Paul Romer and microfoundations

For economists

In an AER P&P paper, Paul Romer talks about many things: a distinction between scientific consensus and political discourse, a divide in growth theory between those that use models based on perfect competition and those using imperfect competition, but mainly the distinction between appropriate mathematical theory and what he calls ‘mathiness’. To better see how these things connect up, and how they could have wider applicability, I suggest reading his blog post first. There he writes:

“the problems I identify in growth theory may be of broader interest. If economists can understand what the problem is in this sub-field, we may be in a better position to evaluate the scientific health of other parts of economics. The field to which scrutiny might first extend is economic fluctuations.”

So how might such a comparison go? The attachment to using perfect rather than imperfect competition could map into an aversion to either price stickiness or the importance/autonomy of aggregate demand, both of which could be labelled as ‘anti-Keynesian’. Keynesian theory is denigrated in some cases not because of empirical evidence but because of the policy implications that may follow from that theory. The microfoundations methodology, as practiced by some, allows those that want to deny the importance of Keynesian effects to continue to study business cycles, because this methodology can place such a low weight on the importance of evidence when it comes to the elements of model building. (Ask not whether price stickiness has empirical support, but whether it has solid microfoundations.)

Paul Romer’s post also links to the idea in this paper by Paul Pfleiderer about theoretical models becoming “chameleons”. To quote: “A model becomes a chameleon when it is built on assumptions with dubious connections to the real world but nevertheless has conclusions that are uncritically (or not critically enough) applied to understanding our economy.” I think we could add that these conclusions are usually associated with defending a particular political view or sectional interest.

It is important to stress that this is not an attack on the microfoundations methodology, just as Paul Romer’s article is not an attack on mathematical modelling. Most DSGE modellers, who are not subject to any political aversion to using price rigidity, happily use this methodology to advance the discipline. But if that methodology is taken too seriously (by what I call here microfoundations purists), so that modellers only look at what they can microfound rather than what they actually see in the real world, it can allow approaches that should have been discarded to live on, perhaps because they support a particular policy position.

A discipline where a huge number of alternative models persist could be described as ‘flourishing’, but risks disintegrating into alternative schools of thought, where some schools have an immunisation strategy that protects them from particular kinds of empirical evidence. As Paul perceptively points out, this makes economics more like political discourse than a scientific discipline. Some people welcome that, or regard it is inevitable - I hope most economists do not. This means we first need to collectively recognise the problem, rather than keeping our heads down to avoid upsetting others. I hope Paul Romer’s article can be part of that process. 

Humility and Chameleons

Macroeconomics tells you to (temporarily) raise, not cut, government spending when we have a recession caused by deficient demand and interest rates are at their lower bound. That is the claim that some of us make. Others say we are being far too sure of ourselves and our subject, in part because there exist models where this is not true. As a result, we should not loudly complain when politicians do not follow this advice. A bit more humility please.

If you think we should have more humility, imagine the following. The UK or US government tomorrow abolishes their independent central bank, and immediately raises rates to 5%, saying it was about time savers had a better deal. Well macroeconomists generally think that independent central banks are a good idea, and we nearly all believe that raising interest rates when inflation is below target and unemployment is high is crazy. But wait a minute. There are models that suggest keeping interest rates low is causing low inflation, and that raising rates could stimulate the economy - I discuss one here. So perhaps we should not be critical of a government that did this. We should be humble, and leave the politicians to do as they please while we get on with our research. Let us make sure we are absolutely sure before shouting too loud.

Why is that wrong? Two reasons. First, the existence of a model that says higher interest rates could stimulate the economy is not in itself evidence that it might. In an interesting paper, Paul Pfleiderer talks about Chameleon models. He defines a chameleon model as “built on assumptions with dubious connections to the real world but nevertheless has conclusions that are uncritically (or not critically enough) applied to understanding our economy.” The model that I discussed where higher rates could stimulate the economy assumes (among other things) agents believe the inflation target is negative, and that raising rates will show them they are wrong. Possible, but highly improbable.

Second, economic policy always takes place in an uncertain environment. Raising interest rates might have reduced inflation in the past, but maybe this time is different? If we wait until we are all absolutely sure about the impact of a policy change, we will wait forever. However, if we are more than 90% certain that raising interest rates, or cutting government spending, will make the recession worse, we should say so. If politicians ignore this advice, we should make sure everyone knows. This is no intellectual game - people’s welfare is at stake.