that economists generally agree on theoretical fundamentals ― the basic models ― and disagree only with regard to values and politics. (Prychitko, 1998, p.1) Nothing could be further from the truth.

    The mission of economics is to figure out how the economic system works and NOTHING else. Economists need the true theory “In order to tell the politicians and practitioners something about causes and best means, the economist needs the true theory or else he has not much more to offer than educated common sense or his personal opinion.” (Stigum)

    Economists do NOT have the true theory but a heap of inconsistent models. Alone for this reason, their answer to the IS-OUGHT question is beside the point. Simon Wren-Lewis argues “It was … an exciting breakthrough. We could now tell policymakers that, if this is the utility function of the representative consumer, and the model was a good representation of reality (yes, I know), this is how you should be trading off output and inflation losses.”

    The fact of this paradigmatic case is, unfortunately, that there never was any trade-off between output and inflation but both evils always come in tandem, i.e. higher inflation=lower output/employment. Economists got the Phillips curve dead wrong.#1 Because of scientific incompetence, the scientific basis for any political valuation is lacking.#2

    Politics and science do not mix, never have, never will. Political economics has produced NOTHING of scientific value in the last 200+ years. In order that economics moves from agenda pushing, infotainment, and sectarian squabbles to science, economists have to be discouraged from assuming the roles of fake scientists, opinion managers, and useful idiots in the political Circus Maximus.#3

    Egmont Kakarot-Handtke

    #1 Economists never understood how the price mechanism works

    #2 Microfoundations R.I.P.

    #3 Krugman and the scientific implosion of economics

  2. Which level, micro or macro, drives outcomes in economics?

    On the Nature of Complex Causality (42:49):

    On the micro level there are agents engaged in making contracts, causing perceived harm via torts and crimes, and doing so within a set of public policy constraints imposed by the political feedback into the economic activity. On the macro level there are policy constraints and the intervening acts of governments such as changes in bankruptcy rules or financial system bailouts or allowing the system to fall into episodes of systemic bankruptcy etc.

    The best laid plans of mice and men often go astray. The market or micro-foundation focused models of economists don't seem to fully recognize and integrate how actual outcomes are recognized via legal and political adaptations when the plans of men and women often go astray.

  3. I think there is a further complication which is not dealt with in the excellent OXREP paper, namely the question what constitutes "policy": the choice of a regime as in DSGE models, a random shock to some policy variable as in VAR models or sonething more messy but realistic as in the SEM methodology. These distinctions make the above mehodomogies much more incompatible than the optimist pragmatism of the OXREP oaper would seem to suggest.

  4. Maybe this is obvious to those more in the know, but why is it that "the simple version of a New Keynesian model that most researchers used implied that inflation deviations were much more important than output deviations.
    Also, shouldn't the disutility" of deviations be cumulative and/or negative deviations from inflation and output trends be weighted greater than positive deviations?

  5. On what planet are central bankers merely channeling the preferences of households. That seems like an obvious problem with Woodford.

    I teach/explain the loss function as an expression of central banker's preferences. What's wrong with that? BTW, they surely do not have symmetric preferences--inflation targets are more like ceilings....

  6. The representative consumer itself is a problem. According to the models, unemployment is Leisure. Is this in the trade-off you mention? Might well explain why the model consistent preferences of the government weigh inflation higher than unemployment. But there is somehthing wrong with the Sargent/Lucas/Prescott idea that unemployment is Leisure (and they really use the phrase Leisure). The freezing point is a characteristic of watet, not of individual water molecules. A society might have different characteristics than its constituent elements.

    When an individual increases his or her efforts to find a job his or her chances to obtain one might increase. On the macro level, this might however not lead to a decrease of unemployment as, if this individual had not increased its efforts, someone else might have filled the job. Stating that unemployment is Leisure, as Prescott in the new handbook of macro-ecnomics does, is not right. There is much more to say about this. Mut more values are hidden behind the model consistent values of the government than you acknowledge


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