Why Frank Smets, chief economist of the ECB, thinks the ECB economic model is wrong
from Merijn Knibbe
Have you ever wondered why an U-3 unemployment rate of 23% in Spain (and rising) and 18% in Greece (and rising) doesn’t seem to bother the European Central Bank (ECB)? I have. And it might have something to do with the kind of models the European Central Bank uses, like the ECB ‘New Area Wide Model” (NAWM), which does not include unemployment as a variable. It literally defines unemployment away. People using this model don’t see what happens to unemployment – and at the ECB they do use this model… And yes, these are the kind of models which people like Greg Mankiw sell to their students. Let’s take a look at this:
The ECB is quite proud of its model:
““The New-Area-Wide Model (NAWM) is a micro-founded open-economy model of the euro area, which is designed for use in the (Broad) Macroeconomic Projection Exercises regularly undertaken by ECB/Eurosystem staff and for policy analysis.
the key features of the model are:
- Its scale – compared with a typical DSGE model – is relatively large.
- Employing Bayesian methods, it estimates 18 key macroeconomic variables, including real GDP, private consumption, total investment, government consumption, exports and imports, a number of deflators, employment and wages, and the short-term nominal interest rate.”
One variable is obviously missing from this list. Unemployment. This is characteristic for neo-classical macro models: the representative consumer which represents the entire sector households in thee models has, of course, only one job. As there is only one, representative, job in these models (or, for that matter: one, representative, house which is partly owner occupied and partly rented). In the models, And representative consumer might work a little less or more – that’s what we call unemployment. But in the models it isn’t, not even U-6, involuntary part time work, unemployment. And it surely never becomes total unemployement (U-3 concept). The representative consumer does not get fired, according to the assumptions of the model, as the he-she entity of the model literally chooses to work a little less or a little more. But let’s quote Frank Smets, chief economists of the ECB, and one of the authors of the NAWM on this:
“Over the past decade an increasing number of central banks and other policy institutions have developed and estimated medium-scale New Keynesian DSGE models. The combination of a good empirical fit with a sound, microfounded structure makes these models particularly suitable for forecasting and policy analysis. However, as highlighted by Galí and Gerter (2009) and others, one of the shortcomings of these models is the lack of a reference to unemployment. This is unfortunate because unemployment is an important indicator of aggregate resource utilization and the central focus of the policy debate.”
I’ll return to the ‘good empirical fit’. For now, we have to emphasize that Smets and some others realised that it’s an omission to leave unemployment out of these models and have been tinkering to introduced some kind of modelling of unemployment into the model and ‘estimated’ the model for the USA. What happens, when unemployment is introduced in such a model? Again according to Frank Smets:
“First, we show that wage markup shocks play a smaller role in driving output and employment fluctuations than previously thought”.
That’s a shocking remark. It means that, according to this new model, severe wage cuts (“negative wage markup shocks”) do not lead to an overnight increase in the number of jobs and production, while the ECB economists using the old NAWM assumed that that would happen, in for instance the Baltics and Spain and Greece and Portugal and Ireland. Ironically, this model was assumed to have a ‘good empirical fit’, a fit which now turns out to have been quite bad. The model (and therewith the ECB economists!) didn’t only even ‘see’ 23% unemployment in Spain, which is bad enough. But introducing unemployment shows that the kind of austerity policies advocated by the ECB do not work the way the ECB assumed these policies to work. At least, according to the new model, which might be wrong too, of course. What a crap. And remember – many of the variables in these models are not estimated but ‘callibrated’, another word for ‘made up’. But the new model at least shows the trade-off between unemployment and prosperity.
This is the kind of stuff people Mankiw have to discuss with their students – especially in an introductory course in economics. Sadly, the students discuss it with Mankiw…
Beyond this, there is of course the usual nonsense, like the use of the word ‘estimation’ while the model isn’t really estimated and the use of ‘social indifference curves’- which really do not exist and even can’t exist, and the talk about micro foundations which aren’t micro at all. Newspeak, in the 1984 sense.
Let’s end with a quote from John Maynard Keynes, from a 1929 Loyd George election pamflet (hat tip Jesse Frederik):
“The Conservative belief that there is some law of nature which prevents men from being employed, that it is ‘rash’ to employ men, and that it is financially ‘sound’ to maintain a tenth of the population in idleness for an indefinite period, is crazily improbable – the sort of thing which no man could believe who had not had his head fuddled with nonsense for years and years. The objections which are raised are mostly not the objections of experience or of practical men. They are based on highly abstract theories – venerable, academic inventions, half misunderstood by those who are applying them today, and based on assumptions which are contrary to the facts…Our main task, therefore, will be to confirm the reader’s instinct that what seems sensible is sensible, and what seems nonsense is nonsense.”