Bookblogging: The failure of micro-based macro

Work on my book-in-progress has been slowed by other commitments, such as work on Queensland privatisation (hopefully this will get me in the right frame of mind for the privatisation chapter), but I’m still moving forward. Here’s a section on the GFC and the failure of the micro-foundations approach to macroeconomics. As always, comments much appreciated

The obvious criterion of success or failure for a macroeconomic theoretical framework is that it should provide the basis for predicting, understanding and responding to macroeconomic crises. If that criterion is applied to the current crisis, the micro-foundations approach to macroeconomics has been a near-total failure.

The failure of the dominant stream in macroeconomics was comprehensive.

First, during the bubble years the dominant approach gave little or no warning of the impending crisis. Neither sophisticated DSGE models nor the more pragmatic but less elegant micro-based models employed by the central banks gave much, if any, warning of the impending crisis.

Second, the dominant approach encouraged a benign view of the developments that gave rise to the crisis such as the growth and globalisation of the financial sector and the associated global imbalances. The boosterism of Alan Greenspan was an egregious example, but it was typical of the majority viewpoint.

Third, even as the crisis developed over the course of 2007 and 2008, its seriousness was persistently underestimated. This was exacerbated by the political context in which supporters of the Republican Administration in the US, a group little concerned with reality at the best of times, sought to deny the existence of a recession in an election year.

Fourth, the near-consensus apparent during the Great Moderation collapsed with the onset of crisis, revealing that the split between Keynesian and New Classical views had never been resolved, but merely papered over.

Fourth, it offered little or no useful guidance on the policy and theoretical issues raised by the crisis. The result that the public policy debate has been driven mostly by economists from outside the micro-foundations school. Advocacy of policies of fiscal stimulus has come, to a large extent,from economists such as Paul Krugman and Brad DeLong whose primary field is not macroeconomics, but who retain a historical understanding informed by Keynesianism. The most effective criticism has come from finance theorists like John Cochrane and Eugene Fama, mostly notable as advocates of the efficient markets hypothesis. Arguments on both sides have been couched in terms familiar to economists of 1970 and earlier, with each side accusing the other of holding views that had been refuted by the 1930s

The roots of this failure may be traced in part to problems with the micro-foundations approach itself. Micro-foundations models take general equilibrium as the starting point – modest variations of the standard classical assumptions suggest that deviations from classical properties are also likely to be modest. Macro models calibrated to the Great Moderation encouraged this assumption, as well as exclusive focus on monetary policy based on Taylor rules, which proved unavailing. The collapse of this position forced economists to shift either to the left (back to older versions of Keynesianism) or to the right (to extreme versions of classicism).

However, the broader intellectual climate of market liberalism, in which thinking about macroeconomic issues was conditioned by the assumptions of the efficient markets hypothesis and the apparent lessons of the Great Moderation. Concerns about market imbalances could not easily be reconciled with the implications of the efficient financial markets hypothesis or with the triumphalism of the Great Moderation.

9 thoughts on “Bookblogging: The failure of micro-based macro

  1. John H. Says:

    Probably better to drop this ad hom John.

    It’s ad hom but it’s accurate:

    The aide said that guys like me were ”in what we call the reality-based community,” which he defined as people who ”believe that solutions emerge from your judicious study of discernible reality.” I nodded and murmured something about enlightenment principles and empiricism. He cut me off. ”That’s not the way the world really works anymore,” he continued. ”We’re an empire now, and when we act, we create our own reality. And while you’re studying that reality — judiciously, as you will — we’ll act again, creating other new realities, which you can study too, and that’s how things will sort out. We’re history’s actors . . . and you, all of you, will be left to just study what we do.”

  2. I know it is accurate but that is not the point. It is not relevant to the subject and comments like have a tendency to alienate readers. Taking cheap shots only degrades the quality of the argument.

  3. You repeated “fourth” twice.

    Also, people saw the imbalances early on but did not understand the full scale of looming bad debts and the reliance of consumer demand on credit growth.

  4. Neither sophisticated DSGE models nor the more pragmatic but less elegant micro-based models employed by the central banks gave much, if any, warning of the impending crisis.

    John I am quite curious about this. You are always singling out DSGE… so, were the old-style, non-dynamic “General Equilibrium” models any more useful than the DSGE models? And what makes these old-style GE models more “pragmatic”?

  5. “Also, people saw the imbalances early on but did not understand the full scale of looming bad debts and the reliance of consumer demand on credit growth”.

    Many did Sean but were roundly ignored. When you see everyone else making heaps of money, prudence goes out the window.

  6. “However, the broader intellectual climate of market liberalism, in which thinking about macroeconomic issues was conditioned by the assumptions of the efficient markets hypothesis and the apparent lessons of the Great Moderation. ”

    There is something missing in this sentence – a verb, I would say. Read it again…

  7. Two things.

    One, I do not know where this passage fits in the wider scheme, or who the audience is. Certainly the technical language will present a barrier to the intelligent but uninformed reader. If it is introduced gently elsewhere, OK, but that means the work has to be read in sequence and not (say) according to the topic the reader might want to pick out – so there is still a barrier.

    Two, many years ago I did an MBA. These issues – systemic risk, etc. – were briefly touched on in the corporate finance texts (though not the lectures), basically mentioning questions some researchers had raised that the valuation techniques only assessed and predicted relative pricing and of their nature did not and could not bring out any systemic across the board issues. These questions about systemic risk were mentioned just enough to show that there was an awareness that they were open questions, that the field was not rigorously complete, but then they were simply let drop because there was nothing to be said and no idea of whether it was a material issue anyway. But at any rate there was an awareness of the incompleteness, i.e. it’s not something that has only just come up as a new idea.

    For what it’s worth, I was interested enough in how balancing out alpha and beta and so on could be sustained that I modelled a simple system that wasn’t being managed (modelling real non-cash quantities using repeated composition of probability generating functions), to see what managing could have to work on. Interestingly, if the expectation was shrinking, the variance shrank at the same exponential rate, but if the expectation was growing, the variance grew at twice its exponential rate (when the expectation was constant, the variance grew linearly) – no matter what the initial variance and expectation were, eventually the negative value from the former would dominate. Now, I know the limits of such models; this didn’t predict anything, but it raised the possibility that – regardless of how you managed one underlying asset against others – the underlying things might have risks that grew faster than expectations, so that eventually they overwhelmed them no matter how you hedged things. This is something to be checked by better analysis and more (and more suitable) data, but it least it told me something about just what the open endedness of the systemic risk question could be leaving open.

  8. If assets markets are not efficient, the combination of Taylor rules and leveraging create volcanic effervescence. This combination is highly dangerous. It is not merely that targeting inflation results in a lack of attention to asset bubbles.
    Take a pool of Chinese saving looking to buy US assets. Add fractional reserve banking. The banks extend overdrafts to permit highly leveraged (paper and real) asset purchases and expand the money supply in the process. Add a flat LM (central banks supply as much cash as banks want so that they can lend a multiple of this money base). Central banks under their Taylor rule inject even more fuel into the asset bubble machine. The dynamics are explosive.
    Hyman Minsky’s financial instability hypothesis is enough to explain much of what has happened, but Taylor rules may have turbocharged the process.

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