by Lars P. Syll

Thanks to latter-day Lucasian new-classical-new-Keynesian-rational-expectations-representative-agents-microfoundations-economists, we are supposed not to - as our primitive ancestors - use that archaic term ‘macroeconomics’ anymore (with the possible exception of warning future economists not to give in to ‘discomfort.’) Being intellectually heavily indebted to the man who invented macroeconomics - Keynes - yours truly firmly declines to concur.

The title of this post is borrowed from a recent article by Sheila Dow in INET Blog (Institute for New Economic Thinking). She argues for a diminished role in macroeconomics for DSGE (Dynamic Stochastic General Equilibrium) models based on "microfoundations".

An excerpt:

But why are DSGE models still in the mix at all, and in a key position? Given all the criticisms, what can such models tell us, even as a ‘first pass at important questions’? Multiple equilibria do allow for discussion of a wider range of scenarios, but any discussion of a particular scenario is still constrained by the requirements of general equilibrium theory. These requirements are at the root of the more fundamental critiques of DSGE. While Vines and Wills set out an impressive research agenda to flesh out this multiple-equilibrium approach, we need to reflect on the constraints imposed by general equilibrium theorising itself.

We therefore need to revisit the fundamental problems with general equilibrium theory and the restrictions it imposes on what is admissible. Individual behaviour needs to be determinate such that indeterminacy can only enter due to an ad hoc restriction or else as a shock. Institutional structures need to be fixed, or else evolve in a deterministic way. Further, the very focus on equilibrium as an outcome of market forces severely constrains the subject matter. This is epitomised by the treatment of uncertainty as risk, or concealed risk. Without being able to absorb the significance of fundamental uncertainty for individual behaviour, for social structures and institutions, and for economics itself, the subject matter and the theoretical structures designed to capture it are inevitably constrained.

The force of these restrictions is embodied in the requirement for microfoundations, whereby all propositions need to be derivable from axioms with respect to individual behaviour. The issue of microfoundations (their role and content) lies at the heart, not only of critiques of general equilibrium theory but also of debate within mainstream macroeconomics itself.

Microfoundations - and a fortiori rational expectations and representative agents - serve a particular theoretical purpose. And as the history of macroeconomics during the last thirty years has shown, this Lakatosian microfoundation programme for macroeconomics is only methodologically consistent within the framework of a (deterministic or stochastic) general equilibrium analysis. In no other context has it been possible to incorporate these kind of microfoundations, with its “forward-looking optimizing individuals," into macroeconomic models.

This is of course not by accident. General equilibrium theory - built on heaps of known to be fictitious assumptions - is basically nothing else than an endeavour to consistently generalize the microeconomics of individuals and firms on to the macroeconomic level of aggregates.

But it obviously doesn’t work. The analogy between microeconomic behaviour and macroeconomic behaviour is misplaced. Empirically, science-theoretically and methodologically, mainstream microfoundations for macroeconomics are defective. Tenable foundations for macroeconomics really have to be sought for elsewhere.

Defenders of microfoundations standardly say there is no alternative. But of course there are alternatives to mainstream general equilibrium microfoundations! Behavioural economics and Goldberg & Frydman’s “imperfect knowledge" economics being two noteworthy examples that easily come to mind.

And for those of us who have not forgotten the history of our discipline, and not bought the sweet-water nursery tale of Lucas et consortes that Keynes was not “serious thinking," we can easily see that there exists a macroeconomic tradition inspired by Keynes (that has absolutely nothing to do with any “new synthesis" or “new-Keynesianism" to do).

Its ultimate building-block is the perception of genuine uncertainty and that people often “simply do not know." Real actors can’t know everything and their acts and decisions are not simply possible to sum or aggregate without the economist risking to succumb to “the fallacy of composition".

Instead of basing macroeconomics on ontological blindness and unreal and unwarranted generalizations of microeconomic behaviour and relations, it is far better to accept the ontological fact that the future to a large extent is uncertain, and rather conduct macroeconomics on this fact of reality.

The real macroeconomic challenge is to accept uncertainty and still try to explain why economic transactions take place - instead of simply conjuring the problem away by assuming uncertainty to be reducible to stochastic risk. That is scientific cheating. And it has been going on for too long now.

The Keynes-inspired building-blocks are there. But it is admittedly a long way to go before the whole construction is in place. But the sooner we get rid of the ontological blindness of mainstream macroeconomics and are intellectually honest and ready to admit that the microfoundationalist programme has come to way’s end - the sooner we can redirect are aspirations and knowledge in more fruitful endeavours. To accomplish this, the starting point needs to be - as Dow so eloquently puts it - “explicit statements about the nature of the real world."