Microfoundations You Can Believe In

|Peter Boettke|

I don't always find David Glasner's post that insightful, though they are always sincere and reflect a commitment to rendering an accurate history of the discipline of economics and political economy.  Therefore, I subscribe to Uneasy Money and am alerted when a new post goes up.  Today's post was a reflection on modern macroeconomics taking off from the Paul Krugman and Stephen Williamson back and forth last week.  But a particular passage from Glasner's post is worth thinking about in a serious way --- and that relates to the question of which microfoundations for macroeconomics.  As Glasner states:

An especially pretentious conceit of the modern macroeconomics of the last 40 years is that the extreme assumptions on which it rests are the essential microfoundations without which macroeconomics lacks any scientific standing. That’s preposterous. Perfect foresight and rational expectations are assumptions required for finding the solution to a system of equations describing a general equilibrium. They are not essential properties of a system consistent with the basic rationality propositions of microeconomics. To insist that a macroeconomic theory must correspond to the extreme assumptions necessary to prove the existence of a unique stable general equilibrium is to guarantee in advance the sterility and uselessness of that theory, because the entire field of study called macroeconomics is the result of long historical experience strongly suggesting that persistent, even cumulative, deviations from general equilibrium have been routine features of economic life since at least the early 19th century. That modern macroeconomics can tell a story in which apparently large deviations from general equilibrium are not really what they seem is not evidence that such deviations don’t exist; it merely shows that modern macroeconomics has constructed a language that allows the observed data to be classified in terms consistent with a theoretical paradigm that does not allow for lapses from equilibrium. That modern macroeconomics has constructed such a language is no reason why anyone not already committed to its underlying assumptions should feel compelled to accept its validity.

Perhaps what we need, to paraphrase Lin Ostrom, is a behavioral approach to the rational expectations theory of macroeconomic activity.  A close reading of Mises and Hayek, I would contend, already produced such a conceptual framework for modern economists to work within and build upon.  As has been pointed out long ago by William Jaffe, from Carl Menger onward, the Austrian tradition did not treat man as a lightening calculator of pleasure and pain, but instead as the central actor in the human drama of economic life caught as he is negotiating constantly between alluring hopes and haunting fears.  

It is man's predicament as a fallible yet capable human chooser making decisions within an uncertain though not unimaginable world of economic possibilities that brings forth the entrepreneurial market process that leads to economic growth and development, results in the dynamic instability of governmental interventionism, and also the ideological excesses of political power brokers that resulted in death and destruction.  We live in a world of imperfect human actors, interacting in the world with imperfect knowledge and within imperfect institutions.  One of our primary tasks as political economists is to explore what institutions enable us to cope with those imperfections, curb delusions, and channel behavior toward peaceful and productive social cooperation; and also to identify those institutions that leave us plagued with imperfections, vulnerable to the whims of others, and unable to navigate the world without conflict and coercion.

This last paragraph is ultimately about comparative instituitonal analysis and it has been a hallmark of the discipline of political economy throughout its history -- e.g., from Adam Smith's critical examination of mercantilism to Ludwig von Mises's critical examination of socialism.  But the "big" question of economic systems, also are relevant for the "smaller" questions of macroeconomic and microeconomic performance. The great German sociologist Hans Albert once wisely remarked to the founders of New Institutional Economics that 'neocloassical economics will never be able to repair its institutional deficiency until it repairs its behavioral deficiency.'  Eventually this resulted in the deployment of Herbert Simon's model of human decision making, rather than the more stripped down optimization exercise of textbook micro; what Vernon Smith refers to as 'ecological rationality' rather than 'constructivist rationality'.  Or to those in the Austrian tradition, what Mises's went at great lengths to argue substantively (don't read exclusively methoodlogically) for in the first 100 pages of Human Action, or what Israel Kirzner would later stress as the Misesian actor in contrast with the Robbinsian maximizers. And these Misesian actors interact with one another within a diversity of institutional contexts -- each structuring incentives and providing a flow of information and feedback.

Focusing on purposeful human action, and specified instituitonal contexts, is also microfoundational in economic and political economy analysis.  But it is a different microfoundation than what has dominated modern macroeconomics.  Time to fix that -- Steve Horwitz should get the nod as the first mover within the contemporary Austrian school to explicitly pick up that challenge of answering which microfoundations of macroeconomics.

Comments

[Bob Subrick]

Here's Leijonhufvud's contribution, "The Varieties of Price Theory: What Microfoundations for Macrotheory" from many years ago: http://econpapers.repec.org/paper/clauclawp/044.htm
I find it useful to revisit.

[Peter Boettke]

Thank you Bob for providing that link ... that is a very important paper I think. I saw Leijonhufvud give a talk at the HES meetings 20+ years ago where he did something along these lines but focused mainly on the contrast between the Walrasian project and the Mengerian project. If my memory is at all correct, it was one of the most intellectual intriguing talks I have ever heard in that sort of context.

I think Leijonhufvud is horribly underappreciated within our discipline.

[Steve Horwitz]

If memory serves Pete, that was in Vancouver right? I recall that talk too, and it was great.

To be honest, my book owes a great deal to AL's essays in the collection *Information and Coordination.* I think Yeager is more under-appreciated than AL is, but AL, Yeager, and Hutt are all folks from whom I learned much and who are severely under-valued by mainstream economists.

I think there are some original things in my book, but in the main, it is a work of synthesis. I tried to bring together a variety of work that all seemed to be circling around exactly the point you raise here: what does macro look like if we take the Mengerian conception of micro seriously, particularly when we tack on the comparative institutional work of Mises, Hayek, Buchanan, Tullock et. al...

[Xerographica]

I'd like to give a solid nod to Rizzo and Whitman for this paper...

http://lawreview.byu.edu/archives/2009/4/4Rizzo.FIN.pdf

...which introduced me to Joel Waldfogel...who deserves the biggest contemporary nod for Scroogenomics...which I just created a Wikipedia entry for...

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

Everything he says about other people making choices for us..."a terrible way to allocate resources"...and "orgy of wealth destruction"...is equally applicable to government planners spending our money.

Should taxpayers be allowed to directly allocate their taxes? Yes. Why?

"Normally we buy things for ourselves when the value exceeds the price, and in so doing, this free choice by individuals maximizes society’s benefit. But gift-giving is entirely different because someone else is choosing for you." - Joel Waldfogel

Making the case for taxpayer sovereignty is really the way to go. Well...unless I'm wrong. That would suck...especially if you guys knew all along but never bothered to tell me. Don't you know that sharing is caring?

Let me prove it...here's the very best salad dressing ever...
http://www.debatepolitics.com/economics/146753-best-salad-dressing-ever.html

[Roger Koppl]

IMHO, what Simon said regarding Cournot applies to rational expectations: it is a "permanent and ineradicable scandal of [macro]economic theory.” And, indeed, in both cases the problem is expectations, including "I think that you think . . . " Besides the fanciful "rationality" assumed, there is the fact that our "microfoundations" reduce the variety of interpretations down to one representative agent. Modern macroeconomics assumes away the coordination problem. By some magic that happens behind the wizard's curtain the competing interpretations of bulls and bears are always so balanced that the faux expectations of the "representative agent" are "rational" in the strong sense that it never wants to revise its forecasting algorithm. The representative agent never learns because it has nothing to learn. We are not facing the problems of macroeconomic theory; we are assuming them away.

[Jerry O'Driscoll]

David Glasner is on the mark on this one. I am a Leijonhufvud student and endorse Pete's comments about him.

And, as always, Roger's somments are excellent. Good quote from Simon.

[Richard Ebeling]

If I may say, this whole topic is one of the most frustrating elements in economics, for an "Austrian."

These "problems" of knowledge, process, adjustment, and expectations; the issue of mathematical formalism (with it's unrealistic assumptions).

They are the same ones that have continued to dominate the "dispute" and "disagreements" about the nature and methods, and conceptual focus of economics since Menger vs. Walras; Hans Mayer vs. "functionalist" theories of price; Mises and Hayek vs. Lange on the quality and characteristics of markets, prices, and competition; Kirzner on entrepreneurship; and the entire topic of macroeconomics vs. microeconomic sequential-temporal processes analysis of the non-neutrality of money of Hayek and Mises vs. Keynes.

It is like a merry-go-round on which the words and structures of part of the arguments get slightly restated or articulated in response to the last round, but the whole thing keeps going in a circle.

The "mainstream" insists that their approach is the only one that is "rigorous" and "scientific." And the "Austrians" emphasize the limits and problems of the mainstream approach in understanding the workings of "real" markets, with hints and suggestions of how a fully process approach might be used instead.

This is now over one hundred and twenty-five years old. Very frustrating, and seemingly unending.

Richard Ebeling

[Barkley Rosser]

Leijonhufvud very wise on these matters.

[Jerry O'Driscoll]

Yes, Barkley.

And Happy New Year to you and all.

[Troy Camplin]

So long as economics uses equilibrium, it's unscientific. It is precisely because the economy is perceived as being an equilibrium system that such nonsense as "market failure," which governments can "fix" come about. The same with socialist calculation.

Of course, it may be that all the social sciences are fundamentally "unscientific" if we take the natural sciences as being "science."

http://zatavu.blogspot.com/2012/12/knowledge-vs-understanding.html

[Barkley Rosser]

Likewise, Jerry, and everybody else as well, :-).