Macroeconomics, The Lucas Critique, Microfoundations, and Modeling in General

byMatt_Simpson10y6th Jun 200913 comments

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I posted this comment in reply to a post by David Henderson over at econlog, but first some context.

Mathew Yglesias writes:

...From an outside perspective, what seems to be going on is that economists have unearthed an extremely fruitful paradigm for investigation of micro issues. This has been good for them, and enhanced the prestige of the discipline. No such fruitful paradigm has actually emerged for investigation of macro issues. So the decision has been made to somewhat arbitrarily impose the view that macro models must be grounded in micro foundations. Thus, the productive progressive research program of microeconomics can “infect” the more troubled field of macro with its prestige...

...But as a methodological matter, it seems deeply unsound. As a general principle for investigating the world, we normally deem it desirable, but not at all necessary, that researchers exploring a particular field of inquiry find ways to “reduce” what they’re doing to a lower level....

...Trying to enhance models with better information about psychology isn’t against the rules, but it’s not required either. What’s required is that the models do useful work.

So why should it be that “in the current regime, if [macro models] are not meticulously constructed from “micro foundations,” they aren’t allowed to be considered”?

To which a commenter replies:

While I’m the first to acknowledge that the current macro research paradigm has given us little useful analysis, there is a standard answer to Matt’s question.

You can start by going to Wikipedia and reading about the Lucas Critique...

I won't reproduce the whole thing, click through to the comment to see a decent summary of the Lucas Critique if you aren't aware of it already.

Henderson, over at econlog, replies:

...Second, the demand for microfoundations, or at least the supply of them, goes back more than 10 years before the date Arnold claims. It goes back at least to Milton Friedman's A Theory of the Consumption Function...,

...Third, interestingly, Milton Friedman himself would probably agree with Yglesias about the idea that there's not necessarily a need for micro foundations for macro. In a 1996 interview published in Brian Snowdon and Howard R. Vane, Modern Macroeconomics, Edward Elgar, 2005, Friedman said:

It is less important for macroeconomic models to have choice-theoretic microfoundations than it is for them to have empirical implications that can be subjected to refutation.

In saying this, Friedman was going back to his positivist roots, which he laid out at length in his classic 1953 essay, "The Methodology of Positive Economics," published in Essays in Positive Economics. There was always an interesting tension in Friedman's work, which he never resolved, between reasoning as a clear-headed economist about people acting based on incentives and constraints and "positivistly" black-boxing it and trying to come up with predictions.

And without further adieu, here's my respone:

I don't think there is a tension in Friedman's thinking at all. We want our models to predict, otherwise, what are they good for? If a model doesn't have microfoundations and predicts well, so what? Microeconomic models, as Yglesias notes, don't have "microfoundations" in psychology. Yet they still do a pretty good job under a variety of circumstances.

The reason microfoundations are necessary is instrumental to predictive power. It turns out that models with microfoundations [tend to] predict better than models without them, in all fields. This is why chemists tend to build their models up from physics and why biologists to the same with chemistry. It also turns out that microeconomics can be quite successful without microfoundations, while macroeconomics is far less successful.

The Lucas critique tells us many of the reasons why macroeconomics needs microfoundations. The main reason microeconomics does not is that it is built from pretty solid intuitions about how individuals act. They aren't perfect, of course, but as a first approximation (instrumental) rationality does a pretty good job of describing human behavior in many cases. And the only way we really do know this is by going out and testing our models which, behavioral economics notwithstanding, have done well.

There's a trade off between accuracy and analytical tractability while modeling. More microfoundations will tend to increase accuracy, but imagine if we started with physics for every single scientific problem. The computations would be insane, so instead we simplify things and ignore some of the microfoundations. It is called a model for a reason, after all.

Friedman is right: if microfoundations do end up being important, models without them will do poorly relative models that use them (and thus the relevant trade off will manifest itself). Note that this is precisely what happened in the history of macro, and kudos to Friedman for realizing that microfoundations were important before the rest of the field. I suspect that macro models [don't] do well in an absolute sense though, but that is another matter entirely.

ack... I should edit my comments better before posting them (notice the use of square brackets).

edit: some minor formatting

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