Friday, July 20, 2012

The Problem with Microfoundations: Bad Micro

Noah Smith, Simon Wren-Lewis and Paul Krugman have already weighed in on this in different ways, but maybe the time has come to be excruciatingly blunt.  Microfoundations for macroeconomics are fine in principle—not indispensable, but useful.  The problem is that what passes for microfoundations in the universe of orthodox macro is crap.

There.  I said it.  I used the “c” word.  But not the “s” word.

It’s nothing more than robotic imitation of teaching exercises to improve math skills, without any consideration for such mundane matters as empirical verisimilitude.  I will mention three crushing faults, each sufficient by itself to blow a wide hole in a supposedly useful model.

1. Utility theory.  Andrew Gelman calls this “folk psychology”; that may be generous.  It is rife with anomalies (see “behavioral economics”), and, most important, it is oblivious to the last several decades of work in psychology, evolutionary biology, neuropsychology, organization theory—all the disciplines where people study behavior in a scientific way.

2. Mono-equilibrium assumptions.  There are no interaction effects to generate multiple equilibria in the microfoundations macro theorists use.  Every individual, firm and product is an isolated atom, floating uninterrupted through space until it bumps into another such atom in the marketplace.  Social psychology, ecology, nonconvex production and consumption spaces?  Forget about it.  In evolutionary biology, by contrast, fitness surfaces are assumed nonconvex from the get-go; it’s central to the discipline.  Failure to recognize the interactive character of economic life leads economists to ask fundamentally wrong questions, like “what’s the equilibrium?” and “what’s the optimum?”  If this isn’t obvious to you already, you can get a longer version of the argument here.  (Note for those who are wondering: no, nonconvexity stemming from interaction effects has nothing to do with market failure.  The existence of externalities is neither necessary  nor sufficient for these effects.  See for yourself.)

3. Path dependence.  Microfoundations means general equilibrium theory, but the flavor it uses is from the mid-1950s.  The Sonnenschein-Debreu-Mantel demonstration (update to the 1970s)  that initial conditions and out-of-equilibrium trades alter the equilibrium itself (they assume away problem #2) has turned GET upside down.

Notice that I haven’t mentioned the standard heterodox criticisms of representative agents and ergodicity.  You can add those if you want.

Now here’s the clincher.  As Krugman points out, faced with the choice between addressing the evidence or maintaining consistency with their microfounded models, macroeconomists as a herd have gone for the second.  This is because they believe that the micro theory they use is really, really, really true, and that no model that cannot be yoked to it can be considered scientific.  And if we actually knew with certainty that mid-50s general equilibrium theory with optimizing agents and no interactions outside the market was the only acceptable framework for thinking coherently about economics, they’d be right.  But they’re not.

Like I said, their microfoundations are crap.


Mike Sax said...

As an interested but cometimes rather bewildered layman I appreciate this piece Pete!

Get tired of hearing these guys act as if those who dispute anything they say just aren't "sublte" enough to get their beautiful models.

Unknown said...

Agreed, but what do you do with the faith based graduate students who have "drunk the kool-aid" and assert the following flawed logic in defense of scientistic micro founded macro: "And now it is the displaced Keynesian crying about the new math (dynamic programming, numerical analysis, stochastic processes) used by the neoclassical economists ushered in by the Kydland and Prescott revolution."
One would think that this type of hubris is in defence of cutting edge analysis --but it isn't; look at the applied sciences for proof: one could not run a chemical plant in the real world with such arcane thinking.

Shane Taylor said...

For anyone who hasn't yet done so, the longer version of Peter's argument is definitely worth reading. (Note: Some familiarity with linear algebra is not required, but it helps.)

Barkley Rosser said...

This why we need behavioral econ to be taken seriously. A lot of practical micro economists do so, but few macro ones, aside from the occasional outlier like George Akerlof. Such things as downward wage rigidity are well understood by behavioral economists, but not the people who provide most of the so-called foundations for most macro modeling.

Gobanian said...

@Shane what do you mean by "the longer version?"

kevin quinn said...

Peter: great post; I have just one nit to pick. You say that the presence of multiple equilibria in and of itself invalidates standard welfare evaluation. I disagree: in the paper, what seems to drive this conclusion is the endogeneity of preferences. But multiple equilibria doesn't per se imply endogenous preferences. As Voltaire said, you can kill a flock of sheep with oaths - and arsenic. The arsenic is doing all the work, though!

Anonymous said...

If they are "standard heterodox criticisms" or not I will leave for others to judge, but if anyne is interested, I would perhaps be allowed to self-indulgently recommend these two posts on my blog

Christian Gormsen said...

This post is so true.
How can this madness endure? Selection of macroeconomists surely plays a role, the microfoundations crap was the reason I did not become a macroeconomist (I'm in international trade).
But the post also underlines how the essential problem is with microeconomics. Why, why, why do we still teach Arrow-Debreu? By what criterion is it a useful model?

Mabel said...

I often encounter the complaint that neoclassical economists know they are wrong, and refuse to enter proper scientific discussions because their errors would be revealed, thereby forfeiting their intellectual ascendance. As an unreconstructed neoclassicist, I often find myself mirroring this same complaint.

So: I have started my own blog in reply to Peter Dorman’s post above:;postID=6706089624071215941

If you would care to join in, I promise to be responsive and to obey the rules of scientific discourse.