Home > Uncategorized > Macroeconomic models — beautiful but irrelevant

Macroeconomic models — beautiful but irrelevant

from Lars Syll

2-format2010Roman Frydman is Professor of Economics at New York University and a long time critic of the rational expectations hypothesis. In his seminal 1982 American Economic Review article Towards an Understanding of Market Processes: Individual Expectations, Learning, and Convergence to Rational Expectations Equilibrium — an absolute must-read for anyone with a serious interest in understanding what are the issues in the present discussion on rational expectations as a modeling assumption — he showed that macroeconomic models founded on the rational expectations hypothesis are inadequate as representation of economic agents’ decision making.  

Those who want to build macroeconomics on microfoundations usually maintain that the only robust policies and institutions are those based on rational expectations and representative actors. As yours truly has tried to show in On the use and misuse of theories and models in economics there is really no support for this conviction at all. On the contrary. If we want to have anything of interest to say on real economies, financial crisis and the decisions and choices real people make, it is high time to place macroeconomic models building on representative actors and rational expectations-microfoundations where they belong – in the dustbin of history.

For if this microfounded macroeconomics has nothing to say about the real world and the economic problems out there, why should we care about it? It is not enough being able to construct ‘beautiful’ models as long as they are irrelevant for explaining and understanding real World phenomena. 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 the real world. 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.

Contemporary economists’ reliance on mechanical rules to understand – and influence – economic outcomes extends to macroeconomic policy as well, and often draws on an authority, John Maynard Keynes, who would have rejected their approach. Keynes understood early on the fallacy of applying such mechanical rules. “We have involved ourselves in a colossal muddle,” he warned, “having blundered in the control of a delicate machine, the working of which we do not understand.”

To put it bluntly, the belief that an economist can fully specify in advance how aggregate outcomes – and thus the potential level of economic activity – unfold over time is bogus …

Roman Frydman & Michael Goldberg

The real macroeconomic challenge is to face and accept uncertainty and still try to explain why economic transactions take place – instead of simply conjuring the problem away by assuming rational expectations and treating uncertainty as if it was possible to reduce to stochastic risk. That is scientific cheating. And it has been going on for too long now.

  1. avneroffer
    April 12, 2016 at 5:44 pm

    What do you think about a recent NBER paper, NEOCLASSICAL MODELS IN MACROECONOMICS
    Gary D. Hansen
    Lee E. Ohanian
    Working Paper 22122
    http://www.nber.org/papers/w22122
    They claim that it does work. Can send you a copy. I am not endorsing it, but you can see that they are trying.

  2. April 13, 2016 at 3:23 am

    I take economists at their word. If they could have used their skills and political connections to build a rational and optimal world they would have. That they could not should have told them all they needed to know about the future of their discipline and economic actions and actors. As a group they’re a little dull, so it did not. I have two problems with the Rational Expectations Theorem.” First, what the hell is rational and how do we know it when we see it? Dictionaries list between 6 and 14 definitions of rational. And they don’t all overlap. Which is the “correct” one to use here? And once we make that choice by what process do we figure out if the actors we want to observe acted in accordance with the definition we selected? Answer these questions and we can go to the next step. Second, what the hell is optimal and how do we know it when we see it? We get a little break with the dictionary definitions. There are generally only two – 1) best or most effective; 2) most desirable or satisfactory. The real issue is how do we determine if the actor has indeed acted the best or most desirable, or has failed to achieve this goal.? At bottom optimal is impossible to assess and even if we think we see it optimal is also impossible to maintain. As one of my old computer modeling associates said often, “fart in the wrong direction and optimal goes out the window.

  3. avneroffer
    April 13, 2016 at 11:58 am

    Sent NBER paper to your academic email

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