Phlogiston, the identification problem, and the state of macroeconomics

Stanislas Wolff, “Phlogiston”

The other day, I argued (as I have many times over the years) that contemporary mainstream macroeconomics is in a sorry state.

Mainstream macroeconomists didn’t predict the crash. They didn’t even include the possibility of such a crash within their theory or models. And they certainly didn’t know what to do once the crash occurred.

I’m certainly not the only one who is critical of the basic theory and models of contemporary mainstream macroeconomics. And, at least recently (and, one might say, finally), many of the other critics are themselves mainstream economists—such as MIT emeritus professor and former IMF chief economist Olivier Blanchard (pdf), who has noted that the models that are central to mainstream economic research—so-called dynamic stochastic general equilibrium models—are “seriously flawed.”

Now, one of the most mainstream of the mainstream, Paul Romer (pdf), soon to be chief economist at the World Bank, has taken aim at mainstream macroeconomics.* You can get a taste of the severity of his criticisms from the abstract:

For more than three decades, macroeconomics has gone backwards. The treatment of identification now is no more credible than in the early 1970s but escapes challenge because it is so much more opaque. Macroeconomic theorists dismiss mere facts by feigning an obtuse ignorance about such simple assertions as “tight monetary policy can cause a recession.” Their models attribute fluctuations in aggregate variables to imaginary causal forces that are not influenced by the action that any person takes. A parallel with string theory from physics hints at a general failure mode of science that is triggered when respect for highly regarded leaders evolves into a deference to authority that displaces objective fact from its position as the ultimate determinant of scientific truth.

That’s right: in Romer’s view, macroeconomics (by which he means mainstream macroeconomics) “has gone backwards” for more than three decades.

Romer’s particular concern is with the “identification problem,” which in econometrics has to do with being able to solve for unique values of the parameters of a model (the so-called structural model, usually of simultaneous equations) from the values of the parameters of the reduced form of the model (i.e., the model in which the endogenous variables are expressed as functions of the exogenous variables). A supply-and-demand model of a market is a good example: it is not enough, in attempting to identify the two different supply and demand equations, to solely use observations of different quantities and prices. In particular, it’s impossible to estimate a downward slope (of the demand curve) and an upward slope (of the supply curve) with one linear regression line involving only two variables. That’s because both supply and demand curves can be shifting at the same time, and it can be difficult to disentangle the two effects. That, in a nutshell, is the “identification problem.”

The problem is similar in macroeconomic models, and Romer finds that many mainstream economists rely on models that require and presume exogenous shocks—imaginary shocks, which “occur at just the right time and by just the right amount” (hence phlogiston)—to generate the desired results. Thus, in his view, “the real business cycle model explains recessions as exogenous decreases in phlogiston.”

The issue with phlogiston is that it can’t be directly measured. Nor, as it turns out, can many of the other effects invoked by mainstream economists. Here’s how Romer summarizes these imaginary effects:

• A general type of phlogiston that increases the quantity of consumption goods produced by given inputs
• An “investment-specific” type of phlogiston that increases the quantity of capital goods produced by given inputs
• A troll who makes random changes to the wages paid to all workers
• A gremlin who makes random changes to the price of output
• Aether, which increases the risk preference of investors
• Caloric, which makes people want less leisure

So, there you have it: in Romer’s view, contemporary mainstream economists rely on various types of phlogiston, a troll, a gremlin, aether, and caloric. That’s how they attempt to solve the identification problem in their models.

But, for Romer, there’s a second identification problem: mainstream economists continue to build and apply these phlogiston-identified dynamic stochastic general equilibrium models because they have “a sense of identification with the group akin to identification with a religious faith or political platform.”

The conditions for failure are present when a few talented researchers come to be respected for genuine contributions on the cutting edge of mathematical modeling. Admiration evolves into deference to these leaders. Deference leads to effort along the specific lines that the leaders recommend. Because guidance from authority can align the efforts of many researchers, conformity to the facts is no longer needed as a coordinating device. As a result, if facts disconfirm the officially sanctioned theoretical vision, they are subordinated. Eventually, evidence stops being relevant. Progress in the field is judged by the purity of its mathematical theories, as determined by the authorities.

I, for one, have no problem with group identification (I often identify with Marxists and many of the other strangers in the strange land of economics). But when it’s identification with a few leaders, and when it’s an issue of the purity of the mathematics—and not shedding light on what is actually going on out there—well, then, there’s a serious problem.

As it turns out, modern mainstream economics has two identification problems—one in the imaginary solution of the models, the other with the imagined purity of the mathematics. Together, the two identification problems mean that what is often taken to be the cutting edge of modern macroeconomics is in fact seriously flawed—and has become increasingly flawed for more than three decades.

But let me leave the last word to Daniel Drezner, who has lost all patience with mainstream economists’ self-satisfaction with their theories, models, and standing in the world:

this is a complete and total crock.

 

*Other mainstream economists, such as Narayana Kocherlakota and Noah Smith, have expressed their substantial agreement with Romer.