The ‘Representative Agent’ Is Always Rational. The Rest of Us Are Not.

Economists have an imaginary person they call a “representative agent,” who is about as realistic as the Easter bunny or the Abominable Snowman. The representative agent is supposed to stand in for all of us in a model of how the economy works: 335 million Americans, for example, boiled down to one. As originally conceived, the representative agent is fully rational and unemotional, forward-looking and with perfect information about all the relevant facts. Just like nobody you know.

For as long as economists have plugged representative agents into their models, which is more than 50 years, other economists — including some of the biggest names in the profession — have pointed out their lack of realism.

“It is clear that the ‘representative’ agent deserves a decent burial,” Alan Kirman, then of European University Institute in Florence, Italy, wrote in The Journal of Economic Perspectives in 1992.

Paul Romer, then of New York University, indicted the representative agent among other culprits in 2016 in a scathing critiquethat began, “For more than three decades, macroeconomics has gone backward.”

“The central problems of finance — bankruptcy, debt and asymmetric information — simply cannot arise in a representative agent model,” Joseph Stiglitz of Columbia wrote in The Oxford Review of Economic Policy in 2018.

There have been attempts over the years to make the representative agent model more realistic, such as introducing the financial sector. Another fix was to bolt on some consumers who aren’t perfectly forward-looking and instead live from paycheck to paycheck. But the basic idea has lived on, partly because it’s easy to understand and compute, and partly because there was nothing better.

But something better is emerging now. It’s called HANK, for Heterogeneous Agent New Keynesian. In a HANK model of the United States, there isn’t one representative agent. There are millions of agents, each with her or his own characteristics: rich or poor, borrower or lender and so on. That heterogeneity makes it easy to see the distributional effects of, say, an increase in government spending.

New Keynesianism, the NK part of the acronym, is the workhorse theory of modern economics. It assumes that people are basically rational and markets are basically efficient but leaves room for imperfections, such as “sticky” prices that don’t change immediately in response to shifts in supply or demand. Being closely tied to New Keynesianism gives HANK a good chance of broad acceptance in the profession.

Last week I spoke and exchanged emails with two of the economists who are churning out research in the young field of HANK: Benjamin Moll, a professor at the London School of Economics and Political Science, and Matthew Rognlie, an assistant professor at Northwestern. It was a fascinating glimpse into a line of thinking that could easily become the mainstream in the next decade.

“I’m actually a bit surprised that there hasn’t been more media coverage of this,” Rognlie emailed me. “I suppose that in academia we always get over-excited about the latest developments, but I do think this one may prove to be quite consequential.”

First, a potted history of macroeconomics. In the 1930s John Maynard Keynes showed that deficit spending by the government could lift an economy out of recession by putting spending money in people’s pockets. But in the 1970s Robert Barro, building on the work of Robert Lucas (who died in May), argued that that trick wouldn’t work because taxpayers would realize that the deficits would eventually have to be paid for, so they would save up for the future tax bills and offset the stimulus.

Trying to deal with the so-called Lucas critique led economists to try to build macroeconomic models on so-called micro-foundations: how individuals behave in the microeconomic world of spending, saving, working and leisure. For tractability, the economists averaged out all people into a single, farsighted individual, our famous representative agent. The die was cast.

Heterogeneous agent models penetrated gradually. They were first used when economists wanted to look at the distributional effects of, say, a tax cut or an interest-rate increase. They started to be used tentatively in the 1990s for macroeconomic estimation. Early practitioners included Per Krusell of Stockholm University, S. Rao Aiyagari of the University of Rochester and Ayse Imrohoroglu, now at the University of Southern California Marshall School of Business.

According to Moll, interest in what’s now called HANK grew after the global financial crisis of 2007-9, which was not foreseen by conventional economic models. But it wasn’t until the past five years that papers started emerging, he said. The acronym was coined by Moll himself along with two co-authors, Greg Kaplan and Giovanni Violante, in a 2018 paper in The American Economic Review, “Monetary Policy According to HANK.”

The newer theories line up better with actual economic outcomes than earlier ones did, Moll said. They’re also better connected to behavioral economics, which recognizes that people are impatient and use failure-prone rules of thumb to make decisions.

If the government sends out $1,000 checks, the representative agent looks to the infinite horizon and decides prudently to put almost all of the money in the bank. In contrast, heterogeneous agents behave heterogeneously. While rich people bank the government money, the many people who are living closer to the edge spend all or most of it. Then comes a second-round effect: That spending pulse leads companies to increase output, hire more workers and so on.

The bottom line is that fiscal policy is far more effective in generating growth in a HANK model than in a representative agent model. HANK models predicted the potency of the pandemic stimulus, which ended up contributing to today’s high inflation, Rognlie said. On the flip side, he said, a HANK model also correctly predicted that high energy prices would weaken Germany’s economy by suppressing consumers’ non-energy spending.

Rognlie has a new paper with Adrien Auclert and Ludwig Straub that uses a HANK model to show that no matter where excess savings start out in an economy, they eventually “trickle up” to the balance sheets of rich people.

HANK also gives more accurate results for monetary policy. In a pure representative agent model, debt isn’t really a thing: Some people borrow, others lend, but it ends up a wash. HANK shows that an interest-rate increase benefits lenders while hurting borrowers. And since borrowers are living more hand-to-mouth, they decrease their spending by more than lenders raise it.

Two changes made HANK possible, Moll said. One is greater computing power. The other is academic training. “To really understand the models and program them up you probably need to have a Ph.D. from the last 20 years,” he said.

HANK is “still in its infancy but it’s catching on quite a bit,” Moll said. He said the Federal Reserve Bank of New York and Norges Bank, the central bank of Norway, have built HANK models, and others, including the European Central Bank, are diving in. Still, he said: “I don’t think it’s going to completely replace the existing models. It’s going to be an additional model that they have at their disposal.”

Outlook: Michael Englund and Benjamin Engen

The latest employment report from the Bureau of Labor Statistics — showing that the economy added 209,000 jobs in June and the unemployment rate fell to 3.6 percent — shows that “overall, the economy is continuing to prove impervious to the ongoing tightening in monetary and fiscal policy since 2021,” Michael Englund and Benjamin Engen of Action Economics in Boulder, Colo., wrote in a client note on Friday. They added that the Federal Reserve’s Federal Open Market Committee “will have little choice” but to raise the federal funds rate at its next meeting on July 25-26 and “perhaps” at the Sept. 19-20 meeting as well. “The labor market remains extremely tight, retail inventories are lean, home construction is trending upward despite elevated mortgage rates, and core price gains have remained uncomfortably firm even as supply chain disruptions are dissipating,” they wrote.

Quote of the Day

“The genius of high dynamism was a restless spirit of conceiving, experimenting and exploring throughout the economy from the bottom up — leading, with insight and luck, to innovation. This grass-roots spirit was driven by the new attitudes and beliefs that defined the modern era, and a full return to high dynamism will require that those modern values prevail again over traditional ones.”

— Edmund Phelps, “Mass Flourishing: How Grassroots Innovation Created Jobs, Challenge, and Change” (2013)

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