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.