Economist Caballero on Macroeconomics: “Fantasyland”

The surprisingly reader-friendly Journal of Economic Perspectives has a symposium on Macroeconomics after the Financial Crisis. I’m working my way through the papers now, starting with a fascinating piece by Caballero on the “core” and “periphery” of contemporary macroeconomics. For Caballero, the periphery of modern macro includes useful analysis of bubbles, liquidity traps, financial disintermediation and the like, and restricts itself to specific problems under semi-realistic assumptions, and thus has provided much of the key explanatory power of economics in the current crisis. On the other hand, Caballero argues that the core includes both New Keynesian and Real Business Cycle theories that emphasize hyperrational agents solving incredibly complicated Dynamic Stochastic General Equilibrium calculations with increasingly complex “frictions” built in to add realism. These models attempt to solve for all variables at once, so to speak. Caballero (2010: 90) argues that the core may suffer from a “pretense of knowledge” problem brought about by its approach of adding more and more complicated deviations into what begins as a simple, straightforward model:

However, I think this incremental strategy may well have overshot its peak and may lead us to a minimum rather than a maximum in terms of capturing realistic macroeconomic phenomena. We are digging ourselves, one step at a time, deeper and deeper into a Fantasyland, with economic agents who can solve richer and richer stochastic general equilibrium problems containing all sorts of frictions. Because the “progress” is gradual, we do not seem to notice as we accept what are increasingly absurd behavioral conventions and stretch the intelligence and information of underlying economic agents to levels that render them unrecognizable.

The beauty of the simplest barebones real business cycle model is, in fact, in its simplicity. It is a coherent description of equilibrium in a frictionless world, where it is reasonable to expect that humans can deal with its simplicity. I would rather stop there (perhaps with space for adding one nominal rigidity) and simply acknowledge that it is a benchmark, not a shell or a steppingstone for everything we study in macroeconomics, which is unfortunately the way the core treats it today.

When a high-profile MIT economist in an AEA-sponsored journal can accuse the core of his subfield of descending “deeper and deeper into a Fantasyland”, I wonder what economic sociology is to do. I mean, we’re not going to come up with better, more authoritative critiques of the unreality of the field than that! So perhaps we should be looking for other tasks – for example, the work of scholars like MacKenzie and Callon who focus on the effects of economic theorizing (independent of its “truth”), or the work of historians of economics like Marion Fourcade who ask, how did economics get to be the way it is in various times and places? Just bashing economics for its unrealistic assumptions seems so… unnecessary? at this point from our discipline. Or at least, if we do so, we must be careful to address the internal critiques along the same lines – from authors like Caballero, as well as the whole behavioral economics movement. What is economic sociology offering that goes beyond these critiques? Etc.

As a fun aside, and research note for myself, Caballero also notes that modern macro models assume that agents possess complicated understandings of the current workings of the economy, and that this knowledge justifies the generalization from everyday microeconomic rationality, yet:

Agents could be fully rational with respect to their local environments and everyday activities, but they are most probably nearly clueless with respect to the statistics about which current macroeconomic models expect them to have full information and rational information. (91)

From this argument we might then conclude that the compilation and distribution of macroeconomic statistical knowledge itself affects the possibilities for rational action. Not that I have any interest in such topics or anything…

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5 Comments

  1. Isaac

     /  December 2, 2010

    Caballero represents an extreme instantiation of the MIT/Harvard emphasis on `small’ models. This divide between the MIT `small’ model and the Minnesota/Rochester/Chicago `large’ model approach to economics goes back a long way…

    One of the more entertaining versions of this is Lawrence Summers, ‘The Scientific Illusion in Macroeconomics,” Scandanavian Journal of Economics, 1991 (http://www.jstor.org/stable/3440321), where he basically says that nobody ever learned anything from a fancy regression or an uber-complicated model because economics isn’t sufficiently true for this to be useful.

    • Thanks for the excellent reference! Just read it. I love this quote:
      “No small part of our current economic difficulties can be traced to ignorant zealots who gained influence by providing answers to questions that others labeled as meaningless or difficult. Sound theory based on evidence is surely our best protection against such quackery.” (Summers 1991: 145-146)
      Probably as relevant now as ever…

      I love the *explicit* invocations of Physics and Biology as parallels. It’s much worse than Sociology, where we are at least somewhat critical of the analogy. Also, the last sentence is fantastic:

      “Macroeconomics could progress in the same way [as Physics]. But progress is unlikely as long as macroeconomists require the armor of a stochastic pseudo-world before doing battle with evidence from the real one.” (146)

      Say what you will about his politics, competence or economics, Summers knows how to write!

  2. joshmccabe

     /  December 6, 2010

    Pretense of knowledge? Hmm… that phrase sounds awfully familar:-)

    • What are you referring to?

      • joshmccabe

         /  December 9, 2010

        If you’re looking for a good direction to take economic sociology, Hayek might be a great place to go. Alas, people only quote him for his cutesy critiques of economics.