As Blanchard notes, DSGE models are based on
microfoundations, and essentially model the behaviour of various representative
optimising agents (firms, households, central banks) whilst making a number of
unrealistic assumptions. These are not just simplifying assumptions – they are probably
downright wrong. One such example is the assumption of pricing behaviour assumed
in such models which is designed to handle nominal rigidities. This so-called
Calvo pricing assumption
is elegant but is not observed in the real world, thus rendering it somewhat
useless. Blanchard goes on to point out
that such models are mathematically dense, and thus are impenetrable even to
many economists. As he put it, they are bad communications devices. My major
criticism of such models, and one echoed by Blanchard, is that they are
designed to fit the theory rather than the data with the result that they are
empirically unsound. This probably reflects the way I was taught to do
econometrics, but there is a quaint old fashioned notion that models should be
congruent with the data.
Paul Krugman argues very strongly that Blanchard is
too kind on such models and that far from offering scope for improvement, they
have led us up an intellectual cul-de-sac. In his view they have contributed no
insight into the workings of the economy and that old-fashioned ISLM models offered
more useful predictions in the wake of the financial crisis than did DSGE
analysis.
Others, such as the always readable Simon Wren-Lewis are less trenchant in their view but
still critical. As SWL put it "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 ... What is at issue is not the existence of DSGE models, but their
hegemony." He has long argued that journal editors have routinely
turned away good papers on the grounds that they do not offer a microfounded or
general equilibrium approach and he offers the hope that "criticism from one of the best
macroeconomists in the world might" prompt them to change their view.
Now I am no academic but I have spent enough time building
and running economic models to know when a modelling paradigm is going broadly
in the right direction. And I am pretty sure that DSGE is not the way for
someone like me to go. My job is to understand how the economy fits together, and
we know that there are structural changes over time which means that things
that once worked no longer do. Estimating structural models allows us to do
that, in order to see whether econometric relationships which once held
continue to do so. The models I use are structural forecasting models, which
would not have looked out of place 20 years ago, and many academic economists dismiss
them out of hand. For one thing, they often struggle to model expectations in a
way which satisfies academic thinking (though I am quite happy to pretend that
the rational expectations revolution never happened). In addition, they are not
identified (i.e. it is impossible to derive a specification for each individual
variable in the equation which gives a unique specification in terms of others
in the system) and the economic theory underpinning such models is often ad
hoc.
To a degree, these criticisms are all valid. But these
models have not been usurped by a superior paradigm, and certainly not by DSGE. I thus have a lot of
sympathy with Krugman's view that macroeconomics has taken a wrong turning. DSGE
models do not help most economists to understand how the world really works, and
they certainly do not help to inform the general public. They are highly sophisticated
mathematical tools which explain the world as many economists think it should
be, rather than as it really is. DSGE models were a brave attempt to try and
move the economic debate forward but they have failed. If economics wants to
be more relevant to the wider policy debate, we need to find better ways of
understanding how the world works, but as Wren-Lewis notes, too much
intellectual capital has been sunken into the field to hope that it will go
away quickly.
However, perhaps macroeconomics is ready for a Popper-style paradigm shift in which empirical falsification will prompt another generation of economists
to push the field in a new direction and get us out of the rut into which we
appear to have sunk. We could certainly do with a bit more public credibility and
in that sense DSGE models are clearly not the way to go.
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