Divided economics
Bridging micro and macro
Economics is traditionally divided into microeconomics and macroeconomics. These three big categories help economists classify knowledge and theory in the field. They interact very often, being employed in various proportions for studies of specific topics. However, they remain separate and distinct. Everybody in the field can easily describe which part of their work is micro and which is macro.
The definitions aren’t difficult to understand. Microeconomics studies small groups of individuals, firms, or single markets. Macroeconomics analyzes aggregate economic data and tries to explain and predict trends in the economy as a whole. Clearly described boundaries between the subfields make comprehending economics easier. Or does it?
Why is economics divided into micro and macro? Was it always like this? The distinction was first drawn in the 1930s. It was a decade of a boom in the development of economic theory, coming from both England and continental Europe. In 1933, Ragnar Frisch, a Norwegian economist who later earned a Nobel prize in economics, coined the term macroanalysis to organize his writing.1 Later the new idea was formalized into macroeconomics as opposed to microeconomics. However, classifying theories into these categories wasn’t as easy as today since there had never been a need to clarify whether a theory belonged to micro or macro. The idea of economics was more unitary. Why did Frisch feel a need to distinguish the subfields?
Economics before the Great Depression
The early economic thinkers, also known as the classical school, including geniuses like Adam Smith, David Ricardo, Jean-Baptiste Say, or John Stuart Mill, were concerned only with what today we would call microeconomics2. Although all of them were interested in the economy as a whole as well, their efforts to describe the macroeconomic processes were limited to historical analysis of trends and events. There was little economic knowledge at the time, so classical geniuses’ brain power and scarce time had to focus on fundamentals. Intuitively, they started with individuals, firms, and single markets. Not only was it an easier task due to the simplicity of these subjects but it also seemed logical to start from the bottom and build up.
Yet the classical school didn’t produce only micro theory. Leon Walras, one of the brightest French economists in history, created a model of general equilibrium describing the conditions necessary for the whole economy to reach the equilibrium state. Eighty years later, Kenneth Arrow and Gerard Debreu developed a more sophisticated general equilibrium model, inspired by Walras’ works, which earned them a Nobel prize. However, even though Walras was definitely concerned with the big-picture economy, it was still just economics.3 His model was built using the same method and descriptive language other economists used. The big picture was built upon individual markets working together. The strong idea of continuation between the earlier work in the field and Walras’ contributions rendered a potential secession unnecessary. Classical economists analyzed different aspects of the economy but they all worked within one economics.
Roaring twenties go to hell
On Black Thursday, October 24, 1929, the Dow Jones Industrial Average (DIJA) index, at the time the main index of the New York Stock Exchange, lost 11% of its value as a result of a market panic. After a decade of amazing economic growth and incorrect investor optimism, the markets crashed suddenly. By the end of the month, the loss grew to 18%, and during the entire Great Depression, which started with Black Thursday, DIJA lost around 89%.4 The effects of the crash spread around the world, hitting Europe especially hard. According to classical economic theory, the markets should have started the adjustment processes and the economy would return to equilibrium over time. However, the recovery was painfully slow, and the sharp decline in the standard of living contrasted with a drastic improvement over the previous decade. The fear and despair over the dire economic situation were perfect conditions for brand-new economic theories to emerge.
The two most notable groups of scholars attempting to explain the causes of the Great Depression were the Keynesian and Austrian Schools. Keynesian theory originated in Cambridge, England where John Maynard Keynes began carving building blocks for a new revolution in economic thought. Austrian theory was born at the University of Vienna and represented by descendants of Carl Menger (initiator of the marginal revolution) and Eugen Bohm-Bawerk (creator of the foundations for the theory of capital).
Keynes vs. Hayek
Keynes was in a perfect position to revolutionize economic thought. Born to a wealthy family, he was the son of a Cambridge professor and a popular public figure due to his book The Economics Consequences of Peace.5 It criticized the Treaty of Versailles and the draconian reparations imposed on Germany and Austria. He wasn’t an economist but a mathematician. A talented and involved investor, he lost most of his assets during the Great Depression. Even before the depression hit, Keynes advocated for government action to increase employment. Amidst the worst economic crisis in history, he concluded that his policy ideas might help the British economy recover. He began his works on a theory to support these claims, involving some of his devoted students. The economic model they came up with did not resemble anything classical economists had ever written. Keynes constructed concepts such as the consumption function, or propensity to consume and save, and one of his students, Richard Kahn, created the famous multiplier to complete the theoretical foundations. According to Keynes, the British economy couldn’t mitigate depression and unemployment because of insufficient demand and excessive savings. Solution? Public works, through which the government redirects the unproductive savings to hire the unemployed, giving them purchasing power they can inject back into the economy, triggering the multiplier effect.6
At the same time, Lionel Robbins from the London School of Economics (LSE) invited Friedrich Hayek from the University of Vienna to give a series of lectures about the contributions he and his colleagues made to explain the workings of the economy and the Great Depression. Shortly after, Hayek got hired at LSE and was tasked to be a counterforce to Cambridge’s Keynes. Austrian economic tradition emphasized a deliberate and detailed analysis of the problems and answering questions using rational deduction. Hayek didn’t view the economy the same way Keynes did. Instead, he opposed almost everything Keynes created. The two economists famously initiated their interactions in a letter chain in which they could not understand each other’s terminologies. While Keynes graphed his consumption function to describe the economy as a monolith, in which the main issue could be insufficient aggregate demand, Hayek drew his triangles to convey that economic structure has multiple heterogeneous stages at which the characteristics of spending are different. Because of that, fiscal policy measures could give the economy only very short-lived relief, followed by a deepened crisis. Keynes viewed simple government expenditure as a panacea, but Hayek was convinced that government only further disrupts the structure of production.7
In the end, Keynes and his Cambridge circle won the debate, mostly due to their optimism and simplicity of policy recommendations. Hayek’s view that the economy is best left alone was condemned amidst the biggest and longest crisis in capitalism’s history. However, both Keynes and Hayek started schools of economic thought that were distinct from the classical school, introducing the problem of diverging theory. The mess their debate caused, resulted in a need to organize economics anew. Ragnar Frisch assessed the Keynesian theory and observed that it’s characterized by a top-down approach. On the other hand, the Austrian theory was bottom-up. Frisch named the top-down approach macroeconomics for its big-picture view, and the bottom-up approach microeconomics because of its emphasis on individual actors and firms.
Maturing of micro and macro
This divergence continued as the top-down approach economists produced more and more theory, most within the Keynesian tradition, and the Austrian School became marginalized and replaced by the Chicago School, also emphasizing macro. The era of the New Deal and industrial policy, followed by the oil crisis, dot-com bubble, and the Great Financial Crisis proved to be a heaven for macroeconomics. The main concern now was the performance of the economy as a whole, macro-scale competition, and monetary policy. In this new world, macroeconomists shined.
The culmination of macroeconomic theory in a purely top-down approach was exhibited in Milton Friedman’s 1953 essay, "The Methodology of Positive Economics.”8 Friedman argued that the assumptions made in an economic model aren’t a critical concern; they can even be outright false. The only thing that matters is the predictive power of the model. According to Friedman, the goal of economics isn’t the accurate description of the economic reality; it aims to provide accurate predictions with the simplest model possible. This strengthened the legitimacy of the Keynesian tradition, which was fully detached from the modeling of individual actors.
However, not everybody championed the rise of fiduciary economics. In the 1970s, an American economist Robert E. Lucas Jr. proposed remodeling of the foundations of macroeconomics. A new stream of thought followed, aiming to provide a framework to explain macroeconomic theory using microeconomics.9 The idea here was very simple: let’s connect the floor (micro) and the ceiling (macro) with solid walls (micro-foundations). But the task itself turned out to be challenging. Today, the search for reliable micro-foundations still continues, with more and less accepted theories (such as rational expectations) already out there. The importance of bridging micro and macro was acknowledged with a Nobel Prize in Economics for Robert Lucas Jr. in 1995.
The fallacious divide
In reality, there’s no such thing as “microeconomy” or “macroeconomy” to be studied by separate subfields. The economy is one continuous organism where interactions between small and big things are crucial to understanding the events and their causes.
The view that macroeconomics can be effective on its own often stems from seeing the economy as a system. Systems have procedures according to which they function and the results returned by a system are traceable and predictable. But the economy is not a system. It does not follow a set of procedures yielding similar outcomes every time. The economy consists of individual actors with subjective preferences, which do not form per constant laws. While systematic thinking is helpful in hard sciences, economics is not a study of atoms or particles charged with energy but conscious humans.
That leads to another important observation, which some economists don’t like to admit and others proudly embrace. Even though economics is not a hard science, many economists would like to treat it as if it were and model their contributions based on contributions made to physics by geniuses such as Einstein or Schroedinger. Each generation of economists tries to make economics like physics, yet it’s neither successful nor desirable. Nowadays, mainstream economics generally rejects the adoption of physics in economics but the legacy of this approach in the contributions of earlier authors remains deeply entrenched within the way economic theory is created.
A unified theory?
So why shouldn’t they just connect the ends of micro and macro? Aren’t the bridging efforts of the rational expectations school enough? Let them connect all the loose ends and we will get a Grand Unified Theory of Economics!
Unfortunately, the solution isn’t this easy. While Robert Lucas Jr. was correct about the need for unity of micro and macro, his approach was wrong. Instead of going back to fundamental, scientific knowledge of microeconomics and building a comprehensive description of the economy on correct principles, he attempted to fit micro theory into the existing, unscientific macroeconomic models. Although his most definitely improved economic theory, it also reinforced the fundamental mistake of the 1930s generation.
Rational expectations school sharpened the predictive accuracy and brought the assumptions closer to the real world. However, it came at the cost of continued misguided efforts to develop the theory made out of thin air.
One economics
What could put economics back on the right track? Acknowledging the basic fault of macroeconomics. Microfoundations are like stitches for an infected wound. While they for sure help, they won’t save the patient unless the antibiotics are administered at the same time. Just as antibiotics kill invasive pathogens, economists need to consider building a new macro theory, this time on correct foundations. Economics studies how humans decide to meet their needs with scarce resources to maximize their well-being. We cannot forget about the centrality of humans in economic theory. In the 1930s, technology didn’t allow for modeling large groups of agents or considering varieties of incentives and policies. Today, we’re more than well-equipped to perform such analyses. Let’s take advantage of computing power not only in econometrics but also to create better macroeconomic theory.
Dimand, R. W. (2007). Edmund Phelps and Modern Macroeconomics. Review of Political Economy, 20(1), 23–39. https://doi.org/10.1080/09538250701661798
Skousen, M. (2022). The making of modern economics: the lives and ideas of the great thinkers. Routledge.
Ibid.
Richardson, G., Komai, A., Gou, M., & Park, D. (2013, November 22). Stock Market Crash of 1929 | Federal Reserve History. Www.federalreservehistory.org; Federal Reserve History. https://www.federalreservehistory.org/essays/stock-market-crash-of-1929
Keynes, J. M. (2017). The economic consequences of the peace. Routledge.
Wapshott, N. (2011). Keynes Hayek: The Clash that Defined Modern Economics. W. W. Norton & Company.
Ibid.
Friedman, M. (1953). The methodology of positive economics.
Microfoundations. (2024, March 5). Wikipedia. https://en.wikipedia.org/wiki/Microfoundations