I thought about titling this post, “Macroeconomics as fortune-telling”, but ultimately decided against it. In any event, there has been much discussion recently about the purported failures of modern macroeconomics. A recent article in the Economist has only fueled the flames. Mario Rizzo provides this pithy summary of the story:
…the article argues that although the dominant macro model, dynamic stochastic general equilibrium theory [DSGE], appears to be in a state of near-total breakdown.
I think that this is a bit of wishful thinking from the folks at the Economist, Mario Rizzo, and those referenced and quoted in the article. The fact of the matter is that the DSGE model is NOT “in a state of near-total breakdown” and nor should it be. Rather the criticism (hatred?) of DSGE models fails to understand both the purpose and the scope of these models.
Since the start of the financial crisis, macroeconomics has undergone a great deal of criticism. This criticism has largely been directed at (1) the inability of macroeconomists to forecast such a severe downturn, (2) the lack of a consensus regarding fiscal policy, and (3) DSGE models. I have already written in great detail about (2) and I think that the evidence and the theory is much more clear-cut than the debate would have you believe. I think that many of the differences of opinion had more to do with ideology than economics. Regardless, the focus of this post will be on (1) and (3).
The failure of macroeconomists to forecast the financial crisis and the subsequent recession is perhaps the foremost criticism. I similarly find this criticism to be the most bizarre. It would be easiest to respond to this criticism and say that economists are not fortune-tellers (as I have done in the past). However, it seems that this is not even an accurate criticism. While macroeconomists as a whole did not predict the recession, there are many who did predict the housing collapse as well as those who predicted a severe recession. Of course, the most outspoken example is Nouriel Roubini. As our friend David Beckworth reminds us, the research staff at the Bank of International Settlements was also out in front of the current crisis:
What do you get when the key insights of Hyman Minsky–prolonged macroeconomic stability can actually be destabilizing if it causes observers to take for granted the “good times” and underestimate risk going forward–and Frederick Hayek–price stability is not a sufficient condition for macroeconomic stability–are accepted by a group of mainstream economists? You get economists who were able to foresee as early as 2003 the current economic crisis and issue a warning. And just who are these economists? They are the research staff at the Bank for International Settlements (BIS), formerly led by William White. Der Spiegel has a great article on William White and his colleagues that highlights how they repeatedly warned central bankers of the dangers lurking ahead but to no avail. What is amazing, is that the BIS is the bank for central banks and had the ear of Alan Greenspan and other central bankers. In other words, these were not a bunch of economic cranks, but serious research economists at a top economic institution who were given a hearing but ignored by top policymakers.
I’m sure that there are other examples, but the fundamental point is that there were prominent researchers out in front of the current crisis, but they were largely ignored until the downturn.
The more important criticism of macro, however, surrounds the dynamic stochastic general equilibrium (DSGE) models. The critics largely contend that these models failed both in their forecasting ability as well as the fact that they often ignore financial markets. The former is largely a criticism of forecasting and not DSGE models (after all, richly specified DSGE models produce better forecasts than other methods).
Much of the criticism seems to result from a failure to understand the use of the DSGE model. These models come in all different forms. There are rather simple models that seek to explain the response of the economy to a specific exogenous shocks. There are others that attempt to evaluate alternative monetary or fiscal policy regimes. Still more are aimed at explaining historical downturns. What’s more, there are models that include financial market frictions (although, admittedly, they are less appreciated than they should be). There are also larger models that are used for forecasting within central banks. Ultimately, there are a wide variety of DSGE models because they are used for a wide variety of purposes. Thus the criticisms of these models must take into account their explicit purpose (which they often do not).
What’s more, the criticisms of DSGE models is used to imply that modern macroeconomics as a whole has failed. This argument demonstrates are clear leap in logic and an ignorance of modern macroeconomics. There are other tools that a large number of economists use. For example, cointegrated VAR models emphasize taking the data to the theory rather than the other way around (as in the DSGE models). What’s more, there has been theoretical work and corresponding empirical evidence that is independent of the both the VAR and DSGE methodology. In fact, one of the most topical issues of the moment is in regards to the liquidity trap and the effectiveness of monetary policy. Many of the articles on this topic do not use DSGE models in their analysis.
I do not want the argument here to be misconstrued. I am not arguing that DSGE models are without flaws, nor am I arguing that they should be the only framework for macroeconomists to work within. I welcome those to follow Mario Rizzo’s advice and to be a “disruption” and think outside of the standard framework. I hope that I have the courage and insight to do so myself. Nonetheless, I don’t think that we need to kill the DSGE model to accomplish this goal.
UPDATE: Menzie Chinn joins the defense:
Reading the recent characterizations of Ph.D. education in our top departments, one would conclude that all one ever learned in a program is how to write out and calibrate dynamic stochastic general equilibrium (DSGE) models, or for the older among us, calibrate a real business cycle model. I have to say that this all seems a little like an all too convenient caricature (and, as I have said repeatedly in the past, these types of models have led to important insights for issues besides crises).
If my conjecture is correct, then the supposed failure of macroeconomics is more the failure of macroeconomics as described in the popular press, rather than of the discipline itself (after all, Joseph Stiglitz is as much of the economics discipline, if not more, than Eugene Fama.) My conclusion: Not quite time to jettison the apparatus of modern macroeconomics.