The failure of macroeconomics (updated)

Mario Rizzo at the ThinkMarkets blog posts on The Failure of Macroeconomics. Rizzo wrotes

The current issue of The Economist has a very interesting article on the turmoil among macroeconomists (“The Other-Wordly Philosophers”). Essentially, the article argues that although the dominant macro model, dynamic stochastic general equilibrium theory [DSGE], appears to be in a state of near-total breakdown, there is no agreement among economists as to what should replace it.

The Economist writes

“Would economists be better off starting from somewhere else? Some think so. They draw inspiration from neglected prophets, like Minsky, who recognised that the “real” economy was inseparable from the financial. Such prophets were neglected not for what they said, but for the way they said it. Today’s economists tend to be open-minded about content, but doctrinaire about form. They are more wedded to their techniques than to their theories. They will believe something when they can model it.”

To be fair, if you can't model, in some way, the phenomenon you are considering how do you know you understand it? Models are used because we can't handle the "real world" as it is, we have to bleak it down into pieces so we can deal with it. The question for macro is then, Are they using the right model for understanding the current crisis?

Rizzo asks

[...] what is the root of the difficulty in which macroeconomics finds itself?

His answer,

I think it is the inability to reconcile a reasonable treatment of radical uncertainty with the strictures of out-of-control formalism. We have come a long way from Alfred Marshall’s idea that one does the mathematics and then burns it. In a 1906 letter to A.L. Bowley (of the Edgeworth-Bowley box fame) Marshall says:

“But I know I had a growing feeling in the later years of my work at the subject that a good mathematical theorem dealing with economic hypotheses was very unlikely to be good economics: and I went more and more on the rules – (1) Use mathematics as a shorthand language, rather than an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life. (5) Burn the mathematics. (6) If you can’t succeed in (4), burn (3). This last I did often.”

Clearly, the adherents of DSGE did not follow points (4) through (6).

But modeling radical uncertainty is a difficult as it is not clear that it can be done within the strictures of any formalism. Risk is the best we have managed to model thus far. If Rizzo has a way to do this, it would indeed be a serious step forward.

Josh Hendrickson at The Everyday Economist ask "Has Macroeconomics Failed?" He writes

Mario Rizzo provides this pithy summary of the story:

…the article argues that although the dominant macro model, dynamic stochastic general equilibrium theory [DSGE], appears to be in a state of near-total breakdown.

I think that this is a bit of wishful thinking from the folks at the Economist, Mario Rizzo, and those referenced and quoted in the article. The fact of the matter is that the DSGE model is NOT “in a state of near-total breakdown” and nor should it be. Rather the criticism (hatred?) of DSGE models fails to understand both the purpose and the scope of these models.

Since the start of the financial crisis, macroeconomics has undergone a great deal of criticism. This criticism has largely been directed at (1) the inability of macroeconomists to forecast such a severe downturn, (2) the lack of a consensus regarding fiscal policy, and (3) DSGE models. I have already written in great detail about (2) and I think that the evidence and the theory is much more clear-cut than the debate would have you believe. I think that many of the differences of opinion had more to do with ideology than economics.

The rest of the Hendrickson posting deals with items (1) and (3). He argues that the as far as forecasting goes the fundamental point is that there were prominent researchers out in front of the current crisis, but they were largely ignored until the downturn. As to point 3, Hendrickson argues that much of the criticism aimed at DSGE models seems to result from a failure to understand the use of the DSGE model.

Given the current crisis, debates like this about macro will only intensify and who knows where they will end. But we have to hope that it will result in a better macro. God knows we need one.

Update: Matt Nolan on Quote 22: Stumbling and Mumbling on Macroeconomics.