A Faustian Bargain?

Reflecting on a recent blog post by Simon Wren-Lewis, Paul Krugman argues that the modern insistence on microfoundations has impoverished macroeconomics by shutting down early understandings of financial markets “because (they) didn’t conform to a particular, highly restrictive definition of what was considered valid theory.”  In Krugman’s libretto, the role of Mephistopheles is played by “freshwater” macroeconomists. 

Krugman uses James Tobin as an example of one of the casualties of adopting freshwater methodology saying that as far as he could tell, Tobin “disappeared from graduate macro over the course of the 80s, because his models, while loosely grounded in some notion of rational behavior, weren’t explicitly and rigorously derived from microfoundations.” Tobin has not disappeared. In my course for instance, Tobin shows up in the section on investment, which is centered around Tobin’s Q (my co-author Matthew Shapiro constantly emphasizes that it should be called Brainard-Tobin’s Q.)  My students (and any graduate student familiar with David Romer’s Advanced Macroeconomics) is well aware of Tobin’s role in this line of work. Tobin’s early ideas on Q-theory were sketches – plausibility arguments – which were subsequently developed in greater detail by Andy Abel, Fumio Hayashi and Larry Summers (and also Michael Mussa). 

Adopting microfoundations does come with a cost. As I mentioned in a previous post, being precise and exact prevents economists from engaging in glib, hand-waiving theorizing. Many analysts (and commentators) see this as a serious limitation.  Using this methodology also has advantages. Being specific allows you to (1) make the theory clear by exposing the necessary components, (2) quantify the effects by attaching plausible values to parameters and (3) learn from the model. This last advantage is one of the biggest benefits to microfoundations.  Setting out a list of assumptions and then following them where they lead may expose flaws in your own understanding; it may lead you to new ideas, and so on. Let me give you two examples.

Suppose someone says that if demand goes up, prices will fall. Here is their argument: if demand goes up, the price is bid up. The price increase reduces demand and so ultimately the price falls. Every statement in this argument is reasonable but the conclusion is incorrect. The way to find the mistake is with a model – in this case a supply and demand model. (The error is a confusion of movements along a demand curve verses shifts in the demand curve.)

Here is another example. In the traditional IS/LM model, investment demand is assumed to depend negatively on the real interest rate. This assumption is important for the functioning of the model – it makes the IS curve slopes down. The assumption itself is based on a slight confusion between the demand for capital and the demand for investment. What would happen if we added some microfoundations? Suppose we removed the ad hoc investment demand curve and instead required that the marginal product of capital equal the real interest rate (the user-cost relationship).  In this case, there would be a positive relationship between output and the real interest rate (the IS curve would slope up! Higher output would require more employment which would raise the marginal product of capital and raise the real interest rate.) An increase in the money supply would cause the real rate (and the nominal rate) to rise. How should we interpret this? One interpretation is that we need to think a bit more about the investment demand component of the model. An alternative reaction would be to say “I know that the original IS/LM model is right; I don’t need the microfoundations; they are just preventing me from getting the right answer.”   

Who came up with this twisted version of the IS/LM model you might ask? Wait for it …

…yep … James Tobin. (1955, see Sargent’s 1987 Macroeconomic Theory text for a brief description of Tobin’s “Dynamic Aggregative Model.”)

Even today, when we analyze the New Keynesian model, it is often done without any investment (this is like having an IS/LM model without the “I”). Adding investment demand can sometimes result in odd behavior. In particular you often get inverted Fisher effects in which monetary expansions are associated with higher output but strangely, higher real interest rates and higher nominal interest rates.  (If you teach New Keynesian models to graduate students I would encourage you to take a look at Tobin’s model.)

It seems that Paul Krugman wants to revise the history of the field a bit. Reading his post it almost seems like he wants us to believe that the Keynesians would have figured out financial market failures if they hadn’t been led astray by microfoundations and rational expectations. This is not true. The main thing New Keynesian research has been devoted to for the past 20 years is an exhaustive study of price rigidity. If anything was holding us back it was the extraordinary devotion of our energy and attention to the study of nominal rigidities. We now know more about the details of price setting than any other field in economics. As financial markets were melting down in 2008, many of us were regretting that allocation of our attention. We really needed a more refined empirical and theoretical understanding of how financial markets did or did not work. 

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17 thoughts on “A Faustian Bargain?

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  2. This is unfortunately not an area of economics I know well, but it seems like a change in the marginal product of capital reflects in a shifting of the demand curve for investment, not in the direction of the demand curve for investment. As a businessperson, whatever the MPC is, and all other things equal, I always want to invest more with a lower interest rate than I do with a higher interest rate. As MPC increases, the interest rate will increase, but not because the demand curve for investment depends positively on the interest rate, but because it depends negatively on the interest rate, but shifts out with increases in MPC. Again, not an area I know well, but this is how it seems. I mean is the IS-LM model for a given MPC, just as a classic supply and demand model for apples is for a given marginal productivity in apple farming – change that MP, and you just change one of the curves; it doesn’t invalidate the model

  3. Chris: Good post.

    “Adding investment demand can sometimes result in odd behavior. In particular you often get inverted Fisher effects in which monetary expansions are associated with higher output but strangely, higher real interest rates and higher nominal interest rates.”

    This is a point that Scott Sumner and I keep making, but which the “Monetary policy can’t do anything more when interest rates are at the ZLB!” guys keep ignoring. The low real interest rates are not a sign of loose monetary policy, but a consequence of tight monetary policy.

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/08/is-this-a-liquidity-trap.html

    This is presumably why it is hard empirically to find a negative effect of interest rates on investment demand. Investment demand does depend negatively on interest rates, but it also depends positively on demand for goods. If most shocks are LM shocks, we would observe a positive relation between investment and interest rates.

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  5. James Tobin is so much more than the Tobin’s q. The fact that teh Tobin’s q is included in standard graduate progrmas is very far from enough evidence that Krugman does not have a point here.
    Hey, I am am fan of DSGE modelling. I find it hard to consider how serious current macroeconomic modelling can depart from that framework. But it has a cost. And that cost is that we are forgetting earlier lessons. And lessons from giants, and Tobin is such a giant, should not be forgotten.

    • Well you are right that there’s a lot more that Tobin did beyond Q-theory but I think you will find that a lot of this stuff is still pretty visible in the graduate (and undergraduate) curriculum. For instance, most students will encounter the Baumol-Tobin model in their training. Most will also encounter the Tobit model for censored regressors. The Tobin Effect is still discussed (somewhat) in theories of money demand. I mentioned that I discuss his dynamic aggregative model in my course on New Keynesian models.

      And we need to be realistic. The graduate course I teach is a first-year core course covering basically all business cycle related stuff in macro. It’s not a course on the life and times of Jim Tobin. By this criterion, Friedman has “disappeared” as well. It’s really just a race to cover as much stuff as possible in a very limited time. The fact that virtually everyone is mentioned to a very limited extent is out of necessity.

      • I take your point about your course. And, of course, I agree with you.
        But let me tell you this, if I may. I still have the general impression that a lot on those classics is forgotten.
        One nice exercise that you can do in your classes, maybe in a more advanced one, would be to tell students to read “forgotten” papers of classic authors, like Stiglitz, Tobin, Kaldor, etc. and try to put some of those ideas in a modern framework. I did that exercise once, with a paper from Shell Stiglitz and Sidrauski published in REStud in 1969. I found remarkable how most, if not all, of their conclusions survived in a modern framework (in that case I used an OLG model).
        PS I don’t think that Friedman is much of an example on this case, most of his contributions have been very carefully explored. But I may be wrong, of course.

  6. Yep, herd mentality is bad.

    Stiglitz already told us more than twenty years ago that we should focus on money as credit, on financial market imperfections and not on wage/price rigidity. Unlike Mankiw, Ball, Romer, Woodford and whoever else worked on the New Keynesian literature he read his Keynes. The position that wage and price flexibility would get an economy out of the underemployment equilibrium which is a classical position against which Keynes argued in his General Theory so the literature should not be called New Keynesian but rather pre-Keynesian.

    About Tobin, we would have been better off without the microfoundation nonsense. Old Keynesians like Tobin, Samuelson and Hicks have been very well aware of the plethora of market failures that cause an underemployment equilibrium to exist and persist. They just did not view it as necessary or efficient to delve into them as they were MACROeconomists.
    Same applies for Stiglitz who did all the revolutionary micro work on asymmetric information. Sure, he did incorporate this into the above mentioned macro models but always in MIT “focus on one problem” style and not via the help of a model which is totally unrealistic and which you would have to amend with numerous market failures to make it realistic: Arrow Debreu.

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  8. Stiglitz is one of my favorite economists. It’s a little difficult for me to think of what his work would be like without microfoundations. Incentives and rationality flow through most of his work.

  9. Yet I doubt that he has any issues with Akerlof’s, Shiller’s or any other economist’s work who focuses on irrationality.
    Of course technically speaking the big advantage of Stiglitz’s oeuvre over such work is its orthodoxy. Just relax one perfect information assumption and “we are not in Kansas anymore”.

    This is precisely why Stiglitz, unlike mainstream macroeconomists, never worked with Arrow-Debreu when he did general equilibrium analysis. AD is simply not a robust model. So while I totally agree with your assessment of the New Keynesian focus upon the wrong market imperfections I disagree about DSGE. “Financial Market Imperfections and Business Cycles” (Greenwald & Stiglitz 1991) is an old but good example of how to use asymmetric information in a macro model.

  10. Well, in my view, the essential lesson of micro has been ignored in the past three decades of free lunch economics which declares consumption is a function of “wealth” and that labor is a drag on the economy. All the debate of late I read talks of stagnant wages, wages that are too high which leads to more “capital” which creates wealth from high profits, but labor refuses to lower its drag on the economy by accepting lower wages and incomes.

    I learned in micro that labor income equals consumer demand. Zero sum.

    If consumption is sacrificed to produce capital which increases production of labor, either wages must rise or the price of production must fall to bring the balance to zero sum.

    Instead, the free lunch economics calls for labor income to fall and profits going to capital to create “wealth”. But the “wealth” isn’t spend as it must be in a microfoundation. If capital has a profit, then that represents economic inefficiency which spurs increased use of labor and capital to deliver more and thus eliminating the profit because labor gets more income from the profits. Remember, capital is built on labor, so more capital consumes labor increasing consumption.

    Today we have very high profits, but no massive employment of labor with those profits to build more capital to further increase production. Of course, more production would require paying more in wages to more people, or lowering prices to increase quantities consumed. Better to restrict production to keep prices high, cut the pay to labor, then blame government for paying people so they can consume what is being produced.

  11. I know almost zero about economics (I have a PhD in biochem)
    Since the 2008 crisis, I’ve been reading a lot of blogs and so forth.
    and as a scientist, one thing that drives me totally crazy is demand curves that are straight, or slightly curved, with no units on the axes – no hint of any sort of quantitation what so ever.
    It is just bizarre: you plot interest rate vs investment, with no units *at all* – is the range of interest rate 0;1 to 1, or 1 to 50 ?
    and no one seems to care
    maybe I know even less then i think

    PS: I’ve never seen even a casual reference to the extensive data that supports the idea that demand is proportional to price; not once (I dimly recall my undergrad econ text, which mentioned a tomato market in S America, and how consumers would pay less for tomatoes from different farmers…right then and there I had a problem, as S American rural tomato markets don’t seem like the US economy)

    • Ezra, you have a completely valid complaint. The main reason for this is just sloppiness on the part of economists. Units are absolutely crucial to making a connection with the real world. I constantly press my students to think about the units they want to express things in — many times this simple question exposes a deep flaw in understanding.

      One reason economists often “ignore” units in casual conversation (and surely in blog posts) is that we often think in terms of *elasticities*. You probably know what an elasticity is but just in case you don’t it’s the differential percent change (the elasticity of quantity Q with respect to price P is (dQ/dP)*P/Q so it scales the derivative by the inverse of the levels. Note that this eliminates the units.) So often when we talk about say labor supply curves we talk in terms of their elasticity (for a realistic labor supply curve for the US, the elasticity is probably no greater than .5 and is probably even smaller. Thus a 1 percent increase in the wage elicits roughly a 1/2 percent increase in labor supply. The data we have to work with are pretty rough so we often treat the relationship as though it were essentially constant elasticity (thus the straight line).

      In any case, you have a perfectly valid gripe and you are to be commended for asking about fundamentals.

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