How Not to Do Macroeconomics
A frustrating recurrence for critics of 'mainstream' economics is the assertion that they are criticising the economics of bygone days: that those phenomena which they assert economists do not consider are, in fact, at the forefront of economics research, and that the critics' ignorance demonstrates that they are out of touch with modern economics - and therefore not fit to criticise it at all.
Nowhere is this more apparent than with macroeconomics. Macroeconomists are commonly accused of failing to incorporate dynamics in the financial sector such as debt, bubbles and even banks themselves, but while this was true pre-crisis, many contemporary macroeconomic models do attempt to include such things. In fact, reputed economist Thomas Sargent charged that such criticisms "reflect either woeful ignorance or intentional disregard for what much of modern macroeconomics is about and what it has accomplished." So what has it accomplished? One attempt to model the ongoing crisis using modern macro is this recent paper by Gauti Eggertsson & Neil Mehrotra, which tries to understand secular stagnation within a typical 'overlapping generations' framework. It's quite a simple model, deliberately so, but it helps to illustrate the troubles faced by contemporary macroeconomics.
The model has only 3 types of agents: young, middle-aged and old. The young borrow from the middle, who receive an income, some of which they save for old age. Predictably, the model employs all the standard techniques that heterodox economists love to hate, such as utility maximisation and perfect foresight. However, the interesting mechanics here are not in these; instead, what concerns me is the way ‘secular stagnation’ itself is introduced. In the model, the limit to how much young agents are allowed to borrow is exogenously imposed, and deleveraging/a financial crisis begins when this amount falls for unspecified reasons, reducing total spending. In other words, in order to analyse deleveraging, Eggertson & Mehrotra simply assume that it happens, without asking why. As David Beckworth noted on twitter, this is just assuming what you want to prove. (They go on to show similar effects can occur due to a fall in population growth or an increase in inequality, but again, these changes are modelled as exogenous).
It gets worse. Recall that the idea of secular stagnation is, at heart, a story about how over the last few decades we have not been able to create enough demand with ‘real’ investment, and have subsequently relied on speculative bubbles to push demand to an acceptable level (this was certainly the angle from which Larry Summers and subsequent commentators approached the issue). It’s therefore surprising – ridiculous, in fact – that this model of secular stagnation doesn’t include banks, and has only one financial instrument: a risk-less bond that agents use to transfer wealth between generations. What’s more, as the authors state, “no aggregate savings is possible (i.e. there is no capital)”. Yes, you read that right. How on earth can our model understand why there is not enough ‘traditional’ investment (i.e. capital formation), and why we need bubbles to fill that gap, if we can have neither investment nor bubbles?
Naturally, none of these shortcomings stop Eggertson & Mehrotra from proceeding, and ending the paper in economists' favourite way...policy prescriptions! Yes, despite the fact that this model is not only unrealistic but quite clearly unfit for purpose on its own terms, and despite the fact that it has yielded no falsifiable predictions (?), the authors go on give policy advice about redistribution, monetary and fiscal policy. Considering this paper is incomprehensible to most of the public, one is forced to wonder to whom this policy advice is accountable. Note that I am not implying policymakers are puppets on the strings of macroeconomists, but things like this definitely contribute to debate - after all, secular stagnation was referenced by the Chancellor in UK parliament (though admittedly he did reject it). Furthermore, when you have economists with a platform like Paul Krugman endorsing the model, it's hard to argue that it couldn't have at least some degree of influence on policy-makers.
Now, I don't want to make general comments solely on the basis of this paper: after all, the authors themselves admit it is only a starting point. However, some of the problems I've highlighted here are not uncommon in macro: a small number of agents on whom some rather arbitrary assumptions are imposed to create loosely realistic mechanics, an unexplained 'shock' used to create a crisis. This is true of the earlier, similar paper by Eggertson & Krugman, which tries to model debt-deflation using two types of agents: 'patient' agents, who save, and 'impatient agents', who borrow. Once more, deleveraging begins when the exogenously imposed constraint on the patient agent's borrowing falls For Some Reason, and differences in the agents' respective consumption levels reduce aggregate demand as the debt is paid back. Again, there are no banks, no investment and no real financial sector. Similarly, even the far more sophisticated Markus K. Brunnermeier & Yuliy Sannikov - which actually includes investment and a financial sector - still only has two agents, and relies on exogenous shocks to drive the economy away from its steady-state.
Whither macroeconomics?Why do so many models seem to share these characteristics? Well, perhaps thanks to the Lucas Critique, macroeconomic models must be built up from optimising agents. Since modelling human behaviour is inconceivably complex, mathematical tractability forces economists to make important parameters exogenous, and to limit the number (or number of types) of agents in the model, as well as these agents' goals & motivations.
Complicated utility functions which allow for fairly common properties like relative status effects, or different levels of risk aversion at different incomes, may be possible to explore in isolation, but they're not generalisable to every case or the models become impossible to solve/indeterminate. The result is that a model which tries to explore something like secular stagnation can end up being highly stylised, to the point of missing the most important mechanics altogether. It will also be unable to incorporate other well-known developments from elsewhere in the field.
This is why I'd prefer something like Stock-Flow Consistent models, which focus on accounting relations and flows of funds, to be the norm in macroeconomics. As economists know all too well, all models abstract from some things, and when we are talking about big, systemic problems, it's not particularly important whether Maria's level of consumption is satisfying a utility function. What's important is how money and resources move around: where they come from, and how they are split - on aggregate - between investment, consumption, financial speculation and so forth. This type of methodology can help understand how the financial sector might create bubbles; or why deficits grow and shrink; or how government expenditure impacts investment. What's more, it will help us understand all of these aspects of the economy at the same time. We will not have an overwhelming number of models, each highlighting one particular mechanic, with no ex ante way of selecting between them, but one or a small number of generalisable models which can account for a large number of important phenomena.
Finally, to return to the opening paragraph, this paper may help to illustrate a lesson for both economists and their critics. The problem is not that economists are not aware of or never try to model issue x, y or z. Instead, it's that when they do consider x, y or z, they do so in an inappropriate way, shoehorning problems into a reductionist, marginalist framework, and likely making some of the most important working parts exogenous. For example, while critics might charge that economists ignore mark-up pricing, the real problem is that when economists do include mark-up pricing, the mark-up is over marginal rather than average cost, which is not what firms actually do. While critics might charge that economists pay insufficient attention to institutions, a more accurate critique is that when economists include institutions, they are generally considered as exogenous costs or constraints, without any two-way interaction between agents and institutions. While it's unfair to say economists have not done work that relaxes rational expectations, the way they do so still leaves agents pretty damn rational by most peoples' standards. And so on.
However, the specific examples are not important. It seems increasingly clear that economists' methodology, while it is at least superficially capable of including everything from behavioural economics to culture to finance, severely limits their ability to engage with certain types of questions. If you want to understand the impact of a small labour market reform, or how auctions work, or design a new market, existing economic theory (and econometrics) is the place to go. On the other hand, if you want to understand development, historical analysis has a lot more to offer than abstract theory. If you want to understand how firms work, you're better off with survey evidence and case studies (in fairness, economists themselves have been moving some way in this direction with Industrial Organisation, although if you ask me oligopoly theory has many of the same problems as macro) than marginalism. And if you want to understand macroeconomics and finance, you have to abandon the obsession with individual agents and zoom out to look at the bigger picture. Otherwise you'll just end up with an extremely narrow model that proves little except its own existence.