Macroeconomics: a theoretical and empirical multiverse

Multiverse, by Leo Villareal (National Gallery, DC) [my photo, 2011].

Update: TL;DR version

Theoretical frameworks organize well established empirical and theoretical results. Using that framework allows your model to be consistent with all of that prior art. Proceeding without a framework means you inevitably pick and choose models and empirical data based on implicit ad hoc theorizing ... basically feelings. Different models and empirical data = different universes.

Update, the second
I. 

A response from John Handley, who seems to favor an ex ante judgment call approach, and who also comments below.

Regarding one of the comments, I am using "RBC" as a generic term for DSGE without sticky prices (which I think is what Wren-Lewis means). The first RBC model (Kydland-Prescott) was the first DSGE model.

II.

And a referral to Eric Lonergan on eclecticism (multiple models with different scopes). This is a great point:

I think the ex post/ex ante problem [Noah Smith] describes is a much more general problem, particularly in areas like economics where you cannot assume the “uniformity of nature”, to borrow a phrase from Hume. ... Now [uniformity of nature] is definitively not true in much of economics, because the structure of the economy is changing. It is highly likely that a model which did explain wage behaviour in the 1970s – and had predictive power in the 1970s – is no longer valid.

I would agree that this may truly be the case, which does render my favored "framework" approach moot. But a) if you only have a decade at a time macro model validity, you could never gather enough data to demonstrate its validity, b) is an implicit theory of how economies operate and c) I think this represents a kind of resignation. We don't have any specific evidence that you can never have a big theory/framework, or one that can operate across decades. We haven't really exhausted the set of possible frameworks to say let's stop trying for a big theory. A lack of imagination (or being difficult to find) is not proof that such things don't exist. I make a similar point in this post (just substitute "state-dependent" with "eclectic") using the example of quantum mechanics. If physicists had decided to just say physics was state dependent, we never would have had the new framework of quantum mechanics. But as Eric says, lack of state dependence is a more intuitive assumption in physics than economics which is a great counterpoint.

Eric does say something else I think is "great, if true":

In fact, that is precisely why an eclectic approach is more rigorous – it requires us to define the regime in which the theory is applicable (perhaps requiring valid micro-foundations) – we are making no claim to universal validity.

That would be great! But economic models never seem to state these regimes (scope conditions). Models are presented as if they apply in any decade, for any country, for upwards of 20 years at a time (on that last one, check out Woodford's presentation [pdf] which has a graph that goes out 20 years and talks about expectations at infinity).

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Original post

Simon Wren-Lewis reviews Dani Rodrik's Economics Rules and is pretty positive about it. It seems there is no change from the early interpretation, and I've written about some of the issues involved before (which I will reference alongside quotes from Wren-Lewis's latest below). The great thing is the specific example Wren-Lewis gives of the general idea he put forward which I talk about here. Here's Wren-Lewis:

Let me give you a simple example from macro. How do we know if most economic cycles are described by Real Business Cycles (RBC) or Keynesian dynamics. One big clue is layoffs: if employment is falling because workers are choosing not to work we could have an RBC mechanism, but if workers are being laid off (and are deeply unhappy about it) this is more characteristic of a Keynesian downturn. This simple test beats any amount of formal econometric comparison.

Noah Smith's point about ex ante versus ex post is relevant -- almost damning. This is literally figuring out which model to use ex post. The only reason the ex post reasoning is not completely beyond the pale is the quote discussed below: Wren-Lewis is a doctor, not a physicist. However, there is more to this; ask yourself some questions: 

Q: What is the typical difference between RBC DSGE models and NK DSGE models? 

A: Sticky prices/wages. 

Q: What are the reasons to use sticky prices/wages? 

A: Claimed to be observed experimentally and necessary to make monetary policy non-neutral in DSGE models. 

Q: How are sticky prices implemented in NK DSGE models? 

A: Usually ad hoc Calvo pricing (aka the Calvo fairy), but also other models. 

Q: What's wrong with the Calvo fairy (and other models)? 

A: They don't look anything like real price changes. 

In fact, Martin Eichenbaum, Nir Jaimovich, and Sergio Rebelo, (2008) "argue that our evidence is inconsistent with the three most widely used pricing models in macroeconomics: flexible price models, standard menu cost models, and Calvo-style pricing models." This isn't just some study that will be overturned by some other study some day ... it's referenced in David Romer's graduate textbook Advanced Macroeconomics. It is well-known that these models are empirically unrealistic.

So a mechanism (Calvo pricing) that is inconsistent with empirical price data is either applied (NK) or not applied (RBC) based on which version of the model would consistent with some other empirical data on unemployment. In this case, empirical data on unemployment (whether unemployment is voluntary) is considered more important in setting scope of the theory than empirical data on prices because ... because why?

There is no good ex ante reason in this case for weighting some empirical results more than others, so we have not only an ex post reason to choose the model, but an ex post weighting of different empirical results. We haven't just decided the NK model works better for policy prescriptions; we've decided we live in a different theoretical and empirical universe. We can pick and choose different theories and different empirical results ex post depending on subjective judgments ("craft").

PS Now I'm sure someone is thinking of the graphs I reproduce here that show a big spike at zero nominal wage change. If you look at those graphs, however, only about 12% of the labor force is in the zero change bin, rising to about 16% during a recession. The remaining 84% of the work force has wages changing by as much as 20%. Much like in the case of prices above -- where sale prices can change the price of a good by 50% instantly -- this really can't be considered micro stickiness. Some workers are getting wage cuts of 20%. Why doesn't that head off involuntary unemployment? It's not part of any economic theory, but I have an answer (in the link at the beginning of this paragraph). It's called macro stickiness, and it stems from the fact that there are still wage increases of 20% and there is no coordination that allows more wage cuts than raises (the distribution of wages doesn't change, so its average doesn't fall). There's an entropic force (a pseudo-force) that arises from the resistance of the distribution to change from the most likely distribution. I go into this more in my paper. And it even can rehabilitate the Calvo fairy -- the Calvo fairy becomes an effective description of macro stickiness.

Here are some more posts from me on nominal rigidity:

Micro stickiness versus macro stickiness 

Macro prices are sticky, not micro prices 

Nominal rigidity is an entropic force

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PPS Below are some additional quotes from Wren-Lewis alongside some additional commentary from me.

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Rodrik spends a good part of the book describing how you ‘navigate among models’. He warns that these methods are as much a craft as a science. Many have picked up on that, presuming that this is something that a proper science would not do. But as I have often said, the best analogies for economics are with medicine rather than physics. When a doctor diagnoses an illness based on symptoms, they could also be said to be using craft rather than science.

There is much more to this than it just being "a proper science would not do". Without specific conditions for when one model applies or not means that when an empirical result invalidates a model, it should invalidate that model for any condition. Not having different rooms in your building (theory) well-separated by fire-walls and fire-doors (scope conditions) means that a fire in one part burns the entire building down. A case of a minimum wage hike in New Jersey not impacting employment (along with several others) means that the Econ 101 theory of supply and demand in an open market has been killed because the Econ 101 theory of supply and demand has no scope conditions.

Even doctors abide by this. If there is some theory of disease X in general and clinical trials or experiments show it doesn't work for disease X, doctors won't use it for disease X. Well, they might, but people tend to get angry and sue if they do ...

The entire theory of disease X is burned down. Since there are more diseases, limiting a theory to a specific disease is an example of a scope condition -- those empirical results about disease X don't necessarily impact disease Y or disease Z.

And doctors nearly always have scope conditions (because they are scientists). Your theory of how neurons work is limited to neurons. And it isn't presented as a theory of how all cells work. Macro models, like those DSGE models above, are nearly always presented as if they always apply. At least always apply in the short run (e.g.) ... which I talk about next.

Some more on this subject in this post:

We built this theory on scope conditions

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It is routine, for example, to split issues up by time: the famous short, medium and long run. A New Keynesian model is not going to tell you much about long run growth, but a Solow growth model does not tell you much about involuntary unemployment.

Simon gives us the only scope conditions economics appears to have. These appear to be so embedded that "growth economics" (i.e. the long run) is basically a separate field from business cycle macro. And this is great! A negative empirical result for a NK DSGE model doesn't burn down the Solow growth model. Ladies and gentlemen: We have a scale!

Except we don't really know what these scales are. They are ad hoc separations created by theoretical fiat. For example, the Solow growth model does not have in it any mention that it only applies in the long run. Actually, it makes certain assumptions about the short run -- effectively saying short run macro fluctuations (the business cycle) either don't happen or average to zero over a very short time scale (less than a couple years). There is probably some way to make sense of this, but economists don't seem to be very concerned with treating scales properly in order to take the long run or short run limits.

More on this in these two posts (and links therein):

Some day my long run will come 

On limits

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Lots of people get hung up on the assumptions behind models: are they true or false, etc. An analogy I had not seen before but which I think is very illuminating is with experiments. Models are like experiments. Experiments are designed to abstract from all kinds of features of the real world, to focus on a particular process or mechanism (or set of the same). The assumptions of models are designed to do the same thing.

Models are not like experiments. Economists remove external effects and confounding factors in order to isolate the system by theoretical fiat. This does not work without a big, successful theoretical framework. For example, physicists can set up thermodynamic thought experiments in textbooks, isolating the system by theoretical fiat, because thermodynamics was already shown to be a successful theory. And the reason physicists were able to set up experiments that isolated the experiments was that the way to isolate the system (with physical distance and barriers) luckily corresponded to our intuition. Macroeconomics is not intuitive, and so any attempt to isolate the system using assumptions is problematic. Essentially, models should be considered not "experiments", but "thought experiments in alternate universes" ... where we don't really know if the universe under consideration is our universe.

Some more on this subject from these two posts:

What's wrong with Dani Rodrik's view of economics 

Thought experiments in alternate universes