‘Uncertainty’ in Contemporary DSGE Modelling: Not Even Wrong

NOT EVEN WRONG

Confusion of thought and feeling leads to confusion of speech.

— John Maynard Keynes

Readers will note that I very rarely discuss DSGE modelling on here. Frankly, I’m not enormously interested. The fad is one in which economists — or, we should rather say: mathematicians with some loose economic training — have come to mistake analogy for literal explanation.

What do I mean by that? Simply that they have taken certain contingent theoretical statements made by previous generations of economists as Iron-Clad laws and then used these as building blocks to construct ever more Byzantine towers that tell us nothing about how the economy actually operates. This has given rise to a funny game where theorists no longer really build models to give us new insights. Rather they tend to try to integrate things that have already happened and thus they try to tailor their models to fit the discourse of the day.

For example, after the 2008 financial crisis a whole proliferation of models incorporating aspects of What Happened appeared. Theorists began to pick up on words that started appearing in the newspapers and so forth and then tried to incorporate these into their models. The models became the manner in which the theorists articulated What Happened to themselves. It is a truly bizarre ritual indeed. The theorists gain a fuzzy understanding of what actually happened and then incorporate this fuzzy understanding in an even fuzzier manner into a DSGE model and then convince themselves that they are engaged in scientific activity when really all they are doing is following a fad or news-trend.

One such approach that might be of particular interest to readers of this blog is an attempt by two economists by the names of Bianchi and Melosi to integrate ‘uncertainty’ into a DSGE model. If that smells funny, it should because the entire construction of such models seeks to eliminate uncertainty. But when you read the paper, entitled Modeling the Evolution of Expectations and Uncertainty in General Equilibrium, you quickly see that the authors do not understand the concepts they are dealing with.

When I read the title I thought to myself: “I bet they have mistaken risk for uncertainty” and indeed this is precisely what they have done. They basically turn the agents in the model into Bayesian calculators that tot up the probability of the economy entering various phases or states.

This leads to some truly bizarre statements. As readers will probably know a key component of uncertainty is due to the fact that we exist in a world where people exercise free decision. Thus we do not and cannot know what people are going to do in the future and must form judgements about the world by trying to anticipate what those around us will do. This is absolutely central to Keynes’ concepts of uncertainty and animal spirits and so on. The authors of the paper, on the other hand, write,

In our framework agents have always enough information to infer what the current state of the economy is or what other agents are doing: High or low growth, Hawkish or Dovish monetary policy, etc. Nevertheless, agents face uncertainty about the statistical properties of what they are observing. For example, agents could be uncertain about the persistence and the destination of a particular state. (p4 — My Emphasis)

After completely butchering the meaning of the term ‘uncertainty’ they proceed to violently attack other concepts. Next on the chopping block is ‘animal spirits’.

…the methods developed in this paper lay down a convenient framework for investigating the effects of changes in economic fundamentals or animal spirits on uncertainty and the feedback effects of such swings in uncertainty on the economic dynamics. (p37)

The authors genuinely think that in deploying Bayes’ probability theorem to human decision-making they have constructed an approach for studying ‘animal spirits’. But of course the very paragraph where Keynes, who knew more than a little bit about the philosophy of probability, introduces the term states crystal clearly that ‘animal spirits’ is unrelated to probability estimates.

Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits — of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. (My Emphasis)

This is a very simple point indeed and one that the authors could easily have picked up from either the source itself or the literature that grew up from it. In Keynesian economics we do not assume (a) that certain aspects of the future are reducible to probability estimates, or (b) that people act in a manner in which they take various events in the future to be calculable in numerical probabilistic terms and then apply this to reality in the form of Bayes’ theorem.

The level of scholarship in contemporary economics is absolutely shocking. Contemporary theorists just pick up on buzzwords that they hear in the media and then assume that they have understood these. Then they scramble to build some arcane model or other in which they assure others that they have captured the meaning of the buzzword in question. The mathematics then becomes a cloak hiding the fact that they have never bothered to actually think through the concepts they are using. Poor scholarship and lack of real understanding is perpetuated behind a wall of mathematics. The trick is that anyone who understands the mathematics is very likely not to understand the ideas in question. And so the whole circus can go on indefinitely.

Economists today no longer debate economics at all. They no longer want to talk about, for example, what the meaning of the idea of animal spirits has for economic theorising. Rather they want to busy themselves as fast as possible with applying whatever new trick they have learned in maths class. And then they think that they are saying something about the real economy! DSGE modelling and those that practice it are truly in the territory of not only not being right but not even being wrong.

Reading papers such as this one might well conclude that economics as an academic discipline is largely dead. Ideas are no longer actually debated. Words lose any clear meaning and become allusions to some mysterious and ever-changing x (did someone say ‘liquidity trap’!?). Mathematical consistency becomes confused with truth. The field becomes so garbled that anyone who wants to learn anything about economics has to tear themselves firmly away from it.

About pilkingtonphil

Philip Pilkington is a London-based economist and member of the Political Economy Research Group (PERG) at Kingston University. You can follow him on Twitter at @pilkingtonphil.
This entry was posted in Economic Theory. Bookmark the permalink.

79 Responses to ‘Uncertainty’ in Contemporary DSGE Modelling: Not Even Wrong

  1. ivansml says:

    “This is absolutely central to Keynes’ concepts”
    “the very paragraph where Keynes introduces the term”
    “In Keynesian economics we do not assume”

    So what? Authors do not claim anywhere that their paper is “keynesian”, much less that it presents a faithful model of Keynes’ thinking on probability. It’s a methodological paper that describes a particular way about how one could capture time-varying Bayesian beliefs in a formal economic model. The approach could be useful or not, but you have not provided a single specific criticism of their work, beyond some general and unsupported claims about how Bayesian framework is stupid (and no, “Keynes said so” is not really an argument).

    “The level of scholarship in contemporary economics is absolutely shocking”

    In fact, it’s the level of scholarship of certain post-Keynesian economists that is embarassing. Instead of engaging with matters of substance, they seem to prefer endless rounds of Keynes exegesis and theology-like debates over semantics. Keynes used a particular definition of the word uncertainty – anyone who uses the term differently must be a fool. Animal spirits? Keynes had said it all already, don’t bother. Attempting to model time-varying beliefs and learning about future in a Bayesian framework – a heresy, didn’t you read Keynes? This is religion, not scholarship.

    • Typical formulation. Cookie cutter. You avoid the criticism and start saying “exegesis” blablabla.

      The criticism is simple: uncertainty does not equal risk. And agents within the economy do not act in line with probability estimates. This is especially so when it comes to savings and investment decisions. If you want to make this claim YOU are the one that must substantiate it. If you do not then you are just engaging in tautology: “People make judgements based on probability estimates because I say they do”.

      This is shockingly easy to understand. You just don’t WANT to understand it because it means that you can’t engage in your totalising GIGO modelling which no one with any skin in the game would touch with a barge pole. So transparent.

      (Also the authors use the Keynesian term ‘animal spirits’ which is well-defined in the literature. They do not understand the meaning. Hence: poor scholarship.)

      • Jan Milch says:

        Balliol Croft, Cambridge
        27. ii. 06
        “My dear Bowley,

        I have not been able to lay my hands on any notes as to Mathematico-economics that would be of any use to you: and I have very indistinct memories of what I used to think on the subject. I never read mathematics now: in fact I have forgotten even how to integrate a good many things.

        marshallBut I know I had a growing feeling in the later years of my work at the subject that a good mathematical theorem dealing with economic hypotheses was very unlikely to be good economics: and I went more and more on the rules — (1) Use mathematics as a short-hand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life. (5) Burn the mathematics. (6) If you can’t succeed in 4, burn 3. This last I did often.

        I believe in Newton’s Principia Methods, because they carry so much of the ordinary mind with them. Mathematics used in a Fellowship thesis by a man who is not a mathematician by nature — and I have come across a good deal of that — seems to me an unmixed evil. And I think you should do all you can to prevent people from using Mathematics in cases in which the English language is as short as the Mathematical …

        Your emptyhandedly,

        Alfred Marshall
        http://www.rasmusen.org/zg601/readings/marshall.htm

  2. ivansml says:

    Thinking that everyone else is a moron – what a level of scholarship, indeed! Although most people would just call it “acting in bad faith”, or more simply “being a dick”.

    So, imagine that I know the difference between risk and uncertainty, and almost surely so do the authors that you criticize and insult. The real question is whether subjective uncertainty (where probabilities in frequentist sense are unknown) can still be formally represented using tools of probability.

    “And agents within the economy do not act in line with probability estimates. This is especially so when it comes to savings and investment decisions.”

    And how do we know that? Have you looked into people’s brains and studied neural correlates of decision-making under uncertainty? Or do you have a well-tested alternative theory providing a good match with data? No? Didn’t think so. Again, your whole evidence is “Keynes said”.

    Well, he also said this:

    “Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation of a series of prospective advantages and disadvantages, each multiplied by its appropriate probability, waiting to be summed.” (QJE 1937 paper)

    Thus even though people make decisions under conditions of uncertainty, not risk, they must act (how else could they?) as if they had in mind list of future possibilities, putting weights on different outcomes. A Bayesian would further assume that these weights satisfy probability axioms and are updated according to Bayes theorem, nothing more. This might still be false, but in principle one could easily make case that it’s compatible with (some of) what Keynes wrote.

    “Animal spirits” is nothing else than reevaluating these weights, in line with new evidence and various updating rules and heuristics that people use (to “behave in a manner which saves our faces as rational, economic men”). The core of Keynes’ argument is not that a particular belief updating rule is wrong – it’s the claim that people’s beliefs can vary over time, sometimes dramatically, and thus influence the economy in a way that previous static equilibrium models couldn’t capture. Interpreted in this wider context, work of Bianchi & Melosi is in fact pretty much “Keynesian”.

    Of course I don’t expect to convince you in any way, since you have made it clear that you have absolutely no interest in understanding this kind of research (why you then keep writing about it is a mystery).

    • So, imagine that I know the difference between risk and uncertainty, and almost surely so do the authors that you criticize and insult. The real question is whether subjective uncertainty (where probabilities in frequentist sense are unknown) can still be formally represented using tools of probability.

      This quote shows clearly that you don’t understand the difference between risk and uncertainty. It’s not me “being a dick”. It’s you being unable to understand the distinction. I can see that from your response and I can see that by the use of the terms ‘uncertainty’ and ‘animal spirits’ in the authors’ paper. That’s on you (and the authors) not on me. Sorry. Everything that follows in your response is based on this fundamental misunderstanding which you have shown time and again.

      But you STILL haven’t answered the central question (which you can’t answer and will never be able to answer): how do you justify thinking that people act in a Bayesian manner when forming decisions? You say that I have to prove that they don’t. But that’s not the way science works (I need not and cannot prove a negative although I can say that I cannot form objective probabilities about future events and so I doubt anyone else can). You have to justify the assertions you make. But you can’t. Because you and the rest of the DSGE modellers are not doing social science. You’re concocting self-referential garbage that is useless and no serious people use for economic analysis. Sorry, but that’s what you guys do. And most people today see through you. My job is to point it out over and over again until people stop emulating you, stop listening to you at central banks and, eventually, your species dies off in the academic sphere. And frankly, its going pretty well right now.

      • ivansml says:

        Risk – random outcomes governed by known frequentist probabilities, as in gambling or insurance.
        Uncertainty – random outcomes where such frequentist probabilities are unknown or inapplicable.

        This is the definition which Keynes used, and which I referred to in my comment. If you have something else in mind, please do enlighten us.

        Justification for Bayesian decision-making is that among decision rules that weigh various outcomes by degrees of belief (which, as Keynes wrote, is what we must do anyway, in one way or other), it satisfies some properties which we might consider as reasonable and rational. Thus it makes a good sense to use it as a benchmark in our models. But I have never claimed that Bayesian theory is the only correct one (in fact, there’s a lot of interesting research being done about its limitations e.g. related to ambiguity aversion), so I don’t see why I should prove anything. It’s you who has written a critical post full of strong hostile words, without backing them up. In fact, your responses here just confirm that you don’t even understand what the underlying debate is about.

      • Pontus says:

        Oh sweet, sweet Phil. First of all, no one claims that “probabilities” are objective, they are generally thought of as subjective (hence the name “subjective expected utility theory”). Can you form subjective probabilities? Or probabilities of probabilities? If the answer is yes, then you’re in Bianchi and Melosi’s world.

        And sure, that is how science works. You can “prove” negative (to the extent that things can be proven at all). Suppose I would say; “the earth does not orbit around the sun”, or “species do not evolve through the survival of the fittest”. Do you seriously think “science” grants me a free pass until I’m proven wrong? Statements like “agents within the economy do not act in line with probability estimates” can of course be tested.

      • @ivansml

        (1) Oh no! You’ve just failed the philosophy of probability 101. Repeat again next semester. But may I suggest that you have taken this course a few times now. Maybe its not your strongest point. Although from the latest gushings from your classmate Pontus, I can tell you for a fact you’re not the worst we’ve seen passing through in recent times.

        (2) You think that it’s “rational and reasonable” to think that people make decisions based on a theory that a fraction of a percent of the population understand? Tell me why do you think that such an assumption is “rational and reasonable”?

        @Pontus

        Before you start with your sophomoric attempts at philosophy maybe you’d care to sit down and have a cup of tea with Bertrand Russell. If you don’t get the reference then the debate is probably a tad outside of your scope.

        Although if you want to set up some experiments seeing if agents act in line with probability (this would be proof of a positive statement, but I digress) I’d be more than happy to attend… oh wait! Someone already did that, didn’t they? And they won a Nobel Prize for it, didn’t they? Remind me… what did they find again?

        As for forming subjective probabilities. You cannot form these for the vast majority of the material that economics deals with. So I guess we’re not in their world (not that we would have been even had I accepted the statement you put forward but I won’t burden you with too much for now… I know it takes a while for the gears to grind in that head of your’s).

      • Pontus says:

        Very poetic, Phil! “A cup of tea with Bertrand Russell”. Bravo!

        It is quite ironic, however, that it was precisely Russell’s teapot argument that I invoked to invalidate your reasoning. Claiming that “people don’t act according to X” and then shifting the burden of proof onto someone else falls exactly into that category.

        But as usual: It is difficult to get a man to understand something, when his livelihood depends on his not understanding it. But it is also really difficult to get a man to understand something when he is dim beyond belief. The combination of the two appears to be a powerful force.

      • ivansml says:

        (1) Oh please do tell me about this sophisticated philosophy of probability that I’m supposedly missing out. Otherwise, I’ll just assume you’ve got nothing to say.

        (2) I learned basic stuff about conditional probability in high school. It’s really not that hard, you should give it a try.

        (3) So you know about Kahneman and Tversky, good for you. Though you may look up bit more about their theory, a Wikipedia definition is a good start: “Prospect theory is a behavioral economic theory that describes the way people choose between probabilistic alternatives that involve risk, where the probabilities of outcomes are known.” (emphasis added)

      • @Pontus

        Time to reread your Russell. Or, you know, just the Wiki page.

        Russell’s teapot, sometimes called the celestial teapot or cosmic teapot, is an analogy first coined by the philosopher Bertrand Russell (1872–1970) to illustrate that the philosophic burden of proof lies upon a person making scientifically unfalsifiable claims rather than shifting the burden of proof to others

        But I don’t really want to debate with you on this one. Rather I want to raise something else. I note that you attended the PKSG workshop to give your commentary on a paper by Toralf Pusch last year. I found your commentary fascinating and I was wondering if you were considering writing it up and publishing it. I wanted to use some of it in my forthcoming book. Any plans on that front? Some of the insights were pretty fresh.

        @ivansml

        (1) What we’re talking about is a circumstance in which NO probability can be formed. Neither objective or subjective. Neither frequentist or Bayesian.

        (2) Good for you. How much of the population do you think understands it sufficiently to apply to all their decisions? Also, do you apply it to all your decisions? If not, why not?

        (3) I know. I was arguing on your terrain. But you still missed the point.

      • Pontus says:

        Did you perhaps miss the part with unfalsifiable claim? You claim that you cannot prove a negative, and that the burden of proof is instead on others. Jeez, Phil, all indians are not in the canoe, are they?

        No, no plans to publish a book. That was just a discussion which is quite common in academic circles.

        But your book is now forthcoming? May I ask under which publisher?

      • Pontus,

        Look back over the discussion. You clearly misread. A lot of what you do is tied up with that.

        Publisher TBA.

        But I didn’t ask you if you were publishing a book. I was asking you about your presentation and whether you would be writing it up. What do you think the most important point you brought to the table was?

      • Pontus says:

        My guess is that you do not have a publisher at all. And if you do, why the secrecy?

        I think I did a reasonable job explaining what Toralf did in his paper. Then I questioned whether it is useful or realist to consider the import-to-GDP ratio as a constant, and that some peculiarities followed (for instance, since world trade collapsed during the financial crisis, Toralf’s calculations suggested that the import share net of intermediate goods used for exports actually rose, and that the fiscal policy was less effective throughout the crisis than in the expansion preceding it. I don’t buy that).

      • No. No publisher as of yet. I’m meeting some this weekend. No secret.

        Right… it was that point about savings and investment that really stood out to me. Do you remember that point? Could you remind me what it was?

      • Pontus says:

        No, I don’t even recall mentioning investment. But your memory seems better than mine, so please go ahead and play your game.

      • Well, it’s just you said you’d been working a lot on something and it seemed to occupy most of presentation that appeared to be your own input on the matter at hand. Here’s a transcription of what I thought to be a fairly representative sample.

        I’ve been working a lot on these things myself… But government spending goes up then S goes up. So, the increase in government spending means that the government must borrow given a certain amount of taxes. It means that the savings must increase in order for the government to spend this money. And some people would argue that that means consumption goes down. If households are going to consume more they have to save less. That is just an identity. (@52.00)

        That statement: if households consume more then they have to save less. You claim that this is an identity. I thought that was fascinating. Now, at first glance I thought to myself “that isn’t an identity, that’s a causal argument”. But as you proceeded with your talk I began to see the wisdom of what you were saying. It really opened my eyes. Could you explain why you thought that was an identity? I’m just saying because it was central to your presentation and if you could summarise your logic I might be able to quote you in my book.

      • Pontus says:

        I don’t think you will get this, but this is a ceteris paribus argument. Holding everything else constant (in particular income), if a household wish to consume more, they must save less. Conversely, if a household wish to save more, they need to consume less. That’s an accounting identity, and not a causal statement. There is also another identity: If the public sector borrows, the private sector lends. Again it will, by accounting, show up as assets and liabilities accordingly on the public and private sectors’ balance sheets. Now, to make any further claims about the transmission mechanism of fiscal policy, these issues have to be addressed.

        I suppose you’re pulling another of your old tricks from the bag: intentionally misinterpreting in order to smear your antagonist. Well go ahead, but it ain’t pretty.

      • Right, yes, holding income constant. I see. Very interesting. And how do you hold income constant if households decide to “consume less”? I mean, E = Y, right? And E = C + I + G + (X -M), right? So, if the households consume less and save more then income cannot — in the stupid economist’s mind, not our minds Pontus! — be held constant, right?

        I mean I obviously totally get your point. But as I said this was very new to me and I would think that others would miss this. Certainly this is something that, say, idiots like Bob Solow and John Maynard Keynes have been getting totally wrong for so many years now its not even funny!

      • Pontus says:

        You are confusing the decision-making and accounting of one household with the decision-making and accounting of all households. I am speaking about the household level where no such coordination is going on.

        But sure, in the aggregate economy everyone cannot be a saver (or a borrower). Something has to give. In the Keynesian cross — which Toralf considered — the only variable free to adjust is output, and hey presto, out comes a change in output. In other models prices are allowed to change too.

      • That’s what I thought! I WAS confused at first!

        At first I thought that your presentation was that of a fumbler. An amateur with no basic grasp of macroeconomic argument. A third tier economist who takes out the anger generated by his obvious inadequacies on internet blogs. But then I realised that, of course! you were talking about a single household for the whole presentation. You were talking about a single household when considering the effects of government spending on savings (why wouldn’t you do this!?). (This even though you said: “If households are going to consume more they have to save less.” But that was obviously you misspeaking).

        I would encourage people to listen to Pontus’ contributions to our good science here. I, for one, will certainly be keeping an eye out on his future professional work. If people who have been watching the little shows he puts on for us on here have ever wondered what he does when he’s not entertaining the crowds, check it out. I know we have some fairly savvy folks reading this blog and I know that they’ll be able to drink from this particular fount of wisdom.

        When can we expect more public presentations, Pontus? We could start a section on the blog where readers ask questions (or post criticisms… but that’s unlikely! LOL!).

      • Pontus says:

        I don’t know where you are saving Phil, but if it’s in the bank the money will normally (and *normally* should be emphasized here) be funnelled to a borrower. That’s why you get interest (and that’s why excess reserves are normally zero). And why does someone borrow and pay interest? Probably to spend. And the borrowers money is worth as much to the shopkeeper as yours.

        So no, your decision to save, in isolation, does not reduce GDP with the same amount (times a multiplier) if you thought so. That’s plain stupid. When everyone does, however, that’s a different story.

      • I don’t know where you are saving Phil, but if it’s in the bank the money will normally (and *normally* should be emphasized here) be funnelled to a borrower. That’s why you get interest (and that’s why excess reserves are normally zero). And why does someone borrow and pay interest? Probably to spend.

        Probably to spend, Pontus? Or definitely to spend? We have to be rather clear on this one for the argument to work, don’t we?

        And why should *normally* be emphasised? Because if things aren’t “normal” you might be wrong?

      • pontus says:

        “Probably to spend, Pontus? Or definitely to spend? We have to be rather clear on this one for the argument to work, don’t we?”

        The only answer consistent with the fact that banks hold zero excess reserves is “definitely to spend”. If the individual would save, fine, it’s just another deposit (or asset bought) passed on to someone else. Ultimately it’s spent. If it’s not, excess reserves would shoot up (precisely as they did since 2008, which is not normal times).

        And no, I’m not wrong when things are not normal. That’s an odd conclusion. The analysis is just different. But it is *not normal* that must be stressed to tie the story together. This is not done by post-Keynesians – nor you – which is wrong and shows a tremendous misunderstanding of the actual workings of the economy.

        As for the household story, one must be capable to keep two arguments in one’s head at the same time to appreciate the reasoning. I believe your capabilities fail you here. The story of the decentralised household presents an obstacle that must be overcome for the argument to work. If you don’t provide it, you have nothing. You obviously lack the level of abstraction to understand this, but it’s your loss, not mine.

        You obviously haven’t read any of my written work.

      • pontus says:

        I follow your work? What work? Your blog? Or unpublished books? No, Phil, I’m sorry to disappoint, if you have actually done any work I have not followed it. And I doubt “we’ve been through this”.

        And diagnosing your opponent? The last bastion of mediocrity. Well done buddy. If you google you can also find my debate with Steve Keen. I’ll bet you’ll enjoy that.

        And what exactly did I “muck up”? So far you haven’t provided a single inconsistency. I suppose you post-Keynesians live happily in your backscratching lala-land hoping that no one will call your bluff. Unfortunately it’s all bunk.

      • Yes, Pontus. I know you find it hard to look in the reflective glass. But you’re here now, reading. You follow my work. The work I do on my blog where I sketch out ideas. You give me hits. You bump me up on Google. I mean, I get that you can’t understand that you’ve mucked up an argument (you have, sorry, that presentation was a mess; after the summary of the authors’ work your ruminations were either confused or said nothing) but surely you can understand that you click on a little tab quite regularly to see what Phil Pilkington has been up to.😉

      • pontus says:

        It’s like looking at a car accident. It’s really sad, but for some reason you just look. I’m sorry to hear that this is “your work”.

        “you have, sorry, that presentation was a mess” Oh well then, that settles it, doesn’t it? Why didn’t you just say so!?

      • I know. And you just can’t not tear yourself away. But for some reason even after listening to the PKSG performance I have no desire to seek out anything else you’ve written.

        Want to know why? Because you’re not… interesting. And I’d prefer to be an interesting car crash than a boring nobody.

      • philippe101 says:

        Pontus,

        “Government spending up means that S goes up. So an increase in government spending means that the government must borrow, given a certain amount of taxes, which means that saving must increase in order for government to spend this money. And some people would argue that that implies that consumption goes down. If households are going to save more they need to consume less, and that’s just an identity… So Robert Barro would for instance say a dollar spent by the government is a dollar borrowed by the government, which must be a dollar less spent by someone else. And that’s exactly what I’m saying here: that if the government must borrow, someone must save, and when someone saves, that person is consuming less.”

        I’m not sure that makes sense. The government spends the money it borrows into the economy – it doesn’t disappear.

        Private saving increases as a result of the government spending.

        Say current private saving equals $100. The government then sells a $100 bond. Private saving is unchanged. The government then spends the $100. Private saving goes up by $100 as a result. Consumption has not gone down.

      • Pontus says:

        Phillippe,

        Happy to engage in a constructive way.

        The problem with your argument is the following: If the government borrows £100, who does it borrow from? If it is from the private sector, their savings in government bonds must rise by the precise same amount (if it is from the CB or if it is through increasing inside money in whatever way, that is monetary policy and is beside the point). That’s an identity. Now, the issue is where do these additional savings in bonds come from. It can either come from a cut in consumption or a shift in the private sector’s portfolio of assets. If the change in portfolio is from investments to government bonds, that’s a fall in demand (I is part of the GDP identity too) by the precise same amount. If the change is in deposits, that’s a fall in someone else’s consumption or investment and a similar fall in demand (assuming zero excess reserves — more on that later). Lastly, if it’s a cut in consumption, the same result happens trivially. Of course, the fall in demand is counteracted one-for-one by the rise in government spending, so the net effect is a wash. However, if it is a portfolio shift out of holding money per se (meaning positive excess reserves) and into government bonds, THEN the story is different and a rise in government spending will immediately add to demand. But that is not normal times, that’s in a liquidity trap. And I’ve been clear about this throughout.

        So why does the Keynesian cross say something different? It assumes that the only moving parts are savings, consumption, and income. And it posits an iron clad positive causal relationship between the three of them. Savings cannot — by assumption — rise without an accompanying rise in income and output (unless we tamper with some constants, which is trivial). With that assumption anything that increases demand for savings (government deficits, net exports, investments) also leads to a rise in supply, which can only happen through a rise in income. This is a very strong assumption — although I do think it has some merit in times of a crisis — but generally it’s false.

      • Wah wah. Wrong.

        (1) Government borrows $100.

        (2) Private savings decline by $100.

        (3) Government spends the $100 the moment it acquires it.

        (4) Government spending accrues to a private sector savings account. (G-T)=(S-I)

        (5) Private sector saving is increased by $100.

        Net change in stock of private sector money saving: $0. Net change in stock of government borrowing: $100. Net change in stock of private sector saving held in government securities: $100.

        Economics is the science of confusing stocks and flows. — Michal Kalecki

      • Pontus says:

        (1) Agree.

        (2) Huh? How did this happen? The government and the private sector both borrow (relative to their previous positions), so S-I<G-T here. How can that be true. I think this part must be emphasized more clearly.

        (3) Wow that's fast. But let's assume it for the sake of the argument.

        (3a) How much is the change in spending right now? Government: +£100, private sector: +£100. Total spending has increased by £200.

        (4) That's an accounting identity relating the liabilities of the government to the (net) assets of the private sector. Stating that "government spending accrues on the private sector's savings account" is grossly misleading. Government debt show up in private savings is more accurate. But sure, the deficit is matched by a rise in saving.

        (5) So now savings go back to normal?

        Conclusions do not follow.

      • (1) N/A.

        (2) Government debits a bank account from a private sector individual (usually a primary market dealer) to the tune of $100 and then hands him/her a government bond.

        (2a) When you talk about borrowing relative to previous positions and so forth you are confusing identities with causal arguments. That was the main problem with your presentation and why it was brought to my attention. Here we are discussing the identities. Not the causal arguments. If you confuse the two you start to fumble.

        (3) N/A.

        (3a) Since we are considering identities and not causal relationships the change in expenditure is $100. It is the $100 that the government borrows and spends.

        (4) No. You’re confused. The cash savings accrue to the private sector. The government takes the cash it borrowed from the primary market dealer and hands it to, say, a policeman in the form of a salary. This then becomes the policeman’s cash savings.

        (5) Here is the new position of the financial accounts as they will show up in the Flow of Funds:

        (i) The primary bond dealer will have -$100 in cash savings taken by the government.

        (ii) The primary bond dealer will have +$100 in financial assets (government bills or bonds) given by the government.

        (iii) The policeman will have +$100 savings in the form of accrued wages from the government.

        (iv) The net private sector cash savings have remained the same as the policeman’s cash savings have increased by the same amount that the primary bond dealer’s cash savings have decreased.

        (v) The net private sector holding of financial assets has increased by $100 in the form of government securities held by the primary bond dealer.

        Now, this is before we talk about the causal chain this will set off which will involve the policeman’s multiplier and so forth. This is important but it is a second step in the argument. If you try to take two steps at once you will fall on your face. The reason we lay it out is to show the net end position of cash savings and financial assets in the system. This is how the FoF will look at the end of the period stated.

        Economic schools of thought do not differ in this regard — except some are more careful to teach national accounting and flow of funds properly than others — the differences in opinion come when we consider the causal effects that the action by the government will have. Your presentation was brought to my attention because it displayed serious confusions on these issues. Next time you can be more careful. If you want to become more familiar with these issues I suggest reading Godley and Lavoie’s book very carefully, ignoring the causal assumptions and exploring the accounting norms they set out carefully.

      • Pontus says:

        The cash savings of this, the cash savings of that. Here’s what I wrote before:

        “However, if it is a portfolio shift out of holding money per se (meaning positive excess reserves) and into government bonds, THEN the story is different and a rise in government spending will immediately add to demand. But that is not normal times, that’s in a liquidity trap. And I’ve been clear about this throughout.”

        So the point I made in the seminar was that this logic holds only if the economy is in a liquidity trap in which there are positive excess reserves (i.e. what you call “cash savings”). You seem to contest this view, yet you return to it when pressed. Funny that. Repeat the same argument with investment savings and you’ll see it’s all bunk. Precisely as I said in the seminar.

      • My contention is that this is an enormously fuzzy argument if you work through it step by step. Your presentation of it in the seminar was particularly poor — even by mainstream standards. Anyway, I don’t have time for this. I have writing to do. Send your students to some of the student-led research groups that are emerging in bulk — both online and in universities — in response to woolly arguments pushed into their heads in the mainstream departments (hello, free market!) if they want their ears cleared out. Most that I’ve encountered said to me “Yeah, we never really knew what those guys were on about. Now we see that they are just fumbling about”.

        In the meantime, here is pretty much the reaction your presentation got from the people on my end.

      • Pontus says:

        My contention of this is that your thinking on these matters is very disorganised. It’s precisely a step-by-step run-through that leads you to the conclusions I presented. I do not know what on earth makes you think that you can judge the quality of a seminar given your limited exposure and grasp of the literature, but I think that hubris has something to do with it.

        But best of luck finding that publisher. Maybe a pdf can count?

      • It’s precisely a step-by-step run-through that leads you to the conclusions I presented.

        LOL! Okay Pontus, I’ll lay down a challenge to you: put what you said into the balance-sheets used in the flow of funds. Seriously. Try it.

        Are you familiar with the flow of funds? Have you used it before? Do you know the accounting norms?

      • Pontus says:

        Sure, here it goes:

        The balance sheet of the private sector evolves according to

        w_t+b_t r_t-D b_t+q_t dd_t -J_t Dq_t – Dx_t=T_t +c_t

        where w_t is labor income, b_t is government debt, q_t is equity (at price J_t paying dividends dd_t), x_t is excess reserves, T_t is taxes and c_t is consumption. The operator D is defined as D x_t=x_{t+1}-x_t. (and just for you sanity: b_t, q_t, x_t are stocks, w_t, dd_t, c_t, T_t are flows)

        The balance sheet of the public sector evolves according to

        D x_t+T_t+Dd_t=g_t+d_t r_t

        where d_t is government debt (stock).

        By GDP accounting, y_t = w_t+q_t dd_t, so we can write the first equation as

        y_t + b_t r_t-D b_t -J_t Dq_t – Dx_t=T_t +c_t

        If you consolidate the private and public sectors constraints you get

        y_t=c_t+g_t+J_t D q_t

        where the last term is investment.

        No let’s focus on the government’s and the private sector’s constraints (repeated for convenience, with d_t=b_t imposed)

        y_t + d_t r_t-D d_t -J_t Dq_t – Dx_t=T_t +c_t
        D x_t+T_t+Dd_t-d_tr_t=g_t

        Now, a deficit financed increase in government spending is matched by an equal rise in Dd_t. So what has to give in the private sector’s constraint? Either a negative change of J_t Dq_t (investment), in c_t, or a negative change in Dx_t. In both first two cases the rise in g_t is precisely offset by a fall in c_t or investment (or a combination of both). In the latter case there is no such offset and the story goes through. But I’ve written this three times now.

        So here’s a challenge for you: Remove x_t from the equations above and repeat the exercise. See what happens.

      • This is not a flow of funds balance sheet. This looks more like something you have cooked up in your noodle that appears to have some sort of reserves constraint on lending (causal argument! not identity! duh!) which means that it cannot discuss the stock-flow relationships that I was trying to make clear to you.

        You’ve defined some arbitrary constraint and then imposed it. You’ve just built your previous muddled argument into equations, solved the equations and then assumed that you’ve proved something. Here is a comment from a philosopher of mathematics that responded to my article today. It is worth reading:

        I taught philosophy of economics for the first time last year, and found this point kept coming up. Coming from a philosophy of math background, it seemed obvious to me that there being sophisticated mathematics in a proof means nothing in terms of knowing whether you’re deriving actual results about the real world. Math is compatible with total real world falsity. But it turned out that to some, this was an idea that needed explication and justification — I found myself having to say quite a bit about the idea of math as a system in which you can make whatever assumptions you want.

        Apart from that, tell me next time you’re embarrassing yourself in public. I might even turn up to throw some questions at you. See how you fair when you’re put on the spot in front of an audience and called out when confusing identities with causal arguments. Others see it they are just too polite to say it. Maybe its time someone pointed it out in a public forum.

        You just keep doing it. It’s truly bizarre. I ask you for a flow of funds balance sheet (an accounting tool), you give me a highly contentious causal account of reserve constraints on government sector borrowing. You’re trying to take two steps forward at the same time and you’re falling flat on your face.

      • Pontus says:

        That’s a stock flow consistent model of a very standard type. You can rearrange the constraint of the private sector to

        y_t + d_t(1+r_t)+q_t(dd_t+J_t)+x_t=T_t +c_t+x_{t+1}+J_t q_{t+1}

        where the left hand side is assets (accrued income plus financial assets) and the right hand side is liabilities (taxes and accounts payable (c_t, x_{t+1},J_t q_{t+1})). The same goes for the government’s constraint.

      • First of all, and for the last time: I didn’t ask you for a model. In your presentation you said that you were discussing identities. Identities are not models/causal arguments. That is what I’ve been saying the whole time. You keep confusing the two. That is why I say you are fumbling.

        If you worked it through consistently you would see that the constraint you are imposing might be highly misleading for any number of reasons. But you can’t even get to that point and I really don’t have time for this.

        Again, tell me when you’re appearing in public next. I’m slightly intrigued…

      • philippe101 says:

        Pontus,

        “The problem with your argument is the following: If the government borrows £100, who does it borrow from? If it is from the private sector, their savings in government bonds must rise by the precise same amount (if it is from the CB or if it is through increasing inside money in whatever way, that is monetary policy and is beside the point)… …. (assuming zero excess reserves — more on that later)… However, if it is a portfolio shift out of holding money per se (meaning positive excess reserves) and into government bonds, THEN the story is different and a rise in government spending will immediately add to demand. But that is not normal times, that’s in a liquidity trap.”

        When the government borrows, the Treasury sells bonds and receives a credit to its account at the central bank. This means that reserves are drained from the commercial banking system and into the Treasury’s account. If there are no excess reserves in the banking system, this will cause the interbank interest rate to rise, unless the central bank intervenes. In a country like the US, the central bank targets a certain interbank interest rate, and so it necessarily intervenes to offset the reserve drain, if a rise in the interbank interest rate is inconsistent with its target.

        Say for example that the US Treasury sells a $100 bond. Assuming there are no excess reserves in the banking system, the Fed will have to add $100 reserves to the system (via repo for example) to ensure that the Treasury’s reserve drain does not cause the Fed Funds rate to rise (assuming it wants the FF rate to remain at its current level). Then, when the Treasury spends, the opposite will happen. The spending will add excess reserves to the banking system, causing the FF rate to fall, unless the Fed intervenes to drain reserves (undoing previous repos for example). In the US they also use a system of Tax and Loan accounts to facilitate the management of reserve balances, but the above describes the basic logic.

        So the reality is that in the US, fiscal and monetary policy, or actions by the Treasury and the Fed, are necessarily closely linked. This is stated clearly in the Fed’s own literature:

        “Repos and reverse repurchase transactions are particularly useful in offsetting temporary swings in the level of bank reserves caused by such volatile factors as float, currency held by the public and Treasury deposits at Federal Reserve Banks.”
        http://www.newyorkfed.org/aboutthefed/fedpoint/fed04.html

        “Understanding the relationship between Federal Reserve credit policy and Treasury cash management is important because the relationship illuminates an important but sometimes unappreciated interface between the Treasury and the Fed. It also underscores the symbiotic relationship between the two institutions, in which each assists the other in fulfilling its statutory responsibilities… At first impression, the Federal Reserve and Treasury mandates might seem sufficiently distinct that the two institutions should be able to function independently of each other. However, the Treasury funnels most of its receipts into, and it disburses most of its payments from, the TGA. Thus, there is a continuous flow of funds from private depository institutions to the TGA and back again. During fiscal year 2010, $11.6 trillion flowed into, and then out of, the TGA. Flows of funds between the TGA and private depository institutions were important prior to the crisis because the TGA is maintained on the books of the Federal Reserve; increases in TGA balances stemming from Treasury net receipts drained reserves from the banking system and, in the absence of offsetting actions, put upward pressure on the federal funds rate. Conversely, decreases in TGA balances resulting from Treasury net expenditures added reserves to the banking system and, absent offsetting actions, put downward pressure on the funds rate. This dynamic created an important interface between Treasury and Federal Reserve operations… If, in the pre-crisis regime, the Treasury had deposited all of its receipts in the TGA as soon as they came in, and if it had held the funds in the TGA until they were disbursed, the supply of reserves available to the banking system—and hence the overnight federal funds rate—would have exhibited undesirable volatility. To dampen the volatility, the Fed would have had to conduct frequent and large-scale open market operations, draining reserves when TGA balances were declining and adding reserves when TGA balances were rising.”

        http://www.newyorkfed.org/research/current_issues/ci18-3.pdf

        The result of this is that it doesn’t matter whether banks have excess reserves or not, as the Fed provides and drains reserves as needed to ensure that payments to and from the Treasury can be made without affecting its interest rate target. What is actually relevant is not excess reserves (or lack thereof), but the interest rate target and general monetary policy of the Fed. If the Fed thinks that government spending will be excessively inflationary, it might raise the FF rate (or allow it to rise), and if not, then it might hold the FF rate steady or lower it.

      • philippe101 says:

        Phil, I’ve got a comment with two links awaiting moderation above.

      • Got it. But you’re wasting your time. Pontus has a model in his head and he will not reevaluate its contents.

        Anyway, outside of his confusing models and identities (which is really the key issue here) you’re conceding to him on the idea that new money creation is needed or else the government bond rate rises. This is not actually clear at all. I will write up a post with historical data on this tomorrow given that there is some confusion on this matter.

      • philippe101 says:

        Phil,

        “you’re conceding to him on the idea that new money creation is needed or else the government bond rate rises”

        In my example above there is only a temporary increase in reserve balances, to facilitate payments to and from the Treasury without disturbing the Fed’s monetary policy.

        However, if the government’s deficit spending resulted in a net increase in reservable bank deposits, then the Fed could increase the amount of reserve balances to meet the increase in required reserves (without changing the FF rate), meaning that the net result of the deficit spending would be an increase in reserve balances and deposits.

      • I know. But you actually don’t need this argument. I’ve written a post with clear data from the UK in the early 18th century (when OMOs were but a sparkle in the BoE governor’s eye). I will post it tomorrow morning. I think you’ll like it. It’s related to the financial theory that I’ve been working on and which appears in one of the chapters in my book.

      • Pontus says:

        Philippe,

        You are correct: If the CB keeps the interbank rate fixed, then the effect is identical whether or not there are excess reserves. This is well known in the literature (see, for instance, Christiano, Eichenbaum and Rebelo (2011)). However, the fiscal policy you are discussing is not valid when the central bank has an inflation target instead of a policy rate target.

        Phil,

        I have no idea why you keep on saying that I’m using a model. I’m using accounting identities only: no causal arguments, no behavioural assumptions. Simply relating stocks to flows in a manner consistent with NIPA. It’s mindblowing that the heterdox’ finest (ehm …) do not know basic accounting.

      • What does one do with a man who is confused about his own confusion?

        A reserve constraint is a causal argument (i.e. a model). If you don’t understand that, I can’t help you.

        But again, do tell me when you’re appearing in public next. Or I might keep an eye out. See how this stands up in public when those that are too polite to say so aren’t falling asleep.

      • Pontus says:

        Philippe,

        Yes that’s the paper. You can see that they even speak about “the constant interest-rate multiplier”, but that they use the situation of a liquidity trap as a natural candidate for this to be the case.

        Phil,

        There are no reserve constraints in the equations I gave you. Reserves are there in notation, you can set them to zero if you wish. I left it unconstrained.

      • I sometimes wonder if you believe some of the stuff you say on here.

        If you want to learn about ‘crowding out’ there will be a post using some data and laying out the argument clearly on here tomorrow morning. I wouldn’t expect that you’ll understand it but if you have any students to whom you are teaching anything to do with government borrowing you might run it by them… Or I could just run it by the group of students at Cambridge who are protesting the teaching that is being done there. Nice work on generating that, by the way. You guys are doing a heck of a job… generating potential customers for my book!😀

      • Also if there are no reserve constraints in your model (yea, its a model) then you have not explained WHY there is a borrowing constraint on various sectors. Again, you’ve laid it out in maths and then assumed it to be correct.

        I take it that you were that kid in class who didn’t understand anything and just repeated what the teacher said to try to get approval. It came across that way in your presentation. “Smart enough guy. But doesn’t seem to have an in depth knowledge of the material he has learned by rote. Confuses repetition with understanding.”. And so on.

      • philippe101 says:

        Pontus,

        “If the CB keeps the interbank rate fixed, then the effect is identical whether or not there are excess reserves… However, the fiscal policy you are discussing is not valid when the central bank has an inflation target instead of a policy rate target.”

        It seems to me that your argument is not really about excess reserves or lack thereof, at all. What you seem to be saying is that the central bank can fully offset any changes in fiscal policy (except at the ZLB?), that it can always hit its inflation target regardless of what happens to fiscal policy, and that it will always choose to fully offset any changes in fiscal policy (except at the ZLB), by raising or lowering the interbank rate (etc). Is this correct?

      • philippe101 says:

        also, you’re saying that (when not at the ZLB) inflation is always at the CB’s target rate, and any expansionary increase in government spending automatically leads the CB to raise the interbank interest rate, which leads to a reduction in private investment and/or consumption which is exactly equal to the increase in government spending. Correct?

      • Pontus says:

        Philippe,

        Yes this is true. Even if there are zero excess reserves, a rise in government spending will have a sharp impact on demand if interbank rates are unchanged. However, if they are unchanged and there are no excess reserved, this rise in government spending will then be followed by increase in the monetary base (which does not happen when there are excess reserves). A lot of economists would consider such an accompanying rise in the monetary base as monetary, and not fiscal, policy.

      • Basically, Philippe, he is saying that the CB will accommodate at the overnight rate. Standard Taylor Rule stuff. Queue: natural rate of interest theory.

      • philippe101 says:

        Pontus,

        if my description of your argument is accurate, and if your argument is correct, then shouldn’t we expect to see the following when looking at past data:

        1. A rising Fed Funds rate whenever the government budget deficit increases.

        2. Inflation constantly at a certain rate (2%, if that is indeed the Fed’s target)

        ?

      • Pontus says:

        Philippe,

        These theoretical predictions are ceteris paribus. That’s why models are used in the first place: To isolate the effect of one variable, holding whatever else we like constant. The data is not so kind. The prediction of the model is instead that the funds rate should be larger relative to the situation in which the budget deficit had not expanded (it goes up, therefore, only in relation to the “counterfactual”). So how do you approach this? Well, you can’t just eyeball historical data charts. You will have to do some econometrics. There are several studies on this topic and I believe the main predictions are correct.

        As for the inflation target, the US doesn’t have one (‘the dual mandate’). But no one would believe, and no relatively realistic model would predict, that the target is always met. But looking at US inflation after the 70’s, it’s a reasonably accurate policy. And looking at Sweden for instance — who has a 2% inflation target enacted in 1992 — the evidence is quite supportive: http://research.stlouisfed.org/fred2/graph/?g=Eky

    • philippe101 says:

      take a deep breath and write the next comment without including an insult. Or write the insult, if it makes you feel better, and then delete it as irrelevant before posting the comment.

    • LK says:

      “The real question is whether subjective uncertainty (where probabilities in frequentist sense are unknown)”

      No, in cases of epistemic probability, frequentist probabilities do not even exist. And probability (if you can give a epistemic probability) and uncertainty is not quantifiable in the way you can quantify the probability of, say, rolling a 6 at a fair game of dice.

    • Pontus says:

      Philippe,

      Yes that’s the paper. You can see that they even speak about “the constant interest-rate multiplier”, but that they use the situation of a liquidity trap as a natural candidate for this to be the case.

      Phil,

      There are no reserve constraints in the equations I gave you. Reserves are there in notation, you can set them to zero if you wish. I left it unconstrained.

  3. paul davidson says:

    ,since the early 1980s I have tried to introduce uncertainty as a statistical concept involving nonergodic stochastic processes . In such a nonergodic process, probability distributions calculated from past and currently available data are not a significant representation of the probability distribution that will govern future outcomes.

    My concept of uncertainty convinced people like Nobel Laureate John Hicks who wrote that he should have called his vision of macroeconomics as a nonergodic system — and that his ISLM model is not Keynes.

    Unforturtunately Paul Samuelson has written that if we are to make economic a science then we must assume the “ergodic ” axiom — and Nobel Laureates Samuelson and Solow, in discussions with me and my analysis, denied the possibility that economics can involve nonergodic systems.

    Thus Dynamic equilibrium fools are merely blindly following Samuelson and Solow who, despite wanting to be labeled Keynesians, had not the slightest idea of what Keynes’s general theory involved.

  4. This Pilkington x Ivansml riot is very representative of what happens within the economics academy. Using the representative agent model, which I’m not fond of, this discussion you had can be aggregated to display the macro behavior of economists debates. It’s almost a non-debate, or a war over semantics. It’s embarrassing that economists with different perspectives cannot have a decent debate without keeping their dicks to themselves. My feeling is that we shouldn’t be so certain about a theory to the point that we cannot even have a productive debate. It shouldn’t be about who is right, We will never have a comprehensible model of the world. It’s clear that by now Ivansml could have understood Pilkington’s point, that uncertainty is about nonergodic processes. But he chooses not to because he is too focused on his position. On the other hand, Ivansml made a very good point quoting QJE 1937 paper, providing a different interpretation for Keynes that intrigued me, for I would have never thought of Keynes saying something like that.
    So, with all due respect, even though I agree with your post and your position about DSGE models, I think you could answer to this particular point that Ivansml has made, for it is the most controversial, and leave aside personal disputes. I’m very curious on how would you answer to this quote from QJE 1937 paper.

    • If you’re interested in following up the Keynes quote read Shackle. He developed a theory of “possibilities” rather than probabilities in this direction.

      As to the tone, you must understand that there is no convincing people on this one. People like ivansml are hardwired to think in this way. This debate started when Keynes published the GT. It’s not a case of convincing people with intellectual capital already sunk. It’s a case of convincing everyone else. And few people engaged in real world activity believe in the fantasies of the DSGE modellers. Otherwise they’d be using the damn models!

    • ivansml says:

      Thiago: Ergodicity has nothing to do with this. Nonergodic world is a problem for rational expectations. RE assumes that agent’s subjective beliefs are (perhaps after a period of learning) equal to objective frequencies of events in the economy, and for the latter to be defined, the economy must be stationary and ergodic. Fair enough, I think this is a legitimate problem. But even in a nonergodic world, people must have some beliefs about the future (whichever way they arrive at them), and I see no apriori reason why these beliefs cannot take form of a Bayesian prior.

      • Bragi Bragason says:

        @Ivansml

        Ergodicity has a lot to do with this…

        “Unfortunately, in most economies, the underlying distributions can shift unexpectedly. This vitiates any assumption of stationarity. The consequences for DSGEs are profound. As we explain below, the mathematical basis of a DSGE model fails when distributions shift (Hendry and Mizon 2014). This would be like a fire station automatically burning down at every outbreak of a fire. Economic agents are affected by, and notice such shifts. They consequently change their plans, and perhaps the way they form their expectations. When they do so, they violate the key assumptions on which DSGEs are built.

        The key is the difference between intrinsic and extrinsic unpredictability. Intrinsic unpredictability is the standard economic randomness – a random draw from a known distribution. Extrinsic unpredictability is an ‘unknown unknown’ so that the conditional and unconditional probabilities of outcomes cannot be accurately calculated in advance.
        Extrinsic unpredictability derives from unanticipated shifts of the distributions of economic variables at unpredicted times. Of these, location shifts (changes in the means of distributions) have the most pernicious effects. The reason is that they lead to systematically biased expectations and forecast failure….

        Most macroeconomic variables have experienced abrupt shifts, of which the Financial Crisis and Great Recession are just the latest exemplars.

        The basic point is simple. We say an error term is intrinsically unpredictable if it is drawn from, for example, a normal distribution with mean µt and a known variance. If the mean of the distribution cannot be established in advance, then we say the error is also extrinsically unpredictable. In this case, the conditional expectation of the shock needs not have mean zero for the outcome at t+1. The forecast is being made with the ‘wrong’ distribution – a distribution with mean µt, when in fact the mean is µt+1. Naturally, the conditional expectation formed at t is not an unbiased predictor of the outcome at t +1.

        It seems unlikely that economic agents are any more successful than professional economists in foreseeing when breaks will occur, or divining their properties from one or two observations after they have happened. That link with forecast failure has important implications for economic theories about agents’ expectations formation in a world with extrinsic unpredictability. General equilibrium theories rely heavily on ceteris paribus assumptions – especially the assumption that equilibria do not shift unexpectedly. The standard response to this is called the law of iterated expectations. Unfortunately, as we now show, the law of iterated expectations does not apply inter-temporally when the distributions on which the expectations are based change over time. …

        Much of the economics literature (e.g. Campbell and Shiller 1987) assumes that such shifts are intrinsically unpredictable since they depend upon the random innovation to information that becomes known only one period later…

        The point is that the new distributional form has to be learned over time, and may have shifted again in the meantime.4 The mean of the current and future distributions (µt and µt+1) need to be estimated. This is a nearly intractable task for agents – or econometricians – when distributions are shifting….

        Unanticipated changes in underlying probability distributions – so-called location shifts – have long been the source of forecast failure. Here, we have established their detrimental impact on economic analyses involving conditional expectations and inter-temporal derivations. As a consequence, dynamic stochastic general equilibrium models are inherently non-structural; their mathematical basis fails when substantive distributional shifts occur.”

        References:

        http://mikenormaneconomics.blogspot.com/2014/06/david-f-hendry-and-grayham-e-mizon-why.html

        http://www.voxeu.org/article/why-standard-macro-models-fail-crises

      • Yup. This is gaining major traction right now.

  5. racontron says:

    wow, so much for a reasonable discussion without ad hominem arguments.

  6. skippy says:

    Juicy thread on the viability of modeling [DSGE] fear against desire… or what does gawd think when he watches me masturbate…. in the full knowlage I know hes watching me…. when I don’t care or…. stop believing [considered {possibility} thought] – in him – full stop.

    skippy…. I needs more pron pilkingtonphil!!!

    Amends~~~

  7. Pingback: Uncertainty in Contemporary DSGE Modeling: Not Even Wrong

  8. Dende says:

    “In fact, it’s the level of scholarship of certain post-Keynesian economists that is embarassing. Instead of engaging with matters of substance, they seem to prefer endless rounds of Keynes exegesis and theology-like debates over semantics.”

    This. Here we have an example of the religious nature of these folks:

    “Thus Dynamic equilibrium fools are merely blindly following Samuelson and Solow who, despite wanting to be labeled Keynesians, had not the slightest idea of what Keynes’s general theory involved.”

    Now there are brilliant Post-Keynesians like Minsky or Koo and of course Godley who spear-headed flow of funds analysis. But guys like Davidson or Pilkington are not even economists. They whine all day about something which they do not understand in the first place and are inherently scientific as they claim that non-ergodicity plus Knightian uncertainty makes the future totally unpredictable. As Ivan said, these folks are indeed in the realm of religion and not in the realm of social science. “Keynes said ABC so you are wrong” (What they are actually doing is of course just focus on the most irrelevant things that Keynes wrote. They talk about non-ergodicity, a term Keynes never used, and Knightian uncertainty which is not in the GT, and not at all about all the dreary technical stuff that is in the GE.) is arguing from authority and inherently unscientific.

    • Most of the above comment is either wrong or incoherent.

      Minsky obviously wrote a lot on issues of uncertainty, for example. Anyone who reads his work would also know that its central to his theories. And Koo is not a Post-Keynesian. Again, we see those low levels of scholarship creeping in. You obviously picked up on Minsky and Koo from Krugman. So, it’s another buzzword. You’re confirming exactly what I discussed in the piece with these comments. Thanks… I guess.

  9. Dende says:

    “My job is to point it out over and over again until people stop emulating you, stop listening to you at central banks and, eventually, your species dies off in the academic sphere. And frankly, its going pretty well right now.”

    Yeah, right. Janet Yellen is so totally listening to you and totally not to people who actually do constructive work every day.
    Central banks have a lot of responsibilities which is why they use actual models. Non-ergodicity and Knightian uncertainty imply that you cannot model anything, the future is unknowable.

    • Again, please provide clear evidence that Yellen makes decisions based on DSGE models and does not just diplomatically support them because of her position in the profession.

      • Wonky says:

        The basic outline of the models the FED has been published. Like most central banks it is pragmatic and uses a core DSGE model plus a periphery with VARs. It is basically a Old-New Keynesian hybrid. Now I hope that they read their Minsky, Godley and Koo and also use Post-Keynesian ingredients like SFC.
        This is important to keep in mind as some folks pretend that CBs are dogmatic Woodfordians.

        Now of course we all know that these models are not ruling, they just inform the decision makers. But not using models and just flying by the seats of your pants (like all the hard money assholes on the board do) is definitely not an option and I doubt that you could explain the recent actions of the FED if you assume that Yellen were ignoring the models.

        As I already wrote, I am not a fan of DSGE. But I am not a fan of people who think that economics should be pre-analytic either. Of course I don’t want to discount methodological criticism, it is vital to make theoretical progress. But this progress has to materialize into something which you can work with and feed with data, i.e. a model.

      • But this progress has to materialize into something which you can work with and feed with data, i.e. a model.

        Why?

  10. Dende says:

    “You think that it’s “rational and reasonable” to think that people make decisions based on a theory that a fraction of a percent of the population understand?”

    Embarassing. Behaving and understanding why you behave the way you do is a large difference. People have done things for millenia and it was not until the 19th century that we developed decent explanations for it. We all behave economically every day but even the best economists in the world do not understand even themselves perfectly.

    It is always the same, you are confused about the most elementary stuff.

    • An epistemologically dubious claim. But even if we take at face value what you’re saying: do you have any evidence that people behave in this way? So far as I know the experimental results show exactly the opposite even when the people are given ergodic distributions.

      You see, the key here is that the onus is on DSGE supporters to prove the argument that agents act in line with Bayesian probability theory. The onus is not on the critics.

  11. Pingback: Thoughts on the Economics Curriculum Reform Movement

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s