Stock-Flow Consistent models: response to Jo Michell

Jo has a thoughtful and constructive response to my post discussing a recent Bank of England paper that presents a new Stock-Flow Consistent (SFC) model. One of the reasons it is constructive is because it is not tribal: too many followers of heterodox schools seem to just want to rubbish mainstream macro and suggest their particular school represents the new dawn. So I thought I might make a few points on Jo’s post that might be helpful.

1. A model that includes a lot of institutional detail is not a virtue in itself: indeed if at the end of the day these institutions do not matter too much it is an unnecessary and distracting feature. A useful way to think about modelling approaches is in terms of the validity of simplifications or short-cuts. It is for this reason that my method of theoretical deconstruction outlined and demonstrated here for large models is so important. By trying to relate large model properties to simpler models, you find out where additional detail is important or unnecessary. And of course, the answer to that problem may be context specific.
   
   
2. I hope I never said SFC modes were “accounting, not economics”, because that statement makes no sense. Any behavioural model contains some kind of theory. What I think I said was that these models often seemed ‘light on theory’, which means that they talk a great deal about the accounting and rather little about theory.
   
   For example, to say that consumers have a desired wealth to income ratio is light on theory. Why do they have such a ratio? Is it because of a precautionary motive? If it is, that will mean that this desired ratio will be influenced by the behaviour of banks. The liquidity structure of wealth will be important, so they may react differently to housing wealth and financial assets. Now the theory behind the equations in the Bank’s paper may be informed by a rich theoretical tradition, but it is normal to at least reference that tradition when outlining the equations of the model.
   
   
3. It is true that stock-flow accounting is important in modelling, in the sense that doing it stops you making silly errors. But it is not dissimilar to identities or market clearing conditions in this respect. You would never call a class of models ‘National Income Identity models’. [1] If the point is to emphasise that stocks matter to behavioural decisions about flows, then that is making a theoretical point. As Jo says, DSGE models are stock-flow consistent, but in the basic model consumers have no desired wealth ratio: it is the latter that matters. So when Jo says this absence should ring alarm bells, he is making a theoretical statement.
   
   I think Jo is right that the SFC name is unfortunate, but you can make a similar case for the name DSGE. It only matters when some people believe that stock-flow consistency is some kind of heterodox invention. Equally the label DSGE becomes a problem when economists start thinking that macroeconomists cannot do partial equilibrium any more, a point that Blanchard makes in his discussion of DSGE models.
   
   
4. When Jo tries to connect the unimportance of stocks in DSGE to the return to full employment I think he is painting with too broad a brush. Let’s take a simple example. In the baseline small open economy model of mainstream macro, a temporary shock that leads to a current account deficit will permanently reduce welfare because net assets permanently fall. The trade balance has to improve, and consumption is therefore lower. A permanent depreciation worsens the terms of trade. In that case what happens to stocks has a permanent effect. Indeed, if you alter the model by replacing the consumption function with one based on Blanchard/Yaari consumers, there would be a feedback from wealth to consumption which would mean this shock would no longer have a permanent effect.
   
   
5. In using the quote of mine about ‘not their field’ from a previous post he is rather unfair. As I go on to say, mainstream macro was at fault in neglecting finance. Pretty well every mainstream macroeconomist will say the same. The point I wanted to make was that it is not true that they all did this because they were sure it didn’t matter, the sector would regulate itself etc etc. What I have argued in this paper is that macroeconomists might well have not neglected the financial sector if they had allowed more traditional aggregate (i.e. non-microfounded) models to continue to be a legitimate area of academic research. Some might want to argue that this neglect of the financial sector reflected that mainstream macroeconomists were inherently neoliberal and believed financial markets looked after themselves. Perhaps some were, but plenty of others were not.
   
   
6. I also think it is a bit unfair to suggest that I was criticising the model in the Bank’s paper. As it represents an alternative to DSGE models it should be welcomed. (Especially so for the Bank. Many public institutions, like the Fed, have maintained their aggregate models alongside DSGE models: the Bank of England has not.) What I was criticising was (a) the emphasis in the paper on the accounting at the expense of theoretical discussion (b) that the paper ignored the non-DSGE non-Post Keynesian modelling tradition.

[1] It may well be that the models I quoted, like the 1970s Treasury model, were SFC because of the influence of Godley, but they would have thought that this was just good modelling, and not a defining aspect of what they were doing. 

More on Stock-Flow Consistent models

This is a follow-up to this post, but which is prompted by this Bank of England paper, which builds a stock-flow consistent model for the UK. If you are not familiar with the term ‘stock-flow consistent’ (SFC) then read on, because in a sense this post is all about why I think the way the authors and others define this class of models is misleading.

SFC models are popular with Post-Keynesians, and the definition you find on Wikipedia is “a family of macroeconomic models based on a rigorous accounting framework, which guarantees a correct and comprehensive integration of all the flows and the stocks of an economy.” Now I suspect any mainstream macroeconomists would immediately respond that any DSGE model is also stock-flow consistent in this sense. This point is made in a post by Noah Smith, and it is completely valid, although otherwise I think his account of the weaknesses of SFC models is wide of the mark.

If you think this is a trivial debate about titles, take this description of the pros and cons of SFC compared to DSGE models taken from the paper:

Take the cons (merits of DSGE compared to SFC) first. Number one is almost definitional: DSGE models have to be microfounded, but SFC models start with aggregate relationships. But that is not a defining feature of SFC models, because there is a long tradition of macro modelling that is not microfounded but starts with aggregates, a tradition that begins well before DSGEs with the simultaneous creation of national accounts data, econometrics and Keynesian economics. This tradition goes by many names: ‘Structural Econometric Models’ (SEMs), ‘Cowles Commission’ (favoured by Ray Fair) or most recently ‘policy models’ (see Blanchard). I’ll just call them aggregate models here.

A key question, therefore, is what marks SFC models out from other aggregate models? The authors obviously think there is something, because of their second ‘con’. The third and fourth ‘cons’ are common to many large SEMs. (I once wrote a paper on how to mitigate the first of these problems.) The fifth ‘con’ just follows from the first.

At first sight the sixth ‘con’ does the same, but I would argue that if there is anything that characterises SFCs among aggregate models it is this. Aggregate models would generally involve an extensive discussion of the theoretical origins of the relationships they used, but if this paper is anything to go by that is less true for SFCs. If you think this last point is unfair, look at the discussion of the consumption function (before equation 4).

This failure to acknowledge the existence of other aggregate models is even more apparent among the ‘pros’. The first and second can be true for any model, including a DSGE model, but the third is critical. It is true, but again it is also true for many aggregate and some DSGE models. As I argue in my previous post, the key point about the archetypal DSGE model is that it does not need to track household wealth, because there is no attempt by consumers (given the theory) to achieve some target value of wealth.

The fourth is true for any model, including DSGE models. The fifth is true for any aggregate model as long as expections variables are explicitly identified. The sixth is also almost bound to be true of any aggregate model, because starting with aggregates and being eclectic (and potentially internally inconsistent) with theory allows you to more closely match the data than DSGEs.

To summarise, if you were to ask how this model compares to other aggregate (non-microfounded) models, the answer would probably be that it takes theory less seriously and it has a rather elaborate financial side.

The New Classical counter revolution had many good and bad consequences, but one of the undesirable consequences was, it seems, to define the equivalent of a year zero in macroeconomics, where nothing that was not in the New Classical tradition created before (or even after) this revolution is deemed to exist. The same should not be true for heterodox economists. If you are going to effectively return to a pre-DSGE tradition, please do not pretend that tradition did not exist.

There is a well known UK professor of econometrics who was very fond of admonishing authors who failed to cite work that they were either extending or just copying. The intention here is not just to do the same. One of the big dangers with any kind of elaborate aggregate model is that you can get bizarre model properties from not thinking enough about the theory, or imposing enough because of the theory. Knowing some of the authors I doubt that has happened in this case. But it would be a mistake for others to believe that the properties of their model show the importance of accounting rather than the theory they have used.