Never Let a Serious Crisis Go to Waste

by Philip Mirowski

  The agents populating DSGE models, functioning as individuals or firms, are endowed with a kind of clairvoyance. Immortal, they see to the end of time and are aware of anything that might possibly ever occur, as well as the likelihood of its occurring; their decisions are always instantaneous yet never in error, and no decision depends on a previous decision or influences a subsequent decision. Also assumed in the core DSGE model is that all agents of the same type—that is, individuals or firms—have identical needs and identical tastes, which, as “optimizers,” they pursue with unbounded self-interest and full knowledge of what their wants are. By employing what is called the “representative agent” and assigning it these standardized features, the DSGE model excludes from the model economy almost all consequential diversity and uncertainty—characteristics that in many ways make the actual economy what it is. The DSGE universe makes no distinction between system equilibrium, in which balancing agent-level disequilibrium forces maintains the macroeconomy in equilibrium, and full agent equilibrium, in which every individual in the economy is in equilibrium. In so doing, it assumes away phenomena that are commonplace in the economy: involuntary unemployment and the failure of prices or wages to adjust instantaneously to changes in the relation of supply and demand. These phenomena are seen as exceptional and call for special explanation.

  While skepticism concerning the DSGE is worn openly in this précis, it was nowhere near as scathing as the disparagement of the model that one hears in private and reads on blogs. Incredulity often focuses upon the presumption of a single immortal representative agent capturing the entire economy. For instance, at the April 2010 meetings of the Institute for New Economic Thinking, I witnessed one famous economist compare coordination failures in DSGE models with the right hand losing track of what the left hand was doing, and the treatment of uncertainty in DSGE as tantamount to diagnosing the onset of Alzheimer’s. You can just imagine the bizarre shapes that “information” assumes in this solipsistic portrait: What can it mean for this godlike agent to learn anything? A good DSGE joke current on the blogs is: “Based on all available information, I rationally expect DSGE models to suck for an infinite number of future periods; and because I am a representative agent, everybody agrees with me.”

  So maybe economist jokes are not all that funny, but there are a few philosophical points to be extracted from the imbroglio. The first is that, within the profession, seeking out the Golden Mean does not guarantee intellectual credibility. The DSGE model was the product of a long series of compromises resulting in what was conceived as best-practice consensus, following a period in which participants had endured what they felt was three decades of bickering, discord, and wrangling over the correct way to theorize in macroeconomics.83 In the middle of the noughties, embrace of the Great Moderation was coupled with declaration of the Great Macro Accord, and the DSGE model was its offspring. Complacency in the world of ideas replicated complacency in the world of policy. In another instance of bad timing, Olivier Blanchard, chief economist of the IMF, decreed: “The state of macro is good . . . macroeconomics is going through a period of great progress and excitement, and there has been, over the past two decades, convergence in both vision and methodology.” “DSGE models have become ubiquitous. Dozens of researchers are involved in their construction. Nearly every central bank has one, or wants to have one.”84 And more astoundingly, all central banks still have one. Indeed, this is an illustration of the thesis proposed in the previous chapter, that the Federal Reserve (and central banks in general) have a much larger influence upon the configuration of the economics profession than often thought. But perhaps it better illustrates the fact that the DSGE model was an attempt to be all things to all sides, a détente imposed from above, emitted from a very few “top-ranked” economics departments rather than a voluntary truce taking hold organically. This had something to do with its clueless setup for its vertiginous fall.

  While there are some good historical summaries of how the rational expectations movement and the so-called Lucas critique killed off the previous Keynesianism of the 1960s and ’70s, there are very few sociological meditations on how economics got from there to the DSGE model. Starting out under the banner of “consistency,” it was insisted that neoclassical microeconomics and macroeconomics had to be fully interchangeable. Second, orthodox macroeconomists came to conflate “being rational” with thinking like an orthodox economist. What this implied was that agents knew the one and only “true model” of the economy (which conveniently was stipulated as identical with neoclassical microeconomics); and since they all knew the same thing, for practical purposes of the model, they were all alike in most relevant respects. Hence, far from congealing an intellectual travesty, it seemed plausible (not to mention mathematically convenient) to portray the entire economy as playing out between the ears of a single person. Thus the “representative agent” fiction in fact constitutes a projection of deep commitments of the existing elite of the orthodox economics profession. That is why it became a shared presumption of neoliberals who believe in the natural healing powers of the market, as well as New Keynesians looking for reasons why the economy falters.

  Consensus is often mistaken for groupthink within the DSGE model, and this tends to mirror a sociological characteristic of the economics profession. Both the “agent” in the DSGE model and in the American profession could not imagine an effective search for truth emerging out of substantial persistent disagreement over fundamentals. Agents in orthodox models are enjoined from “agreeing to disagree”; and economists in good standing must knuckle under as well. The utter revulsion for anything smacking of real heterodoxy, combined with a fear of appearing “unscientific” to outsiders, eventually led to a donnybrook far more drastic than any embarrassment or compromised legitimacy that might have otherwise previously arisen from strident disagreement in the court of public opinion. Indeed, the effect of the crisis has been to bring those repressed disputes out into the open.

  Once the presumption of omniscience broke down, then the consequences of the banishment of methodological self-scrutiny began to be felt. Both the criticisms and defenses of DSGE, at the congressional hearings and elsewhere after the crisis onset, were distressingly unsophisticated, as one might expect as fallout from the ostracism of methodological thought. Robert Solow testified in Congress that DSGE models “didn’t pass the smell test,” introducing a novel olfactory standard for scientific model choice. The defense of DSGE by V. V. Chari at the hearings equally reveals the paucity of resources (and rhetorical skills) possessed by contemporary economists:

  So, any interesting model must be a dynamic stochastic general equilibrium model. From this perspective, there is no other game in town. Modern macroeconomic models, often called DSGE models in macro share common additional features. All of them make sure that they are consistent with the National Income and Product Accounts. That is, things must add up. All of them lay out clearly how people make decisions. All of them are explicit about the constraints imposed by nature, the structure of markets and available information on choices to households, firms and the government. From this perspective DSGE land is a very big tent. The only alternatives are models in which the modeler does not clearly spell out how people make decisions. Why should we prefer obfuscation to clarity? My description of the style of modern macroeconomics makes it clear that modern macroeconomists use a common language to formulate their ideas and the style allows for substantial disagreement on the substance of the ideas. A useful aphorism in macroeconomics is: “If you have an interesting and coherent story to tell, you can tell it in a DSGE model. If you cannot, your story is incoherent.”85

  The rational-expectations crowd tended to take one of two opposed positions: either you couldn’t think rationally without DSGE, or else you couldn’t think about the crisis with it: “These models were designed to describe aggregate economic fluctuations during normal times . . . they are not designed to be theories of financial crises.”86 Perhaps they c
hose one or the other depending upon the character of their audience.

  It is one thing to assert that you personally cannot imagine any other possible way to discuss the macroeconomy than the DSGE; it is quite another (in public, before a tribunal) to insist no one else can either, without babbling incoherently. And then there is the willful zombie response, which can acknowledge the point of all the dissent, but nevertheless retorts that once they have elected to become undead economists, there is no point whatsoever in having intellectual ambitions. Alan Kirman relates the following incident:

  There was this young economist, I think he was at UCLA, who wrote to me when I published this paper called “Whom or What Does the Representative Agent Represent?” (Kirman, 1992). He said: Dear professor, I really agree with what you said. I think it is intellectually absolutely right. Unfortunately, I am a young macroeconomist who is an assistant professor. I build models based on a representative agent. I know how to do that, and I know how to publish that. And I need to get tenure. Once I have got tenure, maybe I will then be able to turn around and start to think about the sorts of models that do not use the representative agent, but unfortunately, what I think will happen is that by then I will have got into the habit of doing it. I will publish my articles, get a decent reputation, I will get a promotion, and I will probably never think about this again. But anyway, thank you very much for the insight!87

  What has been odd given the waves of incredulous disbelief cascading over the economics profession is just how scarce serious rationalizations of steadfast fealty to the DSGE model have been, emitted by orthodox macroeconomists after 2008. One of the very few instances came in a long review of John Quiggin’s Zombie Economics by the monetarist economist Stephen Williamson.88 Although he grumbles that complaints about the uselessness of DSGE models are a “cheap shot,” he nonetheless grudgingly deigns to explain to the madding crowd why macroeconomists circle their wagons around the DSGE. With touching candor, he begins his defense by appealing to “efficiency,” by which he means “It would be silly for macroeconomists to turn down the gifts [neoclassical] theorists have given us.” Why not search where it is easiest? He then points to the trademark “Lucas critique,” which states that for purposes of policy, we need to differentiate causal factors that remain invariant through interventions from those that are altered by them.89 The DSGE model is lauded because it purportedly respects this separation. The amazing aspect of this justification resides in the fact that Lucas and friends unaccountably conflate things that are taken as independent primitives for the mathematical purposes in Arrow-Debreu theory—preferences, endowments, technology—with things that are actually invariant in the world for purposes of macroeconomic policy: a non sequitur if there ever was one. Next, because Williamson thinks the Kydland-Prescott (1977) notion of time inconsistency is one of the deepest insights into the politics of economic policy conceived in the last half-century, he insists only DSGE models encourage the casting of the problem of government versus the private sector as a game where the former attempts to outwit the latter. (As an aside: Amazing how little effort is expended to model firms swindling the government and the public in macroeconomics.) Besides, Williamson says with a yawn, we have already thought of all your picky quibbles, and someone somewhere in the literature has already addressed them. We orthodox make simplifying assumptions (representative agent, rationality, unique equilibrium) because we deem them useful, not because we believe any of this stuff. Anyway, you ask too much of the DSGE model—the purposes that motivate us orthodox macroeconomists rarely intersect with the issues you rabble think we should address: “Prediction need not always be the criterion of success of an economic model . . . By nature, a financial crisis is an unpredictable event . . . The basic real business cycle model was not designed for the purpose of understanding financial crises.” While he sneers at everyone else’s epistemic criteria and explanatory demands, it is significant that Williamson never once feels impelled to make explicit his own nonnegotiable litmus test for legitimate purposes in construction of models. Yet, looking back over his defense, it becomes clear: it is political, in the sense that if a particular model helps reify the neoliberal worldview, than it passes muster a fortiori. Williamson is subconsciously aware of this, since he turns swiftly to indict Quiggin for believing that proponents of DSGE, and zombie economics more generally, are “complicit in the conspiracy to make the rich richer by robbing the poor.” His refutation of this notion comes in the format that some Minneapolis Fed economists (recall: the incubator of rational-expectations theory) made some noises about the dangers of too-big-to-fail, and that some critics of DSGE—he cites an old paper by Larry Summers—often get implicated in the financial crisis. This is a direct quote: “So does Quiggin think Summers is a good guy or a bad guy?”

  The Williamson review reveals the longueurs and lacunae that ensue when an orthodox macroeconomist is forced to bring out into the open what has been drilled into him as prerequisite for obtaining his certificate of congruity with the sanctioned profession.

  This even happens with key critics like Joseph Stiglitz. In a long meditation on the flaws of macroeconomics, he suggests the DSGE was the wrong place to start to formalize macroeconomics, and that even when well-meaning Keynesians tinker with it to address the chorus of complaints, “the improved macro-performance is accompanied by an increased arbitrariness in at least certain specifications . . . the DSGE models have made the wrong trade-offs, focusing on some complexities which are of less importance than those they ignore”; and yet, in the very same paper, he reveals his own ambivalence, writing, “no one can object to models that approximately model the general equilibrium properties of dynamic economies facing endogenous and exogenous shocks, so on one level DSGE is unobjectionable.” No one, that is, except those who trace the disease to the neoclassical model itself.90

  But of course there were alternatives studded throughout the literature, ones that had been proposed repeatedly by those seeking to exit the “big tent” of orthodox macroeconomics. The immediate task is instead to ask, Why are so many economists so loathe to let go of the DSGE? All the usual considerations of inertia and sunk costs of intellectual commitment come into play; but there is something else, as well. One way to understand such intransigence is to explore the possibility that excision of the DSGE cannot staunch the bleeding of the American economics profession; for these economists, renunciation of the DSGE is a slippery slope to the dissolution of the entire economic orthodoxy. Après DSGE, la déluge.

  There were a few economists who had proposed that the monolithic coherence of macroeconomics and neoclassical microeconomics was a sham, but there were not accorded much respect, and were notably absent from the congressional hearings. Perhaps the most prominent was the European economist Alan Kirman. He headed a group of scholars who issued the “Dahlem report” excoriating the economics profession early on in the crisis, and explained his own position in a widely read blog post.91 Kirman suggested that the root problem with macroeconomics was really philosophical: the vaunted foundations of the DSGE model in full neoclassical general equilibrium were illusory. First, he cited some technical results dating from the 1970s stating that full general equilibrium analysis does not allow one to make much of any aggregate generalizations from the behavior of a diverse group of neoclassical agents; and furthermore, except under some strained special circumstances, one cannot guarantee the existence of a unique or stable general equilibrium.92 The reason that DSGE models could pretend there was a full macroeconomic equilibrium was that the fiction of a one-person economy was one of the few cases where (obviously) the individual is identical to the aggregate economy, and that existence proofs were available in that case for a unique stable equilibrium. To put it more bluntly, DSGE models were predicated upon the sole arbitrary special case where neoclassical microeconomics and macro could be logically reconciled. This is a conceptual sticking point that runs so deep in the orthodoxy that they rarely can openly acknowledge i
t. Almost every single generalization about “demand” is obviated in a truly general equilibrium model; and worse, almost all welfare statements are rendered nugatory once the existence of truly heterogeneous agents are admitted.93 Since all orthodox macro depends heavily upon Pareto comparisons of alternative equilibria as benchmarks, such generalization would make it entirely disappear in a puff of smoke.

  Instead of drawing the conclusion that the marriage of micro and macro was doomed, and the DSGE a stillbirth, the profession had chosen to pledge its troth to an outré mutant case and call it the whole world. It would be as though a religious fanatic arranged to live in a hermetic world composed only of Christian Scientist cyborgs, so that he need never encounter anyone who might call his faith in natural healing into question. As Kirman wrote, “both the development of the DSGE model and the efficient markets hypothesis share a common feature—despite the empirical evidence and despite their theoretical weaknesses, their development proceeded as if the criticism did not exist.”94 But isn’t that the very definition of a self-confident orthodoxy?