Paul De Grauwe on the State of Macro

Via Taking Hayek Seriously, here is a link to Paul De Grauwe's new paper "Top Down versus Bottom Up Macroeconomics". The introduction to De Grauwe's paper:

In order to understand the nature of different macroeconomic models it is useful to make a distinction between top-down and bottom-up systems. In its most general definition a top-down system is one in which one or more agents fully understand the system. These agents are capable of representing the whole system in a blueprint that they can store in their mind. Depending on their position in the system they can use this blueprint to take over the command, or they can use it to optimize their own private welfare. These are systems in which there is a one to one mapping of the information embedded in the system and the information contained in the brain of one (or more) individuals. An example of such a top-down system is a building that can be represented by a blueprint and is fully understood by the architect.

Bottom-up systems are very different in nature. These are systems in which no individual understands the whole picture. Each individual understands only a very small part of the whole. These systems function as a result of the application of simple rules by the individuals populating the system. Most living systems follow this bottom-up logic (see the beautiful description of the growth of the embryo by Dawkins(2009)). The market system is also a bottom-up system. The best description made of this bottom-up system is still the one made by Hayek(1945). Hayek argued that no individual exists who is capable of understanding the full complexity of a market system. Instead individuals only understand small bits of the total information.

The main function of markets consists in aggregating this diverse information. If there were individuals capable of understanding the whole picture, we would not need markets. This was in fact Hayek’s criticism of the “socialist” economists who took the view that the central planner understood the whole picture, and would therefore be able to compute the whole set of optimal prices, making the market system superfluous.

My contention is that the rational expectations models are the intellectual heirs of these central planning models. Not in the sense that individuals in these rational expectations models aim at planning the whole, but in the sense that, as the central planner, they understand the whole picture. These individuals use this superior information to obtain the “optimum optimorum” for their own private welfare. In this sense they are top-down models.

In this paper I will contrast the rational expectations top-down model with a bottomup macroeconomic model. This will be a model in which agents have cognitive limitations and do not understand the whole picture (the underlying model). Instead they only understand small bits and pieces of the whole model and use simple rules to guide their behavior. I will introduce rationality in the model through a selection mechanism in which agents evaluate the performance of the rule they are following and decide to switch or to stick to the rule depending on how well the rule performs relative to other rules.