There’s no war now. Pragmatic microfoundationists and an empirical macro that uses minimal theory has taken over.

Simon Wren Lewis’ latest post on Mainlymacro rails against what he sees as an overemphasis on microfoundations in macro models.  Paul Krugman picked up this post, and it was reblogged and retweeted by Brad DeLong and probably others, referring to the notion of ‘macro wars’, between those who microfound, and those who don’t.  Simon points in particular to the failure to incorporate downward nominal rigidity in wages, and other features that spring from behavioural economics.

To recap for the uninitiated, a model that is ‘microfounded’ is one in which you write down explicitly what it is the firms and consumers in the model are trying to do, and what constraints are placed on them when they try to do it.  Microfoundations came to be seen as important for a very good reason.  Namely Robert E Lucas Jnr’s work showing that models that didn’t articulate exactly what agents were doing, but instead just relied on correlations between macro time series, could give very unreliable policy advice.  The example topical at the time was the apparent tendency for unemployment to fall as inflation rose (the long run Phillips Curve).  A tendency that disappears (at least in post Lucas Critique models) if policymakers try to exploit it to lower unemployment permanently.  The risk with non-microfounded models is that all you have is a set of difference equations that don’t really have any economic meaning at all.

First point.  Some notable microfounders have looked at downward nominal rigidity in otherwise standard and microfounded real business cycle models.  For example, this paper by Schmitt-Grohe and Uribe, models the periphery of Europe as suffering from downward nominal wage rigidity;  a credit boom pumps up nominal wages, and then when the crash comes, unemployment soars because wages don’t fall.  Another example:  this paper by Junil Kim, looking a the optimal inflation rate.  Or take this paper by the two Maliars, prominent in the literature on numerical methods for real business cycle models, putting downward nominal wage rigidity into a heterogeneous agent model.   In finance, the idea is alive and well too.  For example this paper by Cohen and coauthors, which goes back to an old 1975 paper by Modigliani and Cohn, arguing that stock prices behave as though investors have nominal illusion.  (Probably one of the necessary ingredients for downward nominal wage rigidity).  Or this, on a similar theme, by Monica Piazzesi, a prominent finance academic who will have started out life learning Lucas’ microfounded model of asset pricing.

There are many other examples too where authors drop the assumption that agents are maximisers or know all about the workings of the model.  Tom Sargent, George Evans and Seppo Honkapohja made their living studying what happens when agents have to learn about the model in the same way that econometricians do.  It is common for modern DSGE models to have rule of thumb consumers that make no complicated intertemporal decision, but simply eat what they earn.

The practice of building in a friction into macro models without explaining where it comes from is extremely widespread.  The ‘New Monetarists’ that revolve around Randall Wright and Steve Williamson would say that all modern New Keynesian models fall foul of this.  The apparently microfounded practice of including (symmetrically) sticky prices and wages is a case in point.  Most users of these models acknowledge that this aspect is not seriously microfounded, and is in fact simply a way of getting real business cycle models to fit the data.  (Even Nobuhiro Kiyotaki, who co-invented it with Olivier Blanchard, called the sticky price part of the model ‘a fairy story’).

In the heterogeneous agents literature, which began as a direct outgrowth of the old Lucas/Kydland/Prescott business cycle models, a key aspect of the model is how agents can store their wealth, if at all.  What kinds of assets can they save into?  Many assume, realistically, that there are very few assets that the typical consumer has access to.  But without explaining why in the model (without microfounding in other words).  In their elegant summary of the state of the art in this literature, Heathcote et al call this a division between ‘model what you see’ and ‘model what you can microfound’.  The same issue colours open economy macro, where results differ markedly between environments where markets are complete and where they are assumed, without microfounding, that they are not.  The literature on credit frictions which the financial crisis has breathed life into also contains many examples of ad-hocery;  the assumption that firms issue standard non-contingent debt, and usually only one period debt.  Borrowing constraints that relate what someone can borrow to the value of their collateral.  All common sense, but not microfounded in the models themselves.

Simon worries that the influence of these microfounded models is too great in our policy institutions.  Well, I’d like to reassure him on that point.  In the Bank of England, generous use is made of other models, and judgement overlaid on the main DSGE model.  Second, many of those who produce the forecast and many of the policymakers have had no direct exposure to these models in their careers, and consequently don’t really understand them.  Many think exactly in terms of older, non microfounded models that Simon and PK would prefer.  There may be much less to worry about than Simon thinks! (At least in the UK).

Perhaps a third of macroeconomists either specialise or have a toe-hold in ’empirical macroeconomics’.  Here the bread and butter model is the vector autoregression. (A system where you regress everything on lags of itself and lags of everything else).  This tool was explained to macroeconomists by Chris Sims, Nobel laureate.  The whole point of it is to avoid making ‘incredible’ assumptions that emerge from particular models.  And instead to interpret them using assumptions that would be true of many models, perhaps all models that the researcher would accept as having something sensible to say.  Debates rage in this literature about just how safe these assumptions are, but this is the proper place for atheoretical modelling, Sims would say.  Not tacking together equations that the researcher thinks roughly describe how firms or consumers go about life.

Simon’s tag-wrestlers in this complaint about microfoundations talk of ‘macro wars’.  I think by this they conceive of macro as a battle between those who are content to use IS/LM or similar models, and those who want to use real business cycle models and their descendants.    But I don’t see it like this at all.  Although the blogging community might manifest this war, and although the IS/LM model is alive and well in introductory macro courses and textbooks, in the community of those publishing in peer-reviewed journals there is no longer any war.  The pragmatic microfounders and empirical macro people have won out entirely.  (At least if you ignore a few policy institutions!).

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5 Responses to There’s no war now. Pragmatic microfoundationists and an empirical macro that uses minimal theory has taken over.

  1. daniels says:

    But the whole annoying thing is how big the discrepancy seems between the academic community you mention at the end, private sector macroeconomists either in macro consultancies or in financial institutions, and many policy institutions (some parts of the IMF’s WEO analysis and a lost of the OECD analysis come to mind).It seems academic macro has basically failed at translating the insights from the modern approach to something that would replace usually static IS/LM analysis as the typical way to analyse macroeconomics (shouldn’t be so hard- in the RBC case it’s mostly just accounting identities,supply and demand curves+some (implicit) taxes/wedges. But not sure undergraduate texbooks by people like Steve Williamson are really changing things).
    Wren Lewis may be making too much of a fuss out of nothing. But the fact remains that there’s a big divide between those who like to see inefficient pricing behaviour in product and labour markets as the main factor in business cycles (the default view in most policy institutions I gather), and those who keep looking for “equilibrium” explanations of why firms would choose not to produce more at lower prices in a recession, or why (marginal) workers wouldn’t want to work for lower wages anyways. In one view, Spanish unions are almost criminal for all the youth unemployment their wage rigidity is causing. In the other, there may be some reason to their madness. Wren Lewis and Krugman make it sound like we know the answer because we see significant delays between wage adjustments for workers who keep their job. Barro and others disagree because that wage rigidity need not say much about the wage adjustment that would have prevented someone from being fired or not being hired. As is often the case, it seems a priori equally intelligent people can look at the same facts and disagree on this.

    • Tony Yates says:

      I think you make some very good points.
      The apparently microfounded sticky price version of the real business cycle model has penetrated many central banks. But some in the original real business cycle tradition don’t accept these models as true to the cause, and are engaged in battles over the micro evidence about whether prices are sticky or not. And even though the models penetrate central banks, there are examples where life continues as it always did. For example, the Bank of England. Policymakers there get on with the job of line-drawing as they always did, and chatting often in terms that are disconnected from modern macro, while a largely poorly trained staff struggles to operate the model in the background.
      I am sure you are right about what is going on in the private sector.
      I don’t know how to explain that.
      I don’t think academics should be blamed. They are not paid to do that translating, and most of them are labouring under very tight incentives to publish in peer-reviewed journals.
      Perhaps it takes a generation or two. Students have to graduate through the microfounded programs, and then go on to lead private sector economics functions and policymaking institutions.
      Or perhaps its simply that what those economists are doing doesn’t require much more than some good nowcasting time series models, and informed chatter about what the policymakers they are trying to shadow are up to.

  2. Although … the thing that troubles me is that unless I’ve misread your posts on the subject, you actually do believe the proposition that S W-L was talking about – ie, that the lack of observed inflation is good evidence that the output gap is small. So while the literature is large enough that for nearly any X, there is some model which deals with X in a DGSE framework, it seems to me that in terms of shaping people’s intuitions about the economy, the “pragmatic” side of things isn’t really anything like influential enough compared to the “fully microfounded”. Furthermore, these things have a habit of becoming influential on a just-too-late basis – nowadays, we hear all sorts about the modelling of financial frictions and crises in a microfounded framework, but back when it might have made a difference nobody wanted to know. Whatever the cause of the next crisis, there is almost certainly someone modelling it now, on their own with nobody paying attention.

    So I think that the “no war” thesis is presuming a hegemony for “pragmatic” microfoundations within the microfounded literature that doesn’t really exist. Purists have allowed small corners of pragmatism to develop, within strict and quarantined limits of how much ad-hoc-ness they’re prepared to tolerate, but still basically want the default position to be full microfoundations; it’s a state of peace that looks more like Kosovo than Sweden. And that’s in policy world – in academia, there are still people running journals and university departments who don’t believe in the existence of asset market bubbles.

    (The thing which sticks in my mind was the debate at the BoE in the 90s over the consumption effect of the Halifax demutualisation windfall. I absolutely remember that there were lots and lots of people working on that one who were *completely* resistant to any ad hoc rule, and dogmatically committed to the proposition that it would be mainly saved on permanent-income grounds. I guess maybe things changed later but a lot of the QB comments on housing equity that I was asking about the other day dealt with credit constraints in a really thin way).

    • Tony Yates says:

      Well, we could be engaging in a semantic debate, as one microfouder’s pragmatism is another’s sacrilege. But. To give you an example of what I mean. There are researchers working on models of sticky prices in the University of Chicago. Sticky price business cycle models, and models with borrowing constraints, are taught on a great many PhD programs, many staffed by the greats of the literature that followed Lucas, Sargent, Prescott, Kydland and Sims. For example: UCLA, NYU, Columbia, MIT, Harvard, UPenn, Princeton, Northwestern, LSE, UCL, Carnegie-Melon, UC Davis, U Oregon. The pragmatism has its limits. You are allowed to say ‘suppose firms won’t change prices this period no matter what’, [actually there are die-hards who won’t allow you to do that, but many of those will allow you to say ‘suppose firms won’t change prices unless the benefits exceed the costs’] or ‘suppose no-one will lend you more than y per cent of the value of your collateral no matter what’. You are not allowed to say ‘suppose aggregate consumption is a function of income and income lagged’. That breaks the rules. The BoE is not a good example of what I’m talking about (though it may be a good example of what you’re talking about when you talk about microfoundations). The debate about whether housing is net wealth or not is like a debate about the classical dichotomy. It’s about broad properties of many models, and rarely involved actually writing one down. Because back then when you were there pretty much no-one knew how to begin to. Now, there are a (frighteningly) small number who do know how to write these models down. One or two survive from the building of COMPASS, and there are maybe a dozen more recent recruits. COMPASS is a model with pragmatic microfoundations. But it is ill-understood by most staff, and most of the policymakers, and cheerfully ignored when it appears from the distance at which they sit that it should be.

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