Posts Tagged ‘DSGE’
In his 1936 book that would give theoretical support to Franklin D. Roosevelt’s New Deal, the British economist John Maynard Keynes wrote the following: “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else.”
There is little doubt that the ideas of economists – their models or theories or ideologies – have had a profound influence on our daily lives. To give just one example: when South Africa’s Monetary Policy Committee decides whether to lower or raise the interest rate, they do so based on a model that predicts the likely effects of the policy change.
But there is not one universal model. Macroeconomists, depending on their school of thought, have different beliefs about how the real world works. Some, like those that propound Real Business Cycle (RBC) theory, argue that business cycle fluctuations are the result of exogenous changes to an economy, and because wages and prices are flexible, there is little that governments can do through fiscal and monetary policy in a downswing. Others, like New Keynesians, see a greater role for government intervention because of things like sticky wages and prices.
Though these ideological disagreements in macroeconomics are nothing new, one would expect that the competition between these ideas would ultimately lead to a better way to explain what is happening in the world. This is, however, not the case, and one of the main reasons the World Bank’s new chief economist, Paul Romer, formerly professor at Stanford and New York University, recently wrote a stinging critique of macroeconomics. “I have observed more than three decades of intellectual regress”, he begins, explaining that macroeconomics has gone down a wrong path and have now reached a dead-end.
The basic premise is this: macroeconomists’ increasingly sophisticated models have ignored real-world evidence. Simon Wren-Lewis of Oxford University explains: “If we look at the rise of Real Business Cycle (RBC) research a few decades ago, that was only made possible because economists chose to ignore evidence about the nature of unemployment in recessions.”
Why would scholars willingly choose to ignore real-world evidence? “The obvious explanation is ideological” says Wren-Lewis. “I cannot prove it was ideological, but it is difficult to understand why – in an area which … suffers from a lack of data – you would choose to develop theories that ignore some of the evidence you have.” Ironically, this shift came at a time when the rest of the profession, fields like labour economics, development economics and international trade, shifted the other way: from theory to empirics.
To be fair, RBC models have become less popular, replaced by ‘New Keynesian’ models. These ones make more realistic assumptions of the real world, like adding sticky wages, but still share many of the same concerns. Because these new generation models, known as Dynamic Stochastic General Equilibrium models, are ‘built from the ground up’ (in other words, built on microeconomic foundations) they are far more appealing theoretically (and technically more difficult to construct) than the structural models of the previous generation, models which only considered the interlinkages of different macroeconomic variables. But in practice they turned out to be less than satisfactory: DSGE models require the modeller to make many assumptions about how individual agents behave, and it turns out that this behaviour is difficult to measure, making the assumptions rather subjective. The result is that, though theoretically plausible, the outcome is often far removed from the real-world evidence. And, most importantly, forecasts – that thing that most people think is an economist’s only job – are often far less accurate with DSGE models than with multiple-equation structural models. That is why most reserve banks, including our own, still mostly rely on structural models to help predict the future outcomes of their policy decisions.
So why continue with DSGE models? This is a consequence of the way scholarship works. In a blog post in response to Romer, Narayana Kocherlakota of the University of Rochester writes: “We tend to view research as being the process of posing a question and delivering a pretty precise answer to that question. In this process, machines that can be used by many scholars to generate answers to wide ranges of questions are highly prized. The King-Plosser-Rebelo real business cycle model was one such machine. The New Keynesian three-equation model is another. And people who have the mathematical and computational skills to make machines even more powerful, so that they can answer even more questions, are naturally highly valued.”
Yet if these ‘answers’ increasingly abstract away from reality, we are not much better off than before. Keynes, who developed a new theory when the existing paradigm could not explain the real world anymore, knew this all too well: “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”
For academic macroeconomics to regain its influence, it needs to be, as Kocherlakota writes, “a lot more flexible in our thinking about models and theory, so that they can be firmly grounded in an improved empirical understanding”. This won’t be easy. As Locherlakota says, it will be “hugely messy work”. Will this generation’s John Maynard Keynes please stand up?
*An edited version of this first appeared in Finweek magazine of 9 February.