Home > Uncategorized > Microfoundations and economic policy choices

Microfoundations and economic policy choices

Lars Syll

41I1CkwyXjLSince there will generally be many micro foundations consistent with some given aggregate pattern, empirical support for an aggregate hypothesis does not constitute empirical support for any particular micro foundation … Lucas himself points out that short-term macroeconomic forecasting models work perfectly well without choice-theoretic foundations: “But if one wants to know how behaviour is likely to change under some change in policy, it is necessary to model the way people make choices” (Snowdon and Vane 2005, interview with Robert Lucas). The question, of course, is why on earth would one insist on deriving policy implications from foundations that deliberately misrepresent actual behavior?

Yes, indeed, why would one?

Defenders of microfoundations and its rational expectations equipped representative agent’s intertemporal optimization often argue as if sticking with simple representative agent macroeconomic models doesn’t impart a bias to the analysis. Yours truly unequivocally reject that unsubstantiated view.

These defenders often also maintain that there are no methodologically coherent alternatives to microfoundations modelling. That allegation is, of course, difficult to evaluate, substantially hinging on how coherence is defined. But one thing I do know, is that the kind of microfoundationalist macroeconomics that New Classical economists and ‘New Keynesian’ economists are pursuing are not methodologically coherent according to the standard coherence definition (see e. g. here). And that ought to be rather embarrassing for those ilks of macroeconomists to whom axiomatics and deductivity is the hallmark of science tout court.

The fact that Lucas introduced rational expectations as a consistency axiom is not really an argument to why we should accept it as an acceptable assumption in a theory or model purporting to explain real macroeconomic processes (see e. g. here). And although virtually any macroeconomic empirical claim is contestable, so is any claim in micro (see e. g. here).

Using formal mathematical modelling, mainstream economists sure can guarantee that the conclusions hold given the assumptions. However, the validity we get in abstract model-worlds does not warrantly transfer to real-world economies. Validity may be good, but it isn’t enough. From a realist perspective, both relevance and soundness are sine qua non.

broken-linkIn their search for validity, rigour and precision, mainstream macro modellers of various ilks construct microfounded DSGE models that standardly assume rational expectations, Walrasian market clearing, unique equilibria, time invariance, linear separability and homogeneity of both inputs/outputs and technology, infinitely lived intertemporally optimizing representative household/ consumer/producer agents with homothetic and identical preferences, etc., etc. At the same time, the models standardly ignore complexity, diversity, uncertainty, coordination problems, non-market clearing prices, real aggregation problems, emergence, expectations formation, etc., etc.

The predominant strategy in mainstream macroeconomics today is to build models and make things happen in these ‘analogue-economy models.’ But although macro-econometrics may have supplied economists with rigorous replicas of real economies, if the goal of theory is to be able to make accurate forecasts or explain what happens in real economies, this ability to — ad nauseam — construct toy models, does not give much leverage.

‘Rigorous’ and ‘precise’ New Classical models — and that goes for the ‘New Keynesian’ variety too — 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.

And — applying a ‘Lucas critique’ on New Classical and ‘New Keynesian’ models, it is obvious that they too fail.

Changing ‘policy rules’ cannot just be presumed not to influence investment and consumption behaviour and a fortiori technology, thereby contradicting the invariance assumption. Technology and tastes cannot live up to the status of an economy’s deep and structurally stable Holy Grail. They too are part and parcel of an ever-changing and open economy. Lucas hope of being able to model the economy as ‘a FORTRAN program’ and ‘gain some confidence that the component parts of the program are in some sense reliable prior to running it’ therefore seems – from an ontological point of view – totally misdirected. The failure in the attempt to anchor the analysis in the alleged stable deep parameters ‘tastes’ and ‘technology’ shows that if you neglect ontological considerations pertaining to the target system, ultimately reality gets its revenge when at last questions of bridging and exportation of model exercises are laid on the table.

keynes-right-and-wrong

Mainstream economists are proud of having an ever-growing smorgasbord of models to cherry-pick from (as long as, of course, the models do not question the standard modelling strategy) when performing their analyses. The ‘rigorous’ and ‘precise’ deductions made in these closed models, however, are not in any way matched by a similar stringency or precision when it comes to what ought to be the most important stage of any research — making statements and explaining things in real economies. Although almost every mainstream economist holds the view that thought-experimental modelling has to be followed by confronting the models with reality — which is what they indirectly want to predict/explain/understand using their models — they all of a sudden become exceedingly vague and imprecise. It is as if all the intellectual force has been invested in the modelling stage and nothing is left for what really matters — what exactly do these models teach us about real economies.

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 millimetre 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 per se say anything about real-world economies.

Proving things ‘rigorously’ in mathematical 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.

  1. Yoshinori Shiozawa
    December 20, 2019 at 1:19 am

    What is now necessary is not to criticize the Lucas critique more than 40 years later. It is useless to criticize microfoundations of New Classical or New Keynesian macroeconomic models. They are efforts in vain. As the old dictum put it, it takes a theory to beat a theory. What we really need is to build true microfoundations for our heterodox macroeconomic theories. Many of Post Keynesian macroeconomic models lack microfoundations and remain at the level of intuitive and primitive arguments.

    Of course, the microeconomics that should give foundations to our macroeconomic models must not be rudimentary or sophisticated neoclassical theories based on equilibrium, marginal productivity and utility optimization, i.e. neoclassical microeconomics. We need a new, more realistic, microeconomics.

    The analytical framework we propose is such a microeconomics and affords microfoundations both for Post Keynesian and evolutionary economics. Please check whether my contention is too bold and boastful.
    https://www.researchgate.net/publication/334508762_Microfoundations_of_Evolutionary_Economics

  2. Edward Zimmer
    December 20, 2019 at 8:58 pm

    In the real world of goods/service businesses, we use an earnings statement (double-entry accounting of all asset, liability, revenue, expense transactions). We have expectations on revenue & expense amounts (daily, weekly or monthly accumulations depending on business). When the amounts deviate from expectations, we drill down into the subsidiary revenue/expense accounts to find the source of the deviation & assess our options for correcting it. Even for a small business, the possibilities are endless. One can formulate a procedure for conducting this drill-down, but I believe trying to do more (eg, logically or mathematically predicting the solution) is impossible.

    • Yoshinori Shiozawa
      December 21, 2019 at 3:48 pm

      As “evidence-based economist” (in his answers to other Syll’s post) put it, “prediction” is only a specific effort among huge number of scientific theory making possibilities. Only in economics, mainstream as well as many heterodox economists are indoctrinated by “prediction” worship monotheism. We should first escape from that indoctrination.

      • Edward Zimmer
        December 21, 2019 at 4:25 pm

        This is interesting. What are these other “theory-making possibilities” & what is their objective if not “prediction”? I’m an engineer/entrepreneur – not an economist – & in my eyes the pursuit of all understanding is to better foresee the likely results of my actions.

      • Yoshinori Shiozawa
        December 22, 2019 at 3:24 am

        Edward,

        Please first see Michael Joffe’s WEB page:
        https://evidence-based-economics.org/
        You may get basic information on making theories without “prediction.”

        If you are an engineer, your primary task is making something and not predicting. In economics, we have a field called mechanism design. I myself am working in a very different field called microfoundations. Its task is to understand how the complex system as the economy works. It covers the whole globe and contains several billions of people and hundreds of millions of firms. It trades probably more than tens of million commodities (products and services). Although it is not as complex as human brains or a multicellular organism or even a single cell of eukaryote, it is quite complex and requires theories that may help to understand how it works.

  3. December 21, 2019 at 9:39 pm

    “It is better to be roughly right than precisely wrong” (Keynes). “What we really need is to build true microfoundations for our heterodox macroeconomic theories” (Yoshinori). I think Yoshinori is precisely wrong: that we need to build true MACRO foundations for our microtheories, i.e. foundations which deliver truly different Keynesian tendencies rather than precise results. “When the amounts deviate from expectations, we drill down into the subsidiary revenue/expense accounts to find the source of the deviation & assess our options for correcting it” (Edward). That sounds to me like Shannon’s communication theory, in which we expect things to go wrong and make provision for detecting and correcting them. It sounds to me like Wiener’s cybernetics, the paradigm in which the dynamic PID logic of navigation corrects errors whatever the journey and however much of it has been completed; whatever the vessel/crew (society) or cargo (economic activity). As Edward says, “the pursuit of all understanding is to better foresee the likely results of my actions”; which is good enough reason for heterodox economists to study the theory of navigation rather than the risks of it.

    • Yoshinori Shiozawa
      December 23, 2019 at 7:32 am

      Dave and Edward,

      Long history of macroeconomic management tells that it is doubtful whether there exists a good steering rule (“governing” in the sense of Wiener) of macroeconomic variables. Such a possibility is not closed but most probably it is a pure aspiration.

      Idea of asking for macrofoundations of microeconomics is not new. Takashi Negishi referred to the idea in the Preface to his book Microeconomic Foundations of Keynesian Economics (1979). Negishi thought that we have an (almost) good macroeconomics (i.e. Keynesian economics) and what is needed is to find microeconomics that is more adapted to Keynesian economics and policies. What Negishi actually did in his book was a trial to justify macroeconomics by means of non-Walrasian economics. This research program has an origin in the works of Clower and Leijonhufvud and was developed by Benacy, Drèze and Malinvaud. It failed and Lucas’s rational expectation “revolution” came soon after it.

      Dave may not see any difference between non-Walrasian economics and our microeconomics, but they are essentially different. The former is based on disequilibrium analysis, whereas our theory is genuine process analysis (or sequence analysis) which traces how economic states change when human agents (with bounded sight and rationality) react to the situation known to them. No notions of equilibrium or disequilibrium are used. (NB: Disequilibrium is a concept which makes sense when we admit equilibrium notion.)

  4. ghholtham
    December 21, 2019 at 10:47 pm

    Representative agent theorising coupled with the assumption of equilibrium is a failed research strategy. It has no intellectual integrity and no explanatory power relative to a primitive income-expenditure model. I agree it is taking an unconscionable time to die but Yoshinori Shiozawa is right that it will linger on until a more respectable and fruitful approach is found and adopted. My hunch is that approach will be based on a diverse population following reasonable procedures in the presence of uncertainty and the system will be evolutionary and will not be in general equilibrium. Mr Shiozawa’s own work avoids equilibrium assumptions; it fits better an industrial economy rather than one based on extraction or agriculture or one which is heavily financialized. We need to develop such heterodox approaches in order to make progress. Dave Taylor has a point too in that individual behaviour is influenced by macroeconomic outcomes. It is not simply a case of aggregating individual decisions; there are feedback loops from macro to micro. It seems clear that computer simulation of such structures will be necessary to generate useful results. There will be no useful theorems reached by analytic solution of simple models. The theory of choice has its uses in improving operations and methods or in designing auctions but has limited explanatory power in macroeconomics.

  5. Edward Zimmer
    December 22, 2019 at 8:26 pm

    I’m likely the dunce at this party, but isn’t the KISS principle being ignored? Doesn’t “reality” have to be grounded in accurate definitions & measurements? I come away from economist papers & blogs with the feeling they’re little more than attempts at counting the number of angels that fit on the head of a pin. The only place I see real definitions/measurements being attempted is in the NIPA accounts (despite the many known problems with the data & methodology). I look at NGDP/NGDI & see an earnings statement for the essential part of an economy – one that’s crying for management by a competent comptroller. Yet I see little effort from the economics community to effectuate such a system – instead I see that effort going into the Fed’s FOFA program, which looks to me like a lost cause

    • Craig
      December 22, 2019 at 10:00 pm

      The basic systemic and temporal universe operations of a new paradigm are always very simple themselves.

      Hunting and Gathering societies simply stopped seemingly necessary enforced moving around and stayed in place. They stopped chasing game to survive and bred and confined them to eat and profit from. In other words, they did the opposite of what they were doing before because it increased their abundance.
      The Reformation was simply the ending of a monopoly power. It was the ending of an arbitrary and indirect rule regarding absolution/resolution of the problem of sin only being available via the sacraments of the Roman Catholic Church, and the realization that one could have a direct and reciprocal relationship with god instead.

      The Copernican cosmological paradigm change was simply the inversion of the positions of the earth and the sun. That inversion was also a transformation in the mind of mankind, a complete inversion of assumed scientific and unchangeable realities, an increase in scientific knowledge and a cutting through and undoing of complexities and orthodoxies that had built up around the former terra-centric paradigm.

      The new paradigm of monetary gifting is simply the opposite of the enforcement of the current Debt Only/Burden/Repayment monetary and financial paradigm.

      Monetary gifting simply ends the monopoly power of credit creation and the equally monopoly paradigm of Debt Only as the sole form and vehicle for the distribution of money. It is the simple realization that a direct and reciprocal monetary and price policy at retail sale enables all agents to better accomplish and partake in the universal purposes of economics, namely production, profit and consumption.

      Direct and reciprocal monetary gifting simply inverts and transforms the individual and systemic monetary realities of scarcity and austerity into abundance for all. It ends the fallaciously assumed orthodoxy that injecting more money into the economy will result in inflation and shows how the timely and strategic injection of more money at retail sale enables the simple and actual solution to the problem of inflation. It increases our knowledge of the economic process and the significances of the point of retail sale and cuts through and undoes many of the complexities and orthodoxies that have built up around the paradigm of Debt Only.

    • Yoshinori Shiozawa
      December 23, 2019 at 7:44 am

      Edward in your post December 20, 2019 at 8:58 pm put it and Dave in his post December 21, 2019 at 9:39 pm repeated it:
      “When the amounts deviate from expectations, we drill down into the subsidiary revenue/expense accounts to find the source of the deviation & assess our options for correcting it”

      I ask Edward and Dave to read my old paper (1999):
      Economics and accounting: A comparison between philosophical backgrounds of the two disciplines in view of complexity theory
      https://www.researchgate.net/publication/233943629_Economics_and_accounting_A_comparison_between_philosophical_backgrounds_of_the_two_disciplines_in_view_of_complexity_theory
      I asked in this paper why accounting reports which are summery of past records can serve as a guide for the future of our decision in the uncertain world.

  6. December 23, 2019 at 8:44 am

    KISS, Edward? The world is complex, and not just men and women disagreeing with each other. I’ve been arguing Shannon’s information paradigm has been just as significant as Newton’s mechanical one, only to be told both are nothing but stories, and theirs is better.

    Well, if we are into stories, how else can we learn about what we cannot directly experience except through stories? The most significant story is how a Father god created a wonderful world for his children, and instead of being happy by being grateful, they made themselves and their Father unhappy by wanting more. How true is that, parents?

    It’s Christmas, and I’m off to celebrate with family the Father offering forgiveness by re-enacting the story, offered another chance of personal happiness by bring grateful. He gave us the best gift on offer: himself in the form of his Son. This despite knowing by personal experience how badly that would end for his Son. As old Polly Cartland [mother of novelist Barbara] once said to our son, our first Duty is to say Thank You.

    For Goodness Sake, have a Happy Christmas! Let us rejoice and be happy, trying to work with instead of against each together in the New Year.

    • Craig
      December 23, 2019 at 5:58 pm

      Yes, everything is more enjoyable, benevolent, free flowing, unitary and complete with grace. Economists should consider it.

  7. Edward Zimmer
    December 23, 2019 at 9:54 pm

    Yoshinori: Thanks for the pointer to your Economics and Accounting paper. I found it to be pleasantly clear & readable (which I can’t say about many economics papers). You seemed to be arguing that accounting needs to play a bigger role in economics. I wholeheartedly agree. I see accounting as the objective measuring tool of economics & see little “science” in economics without that tool. Your phrase from that paper, “plan, do, see and check”, says it all. If you don’t have a reliable “check” you can believe in, you have nothing but subjective hypotheses..

    • Craig
      December 23, 2019 at 10:52 pm

      Yes, accounting is one of man’s greatest tools. The fact is that the entirety of production takes place within the structure of accounting. Money, in a healthy economy, is created as a flow against production and recalled via consumption….minus ALL costs of course, including an EVER INCREASING cost of debt service…..enforced by the present MONOPOLISTIC paradigm of Debt Only.

      Also, virtually the entire process of accounting is a DIRECT and RECIPROCAL process of credits and debits. Ever thought about that anyone? Probably not….it’s such a plain as the nose on your face/part of the woof and warp of the economy that its like breathing….we’re normally unconscious of it, but when one can’t breath they are much more likely to come into present time and cognite on breathing’s utter importance…as both a life preserving process and, in an ABUNDANTLY deep breath…so freeing.

  8. ghholtham
    December 24, 2019 at 12:07 pm

    Every useful macroeconomic model starts with a set of accounting identities based on National Accounts. Most variables correspond to a data series in National Accounts. Price variables are usually implicit deflators, calculated from national accounts. However national accounts variables are flow variables; there are no stock or state variables. Financial statistics are published showing stocks of financial assets and monetary aggregates but there are no satisfactory data for the stock of physical or intellectual capital. National statistical offices sometimes publish data on “capital stock” but these are just the result of a perpetual inventory model with arbitrary assumptions and as for intellectual capital, even the value of existing software programs – well, no-one has found a way to measure that. Various proxies have been tried, like years of schooling, number or patents, all unsatisfactory. When considering the poverty of economics remember the data limitations.

    • Edward Zimmer
      December 24, 2019 at 7:32 pm

      I believe that’s what the Fed’s FOFA program is trying to do, ie, add stock (assets/liabilities) to the NIPA account, which are flow (ie, revenue/expenses). In my view, it’s trying to measure the whole economy, ie, productive plus non-productive. No “stock” can result from the NIPA accounts (since GDP equals GDI) so any resulting “stock” must be coming from the non-productive economy (which I see as the financial industry). If we accept that currency is nothing more than coupons having no “real” value (only that perceived by its users) & understanding how variable & manipulable perception is, it’s hard to see how anything useful can come from trying to measure the economy’s “stock”

      • Craig
        December 24, 2019 at 9:38 pm

        One of the things the new paradigm does is end the paradox of thrift.

  9. Yoshinori Shiozawa
    December 24, 2019 at 2:27 pm

    Economics, management and accounting are three disciplines that emerged from the same root. Unfortunately, they are not closely related with each other now. Each became an independent science rather detached with others. All this was inevitable because microeconomics assumed infinite rationality.

    As I have cited in Subsection 1.2.1 Bounded Rationality of our book (Chapter 1. p.7, referred to in the first answer to this page), Herbert A. Simon, the standard-bearer of management science in the latter half of the 20th century and the first Nobel Prize in economic sciences in the domain of management or business administration, once declared:

    “If there is no limit to human rationality, administrative theory would be barren. It would consist of the single precept: Always select that alternative, among those available, which will lead to the most complete achievement of your goals” (Simon 1997, p.322).

    Economics needs to be changed to a science that admits bounded rationality as one of its first principles. Now there are many economists who admit it but they concede only half-heartedly and do not reflect deeply on the consequences of bounded rationality. If we once admit boundedness of our information gathering and rational reasoning capability, we should reformulate microeconomics from the foundations. We should abandon optimization and equilibrium framework. It is only at that moment that we can again recover intimate relations between three disciplines: economics, management and accounting.

    Economics should and can learn much more than now from management and accounting. Management and accounting can learn more if economics is reborn. Our book is one possible attempt of such reforms of economics.

    • Craig
      December 24, 2019 at 4:44 pm

      “We should abandon optimization and equilibrium framework. It is only at that moment that we can again recover intimate relations between three disciplines: economics, management and accounting.”

      Quite correct. And the only way to do that is recognize that the current monetary pattern/paradigm de-stabilizes the economy and thus a new monetary paradigm is necessary. It is a monetary economy after all, not a veil over barter.

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