This is a follow on to this post, and an earlier post by Paul Krugman. I’m currently reading an excellent account by Jonathan Heathcote et al of “Quantitative Macroeconomics with Heterogeneous Households”. This is the growing branch of mainstream macro that uses today’s computer power to examine the behaviour of systems with considerable diversity, as opposed to a single (or small number of) representative agent(s). (Heterodox economists may also be interested!) I want to talk about the methodological implications of this kind of analysis at some future date, but for now I want to take from it another example of letting theory define reality.
If you have an environment where a distribution of agents differ in the income (productivity) shocks they receive, a key question is how complete markets are. If markets are complete, agents can effectively insure themselves against these risks, and so aggregate behaviour can become independent of distribution. This is a standard microfoundations device in models where you want to examine diversity in one area, like price setting, but want to avoid it spilling over into other areas, like consumption. (As the paper notes, the representative agent that emerges may not look like any of the individual agents, which is one of the points I want to explore later.)
Real world markets are not complete in this sense. We know some of the reasons for this, but not all. So the paper gives two different modelling strategies, which it describes in a rather nice way. The first strategy – which the paper mainly focuses on - is to ‘model what you can see’:
“to simply model the markets, institutions, and arrangements that are observed in actual economies.”
The paper describes the main drawback of this approach as not being able to explain why this incompleteness occurs. The second approach is to ‘model what you can microfound’:
“that the scope for risk sharing should be derived endogenously, subject to the deep frictions that prevent full insurance.”
The advantage of this second approach is that it reduces the chances of Lucas critique type mistakes, where policy actions change the extent of private insurance. The disadvantage is that these models “often imply substantial state-contingent transfers between agents for which there is no obvious empirical counterpart”. In simpler English, they predict much more insurance than actually exists.
The first approach is what I have described in a paper as the ‘microfoundations pragmatist’ position: be prepared to make some ‘ad hoc’ assumptions to match reality within the context of an otherwise microfounded model. I also talk about this here. The second approach is what I have called the ‘microfoundations purist’ position. Any departure from complete microfoundations risks internal inconsistency, which leads to errors like (but not limited to) the kind Lucas described.
As an intellectual exercise, the ‘model what you can microfound’ approach can be informative. Hopefully it is also a stepping stone on the way to being able to explain what you see. However to argue that it is the only ‘proper’ way to do academic macroeconomics seems absurd. One of the key arguments of my paper was that this ‘purist’ position only appeared tenable because of modelling tricks (like Calvo contracts) that appeared to preserve internal consistency, but where in fact this consistency could not be established formally.
If you think that only ‘modelling what you can microfound’ is so obviously wrong that it cannot possibly be defended, you obviously have never had a referee’s report which rejected your paper because one of your modelling choices had ‘no clear microfoundations’. One of the most depressing conversations I have is with bright young macroeconomists who say they would love to explore some interesting real world phenomenon, but will not do so because its microfoundations are unclear. We need to convince more macroeconomists that modelling choices can be based on what you can see, and not just on what you can microfound.