Thursday, November 19, 2009

Unrealism is Not the Problem

At Vox, Paul DeGrawe describes contemporary macro models as "top down" because agents are assumed to know the structure of the world they live in. He writes:
There is a general perception today that the financial crisis came about as a result of inefficiencies in the financial markets and economic actors’ poor understanding of the nature of risks. Yet mainstream macroeconomic models, as exemplified by the dynamic stochastic general equilibrium (DSGE) models, are populated by agents who are maximising their utilities in an intertemporal framework using all available information including the structure of the model – see Smets and Wouters (2003), Woodford (2003), Christiano et al. (2005), and Adjemian, et al. (2007), for example. In other words, agents in these models have incredible cognitive abilities. They are able to understand the complexities of the world, and they can figure out the probability distributions of all the shocks that can hit the economy. These are extraordinary assumptions that leave the outside world perplexed about what macroeconomists have been doing during the last decades.
In its place, he advocates the modeling the economy as a "bottom up" system:
Bottom-up systems are very different in nature. These are systems in which no individual understands the whole picture. Each individual understands only a very small part of the whole. These systems function as a result of the application of simple rules by the individuals populating the system.
While I do think this is worth exploring (his paper will be on my holiday break reading list), his description of contemporary macroeconomics is not quite fair. The models do not imply that macroeconomists believe people really have all this knowledge (we most of us know better than that). Rather, we believe it makes sense to model them as if they do. Milton Friedman famously made this point by noting that it makes sense to model the shots of a champion billiard player as if he has a sophisticated understanding of physics.

It is worth recalling that macroeconomics adopted the paradigm of rational expectations and dynamic optimization because simple and apparently realistic assumptions like adaptive expectations led to situations where people could systematically and repeatedly be fooled, and this tendency could be exploited by policymakers. While rational expectations may be unrealistic, in a world where people are learning and updating their beliefs, one would expect tendencies that lead to significantly suboptimal outcomes to be driven out (and in the context of markets, with the help of competition). So, while real people are groping around in the fog trying to figure out a rough idea of how the world works, we would expect them to arrive at behaviors consistent with those of rational forward looking agents just as a billiard player, by trial-and-error, learns to make shots consistent with the laws of physics.

So the "unrealism" of the assumptions is not, by itself, a problem. The trouble arises if that unrealism leads us to incorrect predictions. Macroeconomics may indeed have gone astray in some ways, and the lack of realism in models may indeed vex non-economists, but the assumption of "incredible cognitive abilities" is not inherently a problem.

Update (11/22): I had a chance to a look at DeGrawe's paper (pdf). Although I disagree with his characterization of modern macroeconomics, I do think his paper is interesting, though I suspect it may be vulnerable to some of the same criticisms as adaptive expectations models. (via Mark Thoma's link to the "Whats Wrong with Modern Macroeconomics" conference papers).

21 comments:

Luis Enrique said...

Time and again I read criticism along the lines of "the calculations economists suppose agents make are far beyond realistic human capacities" - which is true and important as far as it goes, but what baffles me is why the imagine this was not already perfectly obvious, and that the proponents of mainstream economics obviously must think it's worthwhile despite this - what do people who make that argument think's going to happen? Economists are suddenly going to say - oh shit! we hadn't spotted that?

Another thing I read everywhere, from other scientists and philosophers of science, is that Friedman's "positive economics" justification of "unrealistic" modeling is laughably weak and has been convincingly slapped down. This worries me, because I do use Friedman's arguments to justify things to myself.

Jules said...

Luis Enrique:
"Another thing I read everywhere, from other scientists and philosophers of science, is that Friedman's "positive economics" justification of "unrealistic" modeling is laughably weak and has been convincingly slapped down."

Yes, that is my impression too. Logicians and scientists who are aware of Friedman's work dismiss it as too naive and simply wrong. IIRC the philospher Ernst Nagel wrote a very convincing paper criticising Friedman's claims back in the 50's .

Bill C said...

Thanks for the comments. As you say, Luis, perhaps it should be "perfectly obvious" that economic models are not intended to be realistic. But it seems like non-economists often don't get it, and economists sometimes lose sight of it.

Jules said...

The paper by Ernest Nagel was:
"Assumptions in Economic Theory" (pdf)
The American Economic Review, Vol. 53, No. 2 (May 1963)

wjd123 said...

Isn't not modeling reality, modeling unreality, akin to playing with yourself?

One can't even call economic unrealistic modeling an ideal type, because today's first order choice can "easily" change tomorrow into a second order choice.

If their is an ideal economic man or woman it is a person who can be easily conditiones to make economic decisions which constantly lead to worse decisions until the end result is economic ruin.

Ken Houghton said...

You can no more model reality than you can map an area accurately.

However, that doesn't mean that my map--or a GPS--isn't useful, even if it doesn't show that Geo-sized pothole just off the 59th Street Bridge. (I can see that myself.)

The problem is that "adaptive expectations" is (arguably, but the evidence runs that way) closer to reality—i.e., a better map—than rational expectations.

But the Micro people are busy fellating the G-d of R.E., and there is a need for a GUT. (Since, of course, Economics is a Science, and Sciences are all about GUTs.)

Bill C said...

Jules: Thanks! I'll give that a look.

Ken: I think I agree - non-rational expectations models may be useful, not because they are "realistic," but if they give us insight that RE models don't. I think DeGrawe's actual paper is constructive along those lines.

Luis Enrique said...

Bill,

"non-rational expectations models may be useful, not because they are "realistic," but if they give us insight that RE models don't."

Spot on. And RE models are useful because they provide some insights too.

The word "realistic" is not much use. We want models to be realistic in the sense of providing some insight about the real world, but that doesn't mean absolutely every aspect of the model has to be realistic in the sense of providing simulacrum of what is described.

Another thing that baffles me is why biologists don't get pilloried in the same way as economists. Are, for example, models of predator-prey dynamics any more "realistic" in the sense that economists get beaten up about?

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