Macro Economic Theory in Crisis

In the wake of the Great Recession, there has been a growing cacophony of calls to do something about macro-economic theory. There is a growing realization that economic models have a lot of simplifying assumptions that we have ignored or forgotten about when forming economic policy. What Paul De Grauwe wrote is just one example out of many:

How to resolve this crisis in macro-economics? The field must be revamped fundamentally. Some of its shortcomings are obvious. Before the financial crisis, most macroeconomists were blinded by the idea that efficient markets would take care of themselves. They did not bother to put financial markets and the banking sector into their models. This is a major flaw.

There is a deeper problem, though, that will be more difficult to resolve. This is the underlying paradigm of macroeconomic models. Mainstream models take the view that economic agents are superbly informed and understand the deep complexities of the world. In the jargon, they have “rational expectations”. Not only that. Since they all understand the same “truth”, they all act in the same way. Thus modelling the behaviour of just one agent (the “representative” consumer and the “representative” producer) is all one has to do to fully describe the intricacies of the world. Rarely has such a ludicrous idea been taken so seriously by so many academics…

The basic error of modern macro-economics is the belief that the economy is simply the sum of microeconomic decisions of rational agents. But the economy is more than that. The interactions of these decisions create collective movements that are not visible at the micro level.

Understand your assumptions

What a lot of modelers have forgotten is the first rule about model building: understand your assumptions.

Under what circumstances will the model fail?

If you can’t answer that question, or if you believe that the model works under all conditions, then you haven’t fully thought through the modeling process.


Inflation-deflation timer

Take the example of my inflation-deflation timer. While the backtest results look promising, when does this asset allocation model fail?

The inflation-deflation timer was built for a bifurcated environment where investor sentiment is likely to move from one extreme of inflationary heat to the other extreme of deflationary freeze, but not much in between. If other factors were to emerge in the years to come that drives growth patterns, e.g. nanotechnology becomes a transformative technology or the emergence of longer human lifespans changes investment and consumption patterns, the performance of the inflation-deflation timer would become unstable.

I try to think about the basic underlying assumptions behind my models. Do macro-economists do the same? Do you?

Comments

[Dave Wrixon:]

I think the real problem is not so much that it doesn't work, but that successive Fed Chairmen have contrived to disguise the fact that they are totally ignoring it.

Sep 28 01:13 PM

[bob adamson:]

Arguably, we ask too much of macroeconomics and thereby forsake the utility it can offer, properly construed and applied. The two paragraphs may seem tedious but the set the stage to illustrate this argument.

To what system of thought is macroeconomics most analogous? For arguments sake, consider the following categories: (a) mathematics (i.e. a near perfect expression of pure logic), (b) a ‘hard’ science (i.e. like physics or chemistry that applies mathematics to observation in the real world), (c) a social science (i.e. like sociology or anthropology that applies mathematics or logic to observations about society), (d) an applied science (i.e. a systematic application of the findings of a ‘hard’ science or social science to deal with ‘real’ world situations) or (e) a faith system (i.e. a religion or magical belief system to help us make some sense and take action on issues beyond the scope of categories (a) to (d)). Viewing these five categories as a spectrum, are we not on firmest ground if we see macroeconomics as an example of category (d)? Don’t we overreach ourselves when viewing some school of economic thought as falling firmly into category (c) and especially if viewed as a category (a) or (b)? Don’t we risk treating some school of macroeconomics as a category (e) if we become overly frustrated with the reactions of others who disagree with us when we present finding of that school from a category (a), (b) or (c) perspective?

The questions just posed are rhetorical in support of the assertion that macroeconomics is best viewed as an applied science based on very tentative assumptions of a social science nature. In other words, the structure and assumptions of each current school of macroeconomics are too incomplete, unproven and tentative (if considered objectively) to qualify as a well established and widely accepted social science but they form a platform for public policy analysis and debate. The operation of the global economy and the modern nation state requires that such debate take place, thus there is a real need for macroeconomic platforms to frame that debate.

Others will note the limitations of macroeconomics as a social science. This prompts the observation that, even in a physical science such as physics, uncertainty is intrinsic at some level of inquiry; witness the Heisenberg uncertainty principle which postulates that any attempt to measure or observe a physical process entails disturbance of that process and therefore the validity of the observation or measurement. Even the attempt to establish an irrefutable foundation for mathematics has been shown to be futile. That said, we don’t reject the intellectual or practical utility of the study of physics or mathematics simply because absolute “truth” cannot be so uncovered fully. Rather, we look to such study to find unique insights and clues into our existence (insights and clues that may, however, have to be qualified or superseded by later findings).

The axioms upon which a social science such as macroeconomics is founded are generally, at root, intrinsically more tentative than those of mathematic or physics. Further, the systematic public policy application of some finding of some school of macroeconomics at some point of time itself changes the economy (note the Heisenberg uncertainty principle reference above) but we still (despite this tentative and ever shifting environment) need to find as best we can clues and insights to better manage national and international economic development and performance. The alternative of falling into dogmatic rigidity is unacceptable.

Sep 28 05:15 PM

[bob adamson:]

The second sentence in my comments above should have read:

"The two following paragraphs may seem tedious but the set the stage to illustrate this argument."

Sep 28 05:18 PM

[derryl:]

A long ago undergrad buddy of mine complained that economics assumes away all the most interesting questions. This was in the early 70s when economics was beginning to try to establish itself as more of a mathematical art than a 'soft' social science. Factors in social sciences (i.e about us humans) are hard to categorize and quantify, so to mathematize our economic behavior you have to assume away most of our quirks.

But realistically, I think macro belongs in the social science category. Sure we get trends, but they are discontinuous and nobody can predict when they will turn. 'Permabears' can lose years of upside just by 'knowing' that markets must eventually come down 'based on fundamentals'. 'Permabulls routinely have their backsides handed to them on a platter when the worm turns and "who could have seen it coming?", aside from the few who were watching the growth of financial imbalances and recognized what the consequences of financial arithmetic must be.

Macro is a mix of philosophy, political science and political economy, sociology, financial arithmetic, unpredictable scientific advances, unpredictable geopolitical events, and many other causal influences. Macro is the 'big picture' view. It has so many moving parts that almost nobody ever sees them all at once to get a good clear view of this ephemeral 'big picture'. Anybody can make correct predictions, sometimes, or for awhile, by seeing only the part of the picture where the heavy lifting is presently occurring. But then another factor rises up, changes everything, and predictions go the wrong way.

Macro is by far the best tool for analyzing and making some kind of sense of the past, just because macro really can look at 'everything' that may have influenced events. But even physics, which is considered the 'hardest' science of them all, must make do with probabilities rather than certainties about future outcomes. Quantum physics knows that Newton's "laws" of nature are merely laws of averages that apply at our medio level of ordinary experience. At the micro (subatomic) and macro (cosmological) scales Newton's averages are routinely violated, which is possible because in fact there are no hard laws. Only interactions and probabilities. The improbable can occur without violating nature's ways. And the improbable does occur, often.

Economists are mocked for being of the "but on the other hand" variety. Really, though, that's the best we get when trying to predict the future. We can identify causal factors, attempt to weight their near term influence, and get an educated guess about what's coming down the pipeline. But there's no guarantee we identified the right factors or weighted them correctly. And by publicizing a prediction, "Markets to continue rise", we can actually contribute to bringing about that outcome.

There is real uncertainty about the future, in physics and economics both, so "but on the other hand" is just being realistic about our lack of prescience or omniscience. Those whose educated guess proves to be right make big gains, until they bet too much and lose. There are no sure things. Our mistake is in believing that mathematical models can predict the future better than the mere humans who build them.

Sep 29 10:26 PM

[bob adamson:]

derryl -

Another great post.

bob adamson


On Sep 29 10:26 PM derryl wrote:

> A long ago undergrad buddy of mine complained that economics assumes
> away all the most interesting questions. This was in the early 70s
> when economics was beginning to try to establish itself as more of
> a mathematical art than a 'soft' social science. Factors in social
> sciences (i.e about us humans) are hard to categorize and quantify,
> so to mathematize our economic behavior you have to assume away most
> of our quirks.
>
> But realistically, I think macro belongs in the social science category.
> Sure we get trends, but they are discontinuous and nobody can predict
> when they will turn. 'Permabears' can lose years of upside just by
> 'knowing' that markets must eventually come down 'based on fundamentals'.
> 'Permabulls routinely have their backsides handed to them on a platter
> when the worm turns and "who could have seen it coming?", aside from
> the few who were watching the growth of financial imbalances and
> recognized what the consequences of financial arithmetic must be.
>
>
> Macro is a mix of philosophy, political science and political economy,
> sociology, financial arithmetic, unpredictable scientific advances,
> unpredictable geopolitical events, and many other causal influences.
> Macro is the 'big picture' view. It has so many moving parts that
> almost nobody ever sees them all at once to get a good clear view
> of this ephemeral 'big picture'. Anybody can make correct predictions,
> sometimes, or for awhile, by seeing only the part of the picture
> where the heavy lifting is presently occurring. But then another
> factor rises up, changes everything, and predictions go the wrong
> way.
>
> Macro is by far the best tool for analyzing and making some kind
> of sense of the past, just because macro really can look at 'everything'
> that may have influenced events. But even physics, which is considered
> the 'hardest' science of them all, must make do with probabilities
> rather than certainties about future outcomes. Quantum physics knows
> that Newton's "laws" of nature are merely laws of averages that apply
> at our medio level of ordinary experience. At the micro (subatomic)
> and macro (cosmological) scales Newton's averages are routinely violated,
> which is possible because in fact there are no hard laws. Only interactions
> and probabilities. The improbable can occur without violating nature's
> ways. And the improbable does occur, often.
>
> Economists are mocked for being of the "but on the other hand" variety.
> Really, though, that's the best we get when trying to predict the
> future. We can identify causal factors, attempt to weight their near
> term influence, and get an educated guess about what's coming down
> the pipeline. But there's no guarantee we identified the right factors
> or weighted them correctly. And by publicizing a prediction, "Markets
> to continue rise", we can actually contribute to bringing about that
> outcome.
>
> There is real uncertainty about the future, in physics and economics
> both, so "but on the other hand" is just being realistic about our
> lack of prescience or omniscience. Those whose educated guess proves
> to be right make big gains, until they bet too much and lose. There
> are no sure things. Our mistake is in believing that mathematical
> models can predict the future better than the mere humans who build
> them.

Sep 30 12:15 AM

[john s. gordon:]

one observer once said that if all the economists in the country were laid end to end they wouldn't even reach a conclusion.
> jack

Sep 30 08:44 AM