Home > New vs. Old Paradigm Economics, The Economics Profession > Microfounded DSGE models — spectacularly useless and positively harmful

Microfounded DSGE models — spectacularly useless and positively harmful

from Lars Syll

Economists — yours truly included — working within the Post Keynesian tradition, have always maintained that there is  a strong risk that people may find themselves unemployed in a market economy.

And, of course, unemployment is also something that can take place in microfounded  DSGE models — but the mechanism in these models is of a fundamentally different kind.

In the basic DSGE models the labour market is always clearedresponding to a changing interest rate, expected life time incomes, or real wages, the representative agent maximizes the utility function by varying her labour supply, money holding and consumption over time. Most importantly — if the real wage somehow deviates from its “equilibrium value,” the representative agent adjust her labour supply, so that when the real wage is higher than its “equilibrium value,”  labour supply is increased, and when the real wage is below its “equilibrium value,”  labour supply is decreased.

In this model world, unemployment is always an optimal choice to changes in the labour market conditions.  Hence, unemployment is totally voluntary. To be unemployed is something one optimally chooses to be. 

Although this picture of unemployment as a kind of  self-chosen optimality, strikes most people as utterly ridiculous, there are also, unfortunately, a lot of neoclassical economists out there who still think that price and wage rigidities are the prime movers behind unemployment. What is even worse — I’m totally gobsmacked every time I come across this utterly ridiculous misapprehension — is that some of them even think that these rigidities are the reason John Maynard Keynes gave for the high unemployment of the Great Depression. This is of course pure nonsense. For although Keynes in General Theory devoted substantial attention to the subject of wage and price rigidities, he certainly did not hold this view. That’s rather the view of microfounded DSGE modelers, explaining variations in employment (and a fortiori output) with assuming nominal wages being more flexible than prices —  happily disregarding the total lack of empirical evidence for this rather counterintuitive assumption.

Since unions/workers, contrary to classical assumptions, make wage-bargains in nominal terms, they will – according to Keynes – accept lower real wages caused by higher prices, but resist lower real wages caused by lower nominal wages. However, Keynes held it incorrect to attribute “cyclical” unemployment to this diversified agent behaviour. During the depression money wages fell significantly and – as Keynes noted – unemployment still grew. Thus, even when nominal wages are lowered, they do not generally lower unemployment.

In any specific labour market, lower wages could, of course, raise the demand for labour. But a general reduction in money wages would leave real wages more or less unchanged. The reasoning of the classical economists was, according to Keynes, a flagrant example of the “fallacy of composition.” Assuming that since unions/workers in a specific labour market could negotiate real wage reductions via lowering nominal wages, unions/workers in general could do the same, the classics confused micro with macro.

Lowering nominal wages could not – according to Keynes – clear the labour market. Lowering wages – and possibly prices – could, perhaps, lower interest rates and increase investment. But to Keynes it would be much easier to achieve that effect by increasing the money supply. In any case, wage reductions was not seen by Keynes as a general substitute for an expansionary monetary or fiscal policy.

Even if potentially positive impacts of lowering wages exist, there are also more heavily weighing negative impacts – management-union relations deteriorating, expectations of on-going lowering of wages causing delay of investments, debt deflation et cetera.

So, what Keynes actually did argue in General Theory, was that the classical proposition that lowering wages would lower unemployment and ultimately take economies out of depressions, was ill-founded and basically wrong.

To Keynes, flexible wages would only make things worse by leading to erratic price-fluctuations. The basic explanation for unemployment is insufficient aggregate demand, and that is mostly determined outside the labor market.

The classical school [maintains that] while the demand for labour at the existing money-wage may be satisfied before everyone willing to work at this wage is employed, this situation is due to an open or tacit agreement amongst workers not to work for less, and that if labour as a whole would agree to a reduction of money-wages more employment would be forthcoming. If this is the case, such unemployment, though apparently involuntary, is not strictly so, and ought to be included under the above category of ‘voluntary’ unemployment due to the effects of collective bargaining, etc …

The classical theory … is best regarded as a theory of distribution in conditions of full employment. So long as the classical postulates hold good, unemploy-ment, which is in the above sense involuntary, cannot occur. Apparent unemployment must, therefore, be the result either of temporary loss of work of the ‘between jobs’ type or of intermittent demand for highly specialised resources or of the effect of a trade union ‘closed shop’ on the employment of free labour. Thus writers in the classical tradition, overlooking the special assumption underlying their theory, have been driven inevitably to the conclusion, perfectly logical on their assumption, that apparent unemployment (apart from the admitted exceptions) must be due at bottom to a refusal by the unemployed factors to accept a reward which corresponds to their marginal productivity …

Obviously, however, if the classical theory is only applicable to the case of full employment, it is fallacious to apply it to the problems of involuntary unemployment – if there be such a thing (and who will deny it?). The classical theorists resemble Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight – as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry. Something similar is required to-day in economics. We need to throw over the second postulate of the classical doctrine and to work out the behaviour of a system in which involuntary unemployment in the strict sense is possible.

J M Keynes General Theory

People — like Simon Wren-Lewis — calling themselves “New Keynesians” ought to be rather embarrassed by the fact that the kind of microfounded DSGE models they use, cannot incorporate such a basic fact of reality as involuntary unemployment!

Of course, working with representative agent models, this should come as no surprise. The kind of unemployment that occurs is voluntary, since it is only adjustments of the hours of work that these optimizing agents make to maximize their utility.

The final court of appeal for macroeconomic models is the real world, and as long as no convincing justification is put forward for how the inferential bridging de facto is made, macroeconomic modelbuilding is little more than “hand waving” that give us rather little warrant for making inductive inferences from models to real world target systems. If substantive questions about the real world are being posed, it is the formalistic-mathematical representations utilized to analyze them that have to match reality, not the other way around.

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  1. F. Beard
    December 21, 2013 at 12:40 pm | #1

    When robots can do nearly all work except highly creative thinking more reliably and cheaper than humans then how can a large percentage of the population NOT be involuntarily unemployed?

    And if leisure (hard work is not excluded, merely not required) is the goal of most people then why are we so all-fired concerned that a large percentage of the working age population be wage earners where leisure is generally excluded?

    And how much NEGATIVE work is done by, say, superfluous government workers because we place such a high value on employment, be it for good or ill?

    And let’s be very clear, people do NOT need jobs per se, they need income. The fact that so many people desperately need jobs to generate income in a wealthy economy like the US is indicative of unjust wealth distribution such as results, for instance, when banks steal family farms and businesses when they fail from business conditions the banks themselves cause. And when well-paid jobs are automated away with the stolen (via dilution) purchasing power of the general population, including the workers replaced, via the creation of new purchasing power for the so-called creditworthy.

    It all goes back to the counterfeiting cartel for the rich, the government-backed banking system, which works well to create wealth (very broadly defined, no doubt, since pornography, for example, can be profitable in the sense of being able to repay a bank loan with interest) but which works VERY badly to justly distribute wealth since creditworthiness is simply the ability to repay stolen purchasing power with interest to the original thieves, the government-backed banking cartel.

  2. HPS
    December 21, 2013 at 2:54 pm | #2

    This model has always been complete nonsense. What has changed is the acceptance of that “complete nonsense” in the face of a collapsing economy (2008). Reality does have an odd propensity for periodically calling out the ludicrous excesses of theory in the form of very real crises.

  3. Norman L. Roth
    December 21, 2013 at 4:39 pm | #3

    The full explanation of the naturalness & inevitability of “involuntary unemployment” lies at the very heart & soul of the TELOS &TECHNOS paradigm As well as the futility of trying to explain this phenomena,[never mind solving it!]; while holding exogenous, or banishing to ‘ceteris paribus’ land the omnipresent gestalt processes of changes in Technological Time: AND changes in “Tastes” [embodied in the 'Current Conception of the Standard of Life']. Or by endless bouts of theological & ‘scientistic’ shadow -boxing; Which always insist that contemporary economic problems can be explained and solved by finding the right “control” algorithms: The “Holy Grail” that would enable monetary manipulations alone & an inevitable confiscatory tax system, to DICTATE the ” optimal performance” & the very “design” [criteria chosen by whom ?] of all the institutions of a modern complex interactive economy. Conspiratorially-minded afficionados of such ‘solutions’, of ALL persuasions, should consult Aesop’s “fable” of THE GOOSE THAT LAYED the GOLDEN EGGS, for the inevitable outcome of implementing such bizarre control fetishes.Modern economic LIFE is much closer, in the ontological sense, to BEING a great cosmic organism, rather than a controllable “technology”. Because it’s a “dynamic” process that is rooted in the constantly evolving, GESTALT-like consequences of human consciousness. And Spontaneous ordering is the engine of that economic ‘evolving’.That’s why the Keynesian Paradigm is inherently inadequate,albeit the most important & insightful step toward the full & open [i.e. testable for falsehood] Paradigm of Telos & Technos. And why the ‘Libertarian’ [extreme "laissez-faire] branch of the greatly admirable Austrian School,must give up its dogma of an ” action-at-a-distance” /deus-ex-machina cosmic mechanism:That will always, like a great gyroscope in the sky, ensure full employment stability. At least their hearts,if not their heads are in the right place.The same cannot be said about the anti-”market-fundamentalists”: And the discredited & bloody-minded ideologies that lurk behind their “solutions”.
    Norman L. Roth, Toronto, Canada
    Please GOOGLE: [1] Origins of Markets, Norman Roth [2] A New Economic Paradigm, Norman Roth [3] Telos & Technos, Roth [4] Economics of Technos, Roth

    • BFWR
      December 21, 2013 at 8:37 pm | #4

      Your goal is a precise description of what the policies of Social Credit would elicit…seeings how they are an integration of both Telos and Technos.

  4. BFWR
    December 21, 2013 at 6:36 pm | #5

    Technology and technological innovation that eliminates individual incomes are the factors that will finally awaken economists, businesses and individuals to the necessity of the transcendent economic and monetary solutions prescribed by C. H. Douglas and his Social Credit. The only really important question is: Will we awaken before collapse, chaos and likely war in a time of modern weaponry….or not?

  5. Bhaskara II
    December 22, 2013 at 2:18 am | #6

    DSGE (Dynamic stochastic general equilibrium) is a tripple oxymoron:

    Dynamic contradicts equilibrium. (Dynamics can have an equilibrium but not the other way around.)
    Stochastic* contradicts dynamic and or equilibrium.

    *In probability theory, a purely stochastic system is one whose state is non-deterministic so that the subsequent state of the system is determined probabilistically. Any system or process that must be analyzed using probability theory is stochastic at least in part.
    –wikipedia first sentence

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