Should-Read: Jo Mitchell: Dilettantes Shouldn’t Get Excited

Should-Read: Jo Mitchell: Dilettantes Shouldn’t Get Excited: “The Freshwater version of the model concluded that all government policy has no effect and that any changes are driven by an unexplained residual…

…The more moderate Saltwater version, with added Calvo fairy, allowed a rediscovery of Milton Friedman’s main results: an expectations-augmented Phillips Curve and short-run demand effects from monetary policy. The model has two basic equations….

The first… aggregate demand… based on an… assumption about how households behave in response to changes in the rate of interest. Unfortunately, not only does the equation not fit the data, the sign of the main coefficient appears to be wrong. This is likely because, rather than trying to understand the emergent properties of many interacting agents, modellers took the short-cut of assuming that the one big person assumed to represent the economy would simply replicate the behaviour of a single textbook-rational individual—much like assuming that the behaviour of an ant colony would be the same as that of one big textbook ant. It’s hard to see how one can make an argument that this has advanced knowledge beyond what you could glean from a straightforward Keynesian or Modigliani consumption function….

[The second,] the Phillips Curve… appears to have once again broken down….

More complex versions of the model do exist, which purport to capture further stylised macro relationships beyond the standard pair. This is done, however, by adding extra degrees of freedom — justified as essentially arbitrary “frictions” — and  and then over fitting the model to the data. The result is that the models are pretty good at “predicting” the data they are trained on, and hopeless at anything else.

30 years of DSGE research have produced exactly one empirically plausible result—the expectations-augmented Phillips Curve. It was already well known. There is an ironic twist here: the breakdown of the Phillips Curve in the 1970s gave the Freshwater economists their breakthrough. The breakdown of the Phillips Curve now—in the other direction—leaves DSGE with precisely zero verifiable achievements.

Christiano et al.’s paper is welcome in one respect. It confirms what macroeconomists at the top of the discipline think about those lower down the academic pecking order — particularly those who take a critical view. They have made public what many of us long suspected was said behind closed doors…