This is
a follow on to this post,
and an earlier post
by Paul Krugman. I’m currently reading an excellent account by Jonathan
Heathcote et al of “Quantitative Macroeconomics with Heterogeneous Households”.
This is the growing branch of mainstream macro that uses today’s computer power
to examine the behaviour of systems with considerable diversity, as opposed to a
single (or small number of) representative agent(s). (Heterodox economists may
also be
interested!) I want to talk about the methodological implications of this
kind of analysis at some future date, but for now I want to take from it another
example of letting theory define reality.
If you
have an environment where a distribution of agents differ in the income
(productivity) shocks they receive, a key question is how complete markets are.
If markets are complete, agents can effectively insure themselves against these
risks, and so aggregate behaviour can become independent of distribution. This is
a standard microfoundations device in models where you want to examine
diversity in one area, like price setting, but want to avoid it spilling over
into other areas, like consumption. (As the paper notes, the representative
agent that emerges may not look like any of the individual agents, which is one
of the points I want to explore later.)
Real
world markets are not complete in this sense. We know some of the reasons for
this, but not all. So the paper gives two different modelling strategies, which
it describes in a rather nice way. The first strategy – which the paper mainly
focuses on - is to ‘model what you can see’:
“to simply model the markets, institutions, and arrangements
that are observed in actual economies.”
The paper describes the main drawback of this approach as
not being able to explain why this incompleteness occurs. The
second approach is to ‘model what you can microfound’:
“that the scope for risk sharing should be derived
endogenously, subject to the deep frictions that prevent full insurance.”
The advantage of this second approach is that it reduces the
chances of Lucas critique type mistakes, where policy actions change the extent
of private insurance. The disadvantage is that these models “often imply
substantial state-contingent transfers between agents for which there is no
obvious empirical counterpart”. In simpler English, they predict much more
insurance than actually exists.
The
first approach is what I have described in a paper
as the ‘microfoundations pragmatist’ position: be prepared to make some ‘ad
hoc’ assumptions to match reality within the context of an otherwise
microfounded model. I also talk about this here.
The second approach is what I have called the ‘microfoundations purist’
position. Any departure from complete microfoundations risks internal
inconsistency, which leads to errors like (but not limited to) the kind Lucas
described.
As an
intellectual exercise, the ‘model what you can microfound’ approach can be
informative. Hopefully it is also a stepping stone on the way to being able to
explain what you see. However to argue that it is the only ‘proper’ way to do
academic macroeconomics seems absurd. One of the key arguments of my paper was
that this ‘purist’ position only appeared tenable because of modelling tricks
(like Calvo contracts) that appeared to preserve internal consistency, but
where in fact this consistency could not be established formally.
If you
think that only ‘modelling what you can microfound’ is so obviously wrong that
it cannot possibly be defended, you obviously have never had a referee’s report
which rejected your paper because one of your modelling choices had ‘no clear
microfoundations’. One of the most depressing conversations I have is with
bright young macroeconomists who say they would love to explore some
interesting real world phenomenon, but will not do so because its
microfoundations are unclear. We need to convince more macroeconomists that modelling choices can be based on what you can see, and not
just on what you can microfound.
