Calibration — an economics fraud kit

6 November, 2018 at 09:03 | Posted in Economics | 1 Comment

In his well-written and interesting article The Trouble with Macroeconomics, Paul Romer goes to a ​frontal attack on the theories that have put macroeconomics on a path of ‘intellectual regress’ for three decades now:

Macroeconomists got comfortable with the idea that fluctuations in macroeconomic aggregates are caused by imaginary shocks, instead of actions that people take, after Kydland and Prescott (1982) launched the real business cycle (RBC) model …

fraud-kitIn response to the observation that the shocks are imaginary, a standard defence invokes Milton Friedman’s (1953) methodological assertion from unnamed authority that “the more significant the theory, the more unrealistic the assumptions.” More recently, “all models are false” seems to have become the universal hand-wave for dismissing any fact that does not conform to the model that is the current favourite.

The noncommittal relationship with the truth revealed by these methodological evasions and the “less than totally convinced …” dismissal of fact goes so far beyond post-modern irony that it deserves its own label. I suggest “post-real.”

Paul Romer

There are many kinds of useless ‘post-real’ economics held in high regard within mainstream economics establishment today. Few — if any — are less deserved than the macroeconomic theory/method — mostly connected with Nobel laureates Finn Kydland, Robert Lucas, Edward Prescott and Thomas Sargent — called calibration.

In physics,​ it may possibly not be straining credulity too much to model processes as ergodic – where time and history do not really matter – but in social and historical sciences it is obviously ridiculous. If societies and economies were ergodic worlds, why do econometricians fervently discuss things such as structural breaks and regime shifts? That they do is an indication of the unrealisticness of treating open systems as analyzable with ergodic concepts.

The future is not reducible to a known set of prospects. It is not like sitting at the roulette table and calculating what the future outcomes of spinning the wheel will be. Reading Lucas, Sargent, Prescott, Kydland and other calibrationists one comes to think of Robert Clower’s apt remark that

much economics is so far removed from anything that remotely resembles the real world that it’s often difficult for economists to take their own subject seriously.

Instead of assuming calibration and rational expectations to be right, one ought to confront the hypothesis with the available evidence. It is not enough to construct models. Anyone can construct models. To be seriously interesting, models have to come with an aim. They have to have an intended use. If the intention of calibration and rational expectations is​ to help us explain real economies, it has to be evaluated from that perspective. A model or hypothesis without a specific applicability is not really deserving our interest.

Without strong evidence,​ all kinds of absurd claims and nonsense may pretend to be science. We have to demand more of a justification than this rather watered-down version of ‘anything goes’ when it comes to rationality postulates. If one proposes rational expectations one also has to support its underlying assumptions. None is given, which makes it rather puzzling how rational expectations has become the standard modelling​ assumption made in much of modern macroeconomics. Perhaps the reason is that economists often mistake mathematical beauty for truth.

In the hands of Lucas, Prescott and Sargent, rational expectations have​ been transformed from an – in principle – testable hypothesis to an irrefutable proposition. Believing in a set of irrefutable propositions may be comfortable – like religious convictions or ideological dogmas – but it is not science​.

So where does this all lead us? What is the trouble ahead for economics? Putting a sticky-price DSGE lipstick on the RBC pig sure won’t do. Neither will just looking the other way and pretend it’s raining.​


1 Comment

  1. I think you must look to the models used by practicing finance firms, which use programs to slice and dice underlying assets (which can themselves be bonds, thus further removing the underlying from any real assets) so that investors can choose their own prices. Then an investor can optimize a theoretical portfolio using linear algebra, and construct it through financial engineering. Minimum payouts are guaranteed, risk-free. There might still exist the risk that a panic will overcome traders and everything will be devalued, but there is insurance against such states (Goldman Sachs used insurance to come out ahead in the last crisis). The Fed proved to be the insurer of last resort by digitally printing money in 2008 and beyond. And the dollar got stronger.
    Conclusion: working finance models strip out risk and use public institutions as a backstop. Practical finance exploits free lunches and sets prices arbitrarily. Mainstream economics still thinks these things are not possible.

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