Thought for the day: Horatio economists
from Merijn Knibbe
There are more things in heaven and earth, Horatio,
Than are dreamt of in your philosophy.
Recently, two Dutch economists, Johan de Jong and Jasper Verbruggen, published an analysis of the predictive power of economic models (http://www.tpedigitaal.nl/assets/static/1_Jong-Verbruggen-1-2011.pdf).
Their results are clear:
1. Models are to some extent able to predict the present and the recent past (i.e. ‘predicting’ present consumption or inflation before the official estimates are available), but they do lousy when it comes to predicting the future (even three months ahead is difficult).
2. Their analysis clearly shows the biased nature of ‘mainstream’ concepts and definitions (my translation):
“Available analyses of the effectivity of predictions of DSGE models are restricted:
to pre-credit-crisis models … these show that the number of variables which can be predicted by these models is limited …as, for instance, most … models exclude the possibility of involuntary unemployment”
They mention F. Smets and R. Wouters
3. A comparable statement can be made for leaving ‘flow of funds’ data out of traditional models. Including ‘flow of funds’ data into models (for instance: mortgage debt per house-owning household) clearly enhances the ability of economists to identify increasing risks (though it stays almost impossible to predict the exact time of an ‘economic earthquake’ or Minsky moment).
Models, by their nature, of course always leave out variables. That’s not the point. There is no need to include gravity into economic models. But is it wise to leave household debts and involuntary unemployment out of models? No, of course it isn’t. Variables like those are absolutely central to well being and the working of an economy. But it does come in handy, when you want to introduce austerity policies. It’s even a great thing when you want a government to cut back on wages and to dismiss tens of even hundreds of thousands of people as the banks have to get their money: according to the model, all these people are not really out of work, they just don’t want to find a new job! I can understand that people like that idea. But I don’t understand it when economists are not even aware of the characteristics of these kinds of models and really do think that the real world behaves more or less like them, as seems the case with many a DSGE economist. Let’s call the Horatio economists.