It is of course ludicrous, but who cares. The day of the Boston Fed conference in 1978 is fast taking on a symbolic significance. It is the day that Lucas and Sargent changed how macroeconomics was done. Or, if you are Paul Romer, it is the day that the old guard spurned the ideas of the newcomers, and ensured we had a New Classical revolution in macro rather than a New Classical evolution. Or if you are Ray Fair (HT Mark Thoma), who was at the conference, it is the day that macroeconomics started to go wrong.
Ray Fair is a bit of a hero of mine. When I left the National Institute to become a formal academic, I had the goal (with the essential help of two excellent and courageous colleagues) of constructing a new econometric model of the UK economy, which would incorporate the latest theory: in essence, it would be New Keynesian, but with additional features like allowing variable credit conditions to influence consumption. Unlike a DSGE it would as far as possible involve econometric estimation. I had previously worked with the Treasury’s model, and then set up what is now NIGEM at the National Institute by adapting a global model used by the Treasury, and finally I had been in charge of developing the Institute’s domestic model. But creating a new model from scratch within two years was something else, and although the academics on the ESRC board gave me the money to do it, I could sense that some of them thought it could not be done. In believing (correctly) that it could, Ray Fair was one of the people who inspired me.
I agree with Ray Fair that what he calls Cowles Commission (CC) type models, and I call Structural Econometric Model (SEM) type models, together with the single equation econometric estimation that lies behind them, still have a lot to offer, and that academic macro should not have turned its back on them. Having spent the last fifteen years working with DSGE models, I am more positive about their role than Fair is. Unlike Fair, I want “more bells and whistles on DSGE models”. I also disagree about rational expectations: the UK model I built had rational expectations in all the key relationships.
Three years ago, when Andy Haldane suggested that DSGE models were partly to blame for the financial crisis, I wrote a post that was critical of Haldane. What I thought then, and continue to believe, is that the Bank had the information and resources to know what was happening to bank leverage, and it should not be using DSGE models as an excuse for not being more public about their concerns at the time.
However, if we broaden this out from the Bank to the wider academic community, I think he has a legitimate point. I have talked before about the work that Carroll and Muellbauer have done which shows that you have to think about credit conditions if you want to explain the pre-crisis time series for UK or US consumption. DSGE models could avoid this problem, but more traditional structural econometric (aka CC) models would find it harder to do so. So perhaps if academic macro had given greater priority to explaining these time series, it would have been better prepared for understanding the impact of the financial crisis.
What about the claim that only internally consistent DSGE models can give reliable policy advice? For another project, I have been rereading an AEJ Macro paper written in 2008 by Chari et al, where they argue that New Keynesian models are not yet useful for policy analysis because they are not properly microfounded. They write “One tradition, which we prefer, is to keep the model very simple, keep the number of parameters small and well-motivated by micro facts, and put up with the reality that such a model neither can nor should fit most aspects of the data. Such a model can still be very useful in clarifying how to think about policy.” That is where you end up if you take a purist view about internal consistency, the Lucas critique and all that. It in essence amounts to the following approach: if I cannot understand something, it is best to assume it does not exist.