Rethinking Economics Part II: the microfoundations of macroeconomics

Another useful talk I attended at the recent Rethinking Economics conference was by Michelle Baddeley, Professor at UCL, on ‘rethinking the microfoundations of macroeconomics’. Microeconomic analysis concerns itself with the behaviour of individual economic agents or methodological individualism; that is, human agents, firms and households. Macroeconomics analyses the behaviour of the economy as a whole, at the national or global level. Originally, macroeconomics drew on the work of John Maynard Keynes after the publication of his General Theory by examining aggregated behavioural relations such as the consumption and investment functions and their effect on aggregate demand or spending in the macroeconomy.

As mainstream Keynesian economics fell out of favour during the post-war period amid phenomena that it seemed ill-equipped to explain, such as the simultaneous existence of unemployment and inflation, the new classical macroeconomics became influential. The latter emphasised what its proponents called rigorous microfoundations: in this way, what was originally macro was held to be flawed and replaced with representative human agents (consumers or firms) at the micro level. The rational expectations hypothesis assumed that these individuals were super rational planners, did not make systematic mistakes in their behaviour and were quick to respond to news or new information. Markets were assumed to clear, and in finance the efficient markets hypothesis was held to be the correct model. Although this may seem a pale reflection of reality, economists who subscribed to these ideas followed Milton Friedman’s argument that what mattered was not the realism of assumptions but their explanatory power. The new classical economics proposes that unemployment tends to be voluntary, inflation is caused by misguided government policy and business cycles are the result of exogenous (external to the system) shocks.

New Keynesian economics was developed out of the new classical economics by incorporating market imperfections at the micro level that could give rise to the phenomena described by the original Keynesian macroeconomics such as unemployment, but it remained based on microfoundations or the primacy of the individual. New Keynesian economics has arguably become the mainstream approach to macroeconomics, and especially so in the wake of the Great Recession. However it still has limitations including its assumption of individual rationality, optimising behaviour and its exclusion of the financial sector.

Baddeley’s talk was concerned with microfoundations, and ultimately argued that insights from behavioural economics, which draws on psychology to inform economic theory can help us to form better descriptions of the individual agents that make up the economy and give rise to aggregated behaviour. She did question whether the individual was the best building block for analysis of the economy, but left this as an open question requiring further study and reflection.

One of the insights of Keynes’ General Theory was that investment is partly driven by ‘animal spirits’. As Baddeley put it, the latter can be seen as the interaction of action, optimism, spontaneity and entrepreneurship. In Keynes’ work, investment drives economic growth and is a key determinant of the level of employment, through its impact on both aggregate demand or spending, and aggregate supply or capacity. It was suggested that through an understanding of animal spirits we might be able to manage the economy better through the effects of policies on this phenomena.

Unfortunately, animal spirits are emotional and are not easy to measure. They might be sensitive to social and political change, uncertainty (which Keynes drew attention to in several works, and which is emphasised by post-Keynesian economists faithful to his original thinking), the overall state of confidence, and financing constraints. Through a better informed understanding of the psychology of decision-making, Baddeley said, we might be able to improve economic policy outcomes. She suggested that macroeconomic policies should try to accommodate emotional behaviour and mood, revive animal spirits which are likely to be low during a recession, and encourage forward-looking behaviour in investment planning.

Baddeley’s talk also covered some more general points: that government policy could consider new policy goals such as improving well-being (which would require measurement), paying attention to environmental sustainability and protection, and reducing poverty and inequality. These sorts of ideas are already in the public realm but arguably do not receive enough attention. She emphasised that different theories have different insights, and that politics and history affect the models that are used by governments. We should therefore adopt a more pluralistic attitude to economic analysis, something which many conference participants and others would agree with.

Summing up, she argued for a behavioural macroeconomics, incorporating bounded rationality, learning as an out-of-equilibrium process, both extrinsic and intrinsic motivations (ie it’s not all about money), herding and conventions giving rise to social influences and bubbles, unstable risk appetites over time, and socio-psychological influences, perhaps formed by evolutionary processes.

This is all interesting stuff, but as Professor Steve Keen, who was in the audience and is a post-Keynesian, put it, rather than microfoundations of macroeconomics, perhaps we should return to Keynes’ original insight that we need macrofoundations of microeconomics. Thus a study of aggregated systems could better inform our understanding of the economy as an object of enquiry, rather than studying and aggregating individual agents and their properties. Such an approach tends to be associated with more heterodox approaches to economics. Marx began his analysis of capitalism with an appeal to study the social whole, the capitalist mode of production. Keynes and his closest followers, who gave birth to the post-Keynesian school, also emphasised that more holistic categories of analysis such as aggregate consumption, investment, money supply and demand, and overall aggregate demand, have an existence which is dependant on, but irreducible to, the individual. I tend towards agreement with this latter structural approach to the economy. In any philosophy of society, we should not neglect the individual as a causal agent, but can nevertheless examine the larger structural forces which affect and are affected by individual behaviour.

Thus if we want to understand the macroeconomy, we should examine macroeconomic structures, relations, and behaviour which, as we see every time a recession produces unemployment, can overwhelm the individual’s attempt to optimise no matter how much she might wish otherwise.

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