This post develops a point made by Bryan Caplan (HT MT). I have two
stock complaints about the dominance of the microfoundations approach in macro.
Neither imply that the microfoundations approach is ‘fundamentally flawed’ or
should be abandoned: I still learn useful things from building DSGE models. My
first complaint is that too many economists follow what I call the microfoundations purist position: if
it cannot be microfounded, it should not be in your model. Perhaps a better way
of putting it is that they only model what they
can microfound, not what they see. This corresponds to a standard method of
rejecting an innovative macro paper: the innovation is ‘ad hoc’.
My second complaint is that the microfoundations used by
macroeconomists is so out of date. Behavioural economics just does not get a
look in. A good and very important example comes from the reluctance of firms
to cut nominal wages. There is overwhelming empirical evidence for this
phenomenon (see for example here (HT Timothy Taylor) or the work of Jennifer
Smith at Warwick). The behavioural reasons for this are explored in
detail in this book by Truman Bewley, which Bryan Caplan
discusses here. Both money illusion and the importance
of workforce morale are now well accepted ideas in behavioural economics.
Yet debates among macroeconomists about whether and why wages
are sticky go on. As this excellent example (I’ve been wanting to link
to it for some time, just because of its quality) shows, they are not just
debates between Keynesians and anti-Keynesians, so I do not think you can put
this all down to some kind of ideological divide. I suspect nearly all
economists are naturally reluctant to embrace cases where agents appear to miss
opportunities for Pareto improvement - I give another example related to wage
setting here. However in most other areas of the
discipline overwhelming evidence is now able to trump these suspicions. But
not, it seems, in macro.
While we can debate why this is at the level of general
methodology, the importance of this particular example to current policy is
huge. Many have argued that the failure of inflation to fall further in the
recession is evidence that the output gap is not that large. As Paul Krugman in
particular has repeatedly suggested, the reluctance of workers or firms to cut
nominal wages may mean that inflation could be much more sticky at very low
levels, so the current behaviour of inflation is not inconsistent with a large
output gap. Work by the IMF supports this idea. Yet this
is hardly a new discovery, so why is macro having to rediscover these basic empirical truths?
There may be an even more concrete example of the price paid
for failing to allow for this non-linearity in wage behaviour. For all it
inadequacies, the Eurozone Fiscal Compact does at least include a measure of
the cyclically adjusted budget deficit among its many indicators that are meant
to guide/proscribe fiscal policy. However, as Jeremie Cohen-Setton discusses here, the Commission now think they have been
underestimating the output gap. As he suggests, the reason is pretty obvious:
they have overestimated how much the natural rate of unemployment has risen in
this recession. Here is the example he gives for Spain.
 |
Actual unemployment and European Commission estimates of the NAWRU for Spain, from European Commission, 2013 spring forecast exercise. Source Jeremie Cohen-Setton
|
How could the Commission have been so foolish as to believe the
natural rate had risen from 10% to 27% in a few years? Might it be because they
looked at nominal wages in Spain, and inferred from the fact that nominal wages
were not falling that therefore actual unemployment must be close to its
natural rate? If empirical macromodels as a matter of course allowed for the
absence of nominal wage cuts, would they have made such an obvious (to anyone
who is not a macroeconomist) mistake?
I think this example illustrates why it can be dangerous to
rely on DSGE models to guide policy. Yet the influence of DSGE models in policy
making institutions is strong and growing. The Bank of England’s core
forecasting model (pdf) is a fairly basic DSGE construct, and as
far as I can see its wage equation is a standard New Keynesian specification,
with no non-linearity when wage inflation approaches zero. Now I know the Bank
have many other models they look at, and they will undoubtedly have looked at
the implications of a reluctance to cut nominal wages. (I discuss the Bank’s
‘new’ model in more detail here.). However default positions are
important, as the examples I discussed earlier show. Focusing on models where
consistency with fairly simplistic microfoundations is all important, and
consistency with empirical evidence is less of a concern, can distort the way
macroeconomists think.
