Wednesday, December 18, 2013

Microfoundations: PLEASE tell a better story!

A scuffle has broken out among some economists over the touchy topic of microfoundations, i.e. the usual formal requirement that macroeconomic models, to be considered legitimate, must be based on things like households and firms optimizing their intertemporal utility, having rational expectations, and so on. Apparently, things got kicked off by economist Tony Yates, who offered a spirited defense of microfoundations of this kind; he's really irritated that people keep criticizing them and worries that, My God!, this might cause DSGE macroeconomists to lose some credibility! In response, Simon Wren-Lewis came back with an equally spirited argument about why modelling should be more flexible and "eclectic." Noah Smith's summary of the whole disagreement puts everything in context.

Noah makes the most important point right at the end. Simply put, no one (I think) is against the authentic spirit of microfoundations, i.e. the idea that macroeconomic models ought to be based on plausible stories of how the real actors in an economy behave. If you get that right, then obviously your model might stand a chance of getting larger aggregate things right too. The problem we have today is that the microfoundations you find in DSGE models aren't like this in the least. So macromodels are actually based on things we know to be wrong. It's very strange indeed. As Noah puts it:

Yates says I just want to get rid of all the microfoundations. But that is precisely, exactly, 180 degrees wrong! I think microfoundations are a great idea! I think they're the dog's bollocks! I think that macro time-series data is so uninformative that microfoundations are our only hope for really figuring out the macroeconomy. I think Robert Lucas was 100% on the right track when he called for us to use microfounded models.

But that's precisely why I want us to get the microfoundations right. Many of microfoundations we use now (not all, but many) are just wrong. Obviously, clearly wrong. Lots of microeconomists I talk to agree with me about that. And lately I've been talking to some pretty prominent macroeconomists who agree as well. 

So I applaud the macroeconomists who are working on trying to develop models with better microfoundations (here is a good example). Hopefully the humble stuff I'm doing in finance can lead to some better microfoundations too. And in the meantime I'm also happy to sit here and toss bombs at people who think the microfoundations we have are good enough!

I couldn't agree more.

In fact, before coming across this debate this morning, I had intended to make a short post linking to the very informative lecture (below, courtesy of Mark Thoma) by macroeconomist George Evans. Lord knows I spend enough time criticizing economists -- and this recent post discussed the limitations of the learning literature, in which Evans has been a key player -- so I want to make clear that I do admire the things he does.

He tells an interesting story about an economic model (a standard New Keynesian model) that -- when the agents in the model learn in a particular constrained way -- has two different equilibria. One is locally stable and the economy has inflation right around a targeted value. Start out with inflation and consumption and expectations close to that equilibrium and you'll move toward that point over time. The second equilibrium is, however, unstable. If you start out sufficiently far away from the stable equilibrium, you won't go there at all, but will wander down into a deflationary zone (and what happens then I don't know).

This model for aggregate behaviour is based on some fairly simple low-dimensional equations for how current consumption and inflation feed, via expectations, into future values and a trajectory for the economy. I don't know how plausible these equations are. I'm guessing that someone can make a good argument about why they should have the form they do (or a similar form). That story would involve references to how things happening now in the economy would influence peoples' behaviour and their expectations, and then how these would cause certain kinds of changes. To really believe this you'd want to see some evidence that this story is correct, i.e. that people, firms, etc., really do tend to behave like this.

The point I want to make is that -- for someone like myself who has not been socialized to accept the necessity of what currently counts as "microfoundations" -- nothing about the story becomes more plausible when I wade into the equations of the New Keynesian model and see how households and firms independently optimize their intertemporal utilities subject to certain budget constraints. If anything, seeing all this dubious stuff makes me less likely to believe in the plausibility of the low dimensional equations for aggregate variables. And this is precisely the problem with microfoundations of this kind. They don't give a good argument for why the aggregate variables should satisfy these equations. They give a very bad. An unconvincing argument. At least for me.


  1. Thanks for the video but this is a complicated way based on too many assumptions for saying that you should not raise the interest rate when consumption is low. The equations are an overkill and too simplistic. Looks like economists just discovered heteroclinic orbits. This is more than simplicity. It is intellectual fraud.

  2. I have loved your blog. This has helped me out a lot. I have been looking for something with finance. Thanks for sharing. This has helped me out a lot.

  3. awesome and quit interesting thaks for your valuable video
    web design company in coimbatore

  4. This is really quite informative blog such qualitative info I have never seen anywhere.
    Mortgage Advice Bournemouth

  5. Well post and its tell a good story with amazing topics for school boys and its gives me good idea and not too much trouble take note of that these individuals are occupied and have better things to do with their lives thanks for sharing motivation letter scholarship .

  6. It is a great sharing me...I am very much pleased with the contents you have mentioned. I wanted to thank you for this great article. I enjoyed every little bit part of it.Web Design Sydney


  7. شركة نقل عفش
    اهم شركات مكافحة حشرات بالخبر كذلك معرض اهم شركة مكافحة حشرات بالدمام والخبر والجبيل والخبر والاحساء والقطيف كذلك شركة رش حشرات بالدمام ومكافحة الحشرات بالخبر
    شركة مكافحة حشرات بالدمام
    شركة تنظيف خزانات بجدة الجوهرة من افضل شركات تنظيف الخزانات بجدة حيث ان تنظيف خزانات بجدة يحتاج الى مهارة فى كيفية غسيل وتنظيف الخزانات الكبيرة والصغيرة بجدة على ايدى متخصصين فى تنظيف الخزانات بجدة
    شركة تنظيف خزانات بجدة
    شركة كشف تسربات المياه بالدمام
    شركة نقل عفش واثاث


  8. شركة نقل عفش بالرياض وجدة والدمام والخبر والجبيل اولقطيف والاحساء والرياض وجدة ومكة المدينة المنورة والخرج والطائف وخميس مشيط وبجدة افضل شركة نقل عفش بجدة نعرضها مجموعة الفا لنقل العفش بمكة والخرج والقصيم والطائف وتبوك وخميس مشيط ونجران وجيزان وبريدة والمدينة المنورة وينبع افضل شركات نقل الاثاث بالجبيل والطائف وخميس مشيط وبريدة وعنيزو وابها ونجران المدينة وينبع تبوك والقصيم الخرج حفر الباطن والظهران
    شركة نقل عفش بجدة
    شركة نقل عفش بالمدينة المنورة
    شركة نقل اثاث بالرياض
    شركة نقل عفش بالدمام


  9. Remarkable blog combined with delightful driven in the article. Regards originator for use on your good posts combined with brilliant write-up. Terrific websites as well as awesome incorporated for those internet site. Thanks creator into your important distributed as well as superior write-up. In these days go along with relating to the sticking with auto title loans chicago For that matter my spouse and I was given rewarding knowledge all of these.