Shadow-boxing with DSGE Models

Lars Syll has recently linked to a post by Noah Smith criticising DSGE models. Criticising DSGE models is the latest fad in mainstream macroeconomics — hey, it’s easy to use the model that was in fashion just before the crisis as a scapegoat to distract the profession from the fact that they still have no idea how to begin to explain the crisis or its aftermath.

I’m somewhat miffed that Syll gave Smith a pass on this one, to be honest. These criticisms of the DSGE models are so transparently self-serving that they really need to be called out. I can show this quite clearly by breaking down Smith’s argument and reconstructing it in a somewhat different way. Once this is done such criticisms of DSGE models can be seen as what they are: a rearguard defence mounted to prop up a rapidly decaying intellectual program.

Okay, so Smith’s post focuses on the fact that a key component of DSGE models called the Euler Equation is empirically wrong. Basically the Euler Equation states that when interest rates rise consumption will fall. The idea here is that the interest rate is a reward for forgoing consumption — i.e. saving — and so when it rises saving increases and consumption falls.

As Smith notes this simply doesn’t square with the data. In actual fact we see that in reality when interest rates rise consumption also rises. Smith makes no attempt to explain why this is the case — mainstream economists these days, obsessed as they are with their little models, don’t care much about causality and explanation — but it might be worth noting that this is probably, as Nicholas Kaldor noted in his study of the monetarist interest rate hikes in the late-70s and early-80s, due to the fact that higher interest rates add to savings which then produces a sort of wealth effect where the interest income stimulates consumption.

Now, let’s break down the steps implicit in Smith’s argument to see what, for him, constitutes a viable argument.

1. Step one is that a hypothesis is created. In this case it is the idea that consumption should fall when interest rates rise.

2. Step two is that this hypothesis should be tested against the data.

3. Step three is that when we find that the data contradicts the hypothesis then the hypothesis is dropped.

Okay, this all seems pretty obvious, right? Well, why don’t we apply the same criteria to one of the marginalist sacred cows?

You see, in his post Smith notes that the argument he lays out also relies on the idea of a utility-maximising agent whose preferences can be fixed. But of course we all know that this idea does not stand up to empirical scrutiny. After all, Daniel Kahneman won a Nobel Prize in economics showing just that. So, not only do we have data on this hypothesis but we also know that this data is accepted by the mainstream economics community.

Well, by Smith’s own criteria shouldn’t that make the idea of a utility-maximising agent just as dodgy as that of the Euler Equation? Of course it should but Smith marches on regardless without criticising the utility-maximising agent even though it would be falsified using the same criteria as he uses to falsify a theory that he doesn’t like — that is, DSGE models.

This is what mainstream economics has turned into. Economists bicker amongst themselves over models that are obvious nonsense. They will use criteria to prove or to falsify such models that when turned around on beliefs they all hold in common would demolish these too. It is a bizarre show.

Basically this is a group of people vying for the Throne of Macro all the while secretly terrified that anyone will push the scientific criteria they claim to uphold too far and expose the fact that the Emperor is naked. How long can this carnival last? Well, if we look back on the last time such a discourse was firmly entrenched — that is, during the Scholastic era in the Middle Ages — we can be confident that it will last as long as those in power put up with it. With regards to mainstream economics that day might well be coming to an end.


About pilkingtonphil

Philip Pilkington is a macroeconomist and investment professional. Writing about all things macro and investment. Views my own.You can follow him on Twitter at @philippilk.
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6 Responses to Shadow-boxing with DSGE Models

  1. Paul Davidson says:

    that day coming soon to an end! Ha! that’s a laugh! and its nonsense –mainstream are circling the wagons around their thesis of welfare maximizing individuals!

    • I’m not sure, Paul. I think the politics is going to outstrip the economics on this one, to be honest. Like what happened with monetarism in the 1970s.

      • NeilW says:

        The politics will end up being a fudge though. There is nothing I can see that involves any politician doing anything to upset their well-heeled funders.

  2. Kieran Latty says:

    Well, there is already a large and growing literature that now goes beyond the fringe of mainstream economics that explicitly rejects the standard rationality postulates, and which often produces some quite radically egalitarian and/or interventionist conclusions.

    • Yes, but the question then arises: are the non-standard rationality postulates that they are using in line with how people actually behave? All the postulates that I have seen strike me as rather dubious.

      Also the fact that you seem to champion these because they produce “radically egalitarian and/or interventionist conclusions” strikes me as leaving you open to the accusation that you are deciding what you WANT your model to show first and then seeking out a model that shows this.

      But again, that’s not really the issue here. The issue here is that Smith will criticise the DSGE based on the savings/interest rate connection from an empirical point-of-view but he will not criticise the utility maximising agents in the model which are subject to an identical critique.

      • Kieran Latty says:

        That was actually meant to be a reply to Paul. Some of the better work in the the literature I am referring to utilize behavioral functions that incorporate insights from institutionalist and behavioral economics that are very well supported empirically.

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