The failure of contemporary macroeconomic theory?

Macroeconomics may have incentive problems, and there may be a lot of room for improvement or refocus, but I think saying that “contemporary macroeconomic theory has failed” is going too far.

Now, I’ve shown myself to be no fan of some of the economics that has, and will, be performed – I quoted approvingly when Dani Rodrik said that some economists had abused the theory. Similarly I nodded my head when Arnold Kling said the same thing. When Agoraphilia pointed out that the “rational expectations hypothesis” is constrictively narrow (namely in how it treats beliefs and expectations) I jumped around in an orgy of agreement.

However, I don’t think we can call contemporary macroeconomics on its predictive failures and then not attack the rest of the economics discipline on similar grounds.

“Macroeconomics” as a discipline is a fishy animal. According to Wikipedia macroeconomics is the study of the whole national economy. This definition isn’t particularly useful for me – given my belief that all economic systems can be reduced to the actions of individuals. In such a framework macro is merely a subset of micro.

Contemporary macroeconomics has always been explained to me as “applying economic tools to explain stylized facts about the general economy”. In this case people have realised that, even though macro is theoretically a subset of micro, the complicated strategic interactions involved make it difficult to start from the micro structure and move up without more specific information.

The information to frame our analysis then comes from “long-run stylized facts about measured economic variables”.

Now contemporary macroeconomics has made a good showing of explaining these stylized facts – and building a framework that explains them that is consistent with more fundamental economic intuition.

If you don’t believe me about this description, pick up a graduate (or even most undergrad) macro text books from the last 20 years – I bet it starts with a section on stylized facts. If it doesn’t, it will start with a micro description which will implicitly respresent some type of stylized facts.

But macroeconomists didn’t foresee the crisis – so they failed

The focus of macro has been on EXPLANATION, not on prediction or policy prescriptions. Sure there have been economists who have taken that extra step, added some value judgments, and made bad calls – but this failure does not mean the contemporary macro has failed in its goals.

But the goal of macro should be to predict short term fluctuation

Now, if we actually believed the goal of macroeconomists is to predict – not describe we can call them failures in some sense.

But I am trying to understand what discipline would be a success when looking at its predictive accuracy instead of it’s descriptive accuracy. Other economics schools definitely can’t say that they provide massively superior predictions to macroeconomists – financial and microeconomists are consistently releasing papers with relationships that seem to break down as soon as the paper comes out, developmental and growth economists hardly have a track record for accurate descriptions let alone predictions, and behavioural economists are still working on measurement issues.

For the past five years macroeconomists have “under-estimated” growth, because it was above what their stylized facts were telling them. Now they are “over-estimating” growth because it is below what these stylized facts suggest.

There are definitely issues with the models, and better ways that macroeconomists can do things. There is even the possibility for macroeconomists to realise the limits of their own models – something that would go quite a way to improving the economic advice they give 😛 . However, even with all this, I would not term contemporary macroeconomics a failure.

Note: I would also like to point out that I can’t see how anyone can predict things without information – the information economists work with in incomplete (no-one could see Lehman’s balance sheet) and often quite old (there is data from the 90’s that still gets revised). How it is possible to “predict” short-term movements without knowing what happened a year ago it beyond me.

Well then why have economists dropped the last 30 years of research to explain things!!!

Simple, they haven’t. The last 30 years has seen macroeconomists define their field more strongly and begin working on a mathmatical framework for viewing issues.

However, outcomes depend so so so so strongly on subjective assumptions by modellers – as there are just so many issues that we can’t come up with nice objective models for.

The divergence of opinions you hear from all these professional macroeconomists don’t come from some or all of them throwing away the central model – it comes from the fact that they all have different “value judgments” surrounding parts of the world.

Now, sometimes we hear people run back to IS/LM in order to explain the economy – they do this because it is easier to phrase things in this way than to go through the logic of a New Keynesian DSGE model (especially when the rigidities and assumptions in the model aren’t actually there – they are just in the authors head). These guys are all coming from the same framework – they just have different “opinions” they are trying to sell you on.

The research program was never able to solve for all the value judgments required about how the economy works – but that doesn’t mean that it hasn’t been useful. Fundamentally, the work of the last 30 years should make it more obvious WHERE these guys differ – something that makes their conclusions and recommendations more transparent.

I wouldn’t call that a failure.


Just because macroeconomists didn’t anticipate the current crisis doesn’t make the “contemporary macroeconomics a failure”.

Macroeconomics (if not some of the macroeconomists) had long ago realised the limitations of its predictive accuracy – and built a discipline focused on describring and explaining movements in the economy once the data was avaliable.

Even if we then turn around and try to say it is a failure anyway we should remember to apply the same critique to other disciplines – I don’t think we would have much left that would not be termed a “failure”.

The thing is, I agree with many of the criticisms that I linked to above (especially the discussion of how poorly belief formation is treated in macro). But I don’t think the conclusion that “contemporary macro is a failure” logically follows from these critiques.

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  • Andrew Coleman

    Hi Matt,

    I think it is useful to distinguish between the problems with contemporay monetary economics, and the problems with macroeconomics. The wider field of macroeconomics has made reasonable progress in the last twenty years, with some considerable advances in understanding learning and co-ordination. In particulr, the use of matching models has been a worthy advance: this is an area where macro- extends micro-, as it shows the conditions where the interaction of agents each facing microeconomic incentives can lead to quite different aggregate outcomes. This, of course, is or should be the distinguishing feature of macroeconomics: it is the study of the aggregate outcomes that result from the interaction of agents who are different. Modelling the microeconomic incentives facing these agents is only the first part of the story; doing the aggregation, and examining the potential for multiple equilibrium is the other part. Indeed, one of the main criticisms of contemporary macroeconomics is not that it neglects microfoundations, but that it completely over-simplifies the aggregation issue by focussing on representative agent models. For example, the incoherence of much of the debate about saving in New Zealand stems from this neglect of aggregation; there seems to be almost no recognition of Modigliani’s famous point that an economy comprises a mixture of young saving households and elderly dissaving households, and that very little interesting information can be learnt by only examining aggregate saving rates.

    The other major problem with macroeconomics has been its obsession with poorly identified time series analysis – Larry Summers was basically correct two decades ago in saying no one has learnt anything from time series applied to macroeconomic data. However, even here there has been some progress, as there is a growing stream of macro papers based on properly identified structural equations or event studies.

    Monetary economics has faced a different problem, although it too has suffered from the use of representative agent models and far too much time series. (The use of bayesian techniques as a substitute for proper identification is merely the craziest outcome of this tendency.) Here the problem is the over-use of a class of models which, while technically clever, have not yet been developed to a point where they can ask the relevant questions. DSGE models may be the future (perish the thought), but for the last few years they have had a structure that has basically neglected the internal workings of the monetary and financial sectors, and thus been structurally unable to address any of the issues that currently afflict us. Monetary economists seem to have fallen in love with their tools, and in doing so they have ignored issues about which their tools have nothing to say. (They have sat round making better spades rather than digging holes.) This wouldn’t have mattered so much if monetary economics were big enough to encompass a wider range of viewpoints, but in the last fifteen years many traditional approaches to monetary economics (the literature emphasising internally generated credit crises, associated with Bagehot, Marshall,keynes, Von Mises etc) have been largely ignored, possibly because of the progress in DSGE models absorbed most of the energy.

    My favourite analogy on this point is that the problem of monetary policy is similar to driving a car from New York to Chicago at a constant speed. Recently the emphasis has all been about the driver: the use of the brakes, accelerator, and steering wheel to negotiate around external shocks and hindrances to maintain a constant speed. This has lead to the cult of the clever central banker, optimally changing interest rates in response to external shocks. Yet in earlier days, the key issue was choosing to drive at a speed that ensured the engine didn’t overheat, and much of the focus of central banking was on the equivalent of mechanical engineering rather than driving: making sure there was the right amount of water in the radiator, that the red light warning of overheating wasn’t blinking, etc etc. The relative neglect of the earlier literature on credit crises, and the recent emphasis by central bankers on their role in stabilising the economy to external (non-monetary) shocks (rather than shocks that are caused by the operation of the monetary and financial systems) looks like it will be a costly error.

    Monetary economics hasn’t been a total desert, however: economists like Hyun Song Shin and Goodhart have done some really interesting work on internal financial market stability in the last few years, work that is now coming to the fore.

    Perhaps in your studies of sociology, you could study the herd mentality of monetary economists…..


  • Hi Andrew,

    Excellent comment. Would you mind if I put it up as a guest post – as I think it deserves a bit more attention than a comment would give it.

  • Kimble

    How would you respond to the increasingly common criticism of economics that the idea of the “rational man” is far too simplistic? Or that economic theory is too often at odds with empirical research? That the economists reliance on “all other things held constant” means their conclusions are almost certainly wrong?

    These are arguments/accusations I am seeing a lot more these days as a way of disparaging economic thought. And while I do address them, my argument is usually too clumsy to succeed convincingly.

    Would you be able to apply your powers of succinticity to the questions so I can take your answers, paste it where the arguments spring up and shut them down with less effort?

  • “Would you be able to apply your powers of succinticity to the questions so I can take your answers, paste it where the arguments spring up and shut them down with less effort?”

    You must be asking Andrew – because there I’m useless at trying to explain these sorts of things.

    “idea of the “rational man” is far too simplistic”

    When people criticize the “rational man” I think it is a good idea to realise exactly what the rational man is – and what issues there can be with him.

    Rational man is simply a dude that makes choices to maximise his “happiness”. When he makes a choice, these choices are based on his information, beliefs, expectations, and the cost of making that choice. Now the only counter to “rational man” is someone that doesn’t make choices. If we truly believed people don’t make decisions, and outcomes are arbitrarily figured out some other way we shouldn’t use rational man.

    As I believe people do make decisions – I support the general idea of rational man.

    Now, things go a bit hairy when economists go to USE rational man. Often we will assume that our rational man assumes that other agents are rational, has perfect information, and has the capability to make a decision so quickly that processing the information is costless. These assumptions are far too strong – and they lead us to make some silly conclusions.

    These auxiliary assumptions about our “rational man” need to be analysed in more detail – and hell there is a lot of work out there actually looking at these details. As a result, it is an issue we have to keep in mind when using our economic models to make predictions.

    However, the idea of reducing society to the actions of individual agents, agents that are “rational” insofar as they make decision in their own interest, still makes sense.

    “economic theory is too often at odds with empirical research”

    Other theories are often at odds with empirical research.

    There are two things here. 1) Our mode of analysis informs the data – so it is hard to actually conclusively test anything. 2) There are unaddressable, and unmeasured, auxiliary issues when we look at the relationship between variables – as a result the empirical success of a hypothesis is not really the be all and end all.

    “That the economists reliance on “all other things held constant” means their conclusions are almost certainly wrong”

    I don’t like it when people use this argument – because it shows that they have missed to point of economic analysis. In economics we are more often than not trying to DESCRIBE the relationship between factors – not predict or prescribe (at least as a starting point).

    The fact is that other things are never constant – and if we could find out the fundamental relationship between every economic variable we would be happy to just run it through. But we can’t do that. By not assuming ceteris paribus we would not be able to describe or explain the interaction of two variables – as someone could always say it is the “other” variable in our relationship that is causing the result.

    Now – it is possible that our ceteris paribus assumption might include the REAL causal variable of an event, in which case it would be good to instead include that variable. In that case the criticism should be what economists put into their models – not the use of CP clauses.

    Overall – I find that people who usually criticise economics don’t actually know what the assumptions they are criticising mean. I often hear people telling me we need “more microeconomics” and then talking about “currency cylces” as an example of this 😛 I also hear people criticise rational man “because he doesn’t care about other people” – something that illustrates a huge misunderstanding about the difference between “self-interested” and “selfish”.

    There are plenty of good ways to attack what economists sometimes do – but attacking these general assumptions is normally folly. Unless you believe that methodological individualism is false …

    As long as you believe that society can be reduced to the actions of individual agents, the general framework of economics is fine.

  • Kimble

    “As long as you believe that society can be reduced to the actions of individual agents, the general framework of economics is fine.”

    So what you are saying is that the existence of multiple personality disorder and the possibility of demonic possession invalidates the entire field of economics. Gotcha.

  • Or if individuals are lemmings that do things “just because”. You would be surprised how many policy analysts believe that – hence why they think it is a good idea to make programs to force people to do “the right thing”.

    I am actually embarrassingly impatient when I hear people talking like that – so I’m not sure I’ll be able to discuss its merits objectively 😛