Tuesday, February 11, 2014

Economists with hurt feelings

Kartik Athreya is an economist at the Federal Reserve Bank of Richmond. He is a true believer in the modern methods of macroeconomics, and has written a new book entitled Big ideas in Macroeconomics: a non-technical view. I've just had a partial read of the first 50 pages or so on google books.

Athreya is really irritated at all the criticism that macroeconomists have had to endure since the onset of the financial crisis. He famously expressed his irritation a few year ago, demanding that bloggers and non-economists in general shut up and leave discussion of economics to himself and other experts in the field. It seems that the purpose of the new book is to correct all the confusion and explain to everyone why modern macro is so wonderful and right and beyond criticism. I don't think it is going to succeed. Anyone who reads his section on the Walrasian Clearinghouse -- an imaginary mechanism to explain how an economy reaches Walrasian equilibrium -- will pretty quickly come to the conclusion that Athreya's beloved picture of how an economy works is mostly mathematical fantasy.

But actually, I think the book may in this way provide a great service. Anyone who reads it carefully will be able to see for themselves just how fragile and artificial the modern rational expectations approach to macroeconomics really is. I'm going to order the book because, from what I have seen, there will be much to learn, although possibly not about how a real economy works. Readers will experience a close encounter with the reality-defying attitude and arrogance of mainstream macroeconomics. Reading from one who holds it in such high esteem, the reader can also trust that he or she is not being deceived by some ignorant blogger who is setting up straw man arguments (a common response from wounded macroeconomists).

David Glasner has read the book and offers an informative review. One section deserves highlighting, regarding Athreya's tendency to dismiss whole realms of real economic phenomena as irrelevant simply because they don't fit into his preferred modelling methodology:

As Athreya acknowledges in chapter 5, an important issue separating certain older macroeconomic traditions (both Keynesian and Austrian among others) is the idea that macroeconomic dysfunction is a manifestation of coordination failure. It is a property – a remarkable property – of Walrasian general equilibrium that it achieves perfect (i.e., Pareto-optimal) coordination of disparate, self-interested, competitive individual agents, fully reconciling their plans in a way that might have been achieved by an omniscient and benevolent central planner. Walrasian general equilibrium fully solves the coordination problem. Insofar as important results of modern macroeconomics depend on the assumption that a real-life economy can be realistically characterized as a Walrasian equilibrium, modern macroeconomics is assuming that coordination failures are irrelevant to macroeconomics. It is only after coordination failures have been excluded from the purview of macroeconomics that it became legitimate (for the sake of mathematical tractability) to deploy representative-agent models in macroeconomics, a coordination failure being tantamount, in the context of a representative agent model, to a form of irrationality on the part of the representative agent. Athreya characterizes choices about the level of aggregation as a trade-off between realism and tractability, but it seems to me that, rather than making a trade-off between realism and tractability, modern macroeconomics has simply made an a priori decision that coordination problems are not a relevant macroeconomic concern.

A similar argument applies to Athreya’s defense of rational expectations and the use of equilibrium in modern macroeconomic models. I would not deny that there are good reasons to adopt rational expectations and full equilibrium in some modeling situations, depending on the problem that theorist is trying to address. The question is whether it can be appropriate to deviate from the assumption of a full rational-expectations equilibrium for the purposes of modeling fluctuations over the course of a business cycle, especially a deep cyclical downturn. In particular, the idea of a Hicksian temporary equilibrium in which agents hold divergent expectations about future prices, but markets clear period by period given those divergent expectations, seems to offer (as in, e.g., Thompson’s “Reformulation of Macroeconomic Theory“) more realism and richer empirical content than modern macromodels of rational expectations.

Athreya offers the following explanation and defense of rational expectations:
[Rational expectations] purports to explain the expectations people actually have about the relevant items in their own futures. It does so by asking that their expectations lead to economy-wide outcomes that do not contradict their views. By imposing the requirement that expectations not be systematically contradicted by outcomes, economists keep an unobservable object from becoming a source of “free parameters” through which we can cheaply claim to have “explained” some phenomenon. In other words, in rational-expectations models, expectations are part of what is solved for, and so they are not left to the discretion of the modeler to impose willy-nilly. In so doing, the assumption of rational expectations protects the public from economists.

This defense of rational expectations plainly belies the methodological arrogance of modern macroeconomics. I am all in favor of solving a model for equilibrium expectations, but solving for equilibrium expectations is certainly not the same as insisting that the only interesting or relevant result of a model is the one generated by the assumption of full equilibrium under rational expectations. (Again see Thompson’s “Reformulation of Macroeconomic Theory” as well as the classic paper by Foley and Sidrauski, and this post by Rajiv Sethi on his blog.) It may be relevant and useful to look at a model and examine its properties in a state in which agents hold inconsistent expectations about future prices; the temporary equilibrium existing at a point in time does not correspond to a steady state. Why is such an equilibrium uninteresting and uninformative about what happens in a business cycle? But evidently modern macroeconomists such as Athreya consider it their duty to ban such models from polite discourse — certainly from the leading economics journals — lest the public be tainted by economists who might otherwise dare to abuse their models by making illicit assumptions about expectations formation and equilibrium concepts.

See also Noah Smith's comments on the book.

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