Microfoundations are latest big thing on the econoblogosphere. Krugman, Wren-Lewis (and again), Waldmann, Smith (all two of them!) have weighed in on the subject. So let me take a shot.
The idea of reformulating macroeconomics was all the rage when I studied economics as an undergraduate and graduate student at UCLA in the late 1960s and early 1970s. The UCLA department had largely taken shape in the 1950s and early 1960s around its central figure, Armen Alchian, undoubtedly the greatest pure microeconomist of the second half of the twentieth century in the sense of understanding and applying microeconomics to bring the entire range of economic, financial, legal and social phenomena under its purview, and co-author of the greatest economics textbook ever written. There was simply no problem that he could not attack, using the simple tools one learns in intermediate microeconomics, with a piece of chalk and a blackboard. Alchian’s profound insight (though in this he was anticipated by Coase in his paper on the nature of the firm, and by Hayek’s criticisms of pure equilibrium theory) was that huge chunks of everyday economic activity, such as advertising, the holding of inventories, business firms, contracts, and labor unemployment, simply would not exist in the world characterized by perfect information and zero uncertainty assumed by general-equilibrium theory. For years, Alchian used to say, he could not make sense of Keynes’s General Theory and especially the Keynesian theory of involuntary unemployment, because it seemed to exclude the possibility of equilibration by way of price and wage adjustments, the fundamental mechanism of microeconomic equilibration. It was only when Axel Leijonhufvud arrived on the scene at UCLA, still finishing up his doctoral dissertation, published a few years after his arrival at UCLA as On Keynesian Economics and the Economics of Keynes that Alchian came to understand the deep connections between the Keynesian theory of involuntary unemployment and the kind of informational imperfections that Alchian had been working on for years at the micro-level.
So during my years at UCLA, providing microfoundations for macroeconomics was viewed as an intellectual challenge for gaining a better understanding of Keynesian involuntary unemployment, not as a means of proving that it doesn’t exist. Reformulating macroeconomic theory (I use this phrase in homage to the unpublished paper by the late Earl Thompson, one of Alchian’s very best students) based on microfoundations did not mean simply discarding Keynesian theory into the dustbin of history. Unemployment was viewed as a search process in which workers choose unemployment because it would be irrational to accept the first offer of employment received regardless of the wage being offered. But a big increase in search activity by workers can have feedback effects on aggregate demand preventing a smooth transition to a new equilibrium after an interval of increased search. Alchian, an early member of the Mont Pelerin Society, was able to see the deep connection between Leijonhufvud’s microeconomic rationalization of Keynesian involuntary unemployment and the obscure work, The Theory of Idle Resources, of another member of the MPS, the admirable human being, and unjustly underrated, unfortunately now all but forgotten, economist, W. H. Hutt, who spent most of his professional life engaged in a battle against what he considered the fallacies of J. M. Keynes, especially Keynes’s theory of unemployment.
Unfortunately, this promising approach towards gaining a deeper and richer understanding of the interaction between imperfect information and uncertainty, on the one hand, and, on the other, a process of dynamic macroeconomic adjustment in which both prices and quantities are changing, so that deviations from equilibrium can be cumulative rather than, as conventional equilibrium models assume, self-correcting, has yet to fulfill its promise. Here the story gets complicated, and it would take a much longer explanation than I could possibly reduce to a blog post to tell it adequately. But my own view, in a nutshell, is that the rational-expectations revolution — especially the dogmatic view of how economics ought to be practiced espoused by Robert Lucas and his New Classical, Real Business Cycle and New Keynesian acolytes — has subverted the original aims of the microfoundations project. Rather than relax the informational assumptions underlying conventional equilibrium analysis to allow for a richer and more relevant analysis than is possible when using the tools of standard general-equilibrium theory, Lucas et al. developed sophisticated tools that enabled them to nominally relax the informational assumptions of equilibrium theory while using the tyrannical methodology of rational expectations combined with full market clearing to preserve the essential results of the general-equilibrium model. The combined effect of the faux axiomatic formalism and the narrow conception of microfoundations imposed by the editorial hierarchy of the premier economics journals has been to recreate the gap between the Keynesian theory of involuntary unemployment and rigorous microeconomic reasoning that Alchian, some forty years ago, thought he had found a way to bridge.
Update (1:16PM EST): A commenter points out that the first sentence of my concluding paragraph was left unfinished. That’s what happens when you try to get a post out at 2AM. The sentence is now complete; I hope it’s not to disappointing.
Uneasy Money 
David, as always an excellent post. I have only read a little of Alchian’s work, but I am the happy owner of “Economic Forces at Work” which is good collection of a number articles including “Why Money?”. In “Why Money” Alchain also uses uncertainty to explain the existence of money.
By the way Armen Alchain is still alive. He is 97 – soon to be 98.
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Why give the name “Keynes” to everything — especially everything which has roots already in _pre-Keynesian_ economics.
I don’t get it.
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David, the explanation of what happened is simple.
The financial, status & power reward system of the economics profession is run on the basis of _formal_ metrics — its a “whose the smartest man in the room” measured by a single formal metric, who is most clever at constructing formal math mechanisms.
That’s just about all there is to it.
True Knightian uncertainty, open-ended learning, changes in judgment — all of the causal explanatory aspect of economic science can’t be stuffed in to a formal construct. No amount of crossing one’s fingers can change this.
This is all part of the pathological picture economists have of “objectivity” and “objective science”. Economists simply have no idea how to make their activities into a successful / non-pathological contingent causal explanatory science answering problems in our experience — they haven’t come close to doing so. All that have is the mathematicians standard of formal, “objective” “rigor” and a cargo-cult pseudo-scientific use of statistics to make bogus “predictions” which are fake “testable”.
The contingent causal explanatory element of economic science has only an indirect relation to tractable mathematics and equilibrium constructs and any set of “given” elements of the kind found in textbook or whiteboard economic constructs.
Economists will continue to give us fake science — and will continue to neglect the Knightian uncertainty, changes in understanding, discovery, and open-ended learning — as long as they continue to get the explanatory strategy of the science all wrong in pursuit of a model of fake sciences they have acquired from rumors heard in the hallways from the philosophers, engineers, and actual real scientists.
And until they give up on their bogus “smartest man in the room” pretense driven by the the “objective” standard of “who is cleverest at producing and publishing math constructs”.
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who’s
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“But my own view, in a nutshell, is that the rational-expectations revolution — especially the dogmatic view of how economics ought to be practiced espoused by Robert Lucas and his New Classical, Real Business Cycle and New Keynesian acolytes — has subverted the original aims of the microfoundations project. “
David, what do you think about the attempts by those inspired by Lucas to introduce frictions that depart from the full equilibrium model, specifically in order to understand the nature of money. I am thinking folks like Stephen Williamson, Neil Wallace, and Wright & Kiyotaki (search theory). Here, for instance, is Wallace:
“It is widely agreed that in order to address questions like these [he is talking about monetary policy], we require a model different from the standard competitive general equilibrium (SGE) model. The SGE model has no implications for what gets traded for what, has no room for a valued fiat object, and, because it has complete markets which permit all assets to be traded at given prices in any circumstance, does not solve Hicks’ coexistence problem.”
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I think this was way above my head. The part about equilibrium difference between the cumulative and self-correcting is what I got out of the essay.
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“Unfortunately, this promising approach
towards gaining a deeper and richer understanding of the interaction
between
imperfect information and uncertainty, on the one hand,
and, on the other,
a process of dynamic macroeconomic adjustment
in which both prices and quantities are changing,
so that deviations from equilibrium can be cumulative rather than,
as conventional equilibrium models assume, self-correcting.
Here the story gets complicated, …”
Complicated indeed. Re that first sentence in the final paragraph: verb? object? Don’t leave me hanging!
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What I haven’t understood why it’s insufficient simply to *posit* that people are slower to lower prices than to raise them. If wage-earners are slow to drop their wage demands even in the face of unemployment, it is sufficient to explain much of how voluntary unemployment comes about.
The problem, it seems to me, is that economists want there to be some underlying “rational’ behavior in their micro models. But there’s no reason to assume that people behave rationally in those terms – by optimizing some sort of preference function. In fact, there’s lots of examples of people behaving “irrationally’ in precisely these terms. People behave very differently risking something the think they already have compared to something they might gain.
E.g. Give someone $100 and ask him to place a bet on some uncertain result. If he wins he gets another $100, but if he loses, he loses the $100. It is known that people behave very differently than if you offer them a bet where they get $0 if they lose and $200 if they win, even though these are formally the same.
In fact, there’s even some evidence that this behavior appears in other primates as well. See
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“E.g. Give someone $100 and ask him to place a bet on some uncertain result. If he wins he gets another $100, but if he loses, he loses the $100. It is known that people behave very differently than if you offer them a bet where they get $0 if they lose and $200 if they win, even though these are formally the same.”
Start with $100.00
Bet and win – End with $200
Bet and lose – End with $0
Don’t bet – End with $100
Start with $0.00
Bet and win – End with $200
Bet and lose – End with $0
Don’t bet – End with $0
My guess is that people with $100 in hand will be more cautious in their betting while people with nothing to lose will be more whimsical. This only makes sense if not betting is an option.
As for microeconomic foundations for macroeconomics, most of it is B. S. for one reason and one reason only:
Abba Lerner – “Principles of sound finance apply to individuals. They make sense for households and businesses, but do not apply to the governments of sovereign states, capable of issuing money.”
And so if you try to make macro policy based upon possible micro outcomes (threat of bankruptcy, insolvency), you will undoubtedly fail. The Chicago (fresh water) school tries very hard to eliminate finance and contract law from economics in part I believe because it contradicts their support of Laissez Faire government.
It is only because the federal government can enforce contracts that a capitalist system can exist. Laissez Faire government policy and capitalism do not go hand and hand. Capitalism depends on the legal enforcement of contracts that transfer the savings of one individual to the spending of another. True Laissez Faire government would offer no protection of said contracts – aka the Alan Greenspan wet dream.
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Thanks. I guess I should have inferred the sentence completion from the context.
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Lars, Thanks. Alchian is still with us. There still is time for the Nobel Committee to make amends for its inexcusable failure to have awarded Alchian the Nobel Prize. Only a small handful of previous Nobel Laureates have had a better claim than Alchian to the prize.
Greg, Go back and reread my post, obviously a reminiscence about events that took place some years ago. Sorry, but I am in no position to change events that already took place, however much you wish that they had turned out differently.
I do agree with the gist of your criticism of cutting edge economic research, though it is uncharacteristically over the top.
JP, I don’t say, as Greg might, that no worthwhile work has come out of the formalist rational-expectations research program, and I have great admiration for Neil Wallace. And Wright and Kiyotaki and Williamson have done some very worthwhile research. But the style of research that I object to is to posit a general equilibrium model with a unique solution that is rationally expected and then introduce one or two informational imperfections that can be modeled within that equilibrium framework.
Tas, Sorry about that, but what you got was pretty important.
Arb, Thanks, you’re a careful reader. I am actually not sure if that’s the way the sentence was supposed to come out when I first wrote it, but that was the best I could do when I reread it after you queried me.
Mitch, Usually, a model builder does not just posit an unexplained asymmetry. You say that there is no reason to posit rationality. I agree that we should be open to the possibility of non-rationality, but it we just posit irrationality, then a modeler can get away with anything. Departures from rationality need to be rationalized.
Frank, Any good economist, whether from Chicago, Vienna, or Cambridge, understands that capitalism cannot create itself, but is the product of a legal system that is logically prior to capitalism (or the free market or whatever).
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“Frank, Any good economist, whether from Chicago, Vienna, or Cambridge, understands that capitalism cannot create itself, but is the product of a legal system that is logically prior to capitalism (or the free market or whatever).”
Tell it to Greece.
http://news.yahoo.com/greece-secures-biggest-debt-cut-history-132156845.html
“Creditors holding Greek-law bonds who refused to sign up will be forced into the deal, with the Cabinet approving during a meeting Friday the activation of legislation known as “collective action clauses.”
So it would seem contract law (at least in Greece) isn’t worth the paper it is printed on.
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David writes,
“I don’t say, as Greg might, that no worthwhile work has come out of the formalist rational-expectations research program”
David, I don’t say this and don’t believe this. I’ve said the opposite. You can Google it. I’ve said worthwhile things _have_ come out of this research program, and I’ve encouraged folks to continue the attempted expansion of that program into the domains of finance and money and uncertainty, as Stephen Williamson and Michael Woodford and others are attempting to pioneer.
My point is different and far more fundamental. My point is that if you utterly botch the explanatory strategy you end up utterly failing to produce science or anything that is ultimately sound or coherent. It’s Hayek’s argument & its a devastating argument against what the top economists at the top grad school do.
One part of my argument is that you can learn at _tremendous_ about about phenomena from the failure of a research program, and by reaching a comprehension of what that research program fails to achieve or fails to include. What Wittgenstein learned about language and logic from the failure of the formalist project of Frege, Russell and Carnap is one example. The failure of the formalist project in mathematics is another.
Hayek’s “Top 20 Article of the Century”, e.g. “The Use of Knowledge in Society” is another example — the whole article turns on how _knowledge_ and _learning_ are spotlighted in _contrast_ to the causal/explanatory failure of pure equilibrium theory.
The failure to explain how the core formal elements of economics can supply a coherent causal/explanatory enterprise is central and widely noted and discussed fact about economic science, and the topic is decades old, and no one has come forward with a solution that has any plausibility of success or is gaining even the slightest degree of wide argumentative support in the profession.
The profession simply punts on this topic.
What I call for is blunt honesty and straight talk on this central core problem in the science of economics.
Playing pretend on this issue hasn’t helped fix a broken science.
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David –
Allow me to clarify. I am not saying that people are irrational. I am saying that they do not behave according to the simple definitions of “rationality” that microeconomists use.
There is a lot of science already that shows that people behave in the way I described. (The technical term is “loss aversion”. See e.g http://en.wikipedia.org/wiki/Loss_aversion ) There is no point in discussing whether such behavior is “rational” or not. The question is simply whether people are in fact loss averse. If so, you *must* put it in your microeconomic models.
If people are loss averse, it makes complete sense for them to be slower to lower prices than raise them. Lowering a price means acknowledging that they have sustained a loss, which one will be reluctant to do. One would rather hold on to the illusion that their asset (or labor) will eventually fetch the original price.
This seems reasonable enough to me, and it seems largely to remoe the microeconomic objection to the observed macroeconomic effects.
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Here’s a cool article that says more on this subject:
http://www.scientificamerican.com/article.cfm?id=the-prospects-for-homo-economicus
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Make that:
can learn a tremendous amount about phenomena from the failure of a research program
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Frank, Laws are not forever. But that doesn’t mean contracts or contract law are worthless, even in Greece.
Greg, My comment was tongue in cheek, and I take you at your word. My general position is that methodological condemnations of research other people have done, even if justified, rarely accomplishes anything. The only way to change the way other people do research is to do research yourself that other people want to emulate. And the reason they want to emulate it, for the most part, is that they think doing so will lead to their own career advancement. So we are stuck in a self-perpetuating system because of a whole system of dysfunctional incentives. But simply heaping abuse on what other people are doing is not going to improve the situation, though I recognize the self-therapeutic value of doing so.
Mitch, I agree that what counts as rational is not self-evident. Let me stipulate that people behave the way you say they do. You say that such behavior makes it a fact that people are loss averse. It is a fact that the sun rises in the east every morning and sets in the west every evening. Whether that fact supports a theory that the sun revolves around the earth or that the earth revolves around the sun is not clear because the “fact” can be understood in a different way depending on which theoretical framework one is working with. So you can’t cite a single “fact” to prove that your way of looking at the world is correct, unless the alternative way of looking at reality has no way of interpreting the fact in terms of its theoretical view. Economists are loathe to just posit departures from precepts of rationality (bygones are bygones). You yourself refer to it as an illusion. The question is whether there is a different way of looking at the facts that accommodates them without having to accept that such unexplained departures are characteristic of how people make decisions. Thanks for the link.
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David,
I’m not talking about “methodology” — a conception which I’ve repeatedly explained is part of the non-scientific philosophical tradition adopted by economists from philosophers which has made a non-science out of economics.
I’m pointing to a fact about explanatory failure. This is a fact internal to contemporary economics, widely recognized by suppressed on bogus philosophical grounds by economists working within a failed philosophical tradition and acting as law-giving philosophers, and not speaking as successful explanatory scientists.
I’m not talking about “methodology”. “Methodology” is part of the failed Carnap/Mill tradition (part of a wider philosophical legacy).
Kuhn and others pointed out that _successful_ explanatory enterprises provide exemplars and explanatory practices from which people derive explicit articulated norms.
It doesn’t work the other direction — as implied by the failed philosophical tradition embodied by the economists notion of “methodology”.
David writes,
“My general position is that methodological condemnations of research other people have done, even if justified, rarely accomplishes anythin
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The public should not be blocked from knowing the truth about the causal explanatory failure of economic “science” — and the truth about the failure should not be suppressed or hidden.
In fact, there is good reason to believe that putting a fat spotlight on that failure would change behavior — and certainly would change the power relation between the public and its government and that of the pseudo-scientific economists.
In this regard, economists like Russ Roberts and David Colander have been doing a great public services in telling the public the truth about the empty “scientific” and intellectual pretentions of the economist “scientists” being filtered via the guild system of the elite universities, grad schools, and professional journals, etc.
David writes,
“My general position is that methodological condemnations of research other people have done, even if justified, rarely accomplishes anything. The only way to change the way other people do research is to do research yourself that other people want to emulate.”
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This is _not_ how behaviorism was defeated in psychological science.
Behaviorism was defeated by the relentless hard work of people who showed the explanatory failure and cognitive incoherence of the enterprise — showing how it was pseudo-science, not successful science capable of providing coherent causal explanations unified with the rest of our knowledge.
So there is an enormous and significant counter-example against your claim.
People wanted to continue to emulate the experiments and paradigm of behaviorism because it was an easy filter for evaluating grad students and because it created endless material to fill the journals.
But is was a failure as an explanatory enterprise, and was eventually abandoned as a sound way to understand a central domain of science.
David writes,
“My general position is that methodological condemnations of research other people have done, even if justified, rarely accomplishes anything. The only way to change the way other people do research is to do research yourself that other people want to emulate.”
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Because straight and honest talk in this area is taboo, you mistake simple straight honesty with “abuse”.
David writes,
“simply heaping abuse on what other people are doing is”
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The fact that macroeconomists have produced fake “science” which is an explanatory failure is important for a number of reasons.
Central among them is because this fact is a central part of the explanation for _why_ the macroeconomists helped lead us unto the greatest economics boom and bust science the 1920s.
The policies of the macroeconomists have been a failure because their science is a failure.
There’s real explanatory power their, which should not be suppressed because it doesn’t serve the career interests or math tastes of grad school macroeconomists.
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Greg, You said:
“I’m not talking about “methodology” — a conception which I’ve repeatedly explained is part of the non-scientific philosophical tradition adopted by economists from philosophers which has made a non-science out of economics.”
Do you mean Popperian falsificationism explicitly endorsed by Hayek in, among other places, Politics, Philosophy and Economics, which he dedicated to Popper?
You said:
“The public should not be blocked from knowing the truth about the causal explanatory failure of economic “science” — and the truth about the failure should not be suppressed or hidden.”
You can speak the truth as much as you want to, I just don’t think that people will listen if you don’t offer them a better alternative. I applaud the work that Roberts and Colander do in this regard, but it is not exactly transforming the profession. But I think that a good approach would be to explore the economic incentive structure currently in place for self-interested young “scientists” and why the “market” is not functioning optimally if we posit that the goal is to find truth or accumulate socially useful knowledge. That would be a worthy research endeavor very much in the spirit of Armen Alchian and his approach to economics, especially his classic paper on academic tenure.
You said:
“Behaviorism was defeated by the relentless hard work of people who showed the explanatory failure and cognitive incoherence of the enterprise — showing how it was pseudo-science, not successful science capable of providing coherent causal explanations unified with the rest of our knowledge.”
I don’t know enough about the history of psychology to comment, but the mistakes and absurdity of behaviorism were so palpable that I think that it was a doomed enterprise from the start.
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David, Hayek explicitly refutes the falsification criterion of science in that book, giving the example of “essentially complex sciences” such as Darwinian biology, global brain theory and economics. Popper actually accepted Hayek’s argument. See Popper’s autobiography.
David writes,
“Do you mean Popperian falsificationism explicitly endorsed by Hayek in, among other places, Politics, Philosophy and Economics, which he dedicated to Popper?”
Of course, I’m making my own arguments and my own claims.
Hayek learned things over his life time, and changed his mind. He got better as he got older.
My own philosophy of science is informed by the work of Larry Wright and Thomas Kuhn, William Bartley, and David Hull — as well as Hayek and Popper — among many others.
Significantly, I take sides with Kuhn, Hayek, Hull and Bartley against Popper.
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“You can speak the truth as much as you want to, I just don’t think that people will listen if you don’t offer them a better alternative.”
I have given a better alternative. See part II of this paper:
http://www.hayekcenter.org/friedrichhayek/hayekmyth.htm
What I’ve done is laid out Hayek’s contingent causal explanatory strategy set within the broader context of the problem raising patterns in our experience presented by economic phenomena — i.e. putting together all of the elements of Hayek’s picture of economic science spread out over dozens of different books and papers.
The better alternative goes under the name of what Peter Boettke calls “mainline economics”.
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There are a handful of papers in the economics journals on this topic, an excellent one, which deserves much further exploration:
“I think that a good approach would be to explore the economic incentive structure currently in place for self-interested young “scientists” and why the “market” is not functioning optimally if we posit that the goal is to find truth or accumulate socially useful knowledge. That would be a worthy research endeavor very much in the spirit of Armen Alchian and his approach to economics, especially his classic paper on academic tenure.”
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