Last week, Paul Krugman, set off by this blog post, complained about the current state macroeconomics. Apparently, Krugman feels that if saltwater economists like himself were willing to accommodate the intertemporal-maximization paradigm developed by the freshwater economists, the freshwater economists ought to have reciprocated by acknowledging some role for countercyclical policy. Seeing little evidence of accommodation on the part of the freshwater economists, Krugman, evidently feeling betrayed, came to this rather harsh conclusion:
The state of macro is, in fact, rotten, and will remain so until the cult that has taken over half the field is somehow dislodged.
Besides engaging in a pretty personal attack on his fellow economists, Krugman did not present a very flattering picture of economics as a scientific discipline. What Krugman describes seems less like a search for truth than a cynical bargaining game, in which Krugman feels that his (saltwater) side, after making good faith offers of cooperation and accommodation that were seemingly accepted by the other (freshwater) side, was somehow misled into making concessions that undermined his side’s strategic position. What I found interesting was that Krugman seemed unaware that his account of the interaction between saltwater and freshwater economists was not much more flattering to the former than the latter.
Krugman’s diatribe gave Stephen Williamson an opportunity to scorn and scold Krugman for a crass misunderstanding of the progress of science. According to Williamson, modern macroeconomics has passed by out-of-touch old-timers like Krugman. Among modern macroeconomists, Williamson observes, the freshwater-saltwater distinction is no longer meaningful or relevant. Everyone is now, more or less, on the same page; differences are worked out collegially in seminars, workshops, conferences and in the top academic journals without the rancor and disrespect in which Krugman indulges himself. If you are lucky (and hard-working) enough to be part of it, macroeconomics is a great place to be. One can almost visualize the condescension and the pity oozing from Williamson’s pores for those not part of the charmed circle.
Commenting on this exchange, Noah Smith generally agreed with Williamson that modern macroeconomics is not a discipline divided against itself; the intetermporal maximizers are clearly dominant. But Noah allows himself to wonder whether this is really any cause for celebration – celebration, at any rate, by those not in the charmed circle.
So macro has not yet discovered what causes recessions, nor come anywhere close to reaching a consensus on how (or even if) we should fight them. . . .
Given this state of affairs, can we conclude that the state of macro is good? Is a field successful as long as its members aren’t divided into warring camps? Or should we require a science to give us actual answers? And if we conclude that a science isn’t giving us actual answers, what do we, the people outside the field, do? Do we demand that the people currently working in the field start producing results pronto, threatening to replace them with people who are currently relegated to the fringe? Do we keep supporting the field with money and acclaim, in the hope that we’re currently only in an interim stage, and that real answers will emerge soon enough? Do we simply conclude that the field isn’t as fruitful an area of inquiry as we thought, and quietly defund it?
All of this seems to me to be a side issue. Who cares if macroeconomists like each other or hate each other? Whether they get along or not, whether they treat each other nicely or not, is really of no great import. For example, it was largely at Milton Friedman’s urging that Harry Johnson was hired to be the resident Keynesian at Chicago. But almost as soon as Johnson arrived, he and Friedman were getting into rather unpleasant personal exchanges and arguments. And even though Johnson underwent a metamorphosis from mildly left-wing Keynesianism to moderately conservative monetarism during his nearly two decades at Chicago, his personal and professional relationship with Friedman got progressively worse. And all of that nastiness was happening while both Friedman and Johnson were becoming dominant figures in the economics profession. So what does the level of collegiality and absence of personal discord have to do with the state of a scientific or academic discipline? Not all that much, I would venture to say.
So when Scott Sumner says:
while Krugman might seem pessimistic about the state of macro, he’s a Pollyanna compared to me. I see the field of macro as being completely adrift
I agree totally. But I diagnose the problem with macro a bit differently from how Scott does. He is chiefly concerned with getting policy right, which is certainly important, inasmuch as policy, since early 2008, has, for the most part, been disastrously wrong. One did not need a theoretically sophisticated model to see that the FOMC, out of misplaced concern that inflation expectations were becoming unanchored, kept money way too tight in 2008 in the face of rising food and energy prices, even as the economy was rapidly contracting in the second and third quarters. And in the wake of the contraction in the second and third quarters and a frightening collapse and panic in the fourth quarter, it did not take a sophisticated model to understand that rapid monetary expansion was called for. That’s why Scott writes the following:
All we really know is what Milton Friedman knew, with his partial equilibrium approach. Monetary policy drives nominal variables. And cyclical fluctuations caused by nominal shocks seem sub-optimal. Beyond that it’s all conjecture.
Ahem, and Marshall and Wicksell and Cassel and Fisher and Keynes and Hawtrey and Robertson and Hayek and at least 25 others that I could easily name. But it’s interesting to note that, despite his Marshallian (anti-Walrasian) proclivities, it was Friedman himself who started modern macroeconomics down the fruitless path it has been following for the last 40 years when he introduced the concept of the natural rate of unemployment in his famous 1968 AEA Presidential lecture on the role of monetary policy. Friedman defined the natural rate of unemployment as:
the level [of unemployment] that would be ground out by the Walrasian system of general equilibrium equations, provided there is embedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the costs of gathering information about job vacancies, and labor availabilities, the costs of mobility, and so on.
Aside from the peculiar verb choice in describing the solution of an unknown variable contained in a system of equations, what is noteworthy about his definition is that Friedman was explicitly adopting a conception of an intertemporal general equilibrium as the unique and stable solution of that system of equations, and, whether he intended to or not, appeared to be suggesting that such a concept was operationally useful as a policy benchmark. Thus, despite Friedman’s own deep skepticism about the usefulness and relevance of general-equilibrium analysis, Friedman, for whatever reasons, chose to present his natural-rate argument in the language (however stilted on his part) of the Walrasian general-equilibrium theory for which he had little use and even less sympathy.
Inspired by the powerful policy conclusions that followed from the natural-rate hypothesis, Friedman’s direct and indirect followers, most notably Robert Lucas, used that analysis to transform macroeconomics, reducing macroeconomics to the manipulation of a simplified intertemporal general-equilibrium system. Under the assumption that all economic agents could correctly forecast all future prices (aka rational expectations), all agents could be viewed as intertemporal optimizers, any observed unemployment reflecting the optimizing choices of individuals to consume leisure or to engage in non-market production. I find it inconceivable that Friedman could have been pleased with the direction taken by the economics profession at large, and especially by his own department when he departed Chicago in 1977. This is pure conjecture on my part, but Friedman’s departure upon reaching retirement age might have had something to do with his own lack of sympathy with the direction that his own department had, under Lucas’s leadership, already taken. The problem was not so much with policy, but with the whole conception of what constitutes macroeconomic analysis.
The paper by Carlaw and Lipsey, which I referenced in my previous post, provides just one of many possible lines of attack against what modern macroeconomics has become. Without in any way suggesting that their criticisms are not weighty and serious, I would just point out that there really is no basis at all for assuming that the economy can be appropriately modeled as being in a continuous, or nearly continuous, state of general equilibrium. In the absence of a complete set of markets, the Arrow-Debreu conditions for the existence of a full intertemporal equilibrium are not satisfied, and there is no market mechanism that leads, even in principle, to a general equilibrium. The rational-expectations assumption is simply a deus-ex-machina method by which to solve a simplified model, a method with no real-world counterpart. And the suggestion that rational expectations is no more than the extension, let alone a logical consequence, of the standard rationality assumptions of basic economic theory is transparently bogus. Nor is there any basis for assuming that, if a general equilibrium does exist, it is unique, and that if it is unique, it is necessarily stable. In particular, in an economy with an incomplete (in the Arrow-Debreu sense) set of markets, an equilibrium may very much depend on the expectations of agents, expectations potentially even being self-fulfilling. We actually know that in many markets, especially those characterized by network effects, equilibria are expectation-dependent. Self-fulfilling expectations may thus be a characteristic property of modern economies, but they do not necessarily produce equilibrium.
An especially pretentious conceit of the modern macroeconomics of the last 40 years is that the extreme assumptions on which it rests are the essential microfoundations without which macroeconomics lacks any scientific standing. That’s preposterous. Perfect foresight and rational expectations are assumptions required for finding the solution to a system of equations describing a general equilibrium. They are not essential properties of a system consistent with the basic rationality propositions of microeconomics. To insist that a macroeconomic theory must correspond to the extreme assumptions necessary to prove the existence of a unique stable general equilibrium is to guarantee in advance the sterility and uselessness of that theory, because the entire field of study called macroeconomics is the result of long historical experience strongly suggesting that persistent, even cumulative, deviations from general equilibrium have been routine features of economic life since at least the early 19th century. That modern macroeconomics can tell a story in which apparently large deviations from general equilibrium are not really what they seem is not evidence that such deviations don’t exist; it merely shows that modern macroeconomics has constructed a language that allows the observed data to be classified in terms consistent with a theoretical paradigm that does not allow for lapses from equilibrium. That modern macroeconomics has constructed such a language is no reason why anyone not already committed to its underlying assumptions should feel compelled to accept its validity.
In fact, the standard comparative-statics propositions of microeconomics are also based on the assumption of the existence of a unique stable general equilibrium. Those comparative-statics propositions about the signs of the derivatives of various endogenous variables (price, quantity demanded, quantity supplied, etc.) with respect to various parameters of a microeconomic model involve comparisons between equilibrium values of the relevant variables before and after the posited parametric changes. All such comparative-statics results involve a ceteris-paribus assumption, conditional on the existence of a unique stable general equilibrium which serves as the starting and ending point (after adjustment to the parameter change) of the exercise, thereby isolating the purely hypothetical effect of a parameter change. Thus, as much as macroeconomics may require microfoundations, microeconomics is no less in need of macrofoundations, i.e., the existence of a unique stable general equilibrium, absent which a comparative-statics exercise would be meaningless, because the ceteris-paribus assumption could not otherwise be maintained. To assert that macroeconomics is impossible without microfoundations is therefore to reason in a circle, the empirically relevant propositions of microeconomics being predicated on the existence of a unique stable general equilibrium. But it is precisely the putative failure of a unique stable intertemporal general equilibrium to be attained, or to serve as a powerful attractor to economic variables, that provides the rationale for the existence of a field called macroeconomics.
So I certainly agree with Krugman that the present state of macroeconomics is pretty dismal. However, his own admitted willingness (and that of his New Keynesian colleagues) to adopt a theoretical paradigm that assumes the perpetual, or near-perpetual, existence of a unique stable intertemporal equilibrium, or at most admits the possibility of a very small set of deviations from such an equilibrium, means that, by his own admission, Krugman and his saltwater colleagues also bear a share of the responsibility for the very state of macroeconomics that Krugman now deplores.
Uneasy Money 
Wow, it was a truly superb post.
What do you think of the idea of Sraffa (1925, 1926) that partial equilibrium analysis on the level of whole industries and country economies is moot because ceteris paribus clause stops holding and changes in one parameter start effecting everything else, so, for example, for every point of AS curve there’d be an AD curve because they are interdependent on that scale? I think that this fact is certainly destructive for the application of microeconomics on the macro-scale.
Also, do you think of yourself as a heterodox economist?
LikeLike
David: “equilibrium” does not have to mean “market-clearing equilibrium”. For example, it can mean “equilibrium in a search model”, where market-clearing is not really defined. More generally, it can mean “Nash Equilibrium”. We can speak about “equilibria” that are non-Walrasian (or non-Arrow-Debreu).
LikeLike
Nick, OK, I get that. How do you want me to apply that point in the context of my post?
LikeLike
Great post.
It has always surprised me the ease with which economists make assumptions in order to be able to solve equations, and then just translate the result to the real world, without questioning whether the assumptions make sense or not.
A particularly egregious example you point at is that both micro and macro make a “hidden” assumption on the general shape of the economy, which we have no evidence that it actually applies to the real world.
This makes me wonder why Agent Based Modelling is not more prevalent. With ABM you can define agent behaviour (which can be, for some cases, easier to observe than the macro behaviour), and let the model emerge.
As I once posted in the Mainly Macro blog, the three body problem cannot be analytically solved for the general case. What makes economists think that a whole economy can be modeled (and solved!) by a few equations?
LikeLike
David: I don’t know. (Sorry, that’s not a very good answer). But Steve Williamson (for example) could quite correctly respond by saying his search-theoretic models are models of non-Walrasian general equilibrium. So you have the choice between saying that it’s OK to model the economy as being always in equilibrium, just not a market-clearing equilibrium, or else ditch the concept of ‘equilibrium’ altogether. And that requires the hard choice of defining what you mean by “equilibrium”. Does “equilibrium” mean no more than “that which the model predicts”? Or is there some substantive content to the word “equilibrium” which goes beyond any particular model?
Roman P: I think this is a better and clearer way to make that point: Since quantity demanded depends on actual sales of other goods (and quantity supplied (the quantity they *want* to sell) depends on actual sales of other goods too) the AD curve (and AS curve too) is an equilibrium locus. If the economy is at a point off the AD curve, quantity demanded will not in general equal the quantity predicted by the AD curve. (Ditto for AS). This was clarified by the Clower/patinkin/Barro-Grossman/Malinvaud/Benassy “disequilibrium macro” of the 1970’s.
LikeLike
I forgot to add Leijonhufvud’s name to that list.
LikeLike
Friedman was wrong about monetary policy as the cause of the Great Depression and Friedman was wrong about the “natural rate of unemployment”. This also means that Friedman was wrong about the solutions. The solutions have a role for monetary policy but fiscal and regulatory policies are more important.
There are economic “desirable rates of unemployment” for the private sector and there are socially “desirable” rates of unemployment. At any time, the demand for labor by the private sector can be greater or less than the available labor. Business prefers excess labor to allow better matching between employer needs and employees. Government manages the excess labor. Friedman was simply wrong about his natural rate of unemployment, about the ability of government to change structural, fiscal and regulatory features to alter the unemployment rate, and his idea that monetary policy should be the primary tool for labor policy.
Economies are managed by using a combination of monetary, fiscal and regulatory policies that impact the rate of unemployment. If unemployment is higher than is socially desirable, then policy can be changed to create conditions where the unemployment rate is at a socially acceptable level, especially the long term unemployment rate. This can be done through infrastructure investment, workforce investments, and support for research and technology development. This can also be done by direct hiring by BigG to directly provide useful goods and services.
Macro has gone off the rails by an inordinate focus on monetary policy. Monetary policy, the first choice for policy to fine tune an economy, is less good at correcting major changes in employment (typically addressed by fiscal policy automatic stabilizers) and effectively addressing bubbles (requires better regulatory policy). By overemphasizing monetary policy almost to the point of taking regulatory and fiscal actions out of the mix, two the the 3 legs supporting the economic stool have been cut off.
Going forward, the most important advances will be made in the areas of regulatory and fiscal policy. Regulatory ideas such as new versions of trading externalities (cap and trade for example) and risk trading are already becoming more important. Increases in automatic fiscal stabilizers such as infrastructure banks are part of the wave of the future. Those who narrowly focus on monetary policy alone will become the dinosaurs of the future. The dinosaurs can fight it out, but their arguments will be irrelevant to the future.
LikeLike
I will go out on a limb and claim that microeconomists don’t worry much about GE existence and complete markets.
Also, I will again go out on a limb and claim that the sort of microeconomic analysis that looked at airline regulation in the seventies, looked at the advantages and disadvantages of deregulation, and have since looked at the aftermath, don’t deal with the consequences of incomplete markets. But, no one is buying a trip to Tahiti in 2020 on the condition that Chicago as a temperature of 33. Well, we just can’t say anything about airline deregulation.
i will also go out on a limb and claim that microeconomists did not require that the analysis of the airline industry start with consumers maximizing utliity and endowments of labor and land and show that representative agents optimize flights over time.
Am I wrong?
LikeLike
“Besides engaging in a pretty personal attack on his fellow economists, Krugman did not present a very flattering picture of economics as a scientific discipline. What Krugman describes seems less like a search for truth than a cynical bargaining game, in which Krugman feels that his (saltwater) side, after making good faith offers of cooperation and accommodation that were seemingly accepted by the other (freshwater) side, was somehow misled into making concessions that undermined his side’s strategic position.”
I had exactly the same response. Of course, Krugman might be right. Perhaps economics is dominated by political ideology, and prominent theoretical disputes are actually negotiations between powerful policy camps over the details of theoretical rationalizations for a consensus policy agenda whose actual justifications do not lie in the superfices of ostensible theory.
LikeLike
Nick, it could help to designate monetary and non-monetary “equilibriums” – although the second is in complete disarray in developed countries because of cultural and land use changes of the 20th century. However it is important not to label these as dual economies, as they are not at all separate realities in the developed world (as they still are in some parts of the developing world). For example, distortion effects of excess prison use in the U.S. stem from a botched attempt to make up for the ill-defined nature of either illegal or non-monetary activity. And David’s post also seems to also imply the value of macro in large part because of the distortions created by Nash equilibria.
LikeLike
Nick,
Thanks, I guess I’ll look into the Post-Walrasians sooner or later. It is sad that their contributions quietly passed into obscurity (I guess I’ll have to look into their old articles in the digital archives).
LikeLike
Roman P. Thanks so much. Theoretically, Sraffa is surely right. But we still do partial equilibrium analysis because we accept that the partial equilibrium analysis is just an approximation and we assume that, without a really compelling argument to the contrary, the ceteris paribus assumption, even if not strictly valid, will not lead us too far astray. Keynes’s argument about the failure of nominal wage cuts to restore equilibrium to the labor market was a variation on Sraffa’s argument. The AD and AS curves are not really demand and supply curves, they are loci of market equilibria, so they are not necessarily subject to Sraffa’s critique.
Do I think myself as a heterodox economist? Not really. I regard myself as within the broad neoclassical tradition, but I very much dislike the excessive formalism that has overtaken neoclassical economics since the late 1960s and especially the way that macroeconomics has been transformed. That puts in the same boat as people like Leijonhufvud and Laidler.
Felipe, Thanks. I have barely heard of agent based modeling. Where could I go to find out more about it?
Nick, You are right that Williamson could respond that way, but my recollection (and, please correct me if I am mistaken) is that he has rejected the non-market-clearing models of Benassy as intractable or something of that sort. About search models, I think it is perfectly natural to incorporate search models into standard supply demand analysis because the slope of the labor supply curve (given expectations about the distribution of wage offers) reflects the choice between accepting offers at a particular nominal wage versus continued search. With identical wage expectations by a given class of workers, the short-run labor supply curve becomes highly elastic at the expected wage. I don’t view that as inconsistent with market clearing. My conception of equilibrium is Hayekian intertemporal equilibrium in which expectations are realized and planned purchases and sales can all be executed, implying that there are no ex post regrets and no revisions in plans. I agree with your comment to Roman about the AS and AD curves.
Jonny, I was not citing Friedman to agree with him, but I will say that although I am not a huge fan of his, I think the picture is more complicated than you suggest. Regulation is not an on-off variable. We need to think very carefully about what to regulate and how to regulate, but we need to do that across a whole range of activities and products. One size very definitely does not fit all.
Bill, No, you definitely are not wrong. My point is not that we can’t do microeconomics informally. We do microecnomic informally without worrying about whether the model is really logically air-tight. My point is that modern macroeconomists are fooling themselves by thinking that their formalism is somehow scientific, because they have established microfoundations. The microdoundations aren’t there. What we want are macromodels that work and that, at some level, make sense and, if possible, can be reconciled with other propositions in economics. But most of all we want models with some decent predictive (as opposed to forecasting) power.
Dan, Yes, Krugman (if we are understanding him correctly) just might be right. And certainly there is some evidence that would tend to support such a view, which we need go into, at least not now.
Becky, I think that’s an interesting way of putting it. The “equilibrium” reached without some form of monetary or countercyclical policy is a Nash equilibrium in the sense that everyone is optimizing given his own feasible set of choices, but the resulting Nash equilibrium may be sub-optimal. And it is the job of countercyclical policy (broadly construed) to help us reach a superior equilibrium than the one we would get to without it.
LikeLike
David,
ABM is a fancy name for (a kind of) computer simulations. You define in your model the types of agents, their behaviour and the initial state, and let the interactions between the agents go wherever they want.
Here is a website with more information.
http://www2.econ.iastate.edu/tesfatsi/ace.htm
And some macro-specific pointers:
http://www2.econ.iastate.edu/tesfatsi/amulmark.htm
LikeLike
“My point is that modern macroeconomists are fooling themselves by thinking that their formalism is somehow scientific, because they have established microfoundations.”
Thank you for this! I have a degree in the dismal science and the conversations I have with business people without any formal education in the field are fascinating. Opinions range from completely negative to an almost awed respect with roots in the complexities of flashy models. When I break the news to them that the entire field is a complex network of educated guesses, post-hoc structuralism, and political science, I generally get a unified response of, “Oh. Well, now everything makes so much more sense.”
I love the study of economics, particularly development economics, natural resource economics, and applied wtp analysis and find that it can be very informative to decision-makers. As a study, however, I feel as though we take ourselves far too seriously based on the quality of policy outcomes. Just look at the IMF – all certified economists in those hallowed halls.
LikeLike
Reblogged this on constantmoon.
LikeLike
FWIW, I think both sides (Krugman and his conservative opponents) are excessively driven by ideology.
But my real concern is your discussion of rational expectations, and the attempt to somehow link it with GE theory. I can’t take any theory seriously that conflicts with Ratex. Yet I prefer the partial equilibrium approach to macro.. And why even mention “perfect foresight?” No one believes in perfect foresight–yet you group it together with ratex. The term “rational expectations” is very misleading, As McCallum points out it should be called “consistent expectations.” All ratex actually implies is that if your model claims “X is true” then the public in your model should not believe “not X is true.” That and nothing more.
LikeLike
fsateler, Thanks for the links.
Edison, You’re welcome. Economists have a lot of work to do before they can feel really good about themselves.
Scott, I agree about Krugman and his opposition.
About ratex. Aren’t you treating ratex as identical to EMH? I don’t think they are at all the same. EMH is a proposition about the behavior of asset prices. Ratex is an assumption about how the economic agents populating a theoretical model form expectations. Let me quote from an encyclopedia article about rational expectations (Business Cycles and Depressions: An Encyclopedia, edited by D. Glasner, pp. 553-55, Garland, 1997) by Steve Sheffrin (who also wrote Rational Expectations, Cambridge U. Press, 2nd edition 1996).
“Rational expectations models of business cycles have the further property that those expectations are consistent with the actual operation of the model. In particular, this implies that the predictions of variables by economic agents within the model must be the same as the predictions implied by the model itself.”
Ratex also implies that all agents have identical expectations, which is another definition of general equilibrium. Realized prices may turn out to be different from expectations owing to purely stochastic events, but going forward, everyone in the model has the same expectation of all future prices. EMH doesn’t imply that all agents have identical expectations of future prices, just that at any moment prices reflect the existing information so that prices follow a martingale. Rational expectations would mean that there would be no trading of assets, which is obviously not what EMH means.
LikeLike
David: if people have different information sets they can have different, rational, expectations. And there can still be trading of assets if people have different preferences and constraints. The car is worth more to me than to the person selling it to me.
LikeLike
Rational Expectations models can have heterogeneous agents, but since per ratex, all the agents know the other agents preferences, this doesn’t solve any of its problems.
I find Roman Frydman and Michael D. Goldberg* argument that the problem with rational expectations is that it doesn’t take into account real (i.e. Knightian) uncertainty, and therefore that its agents are the equivalent of theoretically perfect socialist central planners. So if you believe that Hayek won the socialist calculation debate, you shouldn’t have much time for rational expectations.
*http://www.amazon.com/Beyond-Mechanical-Markets-Asset-Swings/dp/0691145776/ref=cm_cr_pr_product_top
LikeLike
Fantastic post.
It would be interesting for someone to put together a study of high profile blogs and bloggers since 2007 and just count how many times people have argued over definitions, etc., vs. “here is the data to be explained. Here is the model. Here is how the model came to be the way it is. Here are the predictions of the model. And here is how the model fares when applied to data over the next x periods after its development.” Reading economists debate “rationality” (or what counts as optimizing behavior, or what counts as a shock, and what kind of shock — shock to the willingness to work? technology shock? shock to preferences? expectations shock?) often calls to mind the vitalists.
To make the point in the way I usually think of it, the way modern macroeconomists will puff their chests out about the inviolate chastity of rational optimizing representative agent general equilibrium macroeconomic models but then when it comes time to argue about unforeseen events in the real world resort almost entirely to calling their opponents lying shitheads with no scruples makes me imagine physicists celebrating the sophisticated algebraic structure of quantum field theory but then when the data came in from the LHC reverting to intense personal arguments over the effects of intercessory prayer.
If it’s model-driven and the models are fine, great: argue by taking the models to data, the way all model-driven science is done. Your own personal hermeneutics of rationality (etc.) shouldn’t come into it. Just put it in the model and calculate.
LikeLike
I come a little too late, but that is probably the most instructive post I never read, including much of the excellent comments. Very grateful
LikeLike
“The rational-expectations assumption is simply a deus-ex-machina method by which to solve a simplified model, a method with no real-world counterpart.”
Wow. I couldn’t agree more. David impresses me yet again with his frankness and lack of hackery.
It has struck me more than once that almost any economist from before the 1970s is more interesting, thought-provoking, and true to life than the big players since then (with some exceptions). Samuelson, Marshall, Malthus, Ricardo, Mises, whoever. That’s not a good sign.
LikeLike
Nick, You are right that rational expectations combined with different information sets will lead to different predictions. So I was wrong to imply that asset trading is inconsistent with ratex. I guess I got carried away by my anti-ratex enthusiasm. On the other hand, in the typical macro-model the point is to have all agents come up with expectations that match the prediction of the model so that the solution of a model is a fixed point, giving the model a unique solution.
A H, You are making a stronger claim than even I would make. How do agents know the preferences of other agents? Thanks for the reference to Frydman and Goldberg. I wanted to get their book, but got distracted and then forgot about it. Based on what I’ve seen, I pretty much agree with everything they say.
Choncan, Thanks so much. You are right that a lot of arguments wind up being about nothing more than the use of words. But that’s part of what arguments are for. We have to work out the implications of what we are talking about to understand whether our disagreements are substantive or merely verbal. I don’t think the process can be short-circuited.
Luis, Thanks. I am glad that you found it useful.
Will. Thanks. I also tend to like the old guys better than the newbies, as as evidenced by the subtitle and visual background of this blog.
LikeLike
I agree that the question on the worth of Stephen Willaimson’s sainted “Modern Macro” is not about whether they all get along or not-this was never Krugman’s point. SW made it about that.
What he seemed to be saying was “It’s worse than you think Krugman. The field has long past you dissenters behind.”
However, the specter of a discipline in such locksetp agreement hardly sounds salutory. For it’s own sake you would wish Macro is not quite as smug and insular as SW makes it sound.
All sciences-even “hard sciences” are in addition to being about the genuine pursut of knowledge are also minature societies.
SW is very smug in his society. Of course you’re right that Krugman’s position is not so tenable either. If he’s put off by the way the Freshwater guys have responded to the crisis, does he ask himself why he’s so wholly accepted of their basic paradigm with just small “fricitions” to give it something of a real world feel?
It seems to me the main hope are some heterodox ideas out there since the crash. I don’t know what you think of ideas like evlutionary economics or bringing ideas from physics into economics-but it strikes me that in thissense, Noah Smith himself may suggest alternatives for the future insofar as he comes from a background in physitcs.
LikeLike
David,
You asked about representative agent modelling. some references on complexity theory:
1. Lucid intro to the field by a computer scientist/information theorist:
2. Critique of economics from a complexity theory/evolutionary economics perspective:
3. Macroresilience blog:
http://www.macroresilience.com/
http://alittledisorder.com/all-systems-need-a-little-disorder/
LikeLike
David,
As a first year PhD student I was often perturbed by the devotion to existence of a general equilibrium and the confidence in policy implications stemming from those models. This entire post and subsequent comments has done wonders for remedying my intuition with the current state of economics. It is without a doubt, one of the best posts I’ve read all year. Thank you for all the time and effort you spend helping to teach others through this blog. Hope you have a happy and healthy new year!
LikeLike
Scott said, “all ratex actually implies is that if your model claims “X is true” then the public in your model should not believe “not X is true.” That and nothing more.”
I agree with this, and this could be considered more like a norm of model specification than an actual claim about how agents behave. After all, we write all kinds of things in our models (such as exogenous shocks) that are a “surprise” to agents but are not really surprising to us, since we wrote them down. But we are OK with this, since we do not claim to be able to predict exogenous shocks either. So what appears at first glance as a non-ratex model could still be useful as a description of some possible, but uncertain state of the economy, especially when endowed with other features, such as the “signal extraction problem” which allows agents to be surprised and/or fail to detect states that they should “expect” in some sense.
LikeLike
David
In trying to debunk the stable Phillips Curve so loved by Keynesians, Friedman came up with the “natural rate” concept which started a mouvement down the wrong path…
I also think that in trying to make economics “scientific”, like physics, a Keynesian, such as Paul Samuelson contributed with the concept, borrowed from physics, of the “Correspondence Principle” in his “Foundations…” in 1947. Just as Quantum Theory (study of small bodies) has to have a “correpondence” in Classical physics (study of large bodies), Macroeconomics has to have a correspondence in microeconomics.
Economists have to give up the idea that “economics is (just like) physics”!
LikeLike
David: I agree with you completely about the role of arguments, and I should have been more clear in my post about stating my point explicitly.
I ask myself all the time, after reading some elaborate argument, whether the guy is *calculating* anything — that is to say, whether his domain experience as a technical expert of this formidable machinery is *directly* related to what he’s saying — or whether it’s more of a political/aesthetic judgment, maybe at most backed by intuition he’s developed over the years. (There’s an old Arjo Klamer book of interviews from the 80s with Lucas, Sargent, Solow, Blinder, etc., I recommend it to anyone interested in this kind of thing, copies can usually be had on amazon for a couple dollars.)
To make the point that (for me anyway) it’s less about the mathematics than it is the seeming disconnect between the mathematics and the arguments, let me mention two examples of the kind of people I can read (besides our gracious host) and feel like the argument is honestly presented: Scott Sumner, who is (it seems) almost entirely without elaborate mathematical machinery hidden in some back room somewhere, but who is very clear about saying “here’s what I’m assuming, here’s why I assume it, here’s how I think things work, here are five previous historical circumstances that met these conditions, and here’s what happened in those situations when this or that action was taken”. In a very different way, I also enjoy reading Tom Sargent, because he absolutely goes out of his way to point to *this* paper or *this* model, etc., and I can go look for myself and do the usual thing I’d do when I’m trying to decide whether to believe a model. (He also, despite certainly being someone who has been a rhetorical target for decades, is unfailingly respectful of others, including the ideas of others, in everything I’ve read. I like that because it lets me take his argument more seriously, *especially* when I don’t agree with it, since I’m not distracted by having to plot his Matrix of Assholes and see how it aligns with my own, which is a harder problem to avoid when reading Krugman, for example.)
LikeLike
Same as Joshua. I am an econ undergrad and found this post very interesting. I too wondered about Friedman’s views on ratex and found this:
“I believe that the approach has much to offer us, but I also believe that its proponents, like all proponents of fresh approaches, tend to carry a good thing too far. I would say it has had too much influence up to date. It has made a real contribution, but it is by no means the only, or necessarily even the most useful, approach.”
(http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=3748)
…and this:
“I have no basic disagreement with rational expectations. The question is, “how do you form your rational expectations.” […] If the idea is that people try to predict what is going to happen tomorrow, then rational expectations, in that sense, certainly makes sense, but on what do they base their rational expectations? They base it on past experiences; there is always going to be a lag in expectations catching up.”
(http://www.stanford.edu/~johntayl/Onlinepaperscombinedbyyear/2001/An_Interview_with_Milton_Friedman.pdf)
LikeLike
David, I think you might be putting too much weight on the identical expectations assumptions. It seems to me that this is often just done for convenience, but it’s not really the essence of ratex. The essence of ratex is that aggregate expectations are consistent with the model. Here would be a typical non-ratex argument:
“Fed policy has no permanent effect on exchange rates and inflation expectations at the zero bound, but the markets wrongly think QE does have a permanent effect, and hence prices move on new information relating to QE.”
I have no interest in that sort of model.
LikeLike
Mike, There’s a quote from J.S. Mill writing in the mid-19th century, verbally patting himself and the other classical economists on the back for having solved all the difficult problems in economics. Plus ca change plus c’est la meme chose.
Diego, Thanks so much for the links.
Joshua, Thanks for your comment. Comments like this one are ample reward for the time and effort that I put in to the blog. But the greatest reward is that I have to figure out what I am really thinking before I can put something out there for others to read.
anon, That’s a good way of saying it, but I am not sure I agree that that’s all ratex is about.
Marcus, I totally agree that economics is not just like physics. I actually don’t remember the correspondence principle. I need to go back and look it up in the Foundations.
choncan, I actually read the Klamer book years ago, and may still have it somewhere. It probably would be worth going back and rereading it, to see how the interviewees and the profession have changed since the mid-1980s. It might also help me get a handle on how much I have changed. I totally agree with your assessment of how Scott Sumner presents an argument.
Scott, I guess one of us will have to write a history of thought paper on ratex. So what exactly caused you to become disillusioned or disinterested in macro before the panic of 2008? What, if anything, do you find objectionable in DSGE models?
LikeLike
Highly interesting topic Macroeconomics, and it’s counterpart Microeconomics. The US is a huge country and I’m not surprised that all of the country can be at a very good state. Not in a time of zero interest policy. Time is needed to heal the economy to get an acceptable level of Macroeconomics.
LikeLike
The essay resonated with me. The assumption of equilibrium flies in the face of life experience. The climate is not in equilibrium, ecosystems are not in equilibrium. Complex systems are prone to shifts in state both small and large from small changes in initial state. The economy is not a homogenous set of all seeing actors, its full of people who get sleepy, make mistakes, or steal. The initial assumptions seemed to be false 40 years ago when I was first introduced to economics, and I am more convinced that they are wrong now. As an outsider looking in, I wish those struggling with this problem the willingness to seek new solutions.
LikeLike
Speaking about the state of macroeconomics…David Glasner, what is your opinion of the standard decision theory in academic economics – Subjective Expected Utility?
http://en.wikipedia.org/wiki/Subjective_expected_utility
It’s even more basic than rational expectations. For those of you that don’t know, S.E.U. theory is the brainchild of three mathematicians – Leonard J. Savage, Frank P. Ramsey, and Bruno de Finetti. It was in the 1950ies when S.E.U. gained a strong foothold in the consensus of academic economics.
However, research from scholars like Daniel Ellsberg (see his 1961 article in the Quarterly Journal of Economics and his doctoral dissertation which was finished in 1962 but tragically only published in 2001: Risk, Ambiguity, and Decision), suggest that S.E.U. theory is a very special case. It seems that Daniel Ellsberg’s findings (and the subsequent “ambiguity aversion” literature spawned by his 1961 article in the QJE) point to a more general case.
S.E.U. theory is still in practice, the basic foundation for much of modern macroeconomics. Perhaps it’s time to replace it with a more general theory of decision-making.
BTW, for further reference folks, I recommend reading these articles…
Brady, Michael E. and Howard B. Lee – ‘Dynamics of choice behavior: The logical relation between linear objective probability and Nonlinear Subjective probability’ Psychological Reports, Vol 64(1), Feb 1989, 91-97.
http://www.amsciepub.com/doi/abs/10.2466/pr0.1989.64.1.91
Brady, Michael E. and Howard B. Lee – ‘Theoretical Comparison of the Decision Theories of J. M. Keynes, Kahneman-Tversky, and Einhorn-Hogarth’ – Psychological Reports, Vol 69(1), Aug 1991, 243-251.
http://www.amsciepub.com/doi/abs/10.2466/pr0.1991.69.1.243
Brady, Michael Emmett – ‘J.M. Keynes’s Theoretical Approach to Decision-Making Under Conditions of Risk and Uncertainty’ – The British Journal for the Philosophy of Science 44 (2):357-376 (1993)
Click to access 357.full.pdf
Brady, Michael Emmett – ‘On the Application of J.M. Keynes’s Approach to Decision-Making’ – International Studies in the Philosophy of Science 8 (2):99 – 112 (1994)
http://www.tandfonline.com/doi/abs/10.1080/02698599408573487
Brady, Michael Emmett and Rogerio Arthmar – ‘Keynes’s Lower-Upper Bound Interval Approach to Probability’ – SSRN Working Paper Series
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1546726
LikeLike
“Apparently, Krugman feels that if saltwater economists like himself were willing to accommodate the intertemporal-maximization paradigm developed by the freshwater economists, the freshwater economists ought to have reciprocated by acknowledging some role for countercyclical policy.”
No, he’s pointing out that the saltwater people are persuadable by theories which better match the data, while the freshwater (macro) people simply are not.
LikeLike