DSGE quagmire

15 May, 2015 at 08:52 | Posted in Economics | 2 Comments

Given that unions are weaker than they have been for a century or so, and that severe cuts to social welfare benefits have been imposed in most countries, the traditional rightwing explanation that labour market inflexibility [arising from minimum wage laws or unions], is the cause of unemployment, appeals only to ideologues (who are, unfortunately, plentiful) …

wrong-tool-by-jerome-awAfter the Global Financial Crisis, it became clear that the concessions made by the New Keynesians were ill-advised in both theoretical and political terms. In theoretical terms, the DSGE models developed during the spurious “Great Moderation” were entirely inconsistent with the experience of the New Depression. The problem was not just a failure of prediction: the models simply did not allow for depressions that permanently shift the economy from its previous long term growth path. In political terms, it turned out that the seeming convergence with the New Classical school was an illusion. Faced with the need to respond to the New Depression, most of the New Classical school retreated to pre-Keynesian positions based on versions of Say’s Law (supply creates its own demand) that Say himself would have rejected, and advocated austerity policies in the face of overwhelming evidence that they were not working …

Relative to DSGE, the key point is that there is no unique long-run equilibrium growth path, determined by technology and preferences, to which the economy is bound to return. In particular, the loss of productive capacity, skills and so on in the current depression is, for all practical purposes, permanent. But if there is no exogenously determined (though maybe still stochastic) growth path for the economy, economic agents (workers and firms) can’t make the kind of long-term plans required of them in standard life-cycle models. They have to rely on heuristics and rules of thumb … This is, in my view, the most important point made by post-Keynesians and ignored by Old Old Keynesians.

John Quiggin

Debating moden economics, yours truly often gets the feeling that mainstream economists, when facing anomalies, think that there is always some further “technical fix” that will get them out of the quagmire. But are these elaborations and amendments on something basically wrong really going to solve the problem? I doubt it. Acting like the baker’s apprentice who, having forgotten to add yeast to the dough, throws it into the oven afterwards, simply isn’t enough.

When criticizing the basic workhorse DSGE model for its inability to explain involuntary unemployment, some DSGE defenders maintain that later elaborations — e.g. newer search models — manage to do just that. I strongly disagree. One of the more conspicuous problems with those “solutions,” is that they — as e.g. Pissarides’ ”Loss of Skill during Unemployment and the Persistence of Unemployment Shocks” QJE (1992) — are as a rule constructed without seriously trying to warrant that the model-immanent assumptions and results are applicable in the real world. External validity is more or less a non-existent problematique sacrificed on the altar of model derivations. This is not by chance. For how could one even imagine to empirically test assumptions such as Pissarides’ ”model 1″ assumptions of reality being adequately represented by ”two overlapping generations of fixed size”, ”wages determined by Nash bargaining”, ”actors maximizing expected utility”,”endogenous job openings”, ”jobmatching describable by a probability distribution,” without coming to the conclusion that this is — in terms of realism and relevance — nothing but nonsense on stilts?

The whole strategy reminds me not so little of the following little tale:

Time after time you hear people speaking in baffled terms about mathematical models that somehow didn’t warn us in time, that were too complicated to understand, and so on. If you have somehow missed such public displays of throwing the model (and quants) under the bus, stay tuned below for examples.
But this is far from the case – most of the really enormous failures of models are explained by people lying …
A common response to these problems is to call for those models to be revamped, to add features that will cover previously unforeseen issues, and generally speaking, to make them more complex.

For a person like myself, who gets paid to “fix the model,” it’s tempting to do just that, to assume the role of the hero who is going to set everything right with a few brilliant ideas and some excellent training data.

Unfortunately, reality is staring me in the face, and it’s telling me that we don’t need more complicated models.

If I go to the trouble of fixing up a model, say by adding counterparty risk considerations, then I’m implicitly assuming the problem with the existing models is that they’re being used honestly but aren’t mathematically up to the task.

If we replace okay models with more complicated models, as many people are suggesting we do, without first addressing the lying problem, it will only allow people to lie even more. This is because the complexity of a model itself is an obstacle to understanding its results, and more complex models allow more manipulation …

I used to work at Riskmetrics, where I saw first-hand how people lie with risk models. But that’s not the only thing I worked on. I also helped out building an analytical wealth management product. This software was sold to banks, and was used by professional “wealth managers” to help people (usually rich people, but not mega-rich people) plan for retirement.

We had a bunch of bells and whistles in the software to impress the clients – Monte Carlo simulations, fancy optimization tools, and more. But in the end, the bank’s and their wealth managers put in their own market assumptions when they used it. Specifically, they put in the forecast market growth for stocks, bonds, alternative investing, etc., as well as the assumed volatility of those categories and indeed the entire covariance matrix representing how correlated the market constituents are to each other.

The result is this: no matter how honest I would try to be with my modeling, I had no way of preventing the model from being misused and misleading to the clients. And it was indeed misused: wealth managers put in absolutely ridiculous assumptions of fantastic returns with vanishingly small risk.

Cathy O’Neil


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  1. Lars,
    I wonder if there might not be an additional, half-unconscious political-economy-of-economics reason for this persistent faith in the “technical fix” that will fit the base Chicago-neoclassical model with, as in your example, such “Keynesian” observations as the reality of involuntary unemployment.

    Krugman said somewhere (I think re RBC theories) that the success of an academic theory is actually heavily dependent on its ability to supply “opportunities for clever but not especially creative people to show that they’re clever” (it’s somewhere in his “Peddling Prosperity” book).
    Now, it’s at least arguable that a great deal of the foundational work for individual New Keynesians consisted of very clever ways of reconciling the Neoclassical paradigm with what is observed in the real world (Krugman on trade, Stieglitz and Summers on mergers and their effect on labor productivity, etc.).

    Looked at this way, economics departments in the US seem to display a fairly stable division of effort. The hard-classical school, as a field, makes a living by expanding horizontally (Gary Becker, Steven Levitt) into other areas of inquiry, Lazear’s economic imperialism, while the reasonable-classical guys on the coasts are able to write papers on the basis of what are indubitably such technical feats as managing to fit humdrum economic events (I suppose income distribution divorced from marginal productivity will be the next one) into the DGSE model.
    If the hardcore classical guys make some further-insane assumption (child-slavery is an efficient inter-generational income transfer), then that just supplies more opportunities for some bright young saltwater thing to show that, adding a certain “friction” makes this result break down and therefore allows us to believe once again (what a relief!) that child-slavery is a bad thing.

    The practical point this. Heterodox economists and their readers believe that continual and incisive indication of the shortcomings of the neoclassical orthodoxy will achieve, if nothing else, some kind of attritional effect on the confidence of neoclassicals.
    I’d posit that it’s at least as plausible that, quite to the contrary, the persistence of orthodoxy-challenging events is strictly necessary for the continued viability of a certain kind of career path in economics. The critiques, in other words, will become merely the second-paragraph fodder for some bright tenure-track professor’s paper on how, while “many papers have challenged the ability of the DGSE model to…”, in fact [insert brilliant technical fix here].

    (That is all, and wish of course I’d managed a more elegant presentation of same.)

    • Interesting thougths, but I sure hope you’re wrong on the deeper function of the heterodox critique🙂

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