Wednesday, April 22, 2009

The Microfoundations Digression?

Commentary on the financial crisis has included a great deal of misplaced economist-bashing. Much of this seems based on a misunderstanding of what economists do - the people saying "those stupid economists totally missed the housing bubble" miss the fact the vast majority of us are not forecasters, we are social scientists, and, usually rather narrowly specialized in something other than the housing market.

Brad DeLong points us to FT columnist John Kay, who makes a more serious critique, that the rebuilding of macroeconomics on microeconomic foundations in the wake of the Lucas critique and the rational expectations revolution may have led us astray. He writes:
The past two years have not enhanced the reputation of economists. Mostly they failed to point out fundamental weaknesses of financial markets and did not foresee the crisis, and now they disagree on appropriate policies and on the likely future course of events. Although more economic research has been done in the past 25 years than ever before, the economists whose names are most frequently referenced today, such as Hyman Minsky and John Maynard Keynes, are from earlier generations.

Since the 1970s economists have been engaged in a grand project. The project’s objective is that macroeconomics should have microeconomic foundations. In everyday language, that means that what we say about big policy issues – growth and inflation, boom and bust – should be grounded in the study of individual behaviour. Put like that, the project sounds obviously desirable, even essential. I confess I was long seduced by it.

Most economists would claim that the project has been a success. But the criteria are the self-referential criteria of modern academic life. The greatest compliment you can now pay an economic argument is to say it is rigorous. Today’s macroeconomic models are certainly that.

But policymakers and the public at large are, rightly, not interested in whether models are rigorous. They are interested in whether the models are useful and illuminating – and these rigorous models do not score well here...

...That people respond rationally to incentives, and that market prices incorporate information about the world, are not terrible assumptions. But they are not universal truths either. Much of what creates profit opportunities and causes instability in the global economy results from the failure of these assumptions. Herd behaviour, asset mispricing and grossly imperfect information have led us to where we are today...

There is some truth in that, and I'm more convinced than ever that I made the right choice keeping the IS-LM model and some of chapters 12 and 22 of the General Theory in my intermediate macroeconomics course.

However, microeconomic foundations and departures from perfect rationality are not incompatible; just as the New Keynesians have been able to incorporate imperfect competition and nominal rigidities into dynamic, microfounded models, I would expect to see more "behavioral" elements integrated with some of the tools we currently use.

The broader lesson seems to be that we must keep in perspective the limitations of economic models. I wouldn't be here if I wasn't convinced that they are useful - and I also wouldn't trouble my students with all those equations (an exercise which makes my life harder, as well as theirs), if I didn't see value in them. But no economic model is ever a complete description of the world, and models should be complements to - not substitutes for - intuition.

Much of that intuition can come from studying economic history and history of economic thought; DeLong says:

I think that we ought to be turning out a lot of macroeconomic historians and historians of economic thought, and that only they should be allowed to serve in government or comment on public affairs at least as far as the business cycle is concerned.

A good reading on the tug-of-war between practicality and elegance in modeling is N.G. Mankiw, "The Macroeconomist as Scientist and Engineer" (JSTOR access required).

Last fall, in this earlier post I discussed a similar argument from YouNotSneaky!


Esen said...

That's funny. I was thinking about ditching the IS/LM and going with microeconomic foundations. Maybe I should adopt Robert Shiller's approach instead; I am sure he can find ways to explain the mispricings and bubbles in the markets.

Bill C said...

Thanks, Esen. Its unfortunate that there is a tension between teaching models that are good for discussing policy versus being truer to what we actually use in our research. As for mispricings and bubbles, I think ch. 12 of the General Theory is excellent.