Monday, November 9, 2009

Alan Kirman on Modern Macroeconomics (amv)

Last week, the CESifo Economic Studies Conference in Munich poses the important question of "What's Wrong With Modern Macroeconomics?". Many illuminating papers were presented. The most interesting one, of course only from my point of view, is Alan Kirman's "The Economic Crisis is a Crisis for Economic Theory". I deeply admire Kirman and believe that the profession should listen to him. Here some teasers:

The vision of the world reflected in modern macroeconomic models leaves out aspects of the economy which seem to be central to understanding how it functions and evolves. Indeed, the problem that intrigues many people when they first come to economics is that of explaining how the myriad of disparate individual economic activities come to be coordinated. A modern economy is composed of millions of agents who interact directly and indirectly with each other. Each of them knows a great deal about the activities they are engaged in and a lot about the people whom they interact on a regular basis. They interact intensively and directly with some individuals and less often and more indirectly with others. They have a great deal of very local information but, know much less about the behaviour of the whole economy, other than through some summary statistics. Yet, despite the fact that most of the individuals in the system are not aware of each other’s existence, collectively their activities are remarkably coordinated. The questions that we should be asking, are first, how is it that all these individuals each of them with specific information and abilities organise themselves, for most of the time, in a consistent and for most of the relatively predictable way? Secondly, how is it that the system passes periodically through major upheavals?
So, the question is not to find an alternative explanation as to how the economy arrives at an equilibrium in the classic sense, it is rather, what sort of framework has it developed to achieve all of the coordination that we do observe and how does that self organisation sometimes lead to major phase changes?

Where does this leave us ? Either we continue to try to reconcile aggregate behaviour with that of the standard rational individual, a hopeless task from a theoretical point of view, or we accept that the difference between individual and aggregate behaviour is fundamental and then build models which show this explicitly. Thus aggregation has to move to the centre of the stage. [...] Thus the really basic issue, is that we continue in much of macroeconomic analysis to dismiss the aggregation problem and to treat economic aggregates as though they correspond to economic individuals although this is theoretically unjustified. It is this simple observation that the structure of the models, however sophisticated, that macroeconomists build, unacceptable. But what is worse is that in the anxiety to preserve the scientific foundations, macroeconomists also dismiss the questioning of the soundness of the so-called scientific foundations.

The full force of the Sonnenschein, Mantel, and Debreu (SMD) result is often not appreciated. Without stability or uniqueness, the intrinsic interest of economic analysis based on the general equilibrium model is extremely limited. Morishima (1964) was very clear, when he said, concerning stability, « If economists successfully devise a correct general equilibrium model, even if it can be proved to possess an equilibrium solution, should it lack the institutional backing to realise an equilibrium solution, then the equilibrium solution will amount to no more than a utopian state of affairs which bear no relation whatsoever to the real economy. »

In fact, we know that, in general, there is no simple relation between individual and aggregate behavior, and to assume that behavior at one level can be assimilated to that at the other is simply erroneous. [...] It is worth noting that the SMD results show the weakness of the model but not where that weakness comes from. Nevertheless, the damage was done and many theorists realised just how unsatisfactory the basic model was. What is particularly interesting about that episode is that it was scholars of the highest reputation in mathematical economics who understood the nature of the problem and who brought the edifice down. Indeed, to this day, many economists, usually not pure theorists, continue to use the model as if the SMD results were just a formalistic objection. As a parenthesis it is just worth remarking that something that plays a key role in macroeconomics, information, was an important ingredient of the failure to solve the stability problem. The basic market model has been shown to use remarkably little information when
functioning at equilibrium. But as Saari and Simon (1978) have shown, if there were a mechanism that would take a General Equilibrium, ( Arrow–Debreu) economy to an equilibrium, that mechanism would require an infinite amount of information. Thus, the stability problem was basically unsolvable in the context of the general equilibrium model. To repeat, starting from individuals with standard preferences and adding them up allows one to show that there is an equilibrium but does not permit one to say how it could be attained.