From longandvariable by Tony Yates:
This post is prompted by a twitter exchange some time ago between Adam Posen, Noah Smith and myself over the ‘merit’ of microfoundations. [Here's a storify recap]. And that in turn by the fall-out from the events at the Federal Reserve Bank of Minneapolis, where Naranya Kocherlakota [former microfounding whizz] has begun to push out senior advisors and research economists, including Pat Kehoe and Ellen McGratten. But this debate will be familiar to those following econ blogs for longer than that. It’s tangenitally related to the controversy in the UK over how economics should be taught, fuelled by the student campaign group at Manchester University, and by the initiative led by Wendy Carlin at UCL to reform the curriculum. And it probably surfaces whenever a few economists have a beer and talk shop.
In this twitter exchange, Adam Posen said ‘microfoundations are without merit’. Noah challenged me to substantiate my claim that they do have merit.
The merit in any economic thinking or knowledge must lie in it at some point producing an insight, a prediction, a prediction of the consequence of a policy action, that helps someone, or a government, or a society to make their lives better.
Microfounded models are models which tell an explicit story about what the people, firms, and large agents in a model do, and why. What do they want to achieve, what constraints do they face in going about it? My own position is that these are the ONLY models that have anything genuinely economic to say about anything. It’s contestable whether they have any merit or not.
The early microfoundations project was about pointing out the unreliability of pre-microfoundations models, sometimes known as ‘Cowles Commission’ models, after one of the research centres that sponsored such a model. These were models that were long lists of equations for economic aggregates built out of stories economists had that linked some of these aggregates together [like 'people tend to consume something, plus something else times disposable income' - the consumption function]. This contribution [crystallised in Lucas' 1976 'Critique'] was to note that if policy was based on statistical estimates of these guessed-at relationships, when that policy changed, those relationships may change too, invalidating the original policy choice. So the contribution was negative. It was about warning that another way of doing economics did not have as much merit as first thought, and might in fact entail substantial economic costs.
It seems likely to me that this early contribution ‘had merit’. To me, it seems highly probable that major policy mistakes, informed, for example, by the belief that permanently higher inflation might buy permanently lower unemployment, were avoided. I can’t prove it. But there are dozens of empirical papers exploring this same point, in the light of what Lucas said. The evidence there is not entirely on one side. How could it be? But I would say it was decisively tilted in favour of Lucas/Phelps/Friedman’s warning that higher inflation doesn’t get you lower unemployment forever. Here is an example of recent empirical work on this by Luca Benati that concludes that high inflation doesn’t buy permanently lower unemployment.