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.