Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday 10 October 2014

Are DSGE models distorting policy? - a test case

The debate about the current state of academic macroeconomics continues, but it has reached a kind of equilibrium. Heterodox economists, some microeconomists and many others are actively hostile to the currently dominant macro methodology. Regardless, academic macroeconomists in the papers they write carry on using, almost exclusively, microfounded DSGE models. [1] Critics say this methodology was crucial in missing the financial crisis, but academic macroeconomists respond by highlighting all the work currently being done on financial frictions. I personally think missing the crisis was down to failings of a different kind, but that DSGE did hold back our ability to understand the impact of the crisis. However what I want to suggest here is a forward looking test.

Many of the difficult choices in conducting monetary (and sometimes fiscal) policy involve trade-offs between inflation and unemployment. We saw this in the UK particularly after the crisis, with inflation going well above target during the depth of the recession. What you do in those circumstances depends critically on the costs of excess inflation compared to the costs of higher unemployment. Is 1% higher unemployment worth more or less than 1% higher inflation to society as a whole?

What do New Keynesian DSGE models say about this trade-off? They do not normally model unemployment, but they do model the output gap, which we can relate to unemployment. Their answer is that inflation is much the more important variable, by a factor of ten or more. One reason they do this is that they implicitly assume the unemployed enjoy all the extra leisure time at their disposal. I have discussed other reasons here.

Empirical evidence, and frankly common sense, suggests this is the wrong answer. Thanks to the emergence of a literature that looks at empirical measures of wellbeing, we now have clear evidence that unemployment matters more than inflation. Sometimes, as in this study by Blanchflower et al, it matters much more. Another recent study by economists at the CEP shows that “life satisfaction of individuals is between two and eight times more sensitive to periods when the economy is shrinking than at times of growth”, which as well as being related to the unemployment/inflation trade-off raises additional issues around asymmetry.

So the DSGE models appear to be dead wrong. Furthermore the reasons why they are wrong are not deeply mysterious, and certainly not mysterious enough to make us question the evidence. For example prolonged spells of unemployment have well documented scarring effects (in part because employers cannot tell if unemployment was the result of bad luck or bad performance), which may even affect the children of the unemployed. So it is not as if economists cannot understand the empirical evidence.

Does that mean that the DSGE models are deeply flawed? No, it means they are much too simple. Does that mean that the work behind them (deriving social welfare functions from individual utility) is a waste of time? I would again say no. I have done a little work of this kind, and I understood some things much better by doing so. Will these models ever get close to the data? I do not know, but I think we will learn more interesting and useful things in the attempt. The microfoundations methodology is, in my view, a progressive research strategy.

So academics are right to carry on working with these models. But many academic macroeconomists go further than this. They argue that only microfounded DSGE models can provide a sound basis for policy advice. If you press them they will say that maybe it is OK for policymakers to use more ‘ad hoc’ models, but there is no place for these in the academic journals. In my view this is absolutely wrong for at least two reasons.

First, models that are clearly still at the early development stage should not be used to guide policy when we can clearly do better. In this particular case we can easily do better just by using ad hoc social welfare functions on top of an existing DSGE model. (The Lucas critique does not apply, which is why I like this example.) Yes these hybrid models will be ‘internally inconsistent’, but they are clearly better! Second, to confine academics to just doing development work on prototype experimental models is stupid: academic economists can have many useful things to say starting with aggregate models (as here, for example), and this is not something that policymakers alone have the resources (or sometimes the inclination) to do. (We also know that academics will give policy advice, whatever models they use!) Analysis using these more ad hoc but realistic models should be scrutinised in high quality academic journals.

Let’s be even more concrete. Take the debate over whether we should have a higher (than 2%) inflation target (or some other kind of target), because of the risks of hitting the zero lower bound. If this debate just involves micofounded DSGE models which clearly overweight inflation relative to unemployment, then these models will be guilty of distorting policy. This is not a matter of running some variants away from microfounded parameters (as in this comprehensive analysis, for example), but adopting realistic parameters as the base case. If this is not done, then microfounded DSGE models will be guilty of distorting this policy discussion.

[1] A few elderly bloggers, who use both DSGE and more ‘ad hoc’ models and think the critics have a point, are regarded by at least some academics as simply past their sell-by date.


  1. WRT your footnote, a few elderly academics that are not familiar with computational methods and econometrics, and are not open to anything other than rational expectations, are regarded by younger academics as past their sell-by date. Those who criticize others for not being up on the latest research should first familiarize themselves with post-1990 methodologies.

  2. This is where the ubiquitousness of economists comes into play. Economists are not only scientists, but also political counsellors and frequently lobbyists. DSGE has its place in scientific research, but for now, it does not necessarily lead to better policy choices, though some economists, for ideological or personal reasons, say they do.

  3. Question: Which policy question can be answered by DSGE which can't be handled with a dynamic version of IS-LM?

  4. Isn't the problem that policy is guided by New Keynesian DSGE ? The Old Keynesian DSGE models of Roger Farmer would be a better vehicle for policy issues

    Uncle Charlie

  5. How reliable are unemployment numbers? Maybe start with measuring unemployment and the size of the black economy for all countries using the same definitions, before comparing unemployment numbers.

  6. Has a DSGE model been used to model a Fed policy of maintaining steady growth in NGDP?

  7. So, if current journals don't accept ad-hoc models, why not start one that does? (Genuine question - I can see that it might be a better strategy, for example, to first try persuading existing high impact journals to do so.)

  8. I'm not surprised that economists (almost certainly never made involuntarily unemployed for any length of time) choose to ascribe unemployment to a preference for leisure over work. These are the same people who can explain wage differentials by asserting that some people want to be highly paid and others prefer to relax. In both cases there are no doubt individuals that fit these descriptions but I have never seen a convincing explanation why a recession leads so many to change their preferences at once.

    What you have to remember is that the most important task for an economist who wants to be listened to (and this goes for any kind of consultant) is to be aware of what the client wants to say, and to say it in a way that the client couldn't work out for himself. So micro-foundations, DSGE, multiple differential equations are techniques for wrapping up the present, in the form of advice to keep inflation low, the currency high and make sure that the truly deserving - the people who pay you - get the most goodies.

    Seriously, microfoundations weren't invented when I studied economics, and the idea of maintaining internal consistency, when I discovered it, seemed great. But if the cost is to cling on to 19th century (or earlier) ideas of utility maximisation in the teeth of (or rather in chosen) ignorance of how people really behave then their use is not only wrong but, to the extent that they do influence people and justify selfish behaviour by those who have power, morally corrupt.

    1. Keynes' notion of involuntary unemployment has been forgotten. Neo-Keynesians like Leijonhufvud or the rationing school (Malinvaud et al) made frequently use of it. it was even estimated by econometricians. It seem to be forgotten. Alzheimer or ideology?

  9. I don’t know much about DGSE, but it strikes me the crisis didn’t have much to with the strengths or weaknesses of DGSE: the crises was essentially a failure of the banking industry. Or to be more exact, we had a “Minsky moment”.

    In short, make banks more stable, and that basically solves the problem, unless I’ve missed something.

  10. Simon says:

    "So the DSGE models appear to be dead wrong [...]"

    (in respect of their assessment of the costs of unemployment). I agree.

    But then he goes on to say:

    "Does that mean that the DSGE models are deeply flawed? No, it means they are much too simple."

    I think there's a problem here. DSGE models are already quite complex, mathematically and computationally. If they would have to be made orders-of-magnitude more complicated to even register the existence of involuntary unemployment, this strongly suggests that they are the wrong tool for the job (of short- to medium-run macroeconomics). Particularly when much simpler models of the Keynes/Meade/Hicks type already do a creditable job.

    What sort of marginal benefit might we expect from greatly more complex DSGE models -- assuming they could ever handle unemployment properly? Greater quantitative precision, e.g. in terms of exactly when and by how much monetary or fiscal policy should relax or tighten? That would be nice to have, but I find it very implausible. If that's what Simon has in mind, I'd suggest that he owes us some sort of "proof of concept".

  11. I have to say, Simon, this "defence" of DSGE is a disturbing one. You describe them as "models still in an early development stage" - but they've been the subject of large scale and intensive effort for over 30 years now. And yet they still have failed to take on board such an obvious point that any idiot in the street could tell you - that the welfare losses from involuntary unemployment typically dwarf the welfare losses from inflation rather than the reverse. And note this is something that the current scramble to try and capture financial "frictions" does not address at all. How can you possibly, then, describe DSGE as "a progressive research strategy"?

    Of course David Sweet is right - the failure to tackle this is a sociological more than a methodological problem. A blind spot as large as this one could only ever persist because it is in the interest of certain classes that it persist, as an old bearded economist once tried to explain. Perhaps we should try reading him more than Lucas or Prescott.


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