How Not to Do Macroeconomics

A frustrating recurrence for critics of ‘mainstream’ economics is the assertion that they are criticising the economics of bygone days: that those phenomena which they assert economists do not consider are, in fact, at the forefront of economics research, and that the critics’ ignorance demonstrates that they are out of touch with modern economics – and therefore not fit to criticise it at all.

Nowhere is this more apparent than with macroeconomics. Macroeconomists are commonly accused of failing to incorporate dynamics in the financial sector such as debt, bubbles and even banks themselves, but while this was true pre-crisis, many contemporary macroeconomic models do attempt to include such things. Reputed economist Thomas Sargent charged that such criticisms “reflect either woeful ignorance or intentional disregard for what much of modern macroeconomics is about and what it has accomplished.” So what has it accomplished? One attempt to model the ongoing crisis using modern macro is this recent paper by Gauti Eggertsson & Neil Mehrotra, which tries to understand secular stagnation within a typical ‘overlapping generations’ framework. It’s quite a simple model, deliberately so, but it helps to illustrate the troubles faced by contemporary macroeconomics.

The model

The model has only 3 types of agents: young, middle-aged and old. The young borrow from the middle, who receive an income, some of which they save for old age. Predictably, the model employs all the standard techniques that heterodox economists love to hate, such as utility maximisation and perfect foresight. However, the interesting mechanics here are not in these; instead, what concerns me is the way ‘secular stagnation’ itself is introduced. In the model, the limit to how much young agents are allowed to borrow is exogenously imposed, and deleveraging/a financial crisis begins when this amount falls for unspecified reasons. In other words, in order to analyse deleveraging, Eggertson & Mehrotra simply assume that it happens, without asking why. As David Beckworth noted on twitter, this is simply assuming what you want to prove. (They go on to show similar effects can occur due to a fall in population growth or an increase in inequality, but again, these changes are modelled as exogenous).

It gets worse. Recall that the idea of secular stagnation is, at heart, a story about how over the last few decades we have not been able to create enough demand with ‘real’ investment, and have subsequently relied on speculative bubbles to push demand to an acceptable level. This was certainly the angle from which Larry Summers and subsequent commentators approached the issue. It’s therefore surprising – ridiculous, in fact – that this model of secular stagnation doesn’t include banks, and has only one financial instrument: a risk-less bond that agents use to transfer wealth between generations. What’s more, as the authors state, “no aggregate savings is possible (i.e. there is no capital)”. Yes, you read that right. How on earth can our model understand why there is not enough ‘traditional’ investment (i.e. capital formation), and why we need bubbles to fill that gap, if we can have neither investment nor bubbles?

Naturally, none of these shortcomings stop Eggertson & Mehrotra from proceeding, and ending the paper in economists’ favourite way…policy prescriptions! Yes, despite the fact that this model is not only unrealistic but quite clearly unfit for purpose on its own terms, and despite the fact that it has yielded no falsifiable predictions (?), the authors go on give policy advice about redistribution, monetary and fiscal policy. Considering this paper is incomprehensible to most of the public, one is forced to wonder to whom this policy advice is accountable. Note that I am not implying policymakers are puppets on the strings of macroeconomists, but things like this definitely contribute to debate – after all, secular stagnation was referenced by the Chancellor in UK parliament (though admittedly he did reject it). Furthermore, when you have economists with a platform like Paul Krugman endorsing the model, it’s hard to argue that it couldn’t have at least some degree of influence on policy-makers.

Now, I don’t want to make general comments solely on the basis of this paper: after all, the authors themselves admit it is only a starting point. However, some of the problems I’ve highlighted here are not uncommon in macro: a small number of agents on whom some rather arbitrary assumptions are imposed to create loosely realistic mechanics, an unexplained ‘shock’ used to create a crisis. This is true of the earlier, similar paper by Eggertson & Krugman, which tries to model debt-deflation using two types of agents: ‘patient’ agents, who save, and ‘impatient agents’, who borrow. Once more, deleveraging begins when the exogenously imposed constraint on the patient agent’s borrowing falls For Some Reason, and differences in the agents’ respective consumption levels reduce aggregate demand as the debt is paid back. Again, there are no banks, no investment and no real financial sector. Similarly, even the far more sophisticated Markus K. Brunnermeier & Yuliy Sannikov – which actually includes investment and a financial sector – still only has two agents, and relies on exogenous shocks to drive the economy away from its steady-state.

Whither macroeconomics?

Why do so many models seem to share these characteristics? Well, perhaps thanks to the Lucas Critique, macroeconomic models must be built up from optimising agents. Since modelling human behaviour is inconceivably complex, mathematical tractability forces economists to make important parameters exogenous, and to limit the number (or number of types) of agents in the model, as well as these agents’ goals & motivations. Complicated utility functions which allow for fairly common properties like relative status effects, or different levels of risk aversion at different incomes, may be possible to explore in isolation, but they’re not generalisable to every case or the models become impossible to solve/indeterminate. The result is that a model which tries to explore something like secular stagnation can end up being highly stylised, to the point of missing the most important mechanics altogether. It will also be unable to incorporate other well-known developments from elsewhere in the field.

This is why I’d prefer something like Stock-Flow Consistent models, which focus on accounting relations and flows of funds, to be the norm in macroeconomics. As economists know all too well, all models abstract from some things, and when we are talking about big, systemic problems, it’s not particularly important whether Maria’s level of consumption is satisfying a utility function. What’s important is how money and resources move around: where they come from, and how they are split – on aggregate – between investment, consumption, financial speculation and so forth. This type of methodology can help understand how the financial sector might create bubbles; or why deficits grow and shrink; or how government expenditure impacts investment. What’s more, it will help us understand all of these aspects of the economy at the same time. We will not have an overwhelming number of models, each highlighting one particular mechanic, with no ex ante way of selecting between them, but one or a small number of generalisable models which can account for a large number of important phenomena.

Finally, to return to the opening paragraph, this paper may help to illustrate a lesson for both economists and their critics. The problem is not that economists are not aware of or never try to model issue x, y or z. Instead, it’s that when they do consider x, y or z, they do so in an inappropriate way, shoehorning problems into a reductionist, marginalist framework, and likely making some of the most important working parts exogenous. For example, while critics might charge that economists ignore mark-up pricing, the real problem is that when economists do include mark-up pricing, the mark-up is over marginal rather than average cost, which is not what firms actually do. While critics might charge that economists pay insufficient attention to institutions, a more accurate critique is that when economists include institutions, they are generally considered as exogenous costs or constraints, without any two-way interaction between agents and institutions. While it’s unfair to say economists have not done work that relaxes rational expectations, the way they do so still leaves agents pretty damn rational by most peoples’ standards. And so on.

However, the specific examples are not important. It seems increasingly clear that economists’ methodology, while it is at least superficially capable of including everything from behavioural economics to culture to finance, severely limits their ability to engage with certain types of questions. If you want to understand the impact of a small labour market reform, or how auctions work, or design a new market, existing economic theory (and econometrics) is the place to go. On the other hand, if you want to understand development, historical analysis has a lot more to offer than abstract theory. If you want to understand how firms work, you’re better off with survey evidence and case studies (in fairness, economists themselves have been moving some way in this direction with Industrial Organisation, although if you ask me oligopoly theory has many of the same problems as macro) than marginalism. And if you want to understand macroeconomics and finance, you have to abandon the obsession with individual agents and zoom out to look at the bigger picture. Otherwise you’ll just end up with an extremely narrow model that proves little except its own existence.

 

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  1. #1 by Luther Blissett on April 11, 2014 - 3:19 am

    I would leave a reply, but I’m young not middle aged and therefore a moocher!

    Must tell my Dad about those risk free bonds though, I’ll soon be his debt slave.

    I wish these economists would make a computer simulation using their models, it would be hilarious.

    They never told us in school you could get a well paid job making stuff up for the rich and powerful. Maybe they thought I had ethics and it was rational to hide it from my type.

  2. #2 by Florian Kohlfürst on April 11, 2014 - 9:05 am

    Thouroughly enjoyed the post, and I’d agree with basically all of it. While e.g. the essence of the Lucas Critique might be spot-on, it did indeed end up doing a considerable amount of harm to the field of macroeconomics. Sometimes, macro simply can’t be understood by just adding up all the micro.

  3. #3 by Nick Edmonds on April 11, 2014 - 10:36 am

    I agree with some of this, but I think there are more similarities between this model and heterodox economics than you might think.

    http://monetaryreflections.blogspot.co.uk/2014/04/eggertsson-mehrotra-and-sfc-models.html

  4. #4 by Cameron on April 11, 2014 - 11:31 am

    Without complexity and emergent properties of the system there really is no macro. You end up having to just assume the result you want.

    I have had a top economist tell me that model results ARE simply assumptions being disguised.

    It is metaphysics at its best

    • #5 by Unlearningecon on April 12, 2014 - 12:05 pm

      A logician somewhere needs to go through a series of economic models and show that the conclusions are basically already there in the assumptions.

  5. #6 by Roman Plotnikov on April 11, 2014 - 1:43 pm

    I don’t think that SFC models are the answer because SFC is just a way of how a model is done, but it doesn’t constitute the model itself. At the same time, I believe that SFC is the future of macroeconomic modelling because it allows to prevent certain major errors like confusing stocks and flows or debits and credits. Still, SFC models need an underlying mechanic to function: Kalecki’s profit equation, for example. The really hard part is not discarding the obviously stupid formulas that violate accounting principles, it is a deep understanding of the world.

    Often the problem consists not in disproving the false notions through the formal logic, but in creating consensus of how reality works. If you and your opponent share the same axioms (say, Euclidean geometry) and follow the rules of logic, it is not impossible to prove him that triangles with equal sides must have 60 degree angles. Good luck proving that 2 x 2 = 4 to a person who disregards Peano’s axioms of arithmetics! In that sense, trying to ‘prove’ that banks create money to a person who thinks that banks are nothing but storehouses for wealth is just as futile as trying to convince someone who asserts that we live on Mars. You are playing a sucker’s game. The correct course of action is not appealing to logic, it’s spitting into the liar’s face.

    • #7 by Unlearningecon on April 12, 2014 - 12:12 pm

      Yeah, SFC is just a framework, but it’s less restrictive than the microfounded framework, which is one of the reasons I think it’s more suited to macro modelling.

      And yes, logical validity often seems to be confused with relevance. I believe Krugman basically commented to the effect that endogenous money proponents were just describing how the monetary system worked, rather than having uncovered any economic ‘law’. Well, yeah, that should be economists’ job…

  6. #8 by OSK on April 12, 2014 - 4:32 pm

    “it’s not particularly important whether Maria’s level of consumption is satisfying a utility function. What’s important is how money and resources move around: where they come from, and how they are split – on aggregate – between investment, consumption, financial speculation and so forth”

    Planning fallacy. The first welfare theorem suggests the opposite: if individuals are optimizing absent big externalities, then the macro outcome is optimal absent intervention. You have to provide strong evidence why intervention is necessary.

    I see the economy as more like an ecosystem than a ship. Interventions often have unforeseen, unintended consequences that often do more harm than good.

    And I don’t see how you can even begin to calculate the optimal split between aggregate spending figures with any certainty.

    “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

    • #9 by Unlearningecon on April 12, 2014 - 5:20 pm

      The only ‘strong evidence’ that needs to be provided is evidence for why general equilibrium and the first welfare theorem are relevant in the first place. Otherwise you’re just using an arbitrary theoretical baseline with no empirical justification. In other words, your logic is circular: the first welfare theorem states this so we shouldn’t go against it because that would contradict the first welfare theorem!

      By the way, labelling something ‘x-fallacy’ does not make it so. More interestingly, it is neoclassical economics itself which lends itself to the idea of planning, as the ‘optimal’ criteria you use requires somebody to make judgments about people’s’ welfare and design the system accordingly. Funnily enough, this type of general equilibrium theory (loosely speaking) was used to justify central planning in the 1930s.

      In any case, I never made any policy prescriptions here, and neither did I compare the economy to a ship – you’re just rehearsing some libertarian script. In fact, I objected to the authors recommending policies without any discussion of the hidden ethical assumptions they made. You have many of the same hidden ethical assumptions (Pareto efficiency, optimality, etc) throughout your post, you just present them as a neutral baseline. But that doesn’t mean they aren’t there.

      Interesting Hayek quote. Funny how Hayek didn’t have much trouble recommending policies he approved of. Can you tell me why it’s ok for you and him to do it, but not anyone else?

    • #10 by Eric L on April 14, 2014 - 6:59 am

      “then the macro outcome is optimal absent intervention”

      Stated like someone who doesn’t understand how weak the promise of optimality made by the first welfare theorem is. Pareto optimality is a useful concept when you are trying to optimize in a few dimensions, but Pareto optimizing in 7 billion dimensions is practically equivalent to not optimizing. The concept of Pareto optimality is intended as a way way of narrowing a large number of choices to a smaller number worthy of consideration, but it is a poor defense of any choice in particular. To invoke it is equivalent to handwaving away alternatives with “There will be some tradeoff.” and it’s silly to use it to shift the burden of proof to everyone who doesn’t want your particular Pareto optimal solution given that it’s extremely unlikely anything anyone is proposing to change about the economy would be Pareto worsening (or improving for that matter) over the status quo.

      That aside from the fact that “if individuals are optimizing absent big externalities” are two rather big assumptions.

  7. #11 by NeilW on April 13, 2014 - 7:50 am

    One of the dangers of any of these sort of mathematical models (including the SFC ones) is that they probably won’t ‘run’ when they are applied to the real world.

    The computer abstraction that you have infinite memory, infinite disk and have the entire computer to yourself is very useful for writing a computer program, but you have to deal with the actual finite restrictions in some way when you come to run it – particularly if it is large or long running.

    Similarly with economic models. They often assume infinite liquidity, infinite solvency – particularly at the stress points they are trying to model!.

    Economic models ultimately have to run successfully on the underlying real world monetary systems. Very few, if any, check that they actually do.

    • #12 by Unlearningecon on April 13, 2014 - 11:31 pm

      You’re right that neither heterodox nor mainstream economists mark their beliefs to market enough, and it’s possibly the case that this kind of accuracy just isn’t possible. I’ll readily admit that I have something of a double standard with DSGE versus SFC models, in that I expect less of the latter than of the former, but I think this is justified on the basis that DSGE models have been pushed and pushed, while SFC modelling remains relatively unexplored. What’s more, the mechanics of SFC models (such as endogenous money) are far more realistic, even if their predictive power is equally empty/weak.

      Having said all this, I’m getting more sympathetic to Tony Lawson’s wholesale rejection of complex mathematics. Perhaps the economy – as a complex, social system – is simply not amenable to the kind of regularity we require to have reliable causal links between variables.

  8. #13 by Metatone on April 13, 2014 - 9:35 am

    Great post, but I’d add some different angles:

    1) Philosophical
    The problem here is that (as highlighted in the libertarian comment above) economists are committed to a belief that the economy is a self-stabilising system. This means that their “normal procedure” is to classify many things as “exogenous” because to label destabilising elements as “endogenous” would be to admit that the system is not self-stabilising (and/or has multiple equilibrium points, which brings in the second philosophical problem, economists are unable to admit that in human life/systems, unlike physics, some equilibria are just not acceptable – “naturalism” is just incorrect.)

    As an aside, the comment about “ecosystem” is highly revealing, because it shows again the naive belief in stability. Most eco-systems aren’t stable, that’s just a horizon analysis error.

    2) Technical
    Most economists (as I found through a really tortuous – for both sides – conversation in the comments with Nick Rowe on his blog – have no meaningful education in systems analysis. As such all sorts of basic elements tend to be missing. I think the one that springs to mind most regarding this discussion is the rule: “Thou shalt describe and justify the boundaries of the system you choose for your analysis.” Economists, it seems, are not taught to do this – and so they don’t. As a result they are forever making analysis using implicit definitions of the system, which leads to both errors and great complaint from them when people like me question the definition they have used. Basically, they can’t see my question as valid, because they haven’t been taught to think about it.

    And as usual, there are those who have been taught, but are happy to “go with the tenure flow” and just use the prevailing assumptions of the profession, with no coherent justification…

    3) Sociological
    I don’t know if Eggertson and Mehrotra would defend themselves the way many authors of such studies do: “Well, we make this shock exogenous for now, because we don’t know what it is, but now we’ve proved that it’s important, that’s the stepping stone to more complex studies into what this shock actually is.”

    However, I wouldn’t be surprised if they did take this angle. And strangely enough, you can make a good philosophical and technical argument that this defence is valid. The key problem here is sociological – on average in economics, no one will actually do that further more complex study.
    Now if we’re lucky, E&M will prove me wrong by doing it themselves, but one swallow does not a summer make…

    • #14 by Unlearningecon on April 13, 2014 - 11:40 pm

      Interesting comment. I agree it’s important to define the boundaries of the system you’re studying – economic models right now just seem to be a bunch of mathematical fairy-tales with no clear application. In fact, this is exactly how economists defend them: as ‘cases’ that cannot be falsified but can be drawn on to think about a problem. I’ve yet to decide fully how I feel about this, it’s certainly not science.

      You mention the sociological problem and while I agree, I wonder if it is worthwhile to use this simplified baseline to start thinking about every problem. I mean, engineers don’t use the perfect gas equation as a starting point for every gas then add ‘frictions'; they just switch to a different model. Maybe there is a deeper problem at play here?

      • #15 by Metatone on April 22, 2014 - 2:52 pm

        A very late reply…

        I think you are right, there’s a deeper problem – which I’d sum up as: “economists think they are scientists, when they need to be/need to realise they are engineers.”

        That’s a deeper problem I’ve written about before, so I won’t go into justifying it here today – and it encompasses a bunch of issues – but I think it speaks clearly to the issue about models.

        Economists model themselves (sic) on the archetypal physicists trying to unify Newtonian and Quantum physics. It’s all about building a model – and defending it.

        Good engineers have to use models, so they are generally more agnostic about them. They have rough and ready criteria around “what works.”

        Now I don’t want to overplay this distinction in general. Each approach has it’s place. The main point being, like the Wright Brothers regarding powered flight, our knowledge of economics is still sketchy. So “science” really is “theoretical” and “practical” work needs “engineering” approaches…

  9. #16 by pcle on April 15, 2014 - 6:02 pm

    have you looked at Ashwin’s blog, macroresilience.com? I think he tackles many of the issues that metatone raises about systems ecology. He seems to be operating at a whole other level of understanding compared to standard econ

    • #17 by Unlearningecon on April 17, 2014 - 5:39 pm

      I’ve come across that blog a few times before and enjoyed some the posts, though I confess to not being particularly knowledgeable/interested on the ins and outs of banks etc, which is what he seems to focus on. I’m also curious about your link to systems dynamics & ecology, because I can’t find anything along those lines there. Or am I just not looking hard enough/misinterpreting you?

  10. #19 by Magpie on April 27, 2014 - 11:55 am

    Off topic, but for a good reason: the first 10 volumes of MECW are copyrighted and a radical publisher, historically linked to the Communist Party of Britain is demanding the Marxists Internet Archive to remove that content from their website by April 30th, Labour Day’s eve:

    http://crookedtimber.org/2014/04/24/karlo-marx-and-fredrich-engels-came-to-the-checkout-at-the-7-11/

    • #20 by Unlearningecon on April 28, 2014 - 11:01 am

      Yeah, I’ve seen that. Signed the petition, sent a letter etc. etc. Is there any quick way you know of that I can download all the content from the relevant page? Commenter ‘Matt’ gives a command but I’m pretty sure it’s for Linux.

      • #21 by Steve on April 29, 2014 - 1:49 am

        That website had only uploaded ten volumes, and some of those that are uploaded remain incomplete. A shame it is under attack. Glad you took action to protect it.

        The publisher here in New York charges $24.95 per volume. I think they add $10 per book for international shipping. http://www.intpubnyc.com/Titles.html

        Volume 1, which includes Marx’s doctoral dissertation is indefinitely out of stock. You may want to access Volume 1 while it is available online. A few others are temporarily out of stock, but will be reprinted this year.

  11. #22 by Vetle on May 3, 2014 - 10:31 pm

    I agree with your criticism of the Eggertsson/Mehrotra paper, in the sense that it doesn’t really give much insight. The fact that the model can have negative real interest rates doesn’t mean much if you ask me. That’s possible in the simplest possible OLG model even. If you have a OLG model with only two generations, log utility and a pure endowment economy, it is easy to show that the real interest rate will be negative if the young generation has a larger endowment than the old generation(to be precise it also depends on the discount factor, but that’s beside the point)

    In such a model there is no borrowing, everyone just consumes their endowment, and the prevailing interest rate is the interest rate which is consistent with no borrowing. Of course it would be ridiculous to suggest that the model I proposed above offered any useful insight into anything, even with a negative interest rate!

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