Must-Read: Simon Wren-Lewis: Economics, DSGE and Reality
Must-Read: Simon Wren-Lewis recounts his career history and how it has shaped his thought. I have enormous respect for him. But I still do not understand why it would be a good thing to require that models have all of:
- a representative agent
- an Euler equation governing consumption
- Calvo pricing and the associated forward-looking Phillips Curve
- TFP residuals as an explanatory variable
All of these are either rejected by the data–strongly–or cheat by taking one of your model’s fit errors and claiming that it is a well-understood driving factor:
Simon Wren-Lewis: Economics, DSGE and Reality:
Just before 1990… with colleagues I showed that entering the ERM at an overvalued exchange rate would lead to a UK recession…
A well respected Financial Times journalist responded that we had won the intellectual argument, but he was still going with his heart that we should enter at 2.95 DM/£. The Conservative government did likewise, and the recession of 1992 inevitably followed. This was the first public occasion where academic research that I had organised could have made a big difference to UK policy and people’s lives…. It was also the first occasion that I saw close up academics who had not done similar research but who had influence use that influence to support simplistic reasoning. It is difficult to understate the impact that had on me: being centrally involved in a policy debate, losing that debate for partly political reasons, and subsequently seeing your analysis vindicated but at the cost of people becoming unemployed….
I went to Strathclyde University… to build a new UK model…. The writing was on the wall for this kind of modelling in the UK, because it did not fit the ‘it has to be DSGE’ edict from the US. A third round of funding, which wanted to add more influences from the financial sector into the model using ideas based on work by Stiglitz and Greenwald, was rejected because our approach was ‘old fashioned’ i.e not DSGE. (The irony given events some 20 years later is immense.)… I had no problem moving with the tide…. Having to ensure everything was microfounded I think created more heat than light, but I learnt a great deal from this work which would prove invaluable over the last decade….
After the financial crisis… governments from around the world first went with what macroeconomic theory and evidence would prescribe, and then in 2010 dramatically went the opposite way. The latter event was undoubtedly the underlying motivation for me starting to write this blog…. I discovered not just that the Coalition government’s constant refrain was simply wrong, but also that the Labour opposition seemed uninterested in what I found….
You can see from all this why I have a love/hate relationship to microfoundations and DSGE…. More traditional forms of macromodelling also had virtues that were lost with DSGE…. [But] those who believe microfounded modelling is a dead end are wrong….
Austerity is not the first time good advice has been ignored at considerable cost. And for the few that sometimes tell me I should ‘stick with the economics’, you can see why given my experience I find that rather difficult to do. It is a bit like asking a chef to ignore how bad the service is in his restaurant, and just stick with the cooking.