Talk On Where Macroeconomics Went Wrong

I gave a brusk utter yesterday with this title, which takes roughly of the primary points from my newspaper inward the  OXREP 'Rebuilding Macro' volume  It is mainly of involvement to economists, or those interested inward economical methodology or the history of macroeconomic thought. When I utter close macroeconomics together with macroeconomists below I hateful mainstream academic economists.  

I desire to utter today close where macroeconomics went wrong. Now it seems that this is a topic where everyone has a view. But most of those views receive got a mutual theme, together with that is a dislike of DSGE models. Yet DSGE models are firmly entrenched inward academic macroeconomics, together with inward pretty good every economist that has done a PhD, which is why the Bank of England’s kernel model is DSGE. To sympathise why DSGE is together with then entrenched, I involve to enjoin the even of the New Classical Counter Revolution (NCCR).

If you lot had to choice a newspaper that epitomised the NCCR it would move “After Keynesian Macroeconomics” past times Lucas together with Sargent. Now from the championship you lot would retrieve this was an laid on on Keynesian Economics, together with inward part it was. But nosotros know that revolution failed. Very shortly after the NCCR nosotros had the nascency of New Keynesian economic science that recast key aspects of Keynesian economic science inside a microfoundations [1] framework, together with is straightaway the way nearly all cardinal banks retrieve close stabilisation policy. But if you lot read the text of Lucas together with Sargent it is mainly a manifesto close how to exercise macroeconomics, or what I retrieve nosotros tin hand the sack reasonably telephone phone the methodology of macroeconomics.And on that their revolution was successful, together with it is why nearly all academic macro is DSGE.

Before Lucas together with Sargent consummate macroeconomic models, of both a theoretical together with empirical kind, had justified their aggregate equation using an eclectic mix of theory together with econometrics. Microfoundations were used equally a guide to aggregate equation specification, but if this equation cruel apart inward statistical price when confronted with information inward would non move part of an empirical model, together with would move shunned for inclusion inward theoretical models. Off course of report ‘falling apart ‘ is a real subjective criteria, together with every attempt would move made to attempt together with brand an equation consistent with microfoundations, but typically a lot of the dynamics inward these models were what nosotros would straightaway telephone phone advertizing hoc, which inward this illustration meant information based. .

Lucas famously showed that models of this variety were dependent champaign to what nosotros telephone phone the Lucas critique [2], together with that forms an of import part of Lucas together with Sargent paper. They debate that the entirely sure way to acquire circular that critique is to construct the model from internally consistent microfoundations. But they likewise inquire why wouldn’t you lot desire to construct whatever macroeconomic model that way? Why wouldn’t you lot desire a model where you lot could move sure that aggregate outcomes were the outcome of agents behaving inward a consistent manner

If you lot desire to crystallise why this was a methodological revolution, retrieve close what nosotros mightiness telephone phone admissibility criteria for macro models. In pre-NCCR models equations were selected through an eclectic mixture of theory-fit together with evidence-fit. In the RBC together with later DSGE models internal theoretical consistency is an admissibility criteria. Or to lay it roughly other way, a DSGE model never got rejected because 1 of its equations didn’t gibe the data, but if 1 equation had a theoretical foundation that was inconsistent with the others it would sure enough non move published inward the improve journals.

Have a aspect at almost whatever macro newspaper inward a overstep magazine today, together with compare it to a similar newspaper earlier the NCCR, together with you lot tin hand the sack encounter nosotros receive got been through a methodological revolution. Unfortunately many economists who receive got entirely been taught together with who entirely known DSGE but retrieve of this equally progress. But it is non but progress, because DSGE models involve a shift away from the data. This is inevitable if you lot alter the admissibility criteria away from the data. It inevitably agency macroeconomists root focusing on models where it is tardily to ensure internal theoretical consistency, together with away from macroeconomic phenomenon that are clear inward the information but to a greater extent than hard to microfound.

If you lot are expecting me at this indicate to nation that DSGE models where were macroeconomics went wrong, you lot volition move disappointed. I spent the terminal fifteen years of my query career edifice together with analysing DSGE models, together with I learnt a lot equally a result. The error was the revolution part. In the US, DSGE models replaced traditional modelling inside almost a decade [3]. In my persuasion DSGE models should receive got coexisted with to a greater extent than traditional modelling, each tolerating the other.

To acquire a glimpse of how that tin hand the sack come about aspect at the UK, where a traditional macromodelling scene remained active until the terminate of the millenium. Traditional models didn’t stand upward sill, but changed past times adopting many of the ideas from DSGE such equally rational expectations. Here the trace of piece of job concern human relationship gets a footling personal, because earlier I did DSGE I built 1 of those models, called COMPACT. There are non many macroeconomists who receive got built together with operated both traditional together with DSGE models, which I retrieve gives me roughly insight of the merits of both.

COMPACT was a rational expectations New Keynesian model with explicit credit constraints inward a Blanchard-Yaari type consumption function, a vintage production model, together with multifariousness effects on trade. So inward price of theoretical ideas it was far richer than whatever DSGE model I later worked with. Most of COMPACT’s behavioural equations were econometrically estimated, but it was non an internally consistent model similar DSGE.

COMPACT had an explicit but exogenous credit constraint variable inward the model because inward our persuasion it was impossible to model consumption conduct over fourth dimension without it. Our piece of job was based heavily on piece of job inward the UK of Britain together with Northern Republic of Ireland past times John Muellbauer, together with Chris Carroll was coming to similar conclusions for the US. But DSGE models never faced that number because they worked with de-trended data. Let me piece out why that was important. Empirical piece of job was establishing that you lot could non commence to sympathise consumption conduct over a 20/30 twelvemonth fourth dimension horizon without seeing how the fiscal sector had changed over time, together with at to the lowest degree 1 traditional macroeconomic model was incorporating that finding earlier the terminate of the terminal millennium.. Extensive piece of job on precisely that number did non commence using DSGE models until after the fiscal crisis, where changes inward the fiscal sector had a critical affect on the existent economy. DSGE was behind the curve, but to a greater extent than traditional macroeconomics was not. .

Now I don’t retrieve it is fanciful to retrieve that if at to the lowest degree roughly macroeconomists had continued working with to a greater extent than traditional data-based models amongst those doing DSGE, at to the lowest degree 1 of those models would receive got thought to endogenise the fiscal sector which was determining those varying credit constraints.

So the claim I desire to brand is rather a big one. If DSGE models had continued amongst to a greater extent than traditional, data-based modelling, economists would receive got been much improve prepared for the fiscal crisis when it came. If these 2 methodologies had learnt from each other, DSGE models mightiness receive got started focusing on the fiscal sector earlier the crisis. Of course of report I would never advise that macroeconomics could receive got predicted that crisis, but macroeconomists would receive got sure enough had much to a greater extent than useful things to nation close the affect on the economic scheme when it happened.

Just beingness able to imagine this beingness truthful illustrates that moving to DSGE involved losses equally good equally gains. It inevitably made models less rich together with moved them farther away from the information inward areas that were hard but non impossible to model inward a theoretically consistent way. The DSGE methodological revolution laid out together with then clearly inward Lucas together with Sargent's newspaper changed the focus of macroeconomics away from things nosotros straightaway know were of critical importance.

I’ve been talking close this since I started writing a weblog at the terminate of 2011, but lately nosotros receive got seen similar messages from Paul Romer together with Olivier Blanchard inward this OxREP volume. What I receive got called hither traditional models, together with inward the newspaper I telephone phone Structural Econometric Models, Blanchard calls provocatively policy models. It was provocative because most academic macroeconomists retrieve DSGE models are the entirely models that tin hand the sack exercise policy analysis ‘properly’, but Blanchard suggests policymakers desire models that are closer to the information to a greater extent than than they desire a guarantee of internal consistency, together with they desire models that are quick together with tardily to suit to unfolding problems. The U.S. of A. of America Fed, although it has a DSGE model, likewise has a to a greater extent than traditional model that has similarities to a traditional model similar COMPACT, together with guess which model plays the major role inward the policy process?

[1] Microfoundations agency deriving aggregate equations from microeconomic optimisation behaviour

[2] The Lucas critique argued that many equations of traditional macroeconomic models embodied beliefs close macro policy, together with and then if policy changed the equations would no longer move valid.

[3] The difficulty of identification inward unmarried equation estimation highlighted past times Sims inward 1980 in all probability likewise contributed.  .