Macro muddles

Noah Smith has a new post which displays his great flexibility as a blogger. He's a fairly stern critic of modern macroeconomics, usually. This post is a more or less conscious effort to do mental gymnastics by suspending relevant sense data and seeing just how far it is possible, if one tries really hard, to offer a coherent defense of current practices in mainstream macroeconomics (read: DSGE modelling). One big positive: there was a financial crisis, and DSGE modellers deserve great credit as they have now noticed the importance of the financial system and made strides in including it (in some form at least) in their models. Another: macroeconomists, apparently, are trying to make their models simpler so they can be more useful to policy makers. I say apparently.

Because that's not what I heard at a recent conference from policy makers themselves. My latest Bloomberg column explores a little of what I heard from some of them about what they would like to see more of from macroeconomists.  More realistic finance and more simplicity were certainly on their list, alongside a lot more humility, more acceptance of uncertainty, and more models based on realistic human behavior. They said they haven't seen much of this yet:

... are the top journals in macroeconomics publishing useful work? Judging from a recent conference that included regulators from the U.S. Federal Reserve, the Bank of England, the International Monetary Fund and the Organization for Economic Cooperation and Development, the answer is not encouraging: Six years after a financial crisis that exposed fundamental flaws in the dominant economic theories and models, the profession has made little to no progress in correcting itself.

The policy makers said that top economics journals still aren't publishing research or providing tools that they can apply in their work. The dominant culture favors mathematically complex, intellectually stimulating theories over simpler, more useful ones. "We're in for a long siege,” as one of them put it, “during which useful economics that really works will remain out of the top theoretical journals.” [Read more]

That last quote really struck me. Useful work will stay out of the top journals. How then can they be considered top journals? What am I missing?

At that conference, I gave a short presentation during a panel session. I (cautiously) presented my impression that one reason economists don't want to move away from their models based on rationality and equilibrium is that, in doing so, they will inevitably have to give up some of their favorite theorems and hence be unable to make statements about the possible welfare implications of policies. Taking steps toward realism will invalidate the mathematical basis of their thinking. I see that as a good thing; many economists I believe find it downright frightening.

That is my impression as an outsider, but am pleased to see that economist Peter Dorman believes something similar, a point he made in commenting on Noah Smith's post (h/t Lars Syll):

“….macroeconomists are definitely thinking about heterogeneity.” Come on, you must surely see that one can have both heterogeneity and representative agents. If there are 300 million agents in an economy and you model them as two or three decision-makers, on balance you are doing a lot more homogenizing than heterogenizing. This matters because just about everything we know about complex systems tells us that the density of interaction effects is central. An economy of you, me and a few other people simply isn’t going to have the same dynamics as an economy of millions of interacting agents. This is true even if agent-based modeling turns out to be unproductive. It’s enough to know that the model people are using is systematically giving bad advice. Microfounding macro is a choice, and if the there aren’t any good microfoundations at hand, you don’t have to do it.

“….there’s no clear alternative [to rational expectations].” The previous paragraph applies here as well. If the only microfoundations you can find are empirically disconfirmed, regularly and broadly, then you may just have to postpone this microfounding business until you can come up with better models. Beyond that, I think the core problem is that the models are structured to permit the solution of equilibrium conditions, and that this imposes a restrictive framework for thinking about rationality, optimization. If the point were to model adjustment, we could use a much looser but more empirically defensible conception of rationality. Of course, that would also mean severing economic analysis from welfarism: we’d have to give up trying to answer questions like“what’s the welfare cost of this situation compared to the optimum?” In the end, the attachment of economists, micro and macro alike, to equilibrium models with rational agents is that they want to be able make definitive judgments about what society should do. I prefer Keynes’ dentists: they don’t tell you whether you have an optimal dental structure, but they can help you get the structure you tell them you want.

“….[macro] looks like a vigorous, energetic field full of excited young true believers and respected older figures who are still blazing new trails.” The more accurate criticism of macro is not that it is simply an ideological smokescreen or an unthinking herd, but that it operates on a tilted playing field. It is openly acknowledged that the “leading” (i.e. career-determining) journals have engaged in tendentious selection practices for the past generation. Lots of shoddy research (which in my book includes calibration exercises promoted as “testing” theories) has gotten the star treatment, alongside a stream of genuinely significant macro work. Ideologically loaded assumptions, such as those typically used in public choice, are dropped in without any justification. Not all macro is bad! But the problem is that (a) the bad stuff of a certain ideological orientation gets an extra push that the good stuff doesn’t get, and (b) there isn’t a clear process by which the bad stuff is weeded out over time as its badness becomes evident. We refight the same damned macro battles year after year.

Again, I think economists like to tell stories of a certain kind, stories that fit into a certain framework they find familiar, a framework that links up to all the nice (?) welfare theorems they learned as students. The only problem is that these theorems only apply to a fictitious world that is not at all like our world. So we have the top journals filled with useless theory. Wonderful.