Micro vs. macro
By Scott Sumner
Paul Krugman has an interesting post, where he pushes back against the conventional view that micro is more successful than macro. Here’s Krugman:
So let me talk about three things:
The unsung success of macroeconomics
The excessive prestige of microeconomics
The limits of empiricism, vital though it is
I think Krugman’s basically right, although I’d emphasize some different points.
Krugman spends a lot of time on the IS-LM model, which he finds useful and I do not. He emphasizes the fact that IS-LM allowed him to avoid falling into the trap of expecting QE to lead to high inflation. Rapid increases in the money supply are often inflationary, but not when interest rates are near zero.
I prefer to think in terms of money supply and money demand when trying to explain movements in nominal aggregates. For instance, macroeconomists who understand monetary theory can easily explain why inflation has averaged 2% since 1990, whereas non-economists and economists with non-monetary models have no explanation at all. And no, the following does not constitute an “explanation”:
2. Fiscal policy
3. A miracle happens!
4. 2% inflation for 28 years
Macroeconomists also have a pretty good model of the business cycle. The combination of nominal shocks and sticky wages/prices results in short term movements in employment and output that are highly correlated with short run movements in NGDP. In the long run, wages and prices adjust and the economy goes back to the natural rate. These theories are not perfect (hysteresis is not well understood), but they are pretty good.
So why can’t we predict business cycles? For the same reason that microeconomists cannot predict individual prices—economic theory (such as rational expectations and the EMH) suggests that many types of predictions are almost impossible.
Macroeconomics is also pretty good at explaining long run growth. It seems to be based on 5 factors (human capital, physical capital, technology, natural resources, and good institutions.) Yes, the final one is a bit vague, but probably involves relatively free markets, property rights, non-excessive taxes, etc.
Microeconomists have one highly successful model—perfect competition. But most markets are not perfectly competitive. As soon as you move to imperfect competition, micro is just as ambiguous as macro. Minimum wages? Who knows if they reduce employment? Health care economics? A huge mess, where economists cannot even reach a consensus on the key issues that need to be focused on.
Microeconomics might be a bit more successful in some ways, as the problems being considered are often less complex. As an analogy, macrophysics (earthquake prediction, weather forecasting, etc.) is less precise than microphysics (a rocket’s trajectory through outer space.) But less complexity is the only sense in which micro is more “scientific”.
The law of large numbers allows certain parts of macro (inflation, business cycles, etc.) to actually be better understood than some parts of micro (health care, antitrust, etc.) Inflation is simply about money supply and money demand. In contrast, health care is about barriers to entry, information asymmetries, moral hazard, adverse selection, intellectual property rights, cross-subsidization, mandates, and many other market imperfections.
A macro perspective often gives a more complete picture of the economy. Thus you might (wrongly) assume from micro that immigration would reduce wages. More immigrants means more supply of labor, which means lower wages. Of course this isn’t actually a prediction of micro, but it’s an easy trap to fall into (read commenter Ben Cole). A macroeconomist would notice that America has similar wage levels to Canada, despite roughly 10 times as much immigration. Then she might notice that immigration also increases the demand for labor, indeed at roughly the same rate that the supply of labor rises. This idea is sometimes called the “macro foundations of microeconomics.”
Krugman’s also right that data are not enough; we need to combine data with theory to make sense of the world.
PS. A quick follow-up on my previous post. It was southern Orange County (Trump country) that opposed the nice new airport; the more Democratic northern part of the county supported the project. In other areas of the country, it could easily be the reverse. Remember that next time someone asks you, “why can’t we have nice things?”