Phlogiston, the identification problem, and the state of macroeconomics

Posted: 19 September 2016 in Uncategorized
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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.

  1. I cringe when people blame macroeconomists for failing to predict the crash. The crash was a failure of finance, where it turned out finance was more fragile than people imagined. It was a technical failure, similar to building a technically ambitious concrete roof that then collapses.

    What macroeconomists should have shouted about before the crash is the large and non-obvious amount of stress stored in the system – and the same is true today. What those same macroeconomists should have shouted about just after the crash is how fiscal retrenchment and deleverage are the wrong policies that would tank the economy, while making the speculators take losses would have been the right policies.

    The crash itself is not interesting. It’s an event that marks the release of stresses and a return to equilibrium. What’s interesting are the policies that build up those stresses when there isn’t a crash, and the motivations of people who defend them.

    • Magpie says:

      With all due respect, Pavlos, I am not quite sure I follow you.

      You open with this:

      “I cringe when people blame macroeconomists for failing to predict the crash. The crash was a failure of finance, where it turned out finance was more fragile than people imagined.”

      So, macroeconomists were not at fault, because it was a financial crash. One may or may not agree with that, but that is a position and it’s easy to understand.

      Then, there is this:

      “What macroeconomists should have shouted about before the crash is the large and non-obvious amount of stress stored in the system – and the same is true today.”

      So, macroeconomists were at fault, because there was a large and non-obvious amount of stress stored in the system and they did not warn about it. Again, fair enough, that is an understandable position and one may or not agree with it.

      What is difficult to agree with is the combination of the two. Macroeconomists were at the same time at fault and not at fault.

      So, which of these is your position: were macroeconomists to blame or not?

      “The crash itself is not interesting”.

      Maybe not to you. I beg to differ.

      • Calgacus says:

        What the hell do people have against phlogiston? Not to be too steampunk about it, but stop phlogging an undead horse. Phlogiston is just another name for “valence electrons”. Phlogiston exists. Phlogiston roolz!!!!

        Pretty good economist Ha-joon Chang’s brother, forget his name, is a pretty good philosopher of science. He has a Boston Study (in hist & philosophy of sci) about water, with the latest on phlogiston – noting that the concept has been used in recent (experimental) introductory chemistry classes with success. Ideas like “The issue with phlogiston is that it can’t be directly measured” is a relic of old, logical positivist philosophy of science, that should stay buried. Unlike phlogiston!

      • So if the economists were engineers it’s like asking a bunch of engineers “Why did my car skid off the road?”. The macroengineers could fairly say “Look, it’s not our job to predict whether you’d skid or make it through this turn or the next, but we could tell you at the speed you were going the forces on the car were making it unstable, and that if you did lose your grip you would crash quite badly”.

        Meanwhile the financial engineers could say “Actually, we did design the car to take bends at high speed because we thought you wanted a high performance sports car. Something went wrong, perhaps an unlikely event like ice on the road, or perhaps our risk model wasn’t quite perfect. Anyway we’re glad it was your car and not ours, here’s our fee.”

        The public is often confused because it’s not clear which kind of economist is speaking with which hat. The macro people were supposed to assess the presence of risk or stress in the system, the way Robert Shiller does and most don’t. The financial guys were supposed to understand fragility and tail risks the way Nassim Taleb does and most don’t. Neither group is supposed to “predict the crash” specifically.

  2. David F. Ruccio says:

    Pavlos, ALL of those economists—both macro and finance—tell us their models are best because they accurately predict economic events. That’s THEIR language, not mine. Well, as we know, they DIDN’T predict the crash. Nor COULD they, since their models didn’t even include the possibility of a crash. As far as I’m concerned, that’s on them—both their models and the claims they make of their models.

  3. Magpie says:

    Frankly, your example didn’t help. “The macroengineers could fairly say” whatever they could fairly say. The bottom line is that they didn’t warn the driver. That’s what they didn’t fairly say.

    “The public is often confused because it’s not clear which kind of economist is speaking with which hat.”

    After this discussion, I can’t blame the public.

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