Tuesday, September 08, 2015

Paul Romer has 3 Questions

Paul Romer has questions which should enable me to self assess my economic tribalism. I am very tribal (but in a fairly small tribe.
Consider these two statements:

1. The model in Lucas (1972), Expectations and the Neutrality of Money, made a path breaking contribution to economic theory. It is comparable in importance to the Solow model and the Dixit-Stiglitz formulation of monopolistic competition.

2. The model in Prescott and Kydland (1982), “Time to Build and Aggregate Fluctuations”, has no scientific validity.

Next, consider these two statements:

3. Einstein’s model of the universe based on his theory of General Relativity, made a path breaking contribution to theoretical physics, even though in his first application, Einstein built a model of a steady state universe.

4. Models of a steady state universe have no scientific validity.

In each case, the first statement in the pair is about the contribution of a mathematical model to scientific progress. The second is about the empirical validity of a specific model.

[skip] Here I want to point to a different indicator. Set aside the question of whether or not I am right that 1 and 2 are true. Think of some macroeconomist X that you know. Consider these questions:

A. Would X agree that there is an objective sense in which statements 1 and 2 can be said to be either true or false?

B. Would X agree that a reasonable person could conclude that statements 1 and 2 are both true?

C. Would X be able to examine dispassionately the evidence for and against these two statements and evaluate them independently?

A useful indicator of the degree to which macroeconomics has been infected by tribalism might the fraction of macroeconomists for whom the answers to at least one of the questions A, B, and C would be no.

First and in passing, I note that, after Einstein was introduced, "economic theory" was replaced by "scientific progress" . The implicit assumption is that there is some overlap between economic theory and scientific progress -- that economic theory has progressed. This view is not universally accepted. I am pretty sure that I have a problem with question A. For statement 1 to be true, "path breaking" has to be well defined.

regarding Romer's statement 1, I agree that, when originally presented, the Lucas 72 model, the Solow growth model and the Dixit Stiglitz example had similar scientific status. They were "path breaking" in that they left the existing path -- they were new and different. They were path breaking in that they were highly influential. My problem is that I don't see how that relates to "scientific progress". It was definitely scientific change, but only time could tell if it was an improvement or a worsening.

I also certainly agree with Romer's statement 2. I agree that a reasonable person could conclude that statements 1 and 2 are both true (I don't but I can see how a reasonable person might think that). I can evaluate the second independently from the first, but I need to understand what "path breaking" means to evaluate the first.

Before going on, I'd like to stress that Romer definitely did not compare Lucas '72 and Dixit-Stiglitz to General Relativity -- he compared it to the Solow growth model and the Dixit Stiglitz example of imperfect competition. However, I will contrast them. General Relativity explained an anomaly -- the precession of the perihelion of Mercury. It implied a prediction about how much gravity caused light to curve which was striking shocking and soon confirmed. Since then it has yielded a huge number of predictions which fit the data exactly (so far). It was easily modified to correspond to an expanding universe as the first formulation did, when this was pointed out Einstein added a fiddle factor to reconcile the theory with a steady state universe. Pysicists are quite sure general relativity is not the truth (because it is inconsistent with quantum mechanics and therefore a lot of data). But it is a very empirically successful theory.

In contrast, the Dixit-Stiglitz example did not attempt to explain anomalies not fit by earlier models of imperfect competition. The aim was to make models with imperfect competition tractable. The formulation is an example, and not one considered unusually plausible. They made a modelling choice not a hypothesis (neither would guess that people might actually have Dixit-Stiglitz preferences). Here I think the key cause of the enormous influence of the example was that it meant there was a standard way to handle imperfect competition.

Unfortunately, this is important not because other models are all intractable but because there are no general results. Models with imperfect competition can have a sunspot equilibrium with fluctuations which are not caused by shocks to taste and technology (this can occur if different goods are strategic complements). The set of equilibrium can be huge -- a multidimensional continuum. Together the assumptions of imperfect competition and Nash equilibrium imply almost nothing. The example made it possible to have the illusion that economic theorists understood imperfect competition, but this was discovery by assuming we have a can opener.

The example was fruitful because, once a lot of people decided to explore the same special case, they could discuss its interesting behavior. The fruits however, do not include any good reason to exclude the other problematic cases in which different goods are strategic complements. Theory can grow if people agree on core assumptions. This is progress if the assumptions are useful approximations. Once a field of economic theory has developed, its core assumptions are no longer vulnerable to data. I do not think the the development of a new branch of theory is necessarily scientific progress.

I think economic theory was massively improved by the Dixit-Stiglitz example, because it made economists outside of industrial organization willing to consider imperfect competition. But I think this can be seen as an accidental trick. It gave the impression that there were simple elegant results based on assuming imperfect competition similar to those based on assuming perfect competition. There aren't. Here I cite major Dixit-Stigitz user Paul Krugman

After a while, the new approaches came to seem too liberating; by the early 90s the joke was that a smart graduate student could devise a model to justify any policy. And while some important new theoretical work continued to be done, for example the Melitz work on heterogeneous firms or the Eaton-Kortum work on bilateral trade flows, I think you have to say that the field got tired of clever theorizing and wanted data instead.

I think the point is that this excessive liberation was already implicit given the acceptance of imperfect competition (and the emptiness of theory without data could conceivably have been recognized as soon as economists admitted that they couldn't prove that competition really is perfect, that is over a century ago). By the way, I heard that joke told by Robert Barro in 1988 or 1989 so before the early 90s.

There have been dead ends in natural science. Organic chemistry was once defined as the consideration of how the laws which governed chemical reactions inside living things were different from the laws which governed chemical reactions outside of living things. A Nobel prize in physiology and medicine was awarded for a theory of cancer propagation which is now believed to have no relationship to reality. Lamarckian evolutionary biology survived into the 20th century (and not just in the USSR).

A new branch of mathematics must be a contribution to mathematical progress (perhaps a small and boring one). But a radically new hypothesis which turns out to be totally false was not a contribution to scientific progress. Finding out that it was false was and such dead ends are inevitable in science. But in science development of new theory is not necessarily progress.

OK what about the Solow growth model and the Lucas supply function ? Like Dixit and Stiglitz, Solow mainly made a large number of extreme assumptions yielding a tractable model. Here I think Solow's assumptions were fruitful also in that they fit the data surprisingly well. There are excellent arguments for why one shouldn't be able to treat capital and labor as scalers (single numbers). But empirically, the Solow radical simplification fits the available data surprisingly well. There was no reason to think that the concept of disembodied technology would be useful. But it helps economists fit the data.

Lucas formalized an argument about price level missperception and fluctutations which had been made many times (for example by Keynes in "The General Theory" as Tobin explained to Lucas in 1971). Here again the theoretical change was to assume everything else away. In particular the Lucas model abstracts from the wage system and is population by self employed "suppliers" -- this was an extreme assumption at a time when trade unions were powerful even in the USA. Lucas definitely did not identify a previous conceptual error of treating the expectations unaugmented Phillips curve as a stable relationship -- this is a myth. He added a focus on expectational errors alone and the insistence that economists assume rational expectations. I think this too is unlike Dixit-Stiglitz. The reason is that, in 1972, the Lucas model was obviously grossly false -- it implies that output is a white noise and it was well known that economic fluctuations aren't. it requires that agents have very limited information on the price level when, in fact, they have a lot of information. I think it was clear that Lucas's new research program would be sterile. I think it was entirely sterile. I count new Keynesian models as part of Lucas's intellectual legacy (even though he never recognised the bastards). Here I think nothing was explained by the new models which hadn't been explained by the old models and economic theory did not progress at all. It grew and is a richer branch of applied mathematics, but I think the right direction to go now is back to before Lucas 1972.

I certainly don't think this of the Solow growth model or imperfect competition with a Dixit-Stiglitz preferences or a Dixit-Stiglitz aggregator.

Yes Lucas 1972 was path breaking, but the new path Lucas blazed lead to a dead end.


Anonymous said...

"but I think the right direction to go now is back to before Lucas 1972. "

How far back would you go?


Robert said...

To Samuelson and Solow 1960 . An old post edited down by Brad

Nick Rowe said...

I think Lucas 72 was pathbreaking in that it changed how we think about equilibrium, monetary policy, and the long-run vs short-run distinction. We had to think about the policy rule, not policy actions. Even though the particular theory of business cycles didn't pan out, the way of thinking about policy stuck with us.

(But I guess any serious historian of thought can come up with some other economist who said it earlier.)

But I totally agree that Dixit-Stiglitz is in a different ballpark -- "Here's a neat tractable utility function for doing models with imperfect competition" is not like the Solow Growth model.

The three papers are so different, it's really hard to use them as a measure of tribal affiliation.

Robert said...

Even an unserious historian of thought can. Samuelson and Solow (1960) noted the difference between the short term and the long term. That, even more than Phillips's, was the paper which really launched the Phillips curve literature which Lucas critiqued. Friedman advocated discussing rules rather than actions and very much stressed the short term long term distinction.

What was new in Lucas 1972 is that, in that model, the long term is reached instantly -- the expected value of output the next period is constant. Next period means (at most) next month. This was very new. Earlier economists had the perception that fluctuations lasted longer than a month. It took over a decade for macroeconomists to note that this implied that Lucas's model was not a good approximation to reality.

Certainly this makes me think of breaking paths and other things, but I do not consider it scientific progress.

Nick Rowe said...

Robert: take a New Keynesian model from the late 1970's. How would we answer the question "Does monetary policy have real effects in this model?"

We would say:

The level of M has no real effects.

The variance of M has real effects (for the worse).

The covariance of M wrt other shocks has real effects, that can be for the better or for the worse.

Or, more strictly, we would talk about the effects of the parameters in the monetary policy rule, like M(t) = Mbar + bS(t) + e(t)

We compare two possible worlds, with different monetary policy rules. (The question about the transition from one rule to another was always tricky, and Lucas himself was always very reasonable about how long it would take people to learn the new rule. He was not a nut who thought that we would immediately jump to the new RE equilibrium.)

Anonymous said...

A minor comment: Einstein introduced the cosmological constant to allow for his theory to have solutions corresponding to a static universe. Otherwise according to his original theory, (he believed) that the universe would contract from steady state. Friedmann later showed that his original theory allowed for both possibilities (expansion or contraction) based on the energy density in the universe (he made the assumption that the universe was homogenous and isotropic).

Robert said...

I see an alarming pattern in this comment thread. I wrote "Lucas didn't do that Friedman did that" now anonymous writes "Einstein didn't do that Friedmann did that". I expect the next comment to be that Romer didn't write that Friedmannn wrote that.

Ken Houghton said...

Confusing Friedman with Feynmann is something I do all the time. Especially when Rutgers football is once again proving the former was better about things he stopped discussing than things he continued pontificating about.

Bernard Guerrien said...

Very good post. But
- "But empirically, the Solow radical simplification fits the available data surprisingly well". Yes, because there is an accounting identity behind (eg H. Phelps Brown, H. Simon, F.Fisher, J. Felipe, among others). Not very "scientific".
- Dixit-Stiglitz is a partial equilibrium result. "True" general equilibrium with imperfect competition has been abandoned in the seventieth : impossible to prove existence of at least an equilibrium (eg Giacomo Bonnano, http://www.econ.ucdavis.edu/faculty/bonanno/PDF/JES_1990.pd )

Thornton Hall said...

So much fucking bullshit! What kind of moron used physics to understand human behavior? What kind of moron thinks that all scientific progress is the same as progress in physics?

If you are trying to understand people and you are using physics then you are, literally, retarded, as in cognitively defective.

Robert said...

Dear Nick

I certainly agree that Robert Lucas is the intellectual father of new Keynesian economics. However, I do not consider the shift from old Keynesian economics to new Keynesian economics to be scientific progress. Consider a new Keynesian model from 2008 (say Smets-Wouters). It proved useless in understanding the events of 2008 after having performed less well than univariate time series models in fitting data from 1992 through 2006.

I think the only scientific merit of new Keynesian economics is that it doesn't have some of the false implications of new Classical economics. However, I also consider it a scientific dead end and utterly failed research program. I've written this dozens of times.

The fact that Keynesian economics of the late 70s (and mid 2010s) is hugely influenced by Lucas illustrates the gigantic influence Lucas has had on macroeconomics. It does not demonstrate that Lucas contributed to scientific progress. For that to be the case, one would have to argue that macroeconomics has progressed. When I read papers from the 60s and early 70s or for that matter this book published in 1938, they seem brilliant and far superior to the stuff that's published now. Now this is partly because the old papers I read are selected -- they have become very famous and also were written by Riksbank Nobel memorial prize laureates (Solow, Tobin and Samuelson).

Dear Thornton the kind of moron who used physics to understand human behavior might exist but wasn't mentioned in the post. You and I may suspect that many economists are motivated by physics envy and are pretending to be physicists, but they never admit it.

On the other hand, I think many economists think all scientific progress is like progress in physics. It isn't just that they don't know of (or believe that there has been) progress in psychology and sociology -- they don't know about biology either (it is highly empirical & does not involve much math). They aren't literally retarded or morons -- just arrogant and ignorant as most people are (I sure am especially the arrogant part).

Noah Smith said...

Regarding the incorrect cancer theory that won a Nobel, are you referring to Warburg or Fibiger? Warburg didn't win a Nobel for his theory, and although the particular parasite that Fibiger thought caused cancer was innocuous, many other parasites do cause cancer.