Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 12 August 2016

Blanchard on DSGE

Olivier Blanchard, former director of the IMF’s research department, has written a short critical piece about DSGE models. Forget all the econblog reaction that essentially says he has been too kind: DSGE completely dominates academic macroeconomics, and there is no way that all these academics are going to suddenly decide this research programme is a waste of time. (I happen to think Blanchard is right that it isn’t a waste of time.) What is at issue is not the existence of DSGE models, but their hegemony.

One of Blanchard’s recommendations is that DSGE “has to become less imperialistic. Or, perhaps more fairly, the profession (and again, this is a note to the editors of the major journals) must realize that different model types are needed for different tasks.” The most important part of that sentence is the bit in brackets. He talks about a distinction between fully microfounded models and ‘policy models’. The latter used to be called Structural Econometric Models (SEMs), and they are the type of model that Lucas and Sargent famously attacked.

These SEMs have survived as the core model used in many important policy institutions (except for the Bank of England) for good reason, but DSGE trained academics have followed Lucas and Sargent as viewing these as not ‘proper macroeconomics’. Their reasoning is simply wrong, as I discuss here. As Blanchard notes, it is the editors of top journals that need to realise this, and stop insisting that all aggregate models have to be microfounded. The moment they allow space for eclecticism, then academics will be able to choose which methods they use.

Blanchard has one other ‘note for editors’ remark, and it also gets to the heart of the problem with today’s macroeconomics. He writes “Not every discussion of a new mechanism should be required to come with a complete general equilibrium closure.” The example he discusses, and which I have also used in this context, is consumption. DSGE modellers have of course often departed from the simple Euler equation, but I suspect the ways they have done this (rule of thumb consumers, habits) reflect analytical convenience rather than realism.

What sometimes seems to be missing in macro nowadays is a connection between people working on partial equilibrium analysis (like consumption) and general equilibrium modellers. Top journal editors’ preference for the latter means that the former is less highly valued. In my view this has already had important costs. I argue that the failure to take seriously the strong evidence about the importance of changes in credit availability for consumption played an important part in the inability of macroeconomics to adequately model the response to the financial crisis (for more discussion see here and here). Even if you do not accept that, the failure of most DSGE models to include any kind of precautionary saving behaviour does not seem right when DSGE has a monopoly in ‘proper modelling’. [1]

Criticism of the DSGE hegemony from those outside economics, from macroeconomists who are not part of it, or even from economic policymakers has had little impact on those all important journal editors up until now. Perhaps similar comments from one of the best macroeconomists in the world might.

[1] I discuss the reasons why this may have occurred in relation to Chris Carroll’s work here.

11 comments:

  1. This sounds similar to a three-line whip in party politics.

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  2. Do you mean Dim and Silly Government Easing?

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  3. Eclecticism, anything goes, and the pluralism of false theories
    Comment on Simon Wren-Lewis on ‘Blanchard on DSGE’

    After more than 200 years it is now obvious that economics is a failed science. Orthodox economics in general and DSGE in particular is directly comparable to Geo-centrism in physics. The only difference is that Geo-centrism is dead AND buried since about 500 years while orthodox economics is dead but the majority of economists has not realized it. Those who are vaguely aware that economics is scientifically indefensible, though, do not abandon it but switch into damage control mode. Blanchard is a case in point.

    Wren-Lewis, too, is a case in point. His fallback position is this: “What is at issue is not the existence of DSGE models, but their hegemony.” (See intro)

    False! DSGE always has been indefensible scientific garbage. Wren-Lewis’s damage control consists in shifting the blame on the journals: “Top journal editors’ preference for the latter [general equilibrium models] means that the former [partial equilibrium] is less highly valued.”

    This is ridiculous because the hegemony of Orthodoxy is not an editorial accident but the inevitable result of every half-witted economist doing exactly what he is supposed to do: “It is a touchstone of accepted economics that all explanations must run in terms of the actions and reactions of individuals. Our behavior in judging economic research, in peer review of papers and research, and in promotions, includes the criterion that in principle the behavior we explain and the policies we propose are explicable in terms of individuals, not of other social categories.” (Arrow, 1994)

    Since Adam Smith economics claims to be a science but has never risen above the level of what Feynman called cargo cult science. Science is about formal and material consistency (Klant, 1994). The outstanding characteristic of economists is that they never got this pivotal point of methodology. And these are the results.

    (i) There is Orthodoxy with microfoundations and it has been nicely defined by Krugman: “... most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point.”#1

    (ii) Methodologically, these premises never have been and never will be acceptable.#2

    (iii) When the premises/axioms/foundational propositions are false or contain nonentities the WHOLE theory/model/superstructure is false.

    (iv) Because of this, orthodox policy proposals never had sound theoretical foundations.

    (v) Walrasianism, Keynesianism, Marxianism, Austrianism is materially/formally inconsistent.

    (vi) Keynes started the macrofoundations research program in the General Theory formally as follows: “Income = value of output = consumption + investment. Saving = income - consumption. Therefore saving = investment.” These formal foundations are conceptually and logically defective because Keynes never came to grips with profit.#2

    (vii) Because of this, the macrofoundations approach (including After-Keynesianism, Post Keynesianism, New Keynesianism, and all I=S/IS-LM models) has already been dead in the cradle 85 years ago.

    Review of the Troops. PROVABLY false

    See part 2

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  4. Part 2

    Review of the Troops. PROVABLY false
    • profit theory, since more than 200 years,
    • microfoundations, since 140 years,
    • macrofoundations, since 85 years.

    ALL models that contain maximization-and-equilibrium or I=S/IS-LM are a priori false and this is more than 90 percent of the content of peer-reviewed economic quality journals and 100 percent of textbooks of renowned authors since 1947.

    No more proof of scientific incompetence is needed. Remains only one question for the scientific community: how to get rid of the ‘throng of superfluous economists’ (J. Robinson)? Or, as Wren-Lewis put it: ... there is no way that all these academics are going to suddenly decide this research programme is a waste of time.” Of course, they cannot decide it for themselves, somebody has to expel them ― including Blanchard and Wren-Lewis ― from the scientific community. Eclecticism, anything goes, and the pluralism of false theories is NOT an option.

    Egmont Kakarot-Handtke

    #1 More detailed, the starting point is given with these axioms: “HC1 economic agents have preferences over outcomes; HC2 agents individually optimize subject to constraints; HC3 agent choice is manifest in interrelated markets; HC4 agents have full relevant knowledge; HC5 observable outcomes are coordinated, and must be discussed with reference to equilibrium states.” (Weintraub, 1985). To accept these microfoundations is a reliable indicator of utter scientific incompetence.

    #2 For details and proofs see blog http://axecorg.blogspot.de/ and working papers http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=1210665

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  5. Alexander Harvey13 August 2016 at 04:28

    Does any class of model, DSGE or other, have anything informative to say about the effect of a shock/impulse due to a substantial transfer of money from the Bank of England to the rest of the economy via either a per household or per person gift?

    Even the most basic information would seem to be useful, e.g. the scale of the impulse necessary to produce a signal discernible from noise.

    It would seem unfortunate to take such a measure only to find out that we can have no clear indication of what had been achieved.

    I would be much obliged should anyone here comment on this point.

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  6. I doubt DSGE models are going away anytime soon. Because...

    * They allow academics to churn out thousands paper with non-falsifiable results. (Non-falsifiability is useful; having to retract a paper is embarrassing for everyone involved.) Moreover, existing ideas can be "recycled" into a DSGE framework, making the publication churn even easier to achieve.

    * Having *thousands* of inconsistent models makes it easier for "leaders" to demand their "followers" to find a theoretical justification for a chosen policy.

    BTW the way to make your models mimic human behaviour ("animal spirits") is to *invite humans into your models*.

    "Criticism of the DSGE hegemony from those outside economics, from "macroeconomists who are not part of it, or even from economic policymakers has had little impact on those all important journal editors up until now. Perhaps similar comments from one of the best macroeconomists in the world might."

    This guy:

    http://www.bondeconomics.com/2016/04/olivier-blanchard-joins-japan-is-doomed.html?spref=tw

    Right. But I agree criticism has to come inside the cult too, even if it is mostly pointless.

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  7. The principal difference between DSGE and other schools is their stand on involuntary unemployment.As soon as it can be theoretically proved that involuntary unemployment can result from an appropriate microeconomic model a first blow will have been struck against DSGE.

    I believe I have come up with the definitive proof of involuntary unemployment. See http://www.philipji.com/involuntary-unemployment/

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  8. Why not do a piece on MMT and DSGE ?

    After all they've only been talking about them for 15 years.

    Brian Romanchuck has done a lot of work on this.


    http://www.bondeconomics.com/search/label/DSGE

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  9. Some of the best economics in recent years has been coming out of UMKC.

    It's still DSGE free after all these years.

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  10. "I argue that the failure to take seriously the strong evidence about the importance of changes in credit availability for consumption played an important part in the inability of macroeconomics to adequately model the response to the financial crisis (for more discussion see here and here). "

    Fair enough. But more than that, to properly understand causal mechanism, including what caused the financial crisis, the question has to be bigger than "what is the model". When an historian or (proper) political scientist explains how WWII happened with a view to understand more generally how conflict happens he does not ask "what is the model". There may be independent theories, all of them to some extent may be true and part of the explanation. But there is not one theory. Instead there are series of interrelated events that are required to explain a particular conflict from which general conclusions can be made about the causes of conflict in general.

    Three things

    (1) Economists must stop conflating the meaning of model and theory
    (2) There are some things you cannot model, very likely these are the most important things we need to know - these things should not be excluded from analysis, and if they play a central role in determining real world economics events they should play a central role in the economics discipline
    (3)The end objective of analysis is not to produce a model. It is to put the pieces of evidence (quantitative and qualitative - ie it is not just about data and numbers) together to get a complete an understanding of what we need to know as we can. From this synthesis we outline the key conclusions.

    NK.

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  11. Let's see if I got this right:
    these models use incorrect input data to compute in flawed way results that are not relevant; but that doesn't stop Blanchard from concluding that basically it's all good.

    I mean really, how can the economists profession still be wondering why they are taken less and less seriously?

    Can anyone name a single other scientific discipline where Blanchard's points of criticism would prevail?

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