Equilibrium Macroeconomics and its Skeptics

Recently several economists-- few of whom seem to actually publish technical papers in reputable journals anymore-- led by Paul Krugman have seen fit to attack those who use equilibrium models to study macroeconomics. The thinking seems to go like this: "Equilibrium macroeconomics came mostly out of the University of Chicago and the University of Minnesota, both of which, and the University of Chicago in particular, were bastions of free market economic thought. Since those who oppose the bailout bill on free market grounds are 'clearly' idiots, and since several economists at Chicago in particular oppose the bailout, it must be that equilibrium macroeconomics is a failed endeavor."

Unfortunately, if Krugman had bothered to ever learn modern macroeconomics rather than spending time writing partisan op-eds, he might have learned how broad equilibrium macroeconomics really is. The first question is this: what exactly is equilibrium macroeconomics?

To answer that, I will first start by saying what it is not. Equilibrium macroeconomics is not free market economics, it does not automatically assume that markets are complete and that information is complete and symmetric, and it does not always conclude that market outcomes are Pareto optimal (basically, efficient) and that government intervention is always ill-advised. Twenty-five years ago there was indeed a correlation between belief in the free market and adherence to equilibrium macroeconomic methods, but as the methods have been more adopted, the specific assumptions used in any given model have become much more varied.

Equilibrium macroeconomics essentially rests on two pillars:

1) Agents-- firms, consumers, workers, etc.-- optimize their behavior (basically, they make decisions that they think will bring about whatever outcome they prefer most) given their knowledge of the actions taken by others and their information about the economic environment in general.

2) Aggregate variables-- interest rates, wages, the unemployment rate, etc.-- are the result of the decisions of the agents in the economy, disciplined by some notion of an equilibrium. Often times, the equilibrium condition is market-clearing. In some instances, the equilibrium condition is Nash equilibrium.

Modern macroeconomics has many fathers, perhaps most notably Robert Lucas, Tom Sargent, and Ed Prescott. The first seminal equilibrium macroeconomic model to study the business cycle was the Real Business Cycle model by Kydland and Prescott from the 1980's. That model DID assume that financial markets and information were complete. By implication, this means that people can perfectly insure themselves against economic risk and that the economy is Pareto efficient (ie there is no way the government can make everybody better off). Clearly, at least the result about perfect risk insurance is far from true.

However, it is NOT those particular assumptions of the model-- or the two controversial (or maybe just dead wrong) implications-- that have made the model an enduring baseline macroeconomic model. It is instead the fact that their model was the first to incorporate (1) and (2) to study the causes of business cycles, and that their model explained a sizable proportion of economic fluctuations. Since then, even if Krugman has not noticed, equilibrium macroeconomic has progressed far beyond that model. Here are some examples:

In the 1990's Rao Aiyagari developed a foundational incomplete markets equilibrium macroeconomic model where people face idiosyncratic risk. The result? People cannot insure themselves completely and the economy is not Pareto efficient. Same methodology (ie using (1) and (2)), different specific assumptions, different outcome.

Since then, Per Krusell and Anthony Smith have extended the model by adding aggregate risk. In addition, whereas Aiyagari assumed that financial markets were exogenously incomplete, there has been substantial work in the dynamic contracting literature within macroeconomics that gives rise to endogenously incomplete markets. What are some of the assumptions of these models? Private (incomplete) information and imperfect enforcement.

The equilibrium macroeconomic literature has been extended in many other ways as well. Several macroeconomists have done and continue to do work in developing better heterogeneous agent, incomplete markets models to explain the evolving wealth distribution and the extent to which people can and cannot insure themselves against risk. In addition, there is substantial work being done on incorporating search frictions-- namely, the fact that workers, firms, investors, etc. must actively search for economic opportunities, rather than automatically encountering them-- into equilibrium models. Christoper Pissarides and Dale Mortensen, among others, have developed a benchmark equilibrium model that generates unemployment dynamics far more realistic (and interesting) than the standard classical, full-employment models.

I could go on...

My main point is that equilibrium macroeconomics has become more or less the norm in the field these days, and I cannot think of any successful job market candidates in macroeconomics that work outside the equilibrium framework, broadly defined. The benefit to this framework is not the specific assumptions that individual economists put into their preferred models, but rather:

1) Equilibrium macroeconomic models do not divorce aggregate behavior from the individual actions which must necessarily generate it.

2) They are internally consistent and enforce discipline on the part of the economic modeler.