And also I could throw in rational expectations but the title has enough in it already!
http://noahpinionblog.blogspot.com/2012/04/equilibria-unique-and-not-so-unique.html
Noah Smith has had some interesting posts on models in economics and microfoundations. Of course in light of the 2008 crisis macroeconomics has had to contend with rising skepticism. Krugman wrote a paper that declared it had failed which got a lot of push back. Many of the old timers like Stephen Williamson and of course Robert Lucas-who is largely the father of modern macro himself-pushed back furiously to this.
But much as orthodoxy might not like it the floodgates has opened. As Sumner himself admits there is some truth in Krugman's point that younger economists are quietly looking to new ways of doing marco.
Krugman himself ouf course has long been a fan of Hicks' IS-LM model that ruled macro for many years. Revolutions in macro don't happen that often. Hicks came after Keynes' General Theory. After this IS-LM was the coin of the realm for the next 40 years or so. Then Robert Lucas and the rise of microfoundations and DSGE.
At this point the current DSGE paradigm has been around for about 40 years so it would be good timing based on precedent.
In the last few days Noah Smith has written some posts with suggestions as to what these new models could look like. In a post a few days ago he suggested that what needed to be scrapped in DSGE is equilibrium. There was the suggestion that certain types of models in things like weather forecasting could be the way to go as it would bring back things like uncertainty and Keynes' animal spirits. Such a model would accept and embrace disequilibrium.
Today Noah brought in a guest post from Roger Farmer who had the least gave us some food for thought.
Farmer seems to want to urge us away from the idea of disequilibrium. He does admit that there are some problems with equilibrium in the dominant DSGE models. However he clearly feels that getting rid of equilibrium as such would be throwing out the baby with the bath water.
"As a proponent of models with multiple equilibria, let me say a few words about your very interesting post on disequilibrium. I am a big fan of Bob Lucas' insistence on restricting ourselves to equilibrium models. Why?"
"The idea of disequilibrium is borrowed from the physical sciences where it has meaning in the context of, for example, Newtonian mechanics. A ball rolling down an inclined plane is an example of a physical system in disequilibrium. When it reaches the bottom of the plane, friction ensures that the ball will come to rest. That is an equilibrium. But it is not what we mean by an equilibrium in economics."
"An economic equilibrium, in the sense of Nash, is a situation where a group of decision makers takes a sequence of actions that is best, (in a well defined sense), on the assumption that every other decision maker in the group is acting in a similar fashion. In the context of a competitive economy with a large number of players, Nash equilibrium collapses to the notion of perfect competition. The genius of the rational expectations revolution, largely engineered by Bob Lucas, was to apply that concept to macroeconomics by successfully persuading the profession to base our economic models on Chapter 7 of Debreu's Theory of Value, as opposed to the hybrid models of Samuelson's neoclassical synthesis. In Debreu's vision, a commodity is indexed by geographical location, by date and by the state of nature. Once one applies Debreu's vision of general equilibrium theory to macroeconomics, disequilibrium becomes a misleading and irrelevant distraction."
"The use of equilibrium theory in economics has received a bad name for two reasons."
"First, many equilibrium environments are ones where the two welfare theorems of competitive equilibrium theory are true, or at least approximately true. That makes it difficult to think of them as realistic models of a depression, or of a financial collapse, since the welfare of agents in a model of this kind will be close to the best that can be achieved by a social planner. An outcome that is best, in this sense, does not seem, to me, to be a good description of the Great Depression or of the aftermath of the 2008 financial crisis."
"Second, those macroeconomic models that have been studied most intensively, classical and new-Keynesian models, are ones where there is a unique equilibrium. Equilibrium, in this sense, is a mapping from a narrowly defined set of fundamentals to an outcome, where an outcome is an observed temporal sequence of unemployment rates, prices, interest rates etc. Models with a unique equilibrium do not leave room for non-fundamental variables to influence outcomes. It is not possible, for example, for movements in markets to be driven by sentiment; what George Soros has called "the mood of the market". It is for that reason that conventional theory seeks to explain large asset price swings as disequilibrium phenomena."
"Multiple equilibrium models do not share these shortcomings (see, for example, this) And they do not need to appeal to disequilibrium explanations to account for phenomena that are anomalous when one adopts the unique-equilibrium perspective. But although multiple equilibrium models have advantages in these respects, they lead to a new set of questions. It is easy enough to write down an economic model where more than one outcome is possible. But how would a rational economic agent behave if placed into an environment that was the real world analog of the economist's model?"
"The answer, I believe, is that a model with multiple equilibria
"The belief function is a mapping from past observable variables to expectations of all future variables that are relevant to a decision maker. It is this function that guides behavior when a rational expectations model is indeterminate. The belief function provides a way for social psychology to influence economic outcomes, and in my view; it should be accorded the same methodological status as that of preferences, technology and endowments in a classical or new-Keynesian model."
"Some recent authors have argued that rational expectations must be rejected and replaced by a rule that describes how agents use the past to forecast the future. That approach has similarities to the use of a belief function to determine outcomes, and when added to a multiple equilibrium model of the kind I favor, it will play the same role as the belief function. The important difference of multiple equilibrium models, from the conventional approach to equilibrium theory, is that the belief function can coexist with the assumption of rational expectations. Agents using a rule of this kind, will not find that their predictions are refuted by observation. It is the belief function itself that selects an equilibrium."
"I work with models of multiple equilibrium that have incomplete labor markets (see, for example, this); as a consequence of this incompleteness, these models have multiple steady state equilibria. Incomplete labor market models fit the data better than their classical or new-Keynesian counterparts ( see http://rogerfarmer.com/newweb/pdffiles/farmer_phelps_volume_revision.pdf ). And because they do not imply that all unemployment is socially optimal, they are able to account for the mass human misery caused by persistent unemployment that we observe in periods like the Great Depression or the 2008 financial crisis."
"Like their classical or new-Keynesian counterparts, incomplete labor market models explain data as a unique mapping from fundamentals to outcomes. But fundamentals include more than just technology, preferences and endowments; they also include a role for market sentiment. Outcomes in these models can sometimes be very, very bad."
"This brings me to your excellent post on the use of the disequilibrium assumption in economics. If by disequilibrium, I am permitted to mean that the economy may deviate for a long time, perhaps permanently, from a social optimum; then I have no trouble with championing the cause. But that would be an abuse of the the term 'disequilibrium'. If one takes the more normal use of disequilibrium to mean agents trading at non-Walrasian prices, as in the models of Benassy and Dreze from the 1970s; I do not think we should revisit that agenda. Just as in classical and new-Keynesian models where there is a unique equilibrium, the concept of disequilibrium in multiple equilibrium models is an irrelevant distraction that has been imported, inappropriately, from the physical sciences where equilibrium means something very different from its modern usage in economics."
Obviously as Noah says in his answer to Farmer's observations it is very interesting and deep stuff and a lot of food for thought. I'm not sure in what way disequilibrium means something different in economics than in the physical sciences. I'm not saying Farmer's wrong-I don't know enough at this point to even begin to answer. But he doesn't explain here at least as far as I can tell what this crucial distinction is.
He seems to think that we want to hold on to rational expectations-as we saw in that piece of Krugman back in 1996 addressing some "evolutionary economists" economists mostly don't like to see the assumption of rational agents questioned. Farmer agrees that having one unique equilibrium point has been discredited by the crisis but the answer is to have multiple equilibria rather than disequilibrium which would in a multi equilibrium model be a distraction. I'm not clear why multi equilibira is superior to disequilibrium is a superior model but clearly the questions are of great interest and we certainly hope that these kinds of questions will be made by economists in the coming years.
The main thing is for the old status quo to be questioned. Noah Smith in his answer made this point:
"1. Roger's post addresses, in a much more precise and well-informed way, possibilities (2) and (3) from my last post. But it rejects possibility (1), which involves non-Walrasian prices."
"2. I really like the idea of a "belief function". This is basically chucking Rational Expectations - not because people are irrational, but because the notion, as Lucas thought of it, of people's beliefs coinciding with the equilibrium outcome of an economic model doesn't make a lot of sense in a world of constantly shifting multiple equilibria."
"3. I heavily suspect that I am one of the people importing the idea of "disequilibrium in multiple equilibrium models" from the physical sciences. I am not yet convinced that it is an inappropriate analogy, or that non-Walrasian prices are a fruitless line of inquiry, but I will have to read a lot more to understand properly..."
I did find Farmer's idea about incomplete labor markets is very intriguing and welcome any idea that might question the social optimality of unemployment. How it can ever be considered socially optimal is beyond me.
One commentator to the post, jonny bakho I think nailed some very important questions:
"What if you could perfectly model an economy going forward from this point and under Policy A, real GDP would be 0.2 percent higher after 20 years, inflation would stay at or below 2 percent for the entire time but unemployment would stay above 8 percent for 10 years. In comparison, under Policy B, real GDP would be 0.2 percent lower after 20 years, inflation would go as high as 4 percent, but unemployment would go below 6 percent after only 2 years."
"Which policy would you promote? Does Model A accurately reflect the high negative social costs and effects on wealth inequality? What is the effect on individuals who are unemployed for long periods? Do we tolerate a lost generation of workers to achieve a modest increase in GDP 20 years from now?"
"The problem with the models is VALUES. Which values are most important? Growth? Inequality? Employment? What are the Time frames? Is trading a modest increase in GDP 20 years from now worth the social costs of high unemployment over a substantial portion of the productive years for much of the potential workforce? "
"What if you chose Policy A but some unforeseen shock to the economy occurred that would have made Policy B a better choice for GDP? Would sacrificing the workforce on the alter of high unemployment have been worth the quest for a moderate increase in GDP?"
"Part of the problem is the questions the models are asked to solve. Right now, our biggest problem is unemployment that is too high in the short term. Discussions of long term policy for GDP or inflation are great, but they are starting from current conditions rather than starting 2 years from now after optimal policies for reducing unemployment have been in place. The question we need to ask is, "What policy will most quickly reduce our high unemployment problem with the least negative effects on growth and inflation and once we get to full employment, what policies are best for conditions going forward?"
"This leads to another point that POLICY matters and POLICY goals change over time and feedback into the economic conditions in ways that cannot be anticipated."
"We get arguments about the best policy for GDP and inflation starting with current conditions, but that ignores the most pressing current problem and assumes that we let it fester. Jobs, short term, are an important value in our system and that is not directly reflected in many of the questions the models are asked to solve. The values are bad."
Certainly in principle we want the optimal number we can achieve on higher GDP, lower unemployment, and manageable inflation as is possible. There is question as to how much mutual inclusivity vs. mutual exclusivity there is between these three goals. He's certainly right that right now the overriding objective should be lower unemployment.
In bringing up policy he makes a very important question about modeling. While it's easy to make the debate over models wholly a technocratic one however the question at the margin that begs is how much policy bias do the various models have? Obviously a model that factors in an incomplete labor market is going to give you different policy implications than one who presumes the labor market is wholly complete.
Like the old saying "the medium is the message" one wonders how much "the model presupposes the policy.."
For example, Lucas doesn't like fiscal stimulus so how likely is it that his DSGE will show it as being a favorable option?
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