Microfoundations for people's sake

There are two simple reasons why I like microfoundations:

1. Because the economy is what people do. Understanding and explaining economies is understanding and explaining why people do what they do.

I don't care how well your VAR fits the data, and how well it keeps working across lots of different policy regimes; it's still not an explanation of why people do what they do. It is not an economic explanation. It is instead just another interesting fact about the economy that needs to be explained. Why do people do those things that make your VAR fit the data?

Let me give you two recent examples where I became upset because of lack of microfoundations:

The standard New Keynesian model does not explain why people should expect other people should choose to spend enough to ensure the economy converges towards [the natural rate of] full-employment. It just assumes it, without explaining why. I want to know why people expect other people will choose to do this.

The recent kerfuffles about higher nominal interest rates causing higher inflation. I want to know why higher nominal interest rates would cause people to choose to increase prices more quickly. I got no explanation why.

Those are two very paradoxical examples, because they come from supposedly microfounded models, not VARs. Which is why I got upset. VARs don't even pretend to explain why people do things. I don't get upset at VARs. They are only VARs. I don't expect anything better from them.

2. Because good policy means doing what people want. There are only two questions that matter for policy: Is this macro model like Prisoner's Dilemma? If so, in what ways, if any, could we change the game so it isn't like Prisoner's Dilemma? (Or maybe: Is this macro model like Stag Hunt? And if so, how could we flip it to the "hunt stag" equilibrium?). You can't ask those questions if you don't have people in the model.

We don't care about GDP, for example. We could increase GDP by forcing all the old people out of retirement and making them work. But that maybe isn't what people want. If your model doesn't have people, who want things, we can't tell if a policy change would be good. Unless we don't care about what people want.

We can invent all sorts of reasons about the practical usefulness of microfoundations. But when it comes right down to it, none of them really matter to me. I want microfoundations for their own sake. I want people in the model. I want the model to explain to me why people do what they do, and if a policy change would be good for the people in the model, by helping them get what they want. Incredibly stylised one-dimensional people are much better than none at all.

Comments

[Sandwichman]

"Incredibly sylised one-dimensional people are much better than none at all."

Sylised?

[UnlearningEcon]

Two quick thoughts spring to mind:

(1) It's admirable, in a sense, to want to understand the human foundations of economics. However, sometimes they simply may not be relevant for the matter at hand. All models abstract from things, as economists like to say, and some might abstract from individual actions and motives and look instead at, say, accounting relationships and flows of funds.

(2) What you consider 'microfoundations' could easily be considered just another set of arbitrary mathematical relationships that don't really help us achieve your stated goal. Most economists will happily say "no, people don't really maximise some metaphysical concept called 'utility', but it helps us build models that make predictions etc etc." Now, we can argue about whether this is useful from a modelling perspective until the cows come home, but it does seem that it demonstrably fails to help us understand real people, which is what you want to do. In fact, I think if you really want to understand people's relationship to the economy you're probably better off steering clear of mathematical microfounded models. That's not an outright dismissal of maths for this purpose, but I certainly think things like *asking* people about the economy are a better way to understand their motives and actions, even though economists have historically steered clear of such methods.

[Nick Rowe]

Oops. Fixed.

[Sandwichman]

"*asking* people about the economy are a better way to understand their motives and actions..."

Whoa! What if the point of consulting "incredibly stylised one-dimensional people" instead of real people is to demonstrate that the real people don't really know what they want, that what they say they want is anecdotal but what they really want can be "revealed" from the data?

[Sandwichman]

looks like I left of a closing /i.

[Yep, but I fixed it. NR]

[Nick Rowe]

Unlearning:

1. "All models abstract from things, as economists like to say, and some might abstract from individual actions and motives and look instead at, say, accounting relationships and flows of funds."

Accounting relationships and flow of funds are not economics. They may be useful to help us do economics, like learning how to write, draw graphs, or do math, but they are not economics. Add in a behavioural relationship or two, which tells us what people do, and back it up with some sort of story about why they do it, and now you've got economics.

2. What has math got to do with microfoundations? You can use math, or not use math, with microfounded models or with non-microfounded models. Suppose I tell you a story, in words, to explain one aspect of the world. And suppose the characters in my story are one-dimensional characters. That is an explanation. Maybe one-dimensional characters are all I need to tell that story. Andy wants apples; Betty wants bananas. Andy owns bananas; Betty owns apples. So they trade. I don't need to tell you Andy's age, and hair colour, and whether he believes in God. Those things might matter in another story.

[UnlearningEcon]

1. Well, this is kind of circular. You're defining economics as what you want to do then telling me what I want to do isn't economics. If economics is defined more broadly as 'the study of the economy', it seems obvious that accounting relationships help us understand the economy and are therefore a part of economics. In fact, you basically go on to acknowledge this so I'm a bit confused.

2. OK, you didn't necessarily mean mathematical microfoundations. That's cool, but I felt like your post was defending microfoundations in modern macro or some such. My bad.

[Nick Rowe]

Unlearning: 1. Fair enough. *I* don't think it's economics. But let me try to support my assertion. Accounting, for example, simply tells us how we use words. We define "Y", "C", "I", "G", and "NX" such that Y=C+I+G+NX must be true. It's a statement about semantics only. Maybe useful semantics, but still only semantics. It's a dictionary. It's not a statement about the world. It's like saying "The number of my children = the number of my sons + the number of my daughters". That doesn't explain demographics. The number of my sons and the number of my daughters does not *determine* how many children I have.

[UnlearningEcon]

OK I think we may have two different definitions (or at least applications) of accounting here. You mean it as relationships like S=I, which help us to think but ultimately are tautologies and not "economics". I agree with that.

However, when I say 'accounting' I mean something more like the actual accounting behaviour and practices of businesses, particularly banks (but let's not go there!) and how that helps us to understand their actions or 'microfoundations'.

[Min]

"The standard New Keynesian model does not explain why people should expect other people should choose to spend enough to ensure the economy converges towards full-employment. It just assumes it, without explaining why. I want to know why people expect other people will choose to do this."

I don't think that people choose to spend enough to ensure that the economy converges towards full employment. Why should they? Why would we imagine that they would? It is not like we have to explain that we observe economies converging on full employment. We certainly are not observing that now, are we?

What is the point of having microfoundations to explain phenomena that we do not observe?

[primedprimate]

I may be echoing unlearning econ here, but I am confused by your use of the term microfoundations.

Old Keynesian models have well defined aggregate behavioral relationships - people consume a certain amount of their income, firms invest based on their 'animal spirits' and ex-ante interest rates, etc., etc. Yet, OK models are not typically considered microfounded.

It seems to me that your post is merely asking for the inclusion of well defined and properly motivated behavioral relationships (hence your disapproval of VARs) to explain all the economic action rather than asking for microfoundations as typically construed.

[primedprimate]

And you also want to combine that with a more thoughtful and robust welfare analysis again motivated in terms of what people want. Merely increasing Y is irrelevant, we want to maximize some society-wide objective.

[Mike Sax]

The trouble I get Nick is that how can you be sure that everything can be explained at the individual level? Isn't the point of Macro is that you can understand aggregates in this way?

Even if we agreed-and as indicated above I'm skeptical-that we must be able to explain everything at the micro level, how do we know that one dimensional stylized people are better than no people at all?

After all, is these one dimensional people are nothing like real people wont it lead us down the wrong path?

[Nick Rowe]

Min: I have edited the post so it reads "converging towards the natural rate of employment". And there's a distinction between "converging towards" and "always at".

Primed: a lot of macro in the 50's and 60's was about building microfoundations for the Old Keynesian model. The question is whether those separate bits of microfounding were all consistent with each other. Were the people who decided how much to consume the same people who decided how much money they wanted to hold? That sort of consistency would be something we would want to try to get.

[Nick Rowe]

Primed: "And you also want to combine that ..."

Isn't that what I was saying, in my second reason?

Mike: just because a model has microfoundations doesn't mean it's right. Sure.

And are there (something like) "emergent properties" at the macro level? Sure. That's why macro exists.

[Min]

Nick Rowe: "I have edited the post so it reads "converging towards the natural rate of employment". And there's a distinction between "converging towards" and "always at".

Indeed. :)

But I have a related question. Along the coast of California you may often see people on hang gliders floating above the ocean off the cliffs, held aloft by the updraft from the ocean. OC, this is a temporary phenomenon, because the winds will change. But suppose that the updraft was constant. Would you then say that the hang gliders are converging towards the ocean? Or consider people in offices on the third floor of a building. Would you say that they are converging towards the ground? Or consider a planet in a stable orbit around a star. Would you say that it is converging towards the star?

It is not difficult, is it, to find economic forces that tend towards full employment? Nor is it difficult to find obstacles to it. And on occasion, we see it. But is that enough to say that the economy converges towards full employment?

[Min]

Or "natural rate" of employment? OC, there is nothing natural about a "natural rate". ;)

[Frank Restly]

Nick,

"The recent kerfuffles about higher nominal interest rates causing higher inflation. I want to know why higher nominal interest rates would cause people to choose to increase prices more quickly. I got no explanation why."

If you are a producer, one of your input costs is the cost of capital (time cost of money). If you are limited to debt financing (no publicly traded equity), then changes in your interest cost of capital may be reflected through to the prices you charge for your goods.

What might preclude you from raising your prices facing higher capital costs? A reduction in other costs (taxes, labor, material, equity financing, etc.), an increase in market share relative to financing needs (more goods produced and sold for the same capital input), and/or competition from producers of the same good.

[primedprimate]

Yes - I was just reiterating that your second reason is distinct from your first.

Your first reason is your desire for behavioral relations motivated by actual human behavior; but you don't need a micro-founded model in the usual sense for that. It would be nice, but not necessary even based on your argument (which to me comes across only as a criticism of economics based on accounting identities that are true by definition and VARs that are entirely bereft of motivating theory).

Your second reason invokes the need for micro-foundations to conduct some kind of welfare maximizing but here I would argue that incorrect micro-foundations are dangerous. In any case, even with micro-foundations, welfare maximizing is only defined in terms of some necessarily normative aggregation of different individuals' utilities and those individuals have different levels of income and belong to different generations. A carefully reasoned aggregate model may be better than a carelessly micro-founded one.

[Peter N]

Suppose macroeconomics involves emergent behavior. Microeconomics won't work for that. Biology may be fundamentally based on physics, but you could know all the physics in the world and have learned almost nothing about biology.

The model for economics has been thermodynamics as macro and atomic and molecular physics as micro with statistical mechanics as a basis for thermodynamics. This doesn't seem to work very well. Among other things there is a lack of equivalent conservation laws. Value is not a conserved quantity, though for hundreds of years economists tried to make it one.

Flows of funds may not explain, but they can disprove. If your model contradicts the flows of funds, either your model or your flow data is wrong.

You say:

" If your model doesn't have people, who want things, we can't tell if a policy change would be good."

You also need people who trust things, fear things and consider certain economic behaviors and results unfair and will act on these feelings.

[Nick Rowe]

primed: VARS at least tell you something about the world; accounting identities don't even do that. A model where each behavioural function is microfounded, but the whole model isn't, is like a novel where each chapter makes sense but the chapters don't fit together to tell a coherent story.

Incorrect anything may be dangerous.

Peter N: "Suppose macroeconomics involves emergent behavior."

We know it does. I can't even begin to imagine for example what the "quantity theory" would mean in a partial equilibrium model. But we can build macro models with microfoundations where the QT emerges.

"You also need people who trust things, fear things and consider certain economic behaviors and results unfair and will act on these feelings."

Maybe, maybe not, or maybe it depends on the question. You are arguing for one microfounded model vs another microfounded model.

[Nate K]

Getting to micro-foundations isn't going far enough. Even if we knew what people wanted it's still worth asking why they want it. Individuals and society have an endogenous relationship. It's worth asking if advertising changes people's wants and if fulfilling wants induced by advertising is actually a welfare gain (compared to a hypothetical without advertising). Assuming constant preference functions in light of the evidence from psychology and now in behavioral economics is just not realistic. But if preferences aren't constant, we want to know how they are formed and what makes them change. This means digging beyond micro-foundations. I realize this is asking a lot given that bounded rationality still doesn't seem to have been fully accepted, but I think a lot of the skepticism about micro-foundations stems from the fact that many of the ones used (infinitely lived inter-temporal utility maximizers)are really bad in terms of realistically modeling human behavior.

[Nick Edmonds]

Nicely put, Nick. It's a refreshing antidote to other stuff I've read recently (on other blogs, that is).

[Frances Woolley]

Nick, these two reasons are exactly and precisely what I love about economics. The frustration I have with macroeconomics (as opposed to micro) is that it's really hard, on a macro scale, to make those connections between the economy as a whole and individual people's well-being. I guess your point is that good microfoundations would solve that.

I'm thinking of getting my fourth year students to read this next term so that they can understand what, ultimately, I want them to do in their research papers (find some people, figure out what they're doing, and why).

[Min]

Question: Given the human tendency to trade and make deals, if there were no impediment to that, would the economy converge to full employment? (I suspect not, because the deals could become impediments to trade.)

[Herbert]

I was astonished to read: " I want to know why higher nominal interest rates would cause people to choose to increase prices more quickly. I got no explanation why."

Isn't the explanation straightforward: Interest rates rise -> opportunity cost of holding money rises -> people think they hold too much money -> running down money balances (being impossible in the aggregate, of course) boosts expenditure, hence prices rise.

If correct, this would mean that a tighter money policy could be inflationary. Or conversely, that QE forever could be deflationary.

[Odie]

Herbert,
When interest rates rise people will put money into savings not spend it. That will put downward pressure on interest rates. If the Fed wants to defend the higher rates it will mop up the excess by selling treasuries. Net effect will be less money in circulation, less spending and less pressure on prices. Not to mention that less new loans will be issued with higher interest rates. Empirically proven by Volcker among others 30 years ago that higher interest curbs inflation.

[Frank Restly]

Odie,

"Not to mention that less new loans will be issued with higher interest rates. Empirically proven by Volcker among others 30 years ago that higher interest curbs inflation."

No, not proven by Volcker.

http://research.stlouisfed.org/fred2/graph/fredgraph.pdf?&chart_type=line&graph_id=&category_id=&recession_bars=On&width=630&height=378&bgcolor=%23b3cde7&graph_bgcolor=%23ffffff&txtcolor=%23000000&ts=8&preserve_ratio=true&fo=ve&id=TCMDO,FEDFUNDS&transformation=pc1,lin&scale=Left,Left&range=Custom,Max&cosd=1960-01-01,1954-07-01&coed=2013-07-01,2013-11-01&line_color=%230000ff,%23ff0000&link_values=,&mark_type=NONE,NONE&mw=4,4&line_style=Solid,Solid&lw=1,1&vintage_date=2013-12-17,2013-12-17&revision_date=2013-12-17,2013-12-17&mma=0,0&nd=,&ost=,&oet=,&fml=a,a&fq=Quarterly%2C%20End%20of%20Period,Monthly&fam=avg,avg&fgst=lin,lin

Net annual credit expansion was higher in 1985 than it was at any time during the 1970's. And even during the 1980-1982 recession, net U. S. credit was expanding at a 9% to 10% clip. What broke U. S. inflation was a combination of offshoring (U. S. trade deficit) and a redefinition of the CPI to exclude housing prices in 1983.

"When interest rates rise people will put money into savings and not spend it."

When interest rates rise people will allocate more of their investment to interest bearing securities. The borrower in turn will spend the money that is borrowed.

"Net effect will be less money in circulation, less spending and less pressure on prices." But the money will tend to circulate more quickly because of the higher annual interest payments made by borrowers.

[Miami Vice]

I guess SW isn't the only ones who like to put the cart before the horse. Another horse analogy for monetarists; you can lead a horse to water but you can't make it drink (unless you're Chuck Norris something something, take out loan as cash hot potato).

In fact, I think you are arguing the same point you just don't realize it.

Higher interest rates lead to increased spending.

Or here's the monetarist view reduced to absurdity: tell people fed will allow economy to grow faster leads to higher interest rates leads to increased spending hot potato. All you've done is assume away front running the fed to come to your conclusion they're different.

[Miami Vice]

You've assumed increased demand for loans at the higher rate because the economy is expected to grow faster because of more borrowing at higher rates.

Its the if I tell my child they're beautiful, they will wake up tomorrow and be better looking, fallacy.

[Miami Vice]

Also, isn't the entire monetarist premise based on the idea that an accounting tautology mv=pq has been determined by monetarists to have a specific causal relationship? I think you invoked Hume's thought experiment and some nonsense about Zimbabwe to illustrate this point, just recently?

[Nick Rowe]

Herbert: "Isn't the explanation straightforward: Interest rates rise -> opportunity cost of holding money rises -> people think they hold too much money -> running down money balances (being impossible in the aggregate, of course) boosts expenditure, hence prices rise."

If we hold the stock of money constant, then if (say) an increase in desired investment or a decline in desired saving caused interest rates to rise, then that would indeed increase the opportunity cost of holding money, leading people to try to get rid of money more quickly (increase desired velocity), which increases demand for goods, causing sellers to raise prices. Yes.

But I was talking about a quite different case, where it is the central bank that decides to increase nominal interest rates. Think Wicksell.

[Odie]

Frank,

Thanks for the graph. It clearly shows that the credit expansion in 1985 happened after interest rates were cut in half again. However, the higher rates let to a ~5% drop in credit expansion in 74 and 79 pretty much validating my point. Or why do Central Banks all over the world increase rates when inflation rises? Do you really think that would increase inflation but no one had noticed it until now? Btw. In your graph you show all liabilities. When I deposit $100 in my bank account I create a liability. If the bank buys a treasury with it it creates another liability and so on. You can have a lot of credit expansion that way without ever spending the money to affect prices. If you want to look for real bank loans M1 is a better indicator. That graph shows that in 1979 and 1982 M1 growth slowed down and with it GDP:

http://research.stlouisfed.org/fred2/graph/fredgraph.png?&id=M1,GDP&scale=Left,Right&range=Custom,Custom&cosd=1975-01-06,1975-01-01&coed=1985-12-02,1985-07-01&line_color=%23ff0000,%230000ff&link_values=false,false&line_style=Solid,Solid&mark_type=NONE,NONE&mw=4,4&lw=1,1&ost=-99999,-99999&oet=99999,99999&mma=0,0&fml=a,a&fq=Weekly%2C+Ending+Monday,Quarterly&fam=avg,avg&fgst=lin,lin&transformation=lin,lin&vintage_date=2013-12-17,2013-12-17&revision_date=2013-12-17,2013-12-17

And who put that meme out that higher interest rates will lead to higher interest earnings? No treasury, corporate bond or mortgage will pay a single dime more (except for special cases like ARM or TIPS). Now, someone who wants to take out a new loan will have to pay higher interest. Big difference between a loan issuance and a secondary market transaction. Banks also will have reduced earnings as their assets just dropped in value and may need to attract more capital; another place where those savings can go. And if the Fed sells bonds to defend their rate target you again take money away from spending.

In essence, it has been empirically proven over several decades of monetary policy that higher interest rates do not cause inflation. If models contradict this reality guess who is wrong?!

[Herbert]

@Nick: If we hold the stock of money constant, then if (say) an increase in desired investment or a decline in desired saving caused interest rates to rise, then that would indeed increase the opportunity cost of holding money, leading people to try to get rid of money more quickly (increase desired velocity), which increases demand for goods, causing sellers to raise prices. Yes.

But I was talking about a quite different case, where it is the central bank that decides to increase nominal interest rates. Think Wicksell.

Are the two cases really so different? In first case, the interest rate increases because individuals want to save (= lend) less. In the second case, the interest rate increases because the central bank lends less. I assume that increasing interest rates and reducing credit supply is one and the same policy.

@Nick and Odie: I didn't want to deny that increasing interest rates will tend to reduce inflation in normal times . But times are not normal, at least in Japan. With ultra-easy money (QE) increasing interest rates could dampen money demand. After all, money demand has risen enormously in Japan during the last 15 years because, at interest rates practically zero, money seems to be seen as a perfect substitute of bonds.

Hence the upshot is this: Increasing the money supply normally increases inflation. But if this policy (via declining interest rates) increases money demand more than proportionally it could actually decrease inflation. Any other idea why QE has produced consistent deflation in Japan?

[Nick Rowe]

Herbert: I think the two cases are different, because in the first case the stock of money stays the same, and in the second case the stock of money changes because the central bank changes the nominal interest rate by changing the money supply function.

But, when the central bank does change the money supply function, it matters a lot on how this affects people's expectations about future money supply functions. For example, if the central bank said: "we are increasing the inflation target from 2% to 5%, starting now", and if it were credible, both inflation and nominal interest rates might rise immediately.

[Herbert]

@Nick: For example, if the central bank said: "we are increasing the inflation target from 2% to 5%, starting now", and if it were credible, both inflation and nominal interest rates might rise immediately.

Regarding inflation, our opinions a grossly at variance (which does not happen often). My local car dealer does not care about central bank announcements. Nor does my supermarket. They care about car and supermarket demand, respectively. And they set what they believe to be relative prices pi. What we observe as P is the outcome of such individual decisions.

Modelling the economy by ultra-clever "representative agents" who watch central bank announcements closely is misleading, I believe. P rises only when many firms think raising pi is sensible. This only happens when many individual market demands boost.