Ray Fair on Macroeconometrics

He writes,

Take a typical consumption function where consumption depends on current income and other things. Income is endogenous. In CC models using 2SLS, first stage regressors might include variables like government spending and tax rates, possibly lagged one quarter. Also, lagged endogenous variables might be used like lagged investment. If the error term in the consumption equation is serially correlated, it is easy to get rid of the serial correlation by estimating the serial correlation coefficients along with the structural coefficients in the equation. So assume that the remaining error term is iid. This error term is correlated with current income, but not with the first stage regressors, so consistent estimates can be obtained. This would not work and the equation would not be identified if all the first stage regressors were also explanatory variables in the equation, which is the identification criticism. However, it seems unlikely that all these variables are in the equation. Given that income is in the equation, why would government spending or tax rates or lagged investment also be in? In the CC framework, there are many zero restrictions for each structural equation, and so identification is rarely a problem. Theory rules out many variables per equation.

Pointer from Mark Thoma.

I am afraid that Ray Fair leaves out the main reason that I dismiss macroeconometric models, namely the “specification search” problem. As you can gather from the quoted paragraph, there are many ways to specify a macroeconometric model. Fair and other practitioners of his methods will try dozens of specifications before settling on an equation. As Edward Leamer pointed out in his book on specification searches, this process destroys the scientific/statistical basis of the model.

I have much more to say on this issue, both in my Science of Hubris paper and in my Memoirs of a Would-be Macroeconomist. In the latter, I recount the course that I took with Fair when he was a visiting professor at MIT.

Other remarks:

1. On DSGE, I think that the main vice is the “representative agent” consolidation. It completely goes against the specialization and trade way of thinking. Fighting the whole “representative agent” modeling approach is a major point of the Book of Arnold, or at least it is supposed to be. (I may have been too terse in the macro section of my first draft.)

2. VAR models are just a stupid waste of time. As I said in a previous post, we do not have the luxury of saying that we construct models that correspond with reality. What models do is allow us to describe what a possible world would look like, given the assumptions that are built into it. VAR models do not build in assumptions in any interesting way. That is claimed to be a feature, but in fact it is a huge bug.

I think that the project of building a model of the entire economy is unworkable, because the economy as whole consists of patterns of specialization and trade that are too complex to be captures in a model. But if you forced me to choose between VAR, DSGE, and the old-fashioned stuff Fair does, I would actually use that. At least his model can be used to make interesting statements about the relationship of assumptions to predicted outcomes. But that is all it is good for, and for my money you are just as well off making up something on the back of an envelope.

The Status of Models in Economics

Paul Romer says

Ultimately, the test of the model is its correspondence with the world. If we use certain frameworks, you can understand a much richer set of facts about the world. Growth is a difficult area to work because you’re addressing questions about the very long run, so you don’t have an abundance of data. You’re trying to invoke evidence from history over the very long run. We needed to come up with a way to think about all of these facts about the broad sweep of human history.

Math can be a very clear, concise, effective way to communicate ideas. What I saw in some of the people I was criticizing for mathiness was an almost obstinate adherence to positions, and then a use of any kind of mathematical argument that would support that position. What was missing was one of the characteristics of good science, which is to say “Well, given these new arguments, I may have been wrong before.”

Pointer from Mark Thoma.

Earlier, a reader’s comment brought me to Itzhak Gilboa’s review of a book by Mary Morgan.

Clearly, there are many instances in which economic analysis yields qualitative predictions, providing robust insights that allow us to predict trends, compare economic systems, and so forth. Yet, economics is not considered to be a successful science when quantitative predictions are concerned.

There is, however, another view of economics, by which it can have other successes: it is a field of enquiry whose goal is to critique reasoning about economic phenomena

This is an idea with chewing on. The purpose of a model, either theoretical or empirical, is not to provide a definitive “correspondence with the world,” as Romer would have it. Rather, it is to point out possibilities that deserve the attention of economists and those interested in economic policy.

Paul Romer and I Could Not Disagree More

He writes,

During my time at MIT, Robert Solow was harshly critical of the new classical macro models pioneered by Robert Lucas, dismissive in a way that seemed to me to skirt uncomfortably close contempt. I recall hearing the same type of criticism from Frank Hahn, who must have been visiting MIT. Looking back, perhaps I misinterpreted them because I was not familiar with the sarcasm and put-downs that were a part of British intellectual life that Solow had to confront in his exchanges with Joan Robinson. But if it sounded like contempt to me, others may have heard it the same way.

…The alternative to derision would have been for skeptics to embrace and extend. This was what Stan Fischer and Rudi Dornbusch, who were supervising almost all of the Ph.D. students at MIT doing anything related to macro, were quietly doing at this time. Fischer, Dornbusch, and their students absorbed the rebel critique of traditional macro, saw what something was missing in the first generation of rebel models, and set about extending them. As a result, Fischer and Dornbusch trained a cohort of Ph.D. students at MIT who put the tools of modern macro to work and as Krugman has observed, turned out to be unusually influential. If Dornbusch and Fischer had set the tone for the response to Lucas and his followers, things might have turned out differently. But because of the inherent instability of acrimony, grievance, and factionalism, they and their students could not undo the effect of the more hostile response.

Pointer from Mark Thoma.

I disagree with this so much that I can actually feel my anger.

1. Romer’s point is that Solow set a bad tone for macro, and all difficulties in the subject flowed from that. I call baloney sandwich. Solow did not set the tone for discussions in macroeconomics in this period. As Romer points out, by this point Fischer and Dornbusch dominated macro at MIT at this point.

2. Solow’s problem with Lucas was that Solow thought that reality should take precedence over microfoundations. Solow equated Lucas’ approach to macro with deciding that because one’s theory could not explain how a giraffe could pump adequate blood to its head that one had proven that giraffes do not have long necks.

3. I think that one problem in macro is that there are many theories that are consistent with observed reality. Freshwater macro happens to be one of the few that does not reconcile with reality. It deserves Solow’s disdain.

4. Romer thinks of Dornbusch and Fischer as heroes. To me, they are villains. They pushed the representative-agent, rational-expectations nonsense that is good for nothing but mathematical, er, self-abuse.

5. Even though Solow is a Keynesian partisan and I am not, I still feel connected to him because we share a view of what is wrong with the way macro has been pursued since the 1970s.

Someone recently emailed me that I should put my memoirs of a would-be macroeconomist on Amazon. For now, it’s freely available, and I think that Romer and others interested in his posts should read it. In fact, if you want to read it on Kindle, I am pretty sure that this file will work.

What Math Does and Does Not Do in Economics

Noah Smith updates us on the Paul Romer’s “mathiness” critique. He translates (without necessarily agreeing with) Romer as saying

If I could tell the freshwater economists just one thing, it would be that the rest of economics is doing things differently. Really. We’re out here being honest with each other, trying to get to the truth together, not politicking for our own pet theories. We’re being scientists. You can too. If you get outside your bubble, you’ll see I’m telling the truth.

Pointer from Mark Thoma. My comments:

1. Just as a point of clarification, in the debate between freshwater and saltwater economists, I am certainly not an advocate for freshwater economists. I am definitely in the “plague on both your houses” camp.

2. For this post, I would like to stipulate that saltwater economists are as detached and objective as they claim to be. Put aside my doubts about that for now.

3. What math can do is rigorously connect assumptions with conclusions. You manipulate the equations to show that the conclusions follow from the assumptions.

4. As Noah has pointed out on other occasions, economics differs from physics in that physicists usually can undertake direct tests of their assumptions, while economists generally cannot.

What point (4) means is that when we prove that assumptions a, b, and c together imply outcome X, and we instead observe outcome Y, we have no way of independently testing which of assumptions a, b, and c is untrue in the real world. Because there are so many plausible assumptions available to economists, this means that real world does not constrain economic models nearly as much as it does in physics.

Assumptions persist in economics as they get copied from paper to paper. That is, because of a combination of convenience and path dependence, not because of empirical verification.

I think that this makes the claims of “science” in economics quite dubious, and in macroeconomics downright fraudulent. Even if you think that there is a group of economists who is unbiased and objective, they are not entitled to don white lab coats.

Working More = Markets Working

Tim Harford writes,

A few years ago, the economists Mark Aguiar and Erik Hurst published a survey of how American work and leisure had evolved between 1965 and 2005. Both men and women had more leisure time — although nothing like as much as Keynes had expected. But some people defied this trend. The best educated and the highest earners, both men and women, had less free time than ever. Starting in the mid 1980s, this elite began to drop everything and work ­furiously.

Pointer from Mark Thoma.

What Harford does not mention is what I think is the most important trend, which is the drop in “home production.” We are making much better use of our non-work time, because we enjoy genuine leisure rather than doing unpaid tasks that we do not like.

Several decades ago, when an economist colleague bragged about building a deck on his house, I pronounced the aphorism “Do-it-yourself is a market failure.” He should have been able to earn more income by working more hours as an economist, and then pay someone else to build the deck. But he worked in a fixed-salary position for an employer that did not allow outside consulting.

The main trend is that people are doing less unpleasant work. As Harford notes, some people now enjoy their jobs. People are doing less unpaid housework (as I write this, a paid worker is mowing my lawn). Many people whose unpleasant jobs have been “lost” are now out of the labor force.

Against Identical Expectations

Noah Smith writes,

rational expectations might really be wrong. People might make systematic errors, thinking that booms or busts will last forever. If that’s the case, then it will require the economics profession to abandon one of its strongest orthodoxies. But the payoff could be big if the profession devises models that successfully explain phenomena like bubbles and crashes.

Pointer from Mark Thoma.

Smith cites (preliminary?) research by Jesse Bricker, Jacob Krimmel and Claudia Sahm, who

looked at data from the Survey of Consumer Finances, from before and after the housing crash in 2008. They found that more optimistic ZIP codes — that is, places where people had unrealistically high expectations for their own incomes — were more likely to overpay for houses in the bubble run-up before 2008. These overoptimistic people also took on more debt, and they were more likely to increase borrowing in response to rising house prices.

I have not found a write-up of this work. UPDATE: slides here. But my thoughts:

1. “Rational expectations” is one of an entire class of expectations models that I reject. I call this class “identical expectations,” because it assumes that every individual has the same model of the market and the same information, thus arriving at the same set of expectations. I find this both unrealistic and, as Frydman and Goldberg have pointed out, un-Hayekian, because it assumes away any sort of local knowledge.

2. If we are going to attempt a simple model of expectations, then I would suggest one in which there are two types of traders–momentum traders and contrarian traders. Momentum traders live by the maxim “the trend is your friend.” When prices have risen recently, they expect them to continue to rise. Contrarian traders live by the maxim, “if something cannot go on forever, it will stop.” When prices have risen recently to the point where they are above historical norms relative to fundamental measures of value, contrarian traders expect them to fall.

Momentum traders never see bubbles. Contrarian traders see bubbles everywhere.

Economists tend to be contrarian traders. Robert Shiller is the leading exemplar of this. Not all economists share his views, of course, but hardly any economist would confess to being a momentum trader.

Still, I think that there are times and situations where momentum trading dominates. Both Shiller and John Cochrane see momentum trading as something that can persist for a while in housing markets, because of the high costs facing traders who would try to take advantage of even well-founded contrarian views.

Update: Smith recommends a paper by Hong and Stein.

What the Fed Represents

John Cochrane writes,

The Fed should welcome limits on its responsibilities, and a clear and happy arrangement with Congress.

This might be true in a world where people were focused on implementation of Constitutional principles. But think about what the Fed represents. Do you remember when on health care people were saying that we need something like the Fed for health care?

The Fed represents the idea of experts with esoteric expertise who are independent from Congress. Their exercise of discretionary power is deemed vital for the health of society. The Fed thus represents the ultimate Progressive institution. Rational governance tames the free market. Non-partisan technocrats overcome the flaws in Constitutional democracy.

This mythical Fed is what is threatened by the sorts of laws that Cochrane was asked to testify about.

Don Kohn gives the mainstream response. Pointer from Mark Thoma.

Defining Money Like a State

Kathleen McNamara writes,

single currencies are never the product of debates about optimal economic solutions. Instead, currencies like the U.S. dollar itself are the result of political battles, where motivated actors try to centralize power. This has most often occurred “through iron and blood,” as Otto van Bismarck, the unifier of Germany put it, as a result of catastrophic wars. Smaller geographic units were brought together to build the modern nation state, with a unified fiscal system, a common national language that was often imposed by force, a unified legal system, and, a single currency. Put differently (with apologies to sociologist Charles Tilly), war makes the state, and the state makes the currency.

The U.S. case is instructive. America used to have a chaotic multitude of state currencies and privately issued bank notes, with complex exchange rates between them. This only changed thanks to the Civil War. The American greenback was created in 1863 when Abraham Lincoln’s Republican Party muscled through legislation giving the federal government exclusive currency rights. It was only able to do this because Southern legislators, who opposed more centralization of power, had seceded from the American union.

Pointer from Mark Thoma, who comments, “whether the euro was politically motivated for the most part, or not, economics matters for the sustainability of a political union.”

Price Stickiness is Only One Coordination Failure

Steven Randy Waldman writes,

For both firms and individuals, resistance to downward price adjustment is often rational, even when at a macroeconomic level universal downward adjustment would be desirable (perhaps because the central bank and/or state have failed to accommodate the expected path of nominal incomes, perhaps because nominal exchange rates are rigidly misaligned). If we could wave a magic wand and have wages, prices, and especially debts all simultaneously scale downward, that might be awesome. But, unfortunately, we can’t.

I think both Tyler Cowen and Mark Thoma pointed to this post. Read the whole thing.

The problem with the macroeconomic perspective is that when you think of the economy as a GDP factory, then the only reason you can think of for it not to operate at capacity is that the ratio of M to P is too low. Instead, if you think in terms of PSST, you can think of all sorts of reasons for coordination failure.

The chains of production are really long and complex. Somebody has a job doing “business development” for a company trying to make money out of an app. That job is so far from producing widgets that it is ridiculous.

In addition, pretty much everything we buy is discretionary. The seller of almost any product or service could wake up tomorrow and find the demand for that product or service poised to fall off. Need I cite landline telephones, retail music stores, or taxi drivers?

In the PSST story, the rigidities that matter are the burdens of trying to start a new business and the reluctance of people to relocate and to change occupations. The ratio of M to P just doesn’t amount to a hill of beans in an economy that depends on deep, complex coordination in the market process.