New Keynesian DSGE models and the ‘representative lemming’
from Lars Syll
If all agents are supposed to have rational expectations, it becomes convenient to assume also that they all have the same expectation and thence tempting to jump to the conclusion that the collective of agents behaves as one. The usual objection to representative agent models has been that it fails to take into account well-documented systematic differences in behaviour between age groups, income classes, etc. In the financial crisis context, however, the objection is rather that these models are blind to the consequences of too many people doing the same thing at the same time, for example, trying to liquidate very similar positions at the same time. Representative agent models are peculiarly subject to fallacies of composition. The representative lemming is not a rational expectations intertemporal optimising creature. But he is responsible for the fat tail problem that macroeconomists have the most reason to care about …
For many years now, the main alternative to Real Business Cycle Theory has been a somewhat loose cluster of models given the label of New Keynesian theory. New Keynesians adhere on the whole to the same DSGE modeling technology as RBC macroeconomists but differ in the extent to which they emphasise inflexibilities of prices or other contract terms as sources of shortterm adjustment problems in the economy. The “New Keynesian” label refers back to the “rigid wages” brand of Keynesian theory of 40 or 50 years ago. Except for this stress on inflexibilities this brand of contemporary macroeconomic theory has basically nothing Keynesian about it.
The obvious objection to this kind of return to an earlier way of thinking about macroeconomic problems is that the major problems that have had to be confronted in the last twenty or so years have originated in the financial markets – and prices in those markets are anything but “inflexible”.
And still mainstream economists seem to be impressed by the ‘rigour’ brought to macroeconomics by New-Classical-New-Keynesian DSGE models and its rational expectations and micrcofoundations!
It is difficult to see why.
Take the rational expectations assumption. Rational expectations in the mainstream economists’ world implies that relevant distributions have to be time independent. This amounts to assuming that an economy is like a closed system with known stochastic probability distributions for all different events. In reality it is straining one’s beliefs to try to represent economies as outcomes of stochastic processes. An existing economy is a single realization tout court, and hardly conceivable as one realization out of an ensemble of economy-worlds, since an economy can hardly be conceived as being completely replicated over time. It is — to say the least — very difficult to see any similarity between these modelling assumptions and the expectations of real persons. In the world of the rational expectations hypothesis we are never disappointed in any other way than as when we lose at the roulette wheels. But real life is not an urn or a roulette wheel. And that’s also the reason why allowing for cases where agents make ‘predictable errors’ in DSGE models doesn’t take us any closer to a relevant and realist depiction of actual economic decisions and behaviours. If we really want to have anything of interest to say on real economies, financial crisis and the decisions and choices real people make we have to replace the rational expectations hypothesis with more relevant and realistic assumptions concerning economic agents and their expectations than childish roulette and urn analogies.
‘Rigorous’ and ‘precise’ DSGE models cannot be considered anything else than unsubstantiated conjectures as long as they aren’t supported by evidence from outside the theory or model. To my knowledge no in any way decisive empirical evidence has been presented.
No matter how precise and rigorous the analysis, and no matter how hard one tries to cast the argument in modern mathematical form, they do not push economic science forwards one single millimeter if they do not stand the acid test of relevance to the target. No matter how clear, precise, rigorous or certain the inferences delivered inside these models are, they do not say anything about real world economies.
Proving things ‘rigorously’ in DSGE models is at most a starting-point for doing an interesting and relevant economic analysis. Forgetting to supply export warrants to the real world makes the analysis an empty exercise in formalism without real scientific value.
Mainstream economists think there is a gain from the DSGE style of modeling in its capacity to offer some kind of structure around which to organise discussions. To me that sounds more like a religious theoretical-methodological dogma, where one paradigm rules in divine hegemony. That’s not progress. That’s the death of economics as a science.