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.
