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Reflections on Whether Macroeconomics Needs Microfoundations

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Word ‘economics’ derives from the Greek word meaning ‘management of the household’ – an inherently derivation. ‘The Lucas Critique’ (1976) triggered the recent movement within the economic discipline toward macroeconomic models needing microfoundations – a movement which has led to the removal of IS/LM models from undergraduate textbooks. We can understand microfoundations in economics as an application of methodological individualism. However, many leading economists argue that microeconomic models are particularly ill-suited to study macroeconomic problems such as unemployment. In this essay, we will explore methodological individualism, microfoundations such as representative agents, and holism to conclude that macroeconomics does not need microfoundations.

Keynes was the first to clarify the distinction between macroeconomics and microeconomics and make it possible for us to examine how the two are related. The beginning of the microfoundations movement can be traced back to Adam Smith’s writings that the source of social welfare was the individual welfare of the ordinary man (Hoover, 2001, pp. 61). So much so, that economics by the 1930s was mainly microeconomic and even during the resurgence of macroeconomics there were immediate calls for microfoundations.

‘The Lucas Critique’ (1976) suggests that to predict the effects of policy, one must model the microfoundations – the ‘deep parameters’ that are assumed to govern individual behavior: “if policy makers wish to forecast the response of citizens, they must take the latter into their confidence” (Lucas 1976, pp.42). His writings emerged to explain the failure of the Phillips curve to forecast inflation/unemployment outcomes during the 1970s after policymakers attempted to exploit the relationship. He argued that if the models can account for observed empirical regularities, we could then predict what individuals will do, taking into account the change in policy, and then aggregate individual decisions to calculate the macroeconomic effects of the policy change. Methodological individualism is at the core of the argument that macroeconomics needs microfoundations.

‘Methodological individualism’ coined by Weber’s (1922) student Schumpeter (1908) is the claim that social phenomena must be explained by showing how they result from individual actions, which in turn must be explained through reference to the intentional states that motivate the individual actors (Heath 2005, pp.1). A distinction should be noted between microeconomics and methodological individualism – they should not be directly associated.

Microeconomics does not always concern only the individual as many models focus on firms/households. Weber (Heath 2005, pp.1) argues that action theoretic explanation is central to social-scientific analysis. We must know why people do what they do to be able to understand why large-scale phenomena occur. For example, one may discover correlations between macroeconomic variables such as unemployment/inflation but without understanding the model in terms of rational actions of economic agents, the economic phenomena are left ‘unintelligible’. This is what led Hayek (1944) to argue that economic analysis is incomplete in the absence of microfoundations (Heath 2005). Highlighted by the breakdown of the Phillips curve and also game theory. Hayek (1944, pp.33) argued that methodological individualism enabled us to see the limitations of our own reason, that macroeconomic indicators should be used to describe aggregate behavior not to guide individual action. A major benefit was being able to easily spot fallacies, the greatest of which were the collective action problems.

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Economics is divided between those who believe approach requires methodological individualism and those who believe in holism. Holism, or non-reductionism, is the negation of the methodological individualism thesis (List and Spiekermann 2013, pp.2). List and Spiekermann (2013, pp.4) argue that it is entirely possible that social properties display the most systematic causal relations in some social phenomena. For example, the relation between interest rates and inflation may well be more robust than an individual-level transmission mechanism. List and Spiekermann (2013, pp.3) believe these two opposing viewpoints aren’t always in contrast but being an individualist in some respects is compatible with being a holist in others. Their approach is more practical that in some occasions methodological individualism is optimal, in others it is not.

Macroeconomic models may be more explanatory without microfoundations. List and Spiekermann (2013, pp.21) argue that ‘causal explanatory holism’ is needed under some circumstances i.e. it may be more illuminating to explain concepts at a higher, rather than lower, level of generality. This happens when a system’s higher-level properties are determined by numerous configurations of lower-level properties and hence cannot feasibly be re-described in terms of lower-level properties. Much of the criticism of methodological individualism concerns the relationship between what Watkins called ‘rock-bottom’ explanations and ‘half-way’ ones (Heath 2005, 6.3). An explanation is half-way when it only finds correlations but does not explain them – these types of explanations may be more useful and an explanation is not necessarily deficient if we have not specified an action theoretic mechanism. The debate surrounding US crime reduction during the 1990s lacked microfoundations, explanations were ‘half-way’ i.e. using data to find correlations between punishment and crime rates. It would be great to understand people’s mind-set but understandably we cannot. These half-way explanations can lead to genuine discoveries and can help shape/inform policy (Heath 2005, 6.1).

Microeconomic foundations in macroeconomic models are often conducted through flawed mechanisms. The representative agent has been the main tool by which these micro-foundations are incorporated. These models assume that the choices of all the diverse agents in one sector, i.e. consumers, can be considered as the choices of one ‘representative’ standard utility maximizing individual whose choices coincide with the aggregate choices of the heterogeneous individuals (Kirman 1992, pp.2). This reductionism leads to misleading and often wrong conclusions as there is no direct relation between individual and collective behavior. The reaction of a representative agent is not necessarily the same as the aggregate reaction of the individuals the representative agent ‘represents’ – invalidating the use of such a model (Kirman 1992, pp.3). Furthermore, trying to explain the behavior of a group by one representative individual is constraining and the sum of behavior of individuals may generate complicated dynamics. Hence it is not useful or appropriate to treat the economy as a maximizing representative individual (Kirman 1992, pp.3).

It is almost universally held that the provision of microfoundations for macroeconomics is difficult in practice. Epstein (2014) argues that macroeconomic properties do not even globally supervene on microeconomic ones. He doubts the possibility of microfoundations for macroeconomics altogether. Macroeconomics does not supervene on microeconomics as microeconomic properties fail to exhaustively determine macroeconomic properties. He argues that macro entities causally influence micro entities, thus undermining supervenience theories (Epstein 2014, pp.8). Furthermore, it is not clear whether one would really ‘fix’ the macro entities by ‘fixing’ the micro entities, this is due to the liberty with which macro aggregates are constructed (Epstein 2014, pp.8). Therefore, there is no complete microeconomic explanation of all the macroeconomic phenomena, since the microeconomic properties do not even determine the macro properties. Many have instead turned toward agent-based simulations (ABS) as the way forward for methodological individualism. One of the advantages of ABS is that it allows the systematic study of how the organization of the components affects the overall behavior of the system (Marchionni & Ylikoski 2013, pp.3). The typical aim is to explain macro phenomena from assumptions about agents as well as from various non-individualistic assumptions. However, if some of the key explanatory variables in ABS models cannot be meaningfully interpreted as ‘individualistic’, then ABS explanations should not be regarded as implementations of methodological individualism (Marchionni & Ylikoski 2013, pp.10). This can be highlighted by the Centola, Willer and Macy’s (2005) ‘Emporer Dilemma’ where there are macro assumptions with regards to the distribution of information and individuals that determine the outcomes of the simulations (Ylikoski 2013). The relations between individual agents and the overall configuration of these relations in the population are population-level attributes that do not apply to individuals. Furthermore, conceptualization of micro-macro problems in terms of methodological individualism may lead to biased strategies in ABS research (Wimsatt 1983) – i.e. blind to large-scale structural factors that have significant explanatory importance (Marchionni & Ylikoski 2013, pp.14).

To conclude, understanding macro-phenomenon from an action-theoretic framework may be useful in some scenarios and may help caution against some fallacies. However, it is clear that macroeconomics does not need microfoundations. The attempt at incorporating microfoundations can lead to flawed models through the use of representative agents. In many scenarios, macroeconomic explanations are more explanatory without microfoundations.

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