Wednesday, December 2, 2009

More on the failure of ma(i)croeconomics

From a very good article by Alan Kirman. The quote that preceeds the article is equally illuminating:

“A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.” – Max Planck, A Scientific Autobiography (1949)

The first thing that comes to mind as one follows the debate among economists about the crisis is that economic theory was locked into a bubble that has now burst. The reactions have either been to ignore this and just to wait for the crisis to pass or to herald the return of one of our old heroes, Keynes. Economists seem to be victims of extremely short memories and an inability to anticipate the next theoretical development. We periodically come to believe that we have hit upon the “right model” and that all previous efforts can be consigned to the wastebasket of history. When the current model turns out to be completely at odds with reality, the reflex reaction is to go back to the previous model and to chide the modernists for having lost sight of it. A number of economists have tried to add a little historical perspective (in particular Reinhart and Rogoff (2008) have argued that this crisis is but one of many similar events), but the debate overall remains very short-sighted and ideologically motivated.

All of this seems to be misplaced. Suppose we accept that economic theory, like the economy, is a complex adaptive system. We should then expect to see it continually evolving to take into account both new theoretical insights and the evolution of the economy itself. We will not see theory evolving into a given model that more closely represents the economy since the economy itself is changing. However, we might expect theory to evolve to at least be able to envisage the occurrence of the major crises that periodically shake the economy, and this is where the problem with the response that “we have seen all this before” arises. If we believe that such crises are an inherent feature of the evolution of economies, then surely we should develop models that incorporate them. We might then avoid the usual habit of falling back on the standard equilibrium notions and claim that some major exogenous shock has hit the system. The latter rarely identifies the shock, and it is now widely recognised that almost every significant turning point in all of the major stock price indices was accompanied by no notable news, and hence no shock at all.

A much more reasonable approach would be to accept that these large and abrupt movements are due to the endogenous dynamics of the system. What has become the standard macroeconomic model, DGSE, is justified by its proponents on the grounds that it has more “scientific” foundations than its predecessors. By this they mean that it is based on rational, maximising individuals. But there are two problems with this.

Yet the article focuses on the failure of macroeconomics and the representative agent model. The failure of macroeconomics is wider than this because the same macroeconomists who developed the representative agent model were idealizing the rigor of the microeconomists who could write down a utility function for a consumer.

All of this assumes that we accept the standard axioms of rationality that lead to the second problem. The axioms that are used to define “rationality” are based on the introspection of economists and not on the observed behaviour of individuals. (emphasis mine)

One could say the same about microeconomics - what about the consumer who equalizes marginal utilities across goods? Is this behavior observed or based on introspection? The problem with economic theory is not just with macroeconomics - it is with the entire mathematicization of the field going back at least to Samuelson's Foundations of Economic Analysis. It is with the desire to be precise when precision of human behavior is not possible. It is with economists who delude or pride themselves or ignore or wink at this illusion of a scientific mathematical toy that they believe to be reality.

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