Cutting-edge macroeconomics …

from Lars Syll

No sooner had I finished my comment on the irrelevancy of economics but I had confirmation — albeit unwittingly — in this morning’s Financial Times.  There on the editorial page was a short column by Soumaya Keynes talking about the rise of Hank.

For those of you not on the cutting edge, “Hank” stands for Heterogeneous Agent New Keynesian, as in a complicated model of the economy.

Hank is a whole new way of looking at model economies, with the really big breakthrough being that it includes — roll the drums please — more than one household.

Yes, economists are moving at a rapid pace.  Their research has shown that the economy includes more than one household.

Gasp.

If you are a sociologist or anthropologist you are forgiven at this point for laughing out loud.

Reflect, if you will, on the enormous hubris expressed by Steve Levitt when he criticized economics for becoming too inwardly focused and potentially irrelevant.  His condemnation was absolute.  He said that economics risked falling into the kind of disrepair that, in his mind at least, make sociology and anthropology laughingstocks.  Now, I don’t know sociology or anthropology all that well, but I imagine they don’t base a substantial amount of their theoretical effort on the notion that America has only one household.  Even if that household is “representative”.

Representative of what?  Some Chicago-trained logician masquerading as an economist?

Peter Radford

Yes indeed, ‘Hank’ and similar modelling approaches are nothing but convenient untruths — and still economists rely on them to derive policy implications!

Mainstream economists seem to be impressed by the ‘rigour’ brought to macroeconomics by New-Classical-New-Keynesian DSGE models and its rational expectations and representative agent micro-foundations. It is difficult to see why.

Take the rational expectations assumption. Rational expectations in the mainstream economists’ world imply 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 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 crises 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 forward 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 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.

The kind of knowledge and information we seek in science is something different from what we look for in fiction. Building ‘fictional’ models that we all know are false — not only in the sense that they idealize or abstract from some things (all models do) — in the sense that no matter how many corrections, amendments or ‘successive approximations’ are made, they will never be true of the real-world phenomenon they try to describe or analyze, can’t be the right way to proceed in science. Although that kind of model assumption (often of a mathematical kind) is necessary from a tractability point of view, they are far from harmless since they usually are not possible to ‘relax.’ What drives them is their exact necessary form without which the sought-after results would never obtain. If this kind of economic model — as argued by some economic methodologists — gives us the same kind of knowledge as we get in ordinary fiction, well, then surely we should seriously reconsider what we are doing. Letting tractability, rather than reason, decide what assumptions we make in our theories and models, is not what we need if we want to build a realist and relevant economic science.

Mainstream economists think there is a gain from the DSGE style of modelling in its capacity to offer some kind of structure around which to organise discussions. To me, that sounds more like religious theoretical-methodological dogma, where one paradigm rules in divine hegemony. That’s not progress. That’s the death of economics as a science.

Showing that something is possible in a ‘possible world’ doesn’t give us a justified license to infer that it therefore also is possible in the real world. ‘The Great Gatsby’ is a wonderful novel, but if you truly want to learn about what is going on in the world of finance, I would recommend rather reading Minsky or Keynes and directly confronting real-world finance.

The assumptions and descriptions we use in our modelling have to be true — or at least ‘harmlessly’ false — and give a sufficiently detailed characterization of the mechanisms and forces at work. Models in mainstream economics do nothing of the kind.

Our aspirations have to be more far-reaching than just constructing coherent and ‘credible’ models about ‘possible worlds’. We want to understand and explain ‘difference-making’ in the real world and not just in some made-up fantasy world.  Science has to be something more than just more or less realistic ‘story-telling’ or ‘explanatory fictionalism’. You have to provide decisive empirical evidence that what you can infer in your model also helps us to uncover what actually goes on in the real world.  If you fail to support your models in that way,  you come up with nothing that holds as an explanation of what goes on in the world in which we live.

Postulating ‘representative agents’ equipped with ‘rational expectations’ may help mainstream economists derive sought-after results like ‘equilibrium’, ‘stability’ and downward-sloping demand curves. But telling us that something is possible in a patently artificial fictional world inhabited by ‘representative agents’ equipped with ‘rational expectations’ is not enough. Showing us that something possibly can happen in a model world, is not enough to explain what actually happens in the real world.