Month: March 2017

What’s Wrong With Modern Macro? Part 13 No Other Game in Town

Part 13 in a series of posts on modern macroeconomics. Previous posts in this series have pointed out many problems with DSGE models. This post aims to show that these problems have either been (in my opinion wrongly) dismissed or ignored by most of the profession. 

“If you have an interesting and coherent story to tell, you can tell it in a DSGE model. If you cannot, your story is incoherent.”

The above quote comes from a testimony given by prominent Minnesota macroeconomist V.V. Chari to the House of Representatives in 2010 as they attempted to determine how economists could have missed an event as large as the Great Recession. Chari argues that although macroeconomics does have room to improve, it has made substantial progress in the last 30 years and there is nothing fundamentally wrong with its current path.

Of course, not everybody has been so kind to macroeconomics. Even before the crisis, prominent macroeconomists had begun voicing some concerns about the current state of macroeconomic research. Here’s Robert Solow in 2003:

The original impulse to look for better or more explicit micro foundations was probably reasonable. It overlooked the fact that macroeconomics as practiced by Keynes and Pigou was full of informal microfoundations. (I mention Pigou to disabuse everyone of the notion that this is some specifically Keynesian thing.) Generalizations about aggregative consumption-saving patterns, investment patterns, money-holding patterns were always rationalized by plausible statements about individual–and, to some extent, market–behavior. But some formalization of the connection was a good idea. What emerged was not a good idea. The preferred model has a single representative consumer optimizing over infinite time with perfect foresight or rational expectations, in an environment that realizes the resulting plans more or less flawlessly through perfectly competitive forward-looking markets for goods and labor, and perfectly flexible prices and wages.

How could anyone expect a sensible short-to-medium-run macroeconomics to come out of that set-up?
Solow (2003) – Dumb and Dumber in Macroeconomics

Olivier Blanchard in 2008:

There is, however, such a thing as too much convergence. To caricature, but only slightly: A macroeconomic article today often follows strict, haiku-like, rules: It starts from a general equilibrium structure, in which individuals maximize the expected present value of utility, firms maximize their value, and markets clear. Then, it introduces a twist, be it an imperfection or the closing of a particular set of markets, and works out the general equilibrium implications. It then performs a numerical simulation, based on calibration, showing that the model performs well. It ends with a welfare assessment.

Such articles can be great, and the best ones indeed are. But, more often than not, they suffer from some of the flaws I just discussed in the context of DSGEs: Introduction of an additional ingredient in a benchmark model already loaded with questionable assumptions. And little or no independent validation for the added ingredient.
Olivier Blanchard (2008) – The State of Macro

And more recently, the vitriolic critique of Paul Romer:

Would you want your child to be treated by a doctor who is more committed to his friend the anti-vaxer and his other friend the homeopath than to medical science? If not, why should you expect that people who want answers will keep paying attention to economists after they learn that we are more committed to friends than facts.
Romer (2016) – The Trouble with Macroeconomics

These aren’t empty critiques by no-name graduate student bloggers. Robert Solow and Paul Romer are two of the biggest names in growth theory in the last 50 years. Olivier Blanchard was the chief economist at the IMF. One would expect that these criticisms would cause the profession to at least strongly consider a re-evaluation of its methods. Looking at the recent trends in the literature as well as my own experience doing macroeconomic research, it hasn’t. Not even close. Instead, it seems to have doubled down on the DSGE paradigm, falling much closer to Chari’s point of view that “there is no other game in town.”

But it’s even worse than that. Taken at its broadest, sticking to DSGE models is not too restrictive. Dynamic simply means that the models have a forward looking component, which is obviously an important feature to include in a macroeconomic model. Stochastic means there should be some randomness, which again is probably a useful feature (although I do think deterministic models can be helpful as well – more on this later). General equilibrium is a little harder to swallow, but it still provides a good measure of flexibility.

Even within the DSGE framework, however, straying too far from the accepted doctrines of macroeconomics is out of the question. Want to write a paper that deviates from rational expectations? You better have a really good reason. Never mind that survey and experimental evidence shows large differences in how people form expectations, or the questionable assumption that everybody in the model knows the model and takes it as truth, or that the founder of rational expectations John Muth later said:

It is a little surprising that serious alternatives to rational expectations have never been proposed. My original paper was largely a reaction against very naive expectations hypotheses juxtaposed with highly rational decision-making behavior and seems to have been rather widely misinterpreted.
Quoted in Hoover (2013) – Rational Expectations: Retrospect and Prospect

Using an incredibly strong assumption like rational expectations is accepted without question. Any deviation requires explanation. Why? As far as I can tell, it’s just Kevin Malone economics: that’s the way it has always been done and nobody has any incentive to change it. And so researchers all get funneled into making tiny changes to existing frameworks – anything truly new is actively discouraged.

Now, of course, there are reasons to be wary of change. It would be a waste to completely ignore the path that brought us to this point and, despite their flaws, I’m sure there have been some important insights generated by the DSGE research program (although to be honest I’m having trouble thinking of any). Maybe it really is the best we can do. But wouldn’t it at least be worth devoting some time to alternatives? I would estimate that 99.99% of theoretical business cycle papers published in top 5 journals are based around DSGE models. Chari wasn’t exaggerating when he said there is no other game in town.

Wouldn’t it be nice if there were? Is there any reason other than tradition that every single macroeconomics paper needs to follow the exact same structure, to draw from the same set restrictive set of assumptions? If even 10% of the time and resources devoted to tweaking existing models was instead spent on coming up with entirely new ways of doing macroeconomic research I have no doubt that a viable alternative could be found. And there already are some (again, more on this later), but they exist only on the fringes of the profession. I think it’s about time for that to change.

What’s So Bad About Feeling Good? A discussion of altruism, selfishness, and morality

I think most people believe that the world would be a better place if more people acted altruistically. Rather than focusing on trying to improve their own life, people should think about what they can do to help others. But the more I think about it, the less confident I am that an altruistic society is really something we should strive for.

Let’s take an example. Two people are contemplating volunteering at a center for homeless children. Person A absolutely hates their time there, but they know that the kids benefit, so they reduce their own well being out of a sense of moral duty and do it anyway. For person B, spending time with the kids is the highlight of their week. They know that they are helping the kids, but their primary motivation comes from having fun themselves.

Two questions come out of this example. First, can we really say that either person is acting selflessly? Although initially it would appear that at least person A is selfless, are they really acting against their own interest? Sure they don’t enjoy the time they spend volunteering, but if it makes them feel better about themselves, isn’t that as selfish a motivation as any other? As I discussed in my post on rationality, to an economist selfishness means nothing more than choosing the path that maximizes total (expected) happiness for a person. Person A values being a moral person and even if it comes with a short-term cost, they are willing to bear that cost because the benefit (being free of guilt, reputation, getting into heaven, the knowledge that they did something good, etc.) is even higher.

An even more interesting question comes when we try to evaluate which of the two people is more altruistic. I think it is natural to assume that altruism requires some amount of sacrifice. Even though the end result in the above example is the same – the kids are happy in either case – person B is just satisfying their own desires. How can they be altruistic? And I think that intuition is correct. If we want to make a meaningful distinction between altruism and selfishness, altruism needs to include some kind of sacrifice. If I act without thinking of others, my actions cannot be altruistic even if they coincidentally end up helping others. An entrepreneur that invents a cure for cancer in order to sell it isn’t altruistic even though they save the lives of millions of people. On the other hand, if I actively try to improve the lives of others even when I know it will hurt my happiness in the short run, we can call those truly altruistic actions.

But this definition of altruism makes it difficult to see the appeal of an altruistic society. Is a society where people help others only out of some sense of obligation, where I give only to satisfy some moral code, truly better than one where people love to give away? Would you want to live in a world full of people who act altruistically, constantly sacrificing their own well-being in order to improve the well-being of others? Or would you rather live somewhere where people act to make themselves happy, but their happiness comes directly from helping others?

Of course, the above dichotomy excludes a third outcome, one where everybody acts for themselves at the expense of others. Most would agree that this is by far the worst of the three societies. I definitely agree that our goal should be to avoid this result. The way to do that, however, doesn’t have to come from laws. It doesn’t have to come from religion. It doesn’t have to come from duty or obligation. Forcing people to do good might be effective, but wouldn’t it be a better society when people want to do good?

Fortunately, I think humans have evolved in such a way where we do feel good when we help others. Most of life’s best experiences come from our relationships with others. Love. Friendship. Family. Trust. Gratitude. Respect. Those feelings are some of the most valuable pieces of a happy life. They are impossible to achieve without other people. Someone might be able to get ahead in a purely materialistic sense by seeing their own well-being as their only concern. They’ll get more wealth. More fame. But not more happiness. The best way to get people to act selflessly is to make them aware of the fact that helping others is the best way to help themselves.

An altruistic society consists of a bunch of unhappy people doing their best to make other people feel happy. They help others despite the fact that it makes them feel bad. An ideal society, in my opinion, is one where people help others because it makes them feel good.

What’s Wrong With Modern Macro? Part 12 Models and Theories

Part 12 in a series of posts on modern macroeconomics. This post draws inspiration from Axel Leijonhufvud’s distinction between models and theories in order to argue that the current procedure of performing macroeconomic research is flawed.

In a short 1997 article, Axel Leijonhufvud gives an interesting argument that economists too often fail to differentiate between models and theories. In his words,

For many years now, ‘model’ and ‘theory’ have been widely used as interchangeable terms in the profession. I want to plead the case that there is a useful distinction to be made. I propose to conceive of economic ‘theories’ as sets of beliefs about the economy and how it functions. They refer to the ‘real world’ – that curious expression that economists use when it occurs to them that there is one. ‘Models’ are formal but partial representations of theories. A model never encompasses the entire theory to which it refers.
Leijonhufvud (1997) – Models and Theories

The whole article is worth reading and it highlights a major problem with macroeconomic research: we don’t have a good way to determine when a theory is wrong. Standard economic theory has placed a large emphasis on models. Focusing on mathematical models ensures that assumptions are laid out clearly and that the implications of those assumptions are internally consistent. However, this discipline also constrains models to be relatively simple. I might have some grand theory of how the economy works, but even if my theory is entirely accurate, there is little chance that it can be converted into a tractable set of mathematical equations.

The result of this discrepancy between model and theory makes it very difficult to judge the success or failure of a theory based on the success or failure of a model. As discussed in an earlier post, we begin from the premise that all models are wrong and therefore it shouldn’t be at all surprising when a model fails to match some feature of reality. When a model is disproven along some margin, there are two paths a researcher can take: reject the theory or modify the assumptions of the model to better fit the theory. Again quoting Leijonhufvud,

When a model fails, the conclusion nearest to hand is that some simplifying assumption or choice of empirical proxy-variable is to blame, not that one’s beliefs about the way the world works are wrong. So one looks around for a modified model that will be a better vehicle for the same theory.
Leijonhufvud (1997) – Models and Theories

A good example of this phenomenon comes from looking at the history of Keynesian theory over the last 50 years. When the Lucas critique essentially dismantled the Keynesian research program in the 1980s, economists who believed in Keynesian insights could have rejected that theory of the world. Instead, they adopted neoclassical models but tweaked them in such a way that produced results that were still consistent with Keynesian theory. New Keynesian models today include rational expectations and microfoundations. Many hours have been spent converting Keynes’s theory into fancy mathematical language, adding (sometimes questionable) frictions into the neoclassical framework to coax it into giving Keynesian results. But how does that help us understand the world? Have any of these advances increased our understanding of economics beyond what Keynes already knew 80 years ago? I have my doubts.

Macroeconomic research today works on the assumption that any good theory can be written as a mathematical model. Within that class of theories, the gold standard are those that are tractable enough to give analytical solutions. Restricting the set of acceptable models in this way probably helps throw out a lot of bad theories. What I worry is that it also precludes many good ones. By imposing such tight constraints on what a good macroeconomic theory is supposed to look like we also severely constrain our vision of a theoretical economy. Almost every macroeconomic paper draws from a tiny selection of functional forms for preferences and production because any deviation quickly adds too much complexity and leads to systems of equations that are impossible to solve.

But besides restricting the set of theories, speaking in models also often makes it difficult to understand the broader logic that drove the creation of the model. As Leijonhufvud puts it, “formalism in economics makes it possible to know precisely what someone is saying. But it often leaves us in doubt about what exactly he or she is talking about.” Macroeconomics has become very good at laying out a set of assumptions and deriving the implications of those assumptions. Where it often fails is in describing how we can compare that simplified world to the complex one we live in. What is the theory that underlies the assumptions that create an economic model? Where do the model and the theory differ and how might that affect the results? These questions seem to me to be incredibly important for conducting sound economic research. They are almost never asked.

Why Do We Love Football? A Tale of Seven Super Bowls

It’s been a while since my last blog post and I needed a break from writing about economics and politics, so here’s a post on another important part of my life: football (for my international friends, I mean real football, not that silly game where they actually use their feet)

Source: Wikimedia Commons

February 1, 2015: Undrafted rookie Malcolm Butler runs onto the field in a game that is all but over. 2nd and goal on the 1. Up by 4. Beast Mode ready across the line of scrimmage. But he’s seen this play before. In an instant, certain defeat has transformed into sure victory – and utter misery into sheer euphoria.

Why do we love football? For millions of people, Sundays from September to February have a single purpose – they put their lives on hold to watch a bunch of strangers play what is, on the surface, just a game. I am one of those people. But I’ve often wondered why we care so much about the result of a game that will seemingly have no real effects. Whether the Patriots win or lose, my life goes on essentially unchanged. And yet I spent Super Bowl Sunday pacing around my apartment so tense you would have thought my life depended on it. Why? Aren’t there more important things in life than stupid games?

February 5, 2012: The ball is in his hands. Wes Welker. One of the most sure handed receivers in the history of the NFL. The pass is a bit high, but the ball is in his hands. Until it isn’t. The catch that should have sealed the game ends instead with number 83 lying on the ground, only his head left in his hands.

And why do players and coaches dedicate their lives to this game? Sure some get fame. Some get respect. Some get paid large sums of money. But is that really enough to justify spending every waking hour preparing to play a game that will almost certainly be detrimental to players’ future health? Is it enough to justify staying up late at night watching film to gain even the slightest advantage over another team, or spending a large portion of the year on the road away from their families?

February 3, 2008: An undefeated season on the line. Maybe the best offense to ever play this game has been held to a meager 14 points. And yet somehow they’re up by 4 with 2 minutes to go. Eli Manning breaks away from defenders (who were held) and throws up a prayer. There’s no chance he catches this. It lands on the helmet of David Tyree. There’s no chance he catches this. Rodney Harrison’s arms come inches from the ball. There’s no chance he catches this. He falls to the ground, ball pinned to his head. He caught it.

Perhaps it’s just our savage desire for violence. Does our love of the pigskin come from the same place as the Romans’ love for the gladiators? Is it some sort of evolutionary instinct that compels us to watch grown men beat each other up for 60 minutes? Maybe our ancestors will look back on us with a mix of surprise and disgust. They were entertained by that?! Barbarians!

February 6, 2005: Dynasty. It’s something that’s not supposed to happen in the NFL. The league is designed around the concept of parity. 3 Super Bowls in 4 years? Unheard of. Unheard of, that is, until Tom Brady and Bill Belichick became the ultimate football pair.

We’re not getting anywhere. In fact, football seems like a terrible creation, a blight to be eliminated from a refined society. So let’s talk about something else. Why do we love art? Is it because it looks beautiful? Of course that must be part of it, but I think there’s something deeper. A Picasso painting isn’t beautiful in the common sense of the word, but we still find something about it enticing. It’s unique. Something nobody else in the world could have done. All forms of entertainment share this characteristic. They appeal to us in a purely materialistic sense – because we like what we see and hear. But they also offer us a glimpse at the incredible person behind the creation.

February 1, 2004: Tie game with 4 seconds left. For any normal person the pressure would be suffocating. For Adam Vinatieri it’s just another day at the office. Statisticians say “clutch” doesn’t actually exist. Obviously they haven’t met Mr. Clutch himself.

No other human being on the planet could make the catches made by Odell Beckham. Nobody else can throw a Hail Mary like Aaron Rodgers. To be the absolute best at something, anything, is an experience the vast majority of us can never have (to quote Homer Simpson: “No matter how good you are at something, there’s always about a million people better than you”). But we absolutely love watching those that can. Football offers an opportunity for people to be great. And we love greatness. We love seeing people dedicating their lives to something, becoming the best they can possibly be.

February 3, 2002: The Greatest Show on Turf against a no-name backup quarterback. Nobody gave him a chance. Even with the game tied late in the 4th quarter, the announcers count him out. Just take a knee and play for overtime says John Madden. Instead, he leads the team down the field and Vinatieri splits the uprights for the victory. 

We love the stories. Teams on the brink of defeat that never give up and come through with a win. Players that are counted out from the beginning but show up every day determined to prove the world wrong. And these stories are driven by talented individuals pushing themselves to the limits, breaking the boundaries of what people thought was possible.

February 5, 2017: 28-3. Few Super Bowls have been so one-sided. One team has dominated on both sides of the ball. Their quarterback has a perfect passer rating. Their defense puts pressure on the QB despite lockdown coverage in the secondary. No team has ever come back from more than 10 in a Super Bowl. But no other team has had Tom Brady.

A Picasso painting. A Mozart symphony. A Spielberg film. And a Tom Brady Super Bowl? Many will say I’m crazy to put these in the same category, but I find it hard to find a good reason why they shouldn’t be. The product is different and whether people appreciate one form over another will always come down to a subjective value judgement. Some people are bored to tears by museums. Others can’t stand watching sports. But the final product is less important than the once in a lifetime talent and dedication that created it.

April 16, 2000: With the 199th pick in the NFL draft, the New England Patriots draft Thomas Edward Patrick Brady Jr. Nobody knows it yet, but he’s destined to become the best quarterback of all time, a symbol of everything we love about the game of football.