Economics, DSGE and Reality: a personal story

As I do not win prizes very often, I thought I would use the occasion of this one to write something much more personal than I normally allow myself. But this mini autobiography has a theme involving something quite topical: the relationship between academic macroeconomics and reality, and in particular the debate over DSGE modelling and the lack of economics in current policymaking. [1]

I first learnt economics at Cambridge, a department which at that time was hopelessly split between different factions or ‘schools of thought’. I thought if this is what being an academic is all about I want nothing to do with it, and instead of doing a PhD went to work at the UK Treasury. The one useful thing about economics that Cambridge taught me (with some help from tutorials with Mervyn King) was that mainstream economics contained too much wisdom to be dismissed as fundamentally flawed, but also (with the help of John Eatwell) that economics of all kinds could easily be bent by ideology.

My idea that by working at the Treasury I could avoid clashes between different schools of thought was of course naive. Although the institution I joined had a well developed and empirically orientated Keynesian framework [2], it immediately came under attack from monetarists, and once again we had different schools using different models and talking past each other. I needed more knowledge to understand competing claims, and the Treasury kindly paid for me to do a masters at Birkbeck, with the only condition being that I subsequently return to the Treasury for at least 2 years. Birkbeck at the time was also a very diverse department (incl John Muellbauer, Richard Portes, Ron Smith, Ben Fine and Laurence Harris), but unlike Cambridge a faculty where the dedication to teaching trumped factional warfare.

I returned to the Treasury, which while I was away saw the election of Margaret Thatcher and its (correct) advice about the impact of monetarism completely rejected. I was, largely by accident, immediately thrust into controversy: first by being given the job of preparing a published paper evaluating the empirical evidence for monetarism, and then by internally evaluating the economic effects of the 1981 budget. (I talk about each here and here.) I left for a job at NIESR exactly two years after I returned from Birkbeck. It was partly that experience that informed this post about giving advice: when your advice is simply ignored, there is no point giving it.

NIESR was like a halfway house between academia and the Treasury: research, but with forecasting rather than teaching. I became very involved in building structural econometric models and doing empirical research to back them up. I built the first version of what is now called NIGEM (a world model widely used by policy making and financial institutions), and with Stephen Hall incorporated rational expectations and other New Classical elements into their domestic model.

At its best, NIESR was an interface between academic macro and policy. It worked very well just before 1990, where with colleagues I showed that entering the ERM at an overvalued exchange rate would lead to a UK recession. A well respected Financial Times journalist responded that we had won the intellectual argument, but he was still going with his heart that we should enter at 2.95 DM/£. The Conservative government did likewise, and the recession of 1992 inevitably followed.

This was the first public occasion where academic research that I had organised could have made a big difference to UK policy and people’s lives, but like previous occasions it did not do so because others were using simplistic and perhaps politically motivated reasoning. It was also the first occasion that I saw close up academics who had not done similar research but who had influence use that influence to support simplistic reasoning. It is difficult to understate the impact that had on me: being centrally involved in a policy debate, losing that debate for partly political reasons, and subsequently seeing your analysis vindicated but at the cost of people becoming unemployed.

My time at NIESR convinced me that I would find teaching more fulfilling than forecasting, so I moved to academia. The publications I had produced at NIESR were sufficient to allow me to become a professor. I went to Strathclyde University at Glasgow partly because they agreed to give temporary funding to two colleagues at NIESR to come with me so we could bid to build a new UK model. [3] At the time the UK’s social science research funding body, the ESRC, allocated a significant proportion of its funds to support econometric macromodels, subject to competitions every 4 years. It also funded a Bureau at Warwick university that analysed and compared the main UK models. This Bureau at its best allowed a strong link between academia and policy debate.

Our bid was successful, and in the model called COMPACT I would argue we built the first UK large scale structural econometric model which was New Keynesian but which also incorporated innovative features like an influence of (exogenous) financial conditions on intertemporal consumption decisions. [4] We deliberately avoided forecasting, but I was very pleased to work with the IPPR in providing model based economic analysis in regular articles in their new journal, many written with Rebecca Driver.

Our efforts impressed the academics on the ESRC board that allocated funds, and we won another 4 years funding, and both projects were subsequently rated outstanding by academic assessors. But the writing was on the wall for this kind of modelling in the UK, because it did not fit the ‘it has to be DSGE’ edict from the US. A third round of funding, which wanted to add more influences from the financial sector into the model using ideas based on work by Stiglitz and Greenwald, was rejected because our approach was ‘old fashioned’ i.e not DSGE. (The irony given events some 20 years later is immense, and helped inform this paper.)

As my modelling work had always been heavily theory based, I had no problem moving with the tide, and now at Exeter university with Campbell Leith we began a very successful stream of work looking at monetary and fiscal policy interactions using DSGE models. [5] We obtained a series of ESRC grants for this work, again all subsequently rated as outstanding. Having to ensure everything was microfounded I think created more heat than light, but I learnt a great deal from this work which would prove invaluable over the last decade.

The work on exchange rates got revitalised with Gordon Brown’s 5 tests for Euro entry, and although the exchange rate with the Euro was around 1.6 at the time, the work I submitted to the Treasury implied an equilibrium rate closer to 1.4. When the work was eventually published it had fallen to around 1.4, and stayed there for some years. Yet as I note here, that work again used an ’old fashioned’ (non DSGE) framework, so it was of no interest to journals, and I never had time to translate it (something Obstfeld and Rogoff subsequently did, but ignoring all that had gone before). I also advised the Bank of England on building its ‘crossover’ DSGE/econometric model (described here).

Although my main work in the 2000s was on monetary and fiscal policy, the DSGE framework meant I had no need to follow evolving macro data, in contrast to the earlier modelling work. With Campbell and Tatiana I did use that work to help argue for an independent fiscal council in the UK, a cause I first argued for in 1996. This time Conservative policymakers were listening, and our paper helped make the case for the OBR.

My work on monetary and fiscal interaction also became highly relevant after the financial crisis when interest rates hit their lower bound. In what I hope by now is a familiar story, governments from around the world first went with what macroeconomic theory and evidence would prescribe, and then in 2010 dramatically went the opposite way. The latter event was undoubtedly the underlying motivation for me starting to write this blog (coupled with the difficulty I had getting anything I wrote published in the Financial Times or Guardian).

When I was asked to write an academic article on the fiscal policy record of the Labour government, I discovered not just that the Coalition government’s constant refrain was simply wrong, but also that the Labour opposition seemed uninterested in what I found. Given what I found only validated what was obvious from key data series, I began to ask why no one in the media appeared to have done this, or was interested (beyond making fun) in what I had found. Once I started looking at what and how the media reported, I realised this was just one of many areas where basic economic analysis was just being ignored, which led to my inventing the term mediamacro.

You can see from all this why I have a love/hate relationship to microfoundations and DSGE. It does produce insights, and also ended the school of thought mentality within mainstream macro, but more traditional forms of macromodelling also had virtues that were lost with DSGE. Which is why those who believe microfounded modelling is a dead end are wrong: it is an essential part of macro but just should not be all academic macro. What I think this criticism can do is two things: revitalise non-microfounded analysis, and also stop editors taking what I have called ‘microfoundations purists’ too seriously.

As for macroeconomic advice and policy, you can see that austerity is not the first time good advice has been ignored at considerable cost. And for the few that sometimes tell me I should ‘stick with the economics’, you can see why given my experience I find that rather difficult to do. It is a bit like asking a chef to ignore how bad the service is in his restaurant, and just stick with the cooking. [6]

[1] This exercise in introspection is also prompted by having just returned from a conference in Cambridge, where I first studied economics. I must also admit that the Wikipedia page on me is terrible, and I have never felt it kosher to edit it myself, so this is a more informative alternative.

[2] Old, not new Keynesian, and still attached to incomes policies. And with a phobia about floating rates that could easily become ‘the end is nigh’ stuff (hence 1976 IMF).

[3] I hope neither regret their brave decision: Julia Darby is now a professor at Strathclyde and John Ireland is a deputy director in the Scottish Government.

[4] Consumption was of the Blanchard Yaari type, which allowed feedback from wealth to consumption. It was not all microfounded and therefore internally consistent, but it did attempt to track individual data series.

[5] The work continued when Campbell went to Glasgow, but I also began working with Tatiana Kirsanova at Exeter. I kept COMPACT going enough to be able to contribute to this article looking at flu pandemics, but even there one referee argued that the analysis did not use a ‘proper’ (i.e DSGE) model.

[6] At which point I show my true macro credentials in choosing analogies based on restaurants.