Saturday, January 17, 2015

I strongly disagree with what you are talking about

As a companion piece to my post on some basics of the information transfer model, I'm going to list several things that strongly go against the mainstream of economic thinking ... again in a Vox-style explainer format.

Preferences are irrelevant most of the time to many macro variables

Individual preferences, and metrics for them like utility (or expected utility), are irrelevant to macroeconomic outcomes. This is not to say they are irrelevant to microeconomics. However, the essence behind using the 'information theory shortcut' is that a theory that accurately models preferences at the micro level is so complicated that the result isn't distinguishable from randomness. Yes, you can model the pressure of an ideal gas in a container by calculating accurately all of the collisions between atoms and the walls of the container (we'd make an analogy here between energy and momentum conservation and stable preferences -- the atoms 'want' to conserve energy and momentum), but the resulting list of velocities you'd get for every atom would follow a Maxwell distribution ... even if you started with all the atoms at one side of the container.

Microfoundations are irrelevant to macroeconomics most of the time

This is a somewhat stronger statement than the previous one. The fact that you can do a pretty good job of describing the macroeconomy with a few variables (output, price level, unemployment rate, interest rates, ... it really doesn't matter what you include as long as the length of this list is less than, say, a million variables) and that economies with the same values of these variables tend to be in the same situation means that microfoundations are irrelevant. Why? Let's say your model is really complicated, like one of the Fed's DSGE models that describes 10 variables. That places any given solution in a 10-dimensional space. Now the economy in the US is made of 100's of millions of individual agents. That represents a greater than 100,000,000-dimensional space -- and that's if people are 1-dimensional! In order for your 100,000,000-dimensional microfounded theory to map to a 10-dimensional DSGE model, large portions of your 100,000,000-dimensional space must map to the same point (or subspace) of your 10-dimensional space. In thermodynamics, your 6N dimensional problem, where N is the number of molecules ~ 10^23, maps down to a few dimensions (a small set of variables like temperature, entropy, pressure, etc).

In the information transfer model, we tend to map to 2-dimensional spaces and still have a lot of empirical success. That's why I say 'microfoundations are irrelevant' -- there appears to be a lot of dimensional reduction going on in macroeconomics.

Actually, this is similar to the Sonnenschein–Mantel–Debreu theorem where assumptions about the microeconomics end up having no macroeconomic implications -- but stronger.

You keep saying 'most of the time', why? And why is even this contrary to the economic mainstream?

During recessions, the assumption of information equilibrium seems to break down temporarily. Recessions themselves seem to be an emergent phenomenon (they wouldn't exist for an individual market and they would happen regardless of the specifics of economic agents' preferences in your micro theory). Stories like the babysitting co-op may describe real economic phenomena (mainly a 'story' about the quantity theory of money), but it isn't what is happening in a recession. The 'monetary' contraction in the babysitting co-op may trigger a recession (as appears to have happened in the run-up to the 2008 financial crisis), but it isn't a recession on its own.

Several aspects of the macroeconomy are emergent

Some macro effects don't even exist for the agents in the microeconomic theory, such as sticky prices, secular stagnation and the liquidity trap in the information transfer model. Therefore there is no story you can tell with individual agents that both a) are accurate and b) capture the effect. I'm sure economists can come up with just-so stories to arrive at just about anything, but that's because there aren't limits on stories. This emergence means that for some effects, this statement by Paul Krugman is incorrect:
But behind [the economic model] is a story about people doing stuff: investors selling the currency because yields are down, the currency falling until it’s so low that people figure it has nowhere to go but up.
There is no 'story' behind entropic forces that you can tell for an individual atom. An atom participates in diffusion or osmosis because of entropy (counting states), not from a physical force acting on it. A single molecule of glue isn't sticky. A single molecule doesn't have a temperature (or entropy).

Even the idea of a demand curve or a supply curve is emergent. An atom doesn't exert less pressure because of the diminishing marginal utility of extra volume and a single economic agent doesn't pay a smaller price for an iPad because of the diminishing marginal utility of extra iPads. We as an ensemble of economic agents will buy more iPads at a lower price than a higher one, holding demand constant.

What emphasizes this last point even further is that there are such things as Veblen goods and Giffen goods -- things that individuals will become more likely to buy (or consume more of) if the price goes higher. As an ensemble of agents -- with a sufficiently large basket of goods -- we will still follow the general concept of consuming more goods at lower prices and fewer at high prices.

Sticky prices have no microeconomic story

Although critical to macroeconomics as practiced by the mainstream, nominal rigidity (i.e. sticky prices) has no microeconomic story behind it. I mentioned this in the previous segment, but I thought I'd emphasize it a bit more. Menu costs and Calvo pricing are models that attempt to get the effect of sticky prices into a micro model, but there really isn't much stopping an individual from changing the prices at their own store or lowering their own wage. There is however an entropic force preventing all of us from making those changes.

Adding menu costs or Calvo pricing to the micro models is a bit like adding a 'diffusion force' to atoms.

The liquidity trap has no microeconomic story

I thought I'd call this one out, too. No, the liquidity trap has nothing to do with individuals lacking a preference between a zero interest government debt (at the zero lower bound) and zero interest currency. In fact, the liquidity trap has a gradual onset (not sudden at the ZLB) and has been steadily rendering monetary policy less and less relevant to macroeconomics.

As the number of dollar bills increases (and the size of the economy increases), a given dollar bill is simply more and more likely to be facilitating a transaction in a low growth market. The emergent concept here is an economic temperature that falls as more and more money is added to an economy. Large economies are 'cold' economies.

Where else am I going against the grain? ....



Added 1/18/2015: Exchange rates don't (always) measure inflation

I think this is the best way to introduce this one:
Scott Sumner: Tom, I like Jason, but he needs to learn how to explain his ideas to economists, using intuition. 100% of economists believe that inflation leads to currency depreciation. If you are going to argue the opposite you need a STORY, not just a model, or an empirical study.
That also goes to the idea about a story above. However, in this case, there actually is a story and it's that demand for currency is important, not just supply. In a liquidity trap, inflation and exchange rates appear to decouple. That is how e.g. Switzerland could depreciate its currency and get deflation.

As it is written, though, Sumner is still correct. Inflation leads to depreciation, but depreciation doesn't always lead to inflation.




4 comments:

  1. This is excellent. You must continue your attack. Do not cave in. Your enemy are the economists who will try and obfuscate using their own impregnable mathematics, but you can match them! I do like these arguments, which I've made, sans the math, at TheMoneyIllusion where Sumner blogs. Specifically, as early as late last year I said Sumner's NGDPLT is prone to wild fluctuations if it is tied to a futures market (I was thinking of the Gambler's Ruin paradox, which is what happens when a bet is not tied to something concrete, namely, it goes to zero), and, that prices are not sticky (wages are a bit, but not over time). I see you've made two posts that confirm this, using math, which I've already used at Sumner's blog. Blog on! We can make a difference, we newbies can rock these jaded economists! The important point in our favor is our realization that economics is a non-linear system that has no closed-source, exact equation. Within limits, the equations can go up, down or sideways even given the same initial conditions. Case in point: the Great Depression was essentially a problem that went away on its own, when WWII came along, yet every economist in disparate countries claims credit for governments overcoming it, even when the policies differed country-by-country. See Larry Bartels' quote here: http://www.mischiefsoffaction.com/2015/01/more-evidence-that-depressions-dont.html

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    Replies
    1. Hello Ray, I appreciate your enthusiasm.

      However, I think you may have misunderstood what I've said about sticky wages and prices. While there is no microeconomic force making wages or prices sticky, there is an emergent (entropic) macroeconomic force that does so. No individual wage or price is sticky, but collectively, they are.

      http://en.wikipedia.org/wiki/Emergence

      http://en.wikipedia.org/wiki/Entropic_force

      Delete

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