Why DSGE is such a spectacularly useless waste of time

10 Jan, 2014 at 18:54 | Posted in Economics | 5 Comments

Noah Smith has a nice piece up today on what he considers the most “damning critique of DSGE:”

If DSGE models work, why don’t people use them to get rich?

When I studied macroeconomics in grad school, I was told something along these lines:

“DSGE models are useful for policy advice because they (hopefully) pass the Lucas Critique. If all you want to do is forecast the economy, you don’t need to pass the Lucas Critique, so you don’t need a DSGE model.”

This is usually what I hear academic macroeconomists say when asked to explain the fact that essentially no one in the private sector uses DSGE models. Private-sector people can’t set economic policy, the argument goes, so they don’t need Lucas Critique-robust models.

The problem is, this argument is wrong. If you have a model that both A) satisfies the Lucas Critique and B) is a decent model of the economy, you can make huge amounts of money. This is because although any old spreadsheet can be used to make unconditional forecasts of the economy, you need Lucas-robust models to make good policy-conditional forecasts …

So now let’s get to the point of this post. As far as I’m aware, private-sector firms don’t hire anyone to make DSGE models, implement DSGE models, or even scan the DSGE literature. There are a lot of firms that make macro bets in the finance industry – investment banks, macro hedge funds, bond funds. To my knowledge, none of these firms spends one thin dime on DSGE. I’ve called and emailed everyone I could think of who knows what financial-industry macroeconomists do, and they’re all unanimous – they’ve never heard of anyone in finance using a DSGE model …

So maybe they’re just using the wrong DSGE models? Maybe they’re using Williamson (2012) instead of Williamson (2013) … But if finance-industry people can’t know which DSGE model to use, how can policymakers or policy advisors?

In other words, DSGE models … have failed a key test of usefulness. Their main selling point – satisfying the Lucas critique – should make them very valuable to industry. But industry shuns them.

Many economic technologies pass the industry test. Companies pay people lots of money to use auction theory. Companies pay people lots of money to use vector autoregressions. Companies pay people lots of money to use matching models. But companies do not, as far as I can tell, pay people lots of money to use DSGE to predict the effects of government policy …

As I see it, this is currently the most damning critique of the whole DSGE paradigm.

Although I think the unsellability of DSGE — private-sector firms do not pay lots of money to use DSGE models — is a strong argument against DSGE, it is not a killing magic bullet or the most damning critique of it.

unemployment

In the basic DSGE models the labour market is always cleared – responding to a changing interest rate, expected life time incomes, or real wages, the representative agent maximizes the utility function by varying her labour supply, money holding and consumption over time. Most importantly – if the real wage somehow deviates from its “equilibrium value,” the representative agent adjust her labour supply, so that when the real wage is higher than its “equilibrium value,” labour supply is increased, and when the real wage is below its “equilibrium value,” labour supply is decreased.

In this model world, unemployment is always an optimal choice to changes in the labour market conditions. Hence, unemployment is totally voluntary. To be unemployed is something one optimally chooses to be.

Although this picture of unemployment as a kind of self-chosen optimality, strikes most people as utterly ridiculous, there are also, unfortunately, a lot of neoclassical economists out there who still think that price and wage rigidities are the prime movers behind unemployment. DSGE models basically explains variations in employment (and a fortiori output) with assuming nominal wages being more flexible than prices – disregarding the lack of empirical evidence for this rather counterintuitive assumption.

Keynes held a completely different view. Since unions/workers, contrary to classical assumptions, make wage-bargains in nominal terms, they will accept lower real wages caused by higher prices, but resist lower real wages caused by lower nominal wages. However, Keynes held it incorrect to attribute “cyclical” unemployment to this diversified agent behaviour. During the depression money wages fell significantly and unemployment still grew. Thus, even when nominal wages are lowered, they do not generally lower unemployment.

In any specific labour market, lower wages could, of course, raise the demand for labour. But a general reduction in money wages would leave real wages more or less unchanged. The reasoning of the classical economists was, according to Keynes, a flagrant example of the fallacy of composition. Assuming that since unions/workers in a specific labour market could negotiate real wage reductions via lowering nominal wages, unions/workers in general could do the same, the classics confused micro with macro.

Lowering nominal wages could not – according to Keynes – clear the labour market. Lowering wages – and possibly prices – could, perhaps, lower interest rates and increase investment. It would be much easier to achieve that effect by increasing the money supply. In any case, wage reductions was not seen as a general substitute for an expansionary monetary or fiscal policy. And even if potentially positive impacts of lowering wages exist, there are also more heavily weighing negative impacts – management-union relations deteriorating, expectations of on-going lowering of wages causing delay of investments, debt deflation et cetera.

The classical proposition that lowering wages would lower unemployment and ultimately take economies out of depressions, was ill-founded and basically wrong. To Keynes, flexible wages would only make things worse by leading to erratic price-fluctuations. The basic explanation for unemployment is insufficient aggregate demand, and that is mostly determined outside the labour market.

People calling themselves “New Keynesians” ought to be rather embarrassed by the fact that the kind of DSGE models they use, cannot incorporate such a basic fact of reality as involuntary unemployment. Of course, working with representative agent models, this should come as no surprise. The kind of unemployment that occurs is voluntary, since it is only adjustments of the hours of work that these optimizing agents make to maximize their utility.

To me, this — the inability to explain involuntary unemployment — is the most damning critique of DSGE.

5 Comments

  1. I am a little confused. Admittedly the DSGE was intended to satisfy the Lucas critique, but only by maintaining that policy can only have an impact via the microfoundations. This led to a meta-policy of paying no attention to other aspects (such as financial regulation), which seems to have been disastrous, suggesting that the assumptions of DSGE are false and that a naïve belief in it can undermine the assumed equilibrium.

  2. “People calling themselves “New Keynesians” ought to be rather embarrassed by the fact that the kind of DSGE models they use, cannot incorporate such a basic fact of reality as involuntary unemployment. ”

    But is there a model that can incorporate it other than using it as an explanatory variable? If I understand correctly (big “if” I admit), Keynes used involuntary unemployment as an independent variable, not as a prediction/dependent variable. In this sense, Keynesian economics do not provide an explanation of this phenomenon, which in my view is due to so many different factors and so complex to model that it is better to introduce as a dummy variable or consider it as an epiphenomeno alltogether.

  3. […] Why DSGE is such a spectacularly useless waste of time Lars P. Syll […]

  4. Reblogged this on MERCIAR BUSINESS CONSULTING and commented:
    Another very clear and consise explanation, Lars…

  5. We have a de-centralized economy, coordinated by money and finance, and the core issue is how well does that decentralized economy perform. Are the scattered agents able to act and coordinate among themselves in an effective manner? Does the system enable them to live productive lives, or frustrate those private ambitions?

    Involuntary unemployment is a clear failure for a de-centralized money economy. Keynes’ most salient achievement as an economist was establishing that involuntary unemployment is an unambiguous loss for society, requiring a public policy response and remedy. It was a mortal blow against laissez faire, and one that conservatives will never forgive.

    The conservative ambition is not to explain “involuntary unemployment”, but to explain away the unambiguous, deadweight social loss that it demonstrates. An efficient economy would make at least some use of all available resources. The conservatives want to show that the waste represented by involuntary unemployment is, in fact, functional, that is a socially useful response or adaptation to, say, possibly, technological change, or at least, an inevitable by-product of efficient adaptation.

    Public policy intervention to manage the macro-economy, in this view, risks pre-empting that efficient adaptation to changing circumstances, the exact and detailed nature of which may be unknowable to central authority. (The ability to process locally embedded, detailed information properly is one of the strengths of a de-centralized economy, supposedly.)

    While there are certainly elements of cruelty in the conservative insistence on laissez faire, or even austerity, in the face of large-scale failures of the money economy, which cause enormous suffering, it is not the completely crazy view, implied when New Keynesians make fun of Casey Mulligan.

    New Keynesian use of DSGE to show that simple “frictions” (e.g. menu costs of changing prices and wages) improve the explanatory power of DSGE models as highly stylized descriptions neither confronts the conservative challenge on its own terms, nor does it produce models with the kind of predictive power, which might have commercial value.

    We are left without much serious thought about the principles and values, which ought to guide central authority in its management and oversight of a de-centralized money economy. What is the public good, and how should democracy hold public authority responsible and accountable for macro-economic performance?

    Explaining 75+ years after publication of the General Theory why falling wages amid high rates of unemployment are unlikely to remedy a high rate of unemployment is a cul-de-sac of the mind. For changes in prices and wages to guide a market economy back to an efficient, full-employment general equilibrium requires that markets clear, that is, there has to be at least the possibility of a market-clearing equilibrium in every market. We live in an economy, in which actual markets are exceptional — there are basically only a few financial and commodity markets in operation — all other exchange is administered by and between hierarchies. These metaphorical markets managed by hierarchy usually don’t have a market-clearing equilibrium in price; that’s often a prime reason those prices are formed by administrative process. Increasing returns and sunk-cost investments in structures of monopolistic competition mean that, typically, marginal cost is less than average cost and declining. There can be no market-clearing equilibrium — strictly speaking, no “market” equilibrium in price exists at all in a mathematical sense, which is why these metaphoric markets are administered, and not real markets, at all. Sellers, typically, want to sell more at current prices — not just labor wants more employment at current wages; every merchants wants to sell more widgets, which is why they invest in advertising and marketing on an enormous scale, advertising and marketing being among the instruments of administrative price formation and management.

    That the macro-economy behaves as it does, because a great many sellers would like to sell more goods and services at the current price, is well-recognized by mainstream economists, even if it is not, apparently, well-understood. Most would claim that they have incorporated monopolistic competition into their thinking about the underlying microeconomy for at least 40 years. And, yet, the mythology of Walrasian general equilibrium in price persists. Logically, you cannot have both.

    The economy we have, decentralized but dominated by hierarchy not markets, is not focused on achieving the purely allocational efficiency contemplated by Walras (or Samuelson for that matter). Hierarchies are engaging in domination, the exercise of political power, and the achievement of important technical efficiencies by management of production processes. Where textbook economics can assume away the processes by which managerial and technical efficiency is achieved, in the actual world, solving these problems is something economic actors do, in addition to allocating resources, and prices are usually administered in subordination to solving these problems.

    We need to think realistically about the economy we have, and then, maybe, we could start thinking about what public, central authority should be doing to improve its operation. Progressives would disagree with conservatives, no doubt, but, at least, we could disagree productively about profound issues that matter. As things are, the arguments might as well be scholastic disputes about how many angels dance on the head of a pin.


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