The value of microfoundations
Here is Noah Smith on microfoundations, responding to Matt Yglesias (here and here, here is also a Krugman post on the topic). I am usually pro-microfoundations, though without any particular philosophy of science-derived attachment to the idea. Here is why:
1. In some very important, simple, and intuitive models, there is nominal stickiness but money is still neutral. Caplin and Spulber 1980 is one of my favorite pieces and time spent studying their model will be repaid with value. I don’t think the model applies to 2007-2009, or say 1929-1933, when we have “out of the ordinary” shocks, but it may apply to many other time periods.
2. Often the data suggest that money is neutral or roughly neutral or at least the data are not inconsistent with neutrality. I know that one does not hear much about that in today’s economics blogosphere, but I kid you not. Again, I differ strongly from this literature for “the times which really matter,” such as 2007-2009 or 1929-1933, but still I take the data seriously. Try this relatively “atheoretical” piece by Harald Uhlig, which does not reject monetary neutrality (nor does it cover 2007-2009). Nominal stickiness models have trouble explaining why money doesn’t matter more than in fact it does. Understanding microfoundations will keep you out of the trouble you will get in if you keep trying to use money to expand output.
3. We can try to nudge people into more flexible wages, but again that requires some understanding of microfoundations. The Fed can prevent any risk of a deflationary downward spiral, and please note it is no coincidence we are in the two percent inflation range. You don’t have to view this as a high return activity to favor it (it is funny how the mere mention of wage nudges will cause many people to suddenly turn against the nudge idea, at least temporarily.)
4. Microfoundations don’t have to mean intertemporal maximization with extreme assumptions about rational or well-behaved preferences. George Akelof has written some of the best papers on microfoundations. Nor do microfoundations have to mean staking out an extreme position on the Lucas critique.
5. There are plenty of flex-wage professions which still have been seeing high unemployment. Like real estate agents. Or what happened to all those Mexicans who used to stand around on street corners? Were their wages sticky too? I don’t think so. Does their return to unemployment or underemployment in Puebla refute the sticky wage model? I personally don’t think so, but it’s hard to answer that question — an obvious one to a critical observer — without a clear sense of microfoundations.
6. Just how bad is monopoly? We wish to know when designing a competition policy. Under some microfoundations models, the existence of market power is essential for ongoing stickiness, in other models not. This question matters, and we need microfoundations to better resolve it.
7. Should a government subsidize, tax, or be neutral toward contract indexation? Try answering that question, or even getting started on it, without some sensible microfoundations.
8. If you are trying to end a hyperinflation or high rate of inflation, do you need to get fiscal policy right, in some kind of credible manner, before enacting monetary restraint? It is hard to imagine answering this question without good microfoundations.
I could go on. I am worried that people are rejecting microfoundations because they think microfoundations imply objectionable attitudes toward macro policy. But note: if those attitudes are objectionable and indeed wrong, they won’t be implied! It is entirely defensible to argue “we should have a more expansionary monetary policy today, even without the microfoundations to support that view.” It is much tougher to argue “economics should deemphasize microfoundations altogether.” The broader the range of questions one considers, the more important microfoundations turn out to be.