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Rebuilding macroeconomics: Initial reflections on a major theory project

The ‘Rebuilding Macroeconomic Theory Project’ came to an end in the most recent volume of the Oxford Review of Economic Policy; how were the various papers’ conclusions received?

By: Date: January 29, 2018 Topic: Global Economics & Governance

The latest volume of the Oxford Review of Economic Policy (OREP) marks the conclusion of the Rebuilding Macroeconomic Theory Project. According to David Vines and Samuel Wills, the two economists who conceived it, the central purpose of the project was to invite “a number of leading macroeconomists to describe how the benchmark New Keynesian model might be rebuilt, in the wake of the 2008 crisis”. For Martin Sandbu, it is “the most impressive post-crisis effort of rethinking how macroeconomics should be done, by many of the field’s top practitioners”. This blogs’ review focuses on the initial reactions in the blogosphere to some of the papers.

Martin Sandbu in his Free Lunch column for the Financial Times summarises the contributions in a series of articles. One of his takes from the project relates to the role of microfoundations, “the different assumptions about microeconomic behaviour and the macroeconomic relationships they give rise to”. He diagnoses the lack of a convincing theory of such microeconomic behaviour as the key issue with microfoundations and, therefore, calls for more openness in deciding which microfoundations to adhere to.

For Sandbu, continuous trial and the ensuing “disagreement about which micro assumptions are ad hoc and which are well-founded” is the only way forward. Importantly, he stressed the need to incorporate this pluralism under a common, basic framework, namely the current standard Dynamic Stochastic General Equilibrium (DSGE) approach.

The debate about the role of microfoundations is one in which multiple co-authors of the OREP volume engage. Simon Wren-Lewis, one of the contributors focusing specifically on microfoundations in his paper, sees what he calls “microfoundations hegemony” as the central roadblock to the advancement of macroeconomics.  Since publication, he has followed up with two blogs in which he levels two criticisms: that the hegemony is stifling valuable alternative approaches to macroeconomics, and that microfoundations have been obfuscating value judgments made by the modelers.

The first criticism has to do with the preponderance of achieving internal consistency in a model, over other considerations such as empirical support; for example, augmenting the standard modelling of consumption with a term for the level of unemployment, with the purpose of building a model that fits the data better, could be rejected for failing to satisfy this theoretical internal consistency. Wren-Lewis’ argument is that alternative approaches to macroeconomics in general are dismissed, that this has led to diverting attention and, by consequence, slowing down progress in the field. Rather than rejecting the microfoundations approach, he believes that it is one of many complementary methodologies.

In his second criticism, he maintains that the primacy of internally-consistent, microfounded macroeconomics has rendered choices that modellers make on the basis of value judgements harder to trace. As an example Wren-Lewis mentions the replacement of ad-hoc policymaker preferences regarding deviations of output and inflation with internally consistent ones, derived from the preferences of the representative consumer inhabiting the model. Not only were the resulting preferences unrealistic compared to empirical evidence, but they had also taken “a value judgement away from policy makers”.

Paul Krugman’s paper also elicited response. Among the many points he raises, Krugman makes the following remark: in contrast to previous episodes, namely the Great Depression of the 1930s and the stagflation of the 1970s, “there hasn’t been a big new idea” in macroeconomics this time around. This, he says, is because macroeconomics proved “good for government work”. Krugman justifies his “controversial answer” by arguing that the policy prescriptions suggested by macroeconomics were the right ones and proved to be sufficient in avoiding economic disaster. For him, the failure to see the crisis coming does not pose a “deep conceptual issue” for economic models: it was not a lack of understanding of the possible mechanism” but a lack of attention to the right data” (e.g. overlooking institutional changes in the financial sector, the rise in household debt and looking at house-price growth in the aggregate rather than at a more local level).

In his Project Syndicate article, Robert Sidelsky takes issue with that point of Krugman’s. Firstly, ignoring the “right data” is a conceptual problem for New Keynesian economics, because the choice of evidence is theory-driven: theory took for granted that financial institutions accurately price risk and this is why it missed the fact that financial institutions actually under-priced risk. Secondly, the adoption of the New Keynesian policy prescription was short-lived and proved that there is no intellectual case made by the theory for sustained intervention.

In opposition to Krugman, Sidelsky thus concludes that macroeconomics needs to come up with a new big idea. He asserts that macroeconomists need to acknowledge radical uncertainty in their theories in order to build policy intervention in good times to avoid bad times.

What seems safe to assume at this point is that we have seen only a small part of the response bound to be generated by the comprehensive and diverse collection of opinions contained in the OREP tome.

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