No seriously, Macro *IS* Hard

It’s one of my favorite phrases while writing on EFE. And it is a favorite for a reason: it is true.

And today’s post is about an excellent essay by David Glasner, author of the excellent blog Uneasy Money.

I usually excerpt bits and blobs of whichever essay I am recommending to you, and I will get to that part eventually, but today, I want to spend some time in explaining why it is that I find macro so hard.

One, modeling a firm is hard enough. Trying to model an entire economy entails massive abstraction, and so whatever conclusions you reach are likely to be little more than informed guesses.

Two, time. A simple word, but with massive implications. You can call it what you like, but the basic simple point is that any project that lasts for more than a day is taking a bet on what the future is going to look like. And the uncertainty that is necessarily associated with the future means that your estimates are guaranteed to be wrong. Mostly correct if you’re lucky, somewhat off the mark if it is business as usual, and hopelessly off target if you’re unlucky.

Consider this from The Economist:

The dearth of chips is a consequence of the pandemic, which boosted demand from makers of electronic devices for those stuck at home during lockdowns. Car firms also underestimated the rapid pace of recovery this year. Expecting weak sales, in 2020 they pared back orders. Although carmakers spent $40bn or so on chips in 2019, that accounted for only a tenth of global demand, which puts them low in the semiconductor pecking order. This makes orders hard to reinstate.

Three, in my mind, used to be kind of related to two. Time also meant that much like your assumptions would eventually be wrong, so also would the assumptions of your suppliers and customers be wrong. And those assumptions being wrong would mean that all plans would need constant modification on an ongoing basis. Which makes the study of macroeconomics hard, but also endlessly interesting.

But David Glasner’s post raised a point that is well worth thinking about:

When contesting the presumed necessity for macroeconomics to be microeconomically founded, I’ve often used Marshall’s partial-equilibrium method as a point of reference. Though derived from underlying preference functions that are independent of prices, the demand curves of partial-equilibrium analysis presume that all product prices, except the price of the product under analysis, are held constant. Similarly, the supply curves are derived from individual firm marginal-cost curves whose geometric position or algebraic description depends critically on the prices of raw materials and factors of production used in the production process. But neither the prices of alternative products to be purchased by consumers nor the prices of raw materials and factors of production are given independently of the general-equilibrium solution of the whole system.
Thus, partial-equilibrium analysis, to be analytically defensible, requires a ceteris-paribus proviso. But to be analytically tenable, that proviso must posit an initial position of general equilibrium. Unless the analysis starts from a state of general equilibrium, the assumption that all prices but one remain constant can’t be maintained, the constancy of disequilibrium prices being a nonsensical assumption. (Emphasis added)

That’s…a convenient assumption, at the very least, even for an economist.

It gets worse (or if you enjoy thinking about this sort of thing, better):

Unless general equilibrium obtains, prices need not equal costs, as measured by the quantities and prices of inputs used by firms to produce any product. Partial equilibrium analysis is possible only if carried out in the context of general equilibrium. Cost cannot be an independent determinant of prices, because cost is itself determined simultaneously along with all other prices.

Towards the end of the post, David Glasner helps us understand why comparative-statics are extremely limited tools.

Very briefly (please do read the entire post),

1. the fact that you must begin in a state of disequilibrium,

2. plus the fact that the movement towards some (potential) equilibrium will take time,

3. and finally, the lack of a guarantee that changes in this dynamic system will move us towards equilibrium…

… imply that one should use partial-equilibrium analysis only when fully aware of its limitations.

As David Glasner reminds us, none of this is new or path-breaking, but as students of economics, it is helpful to remind ourselves that, well, macro is hard.