Home > Uncategorized > Where modern macroeconomics went wrong

Where modern macroeconomics went wrong

from Lars Syll

In issue 1-2 (2018) of Oxford Review of Economic Policy, the editors have invited some well-known contemporary mainstream macroeconomists (including e.g. Simon Wren-Lewis, Randall Wright, Olivier Blanchard, Ricardo Reis, Joseph Stiglitz) to give their views on how to rebuild macroeconomic theory for the future.

economist_cover_oh_fuck_september_2008Some of the contributions are interesting to read. Others — like Wren-Lewis and Blanchard — seem to think that we can basically just go on with our microfounded DSGE models and complement them with one or other structural econometric model (SEM). Two bads, however, do not add up to one good.

Joseph Stiglitz article on Where Modern Macroeconomics Went Wrong acknowledges that his approach “and that of DSGE models begins with the same starting point: the competitive equilibrium model of Arrow and Debreu.” That is, however, probably also the reason why Stiglitz’ suggestions for rebuilding macroeconomics don’t go far enough.

It’s strange that mainstream macroeconomists still stick to a general equilibrium paradigm more than forty years after the Sonnenschein-Mantel-Debreu theorem — SMD — devastatingly showed that it  is an absolute non-starter for building realist and relevant macroeconomics: 

SMD theory means that assumptions guaranteeing good behavior at the microeconomic level do not carry over to the aggregate level or to qualitative features of the equilibrium …

24958274Given how sweeping the changes wrought by SMD theory seem to be, it is understandable that some very broad statements about the character of general equilibrium theory were made. Fifteen years after General Competitive Analysis, Arrow (1986) stated that the hypothesis of rationality had few implications at the aggregate level. Kirman (1989) held that general equilibrium theory could not generate falsifiable propositions, given that almost any set of data seemed consistent with the theory …

S. Abu Turab Rizvi

New Classical-Real Business Cycles-DSGE-New Keynesian microfounded macro models try to describe and analyze complex and heterogeneous real economies with a single rational-expectations-robot-imitation-representative-agent. That is, with something that has absolutely nothing to do with reality. And — worse still — something that is not even amenable to the kind of general equilibrium analysis that they are thought to give a foundation for since SMD unequivocally showed that there did not exist any condition by which assumptions on individuals would guarantee either stability or uniqueness of the equilibrium solution.

Opting for cloned representative agents that are all identical is of course not a real solutionto the fallacy of composition that SMD points to. Representative agent models are — as I have argued at length here — rather an evasion whereby issues of distribution, coordination, heterogeneity — everything that really defines macroeconomics — are swept under the rug.

Of course, most macroeconomists know that to use a representative agent is a flagrantly illegitimate method of ignoring real aggregation issues. They keep on with their business, nevertheless, just because it significantly simplifies what they are doing. It reminds — not so little — of the drunkard who has lost his keys in some dark place and deliberately chooses to look for them under a neighbouring street light just because it is easier to see there.

General equilibrium is fundamental to economics on a more normative level as well. A story about Adam Smith, the invisible hand, and the merits of markets pervades introductory textbooks, classroom teaching, and contemporary political discourse. The intellectual foundation of this story rests on general equilibrium, not on the latest mathematical excursions. If the foundation of everyone’s favourite economics story is now known to be unsound — and according to some, uninteresting as well — then the profession owes the world a bit of an explanation.

Frank Ackerman

Almost a century and a half after Léon Walras founded general equilibrium theory, economists still have not been able to show that markets lead economies to equilibria. We do know that — under very restrictive assumptions — equilibria do exist, are unique and are Pareto-efficient. But — what good does that do? As long as we cannot show that there are convincing reasons to suppose there are forces which lead economies to equilibria — the value of general equilibrium theory is nil. As long as we cannot really demonstrate that there are forces operating — under reasonable, relevant and at least mildly realistic conditions — at moving markets to equilibria, there cannot really be any sustainable reason for anyone to pay any interest or attention to this theory.

A stability that can only be proved by assuming Santa Claus conditions is of no avail. Most people do not believe in Santa Claus anymore. And for good reasons — Santa Claus is for kids.

Continuing to model a world full of agents behaving as economists — ‘often wrong, but never uncertain’ — and still not being able to show that the system under reasonable assumptions converges to equilibrium (or simply assume the problem away), is a gross misallocation of intellectual resources and time.

  1. David Harold Chester
    July 26, 2018 at 8:34 am

    The claim that macro-economists have failed to show that equilibrium is the result of the system trying to self-stabilize, is false. It is a natural process, just like water finding bits own level and it is associated with competition and free markets.The proof is when there fails to be equilibrium and the part that is free mainly the entrepreneurs, will cause it to respond to finding a lower state of production cost. Monopolies oppose this but they cannot affect the whole of the Big Picture and on aggregate equilibrium will dominate..

  2. Robert Locke
    July 26, 2018 at 9:48 am

    And so?

  3. July 26, 2018 at 10:30 am

    Perhaps micro-foundation models would work if economists did them properly as large scale simulations of heterogeneous agents. But do they have predictive value? The standard way of doing science is to measure the real world, make a model, run the model to make predictions, then check the predictions. Tweak the model to make better predictions, then iterate. I’m not sure economists do that with any theory.

    • Frank Salter
      July 26, 2018 at 11:03 am

      Please note that scientific theories are NOT model based. Theories mainly arise from first principles analysis and are required to match the empirical facts or they are NOT theories.

      Frequently, models are based upon several physical processes acting at the same time. Furthermore, they are based upon differential equations which only have numerical solutions. Economists attempt to force square pegs into round holes and then claim that they fit.

      I do not with to disagree with Pavlos Papageorgiou’s general arguments only to the use of the word “model”!

    • July 26, 2018 at 3:25 pm

      Pavlos Papageorgiou (July 26, 2018 at 10:30 am)

      Micro-founations in economics normally means the act to explain macroeconomics or other field of economics by neoclassical general equilibrium model. Many of heterodox economists and I are opposed to this general equilibrium theory on various reasons. Sonnenschein-Mantel-Debreu theorem is one of them. (I am not thinking that this theorem is not so crucial evidence that general equilibrium theory is false.)

      In my opinion, it is necessary (1) to build a new micro-theory that can be a basis of economic analysis and (2) to try to explain macroeconomic phenomena by this theory and many observed facts. As for (1), I am thinking that such basic theory is almost constructed.

  4. Franklin
    July 26, 2018 at 3:26 pm

    Honestly i agree with this post. For too long the value of economics is seen not in the usefulness of the various existing models but the brains behind them. Instead of economists to wake up to the reality of the usefullessness of there models to real word issues they are busy working with models that have failed even themselves. Economists have failed to realize that what works out there is nothing but idea. A business man does not go looking for an economics textbook to solve his economic woes. Thus if economics does not include idea as its foundation then it,ll never get in touch with reality. Economic models that have no relationship with idea is bound to fail because real life solution and issues lies in idea

  5. July 26, 2018 at 6:02 pm

    It is true that mainstream economics could not show that a system under reasonable assumptions converges to equilibrium. However, Lars Syll and readers of this blog should know that there exists now a more realistic system that shows a strong stability property. Of course, the system is totally different from neoclassical general equilibrium one (or Arrow-Debreu type competitive economy).

    The new system is composed of (large number of) firms and consumers. Managers of firms have only a myopic view (they only know prices of their inputs or possible substitues) and minimal rationality (calculate an average of each day sales). The network of production can be highly complex, because input products are produced by means of labor and arbitrary number of produced products. The final demand (for each product) is composed of two groups. One is the consumers’ demand. It may change day by day. The second group of final demand consists of investments in fixed capital goods (installments and equipments). Taniguchi and Morioka proved that this roughly described quantity adjustment process can follow the slow change of final demand flows. If the demand remains constant for a certain length of time, the process converges to production level that gives the net product equal to the final demand.

    Together with modernized classical theory of values, we have now better and firm theory on which to advance micro and macro analyses. It is now time to go one step forward. The era of criticism alone is over.

  6. Helen Sakho
    July 27, 2018 at 5:23 am

    I would add something to agree with most of what colleagues have said, and perhaps added a few words on economic models, but quite honestly (I know, it’s a sign of backwardness for a staunch feminist) I am always completely turned off when I see the “F” word. Please do watch an episode of “Mind your Language”. I strongly recommend it.

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