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.