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.