DSGE models – empirically irrelevant and logically incoherent

from Lars Syll

Something about the way economists construct their models doesn’t sit right.

Economic models are often acknowledged to be unrealistic, and Friedmanite ‘assumptions don’t matter‘ style arguments are used to justify this approach. The result is that internal mechanics aren’t really closely examined. However, when it suits them, economists are prepared to hold up internal mechanics to empirical verification – usually in order to preserve key properties and mathematical relevance. The result is that models are constructed in such a way that, instead of trying to explain how the economy works, they deliberately avoid both difficult empirical and difficult logical questions. This is particularly noticeable with the Dynamic Stochastic General Equilibrium (DSGE) models that are commonly employed in macroeconomics …

The fact is that DSGE models themselves are not “empirically relevant”. They assume that agents are optimising, that markets tend to clear, that the economy is an equilibrium time path. They use ‘log linearisation’, a method which doesn’t even pretend to do anything other make the equations easier to solve by forcibly eliminating the possibility of multiple equilibria. On top of this, they generally display poor empirical corroboration. Overall, the DSGE approach is structured toward preserving the use of microfoundations, while at the same time invoking various – often unrealistic – processes in order to generate something resembling dynamic behaviour.

Economists tacitly acknowledge this, as they will usually say that they use this type of model to highlight one or two key mechanics, rather than to attempt to build a comprehensive model of the economy. Ask an economist if people really maximise utility; if the economy is in equilibrium; if markets clear, and they will likely answer “no, but it’s a simplification, designed to highlight problem x”. Yet when questioned about some of the more surreal logical consequences of all of the ‘simplifications’ made, economists will appeal to the real world. This is not a coherent perspective.

Neoclassical economics uses an ‘axiomatic deductive‘ approach, attempting to logically deduce theories from basic axioms about individual choice under scarcity. Economists have a stock of reasons to do this: it is ‘rigorous’; it bases models on policy invariant parameters; it incorporates the fact that the economy ultimately consists of agents consciously making decisions, etc. If you were to suggest internal mechanics based on simple empirical observations, conventional macroeconomists would likely reject your approach.

Modern DSGE models are constructed using these types of axioms … This allows macroeconomists to draw clear mathematical implications from their models, while the assumptions are justified on the grounds of empiricism … Yet the model as a whole has very little to do with empiricism, and economists rarely claim otherwise. What we end up with is a clearly unrealistic model, constructed not in the name of empirical relevance or logical consistency, but in the name of preserving key conclusions and mathematical tractability …

A consequence of this methodological ‘dance’ is that it can be difficult to draw conclusions about which DSGE models are potentially sound. One example of this came from the blogosphere, via Noah Smith. Though Noah has previously criticised DSGE models, he recently noted – approvingly – that there exists a DSGE model that is quite consistent with the behaviour of key economic variables during the financial crisis. This increased my respect for DSGE somewhat, but my immediate conclusion still wasn’t “great! That model is my new mainstay”. After all, so many DSGE models exist that it’s highly probable that some simplistic curve fitting would make one seem plausible. Instead, I was concerned with what’s going on under the bonnet of the model – is it representative of the actual behaviour of the economy?

Sadly, the answer is no. Said DSGE model includes many unrealistic mechanics: most of the key behaviour appears to be determined by exogenous ‘shocks’  to risk, investment, productivity etc without any explanation. This includes the oft-mocked ‘Calvo fairy’, which imitates sticky prices by assigning a probability to firms randomly changing their prices at any given point. Presumably, this behaviour is justified on the grounds that all models are unrealistic in one way or another. But if we have constructed the model to avoid key problems … how can we justify using something as blatantly unrealistic as the Calvo fairy? Either we shed a harsh light on all internal mechanics, or on none …

I am aware that DSGE and macro are only a small part of economics, and many economists agree that DSGE – at least in its current form – is yielding no fruit (although these same economists may still be hostile to outside criticism). Nevertheless, I wonder if this problem extends to other areas of economics, as economists can sometimes seem less concerned with explaining economic phenomena than with utilising their preferred approach. I believe internal mechanics are important, and if economists agree, they should expose every aspect of their theories to empirical verification, rather merely those areas which will protect their core conclusions.

Unlearning Economics

To me this confirms what I have been arguing for years now – neoclassical economic theory is in the story-telling business.

Neoclassical economics has since long given up on the real world and contents itself with proving things about thought up worlds. Empirical evidence only plays a minor role in economic theory, where models largely function as a substitute for empirical evidence. But “facts kick”, as Gunnar Myrdal used to say. Hopefully humbled by the manifest failure of its theoretical pretences, the one-sided, almost religious, insistence on axiomatic-deductivist modeling as the only scientific activity worthy of pursuing in economics will give way to methodological pluralism based on ontological considerations rather than formalistic tractability.

Modern macroeconomics builds on the myth of us knowing the “data-generating process” and that we can describe the variables of our evolving economies as drawn from an urn containing stochastic probability functions with known means and variances.

In the end this is what it all boils down to. We all know that many activities, relations, processes and events are genuinely uncertain. The data do not unequivocally single out one decision as the only “rational” one. Neither the economist, nor the deciding individual, can fully pre-specify how people will decide when facing uncertainties and ambiguities that are ontological facts of the way the world works.

Some macroeconomists, however, still want to be able to use their hammer. So they decide to pretend that the world looks like a nail, and pretend that uncertainty can be reduced to risk. So they construct their mathematical models on that assumption.

If macroeconomic models – no matter of what ilk –  build on microfoundational assumptions of representative actors, rational expectations, market clearing and equilibrium, and we know that real people and markets cannot be expected to obey these assumptions, the warrants for supposing that conclusions or hypothesis of causally relevant mechanisms or regularities can be bridged, are obviously non-justifiable. Incompatibility between actual behaviour and the behaviour in macroeconomic models building on representative actors and rational expectations-microfoundations is not a symptom of “irrationality”. It rather shows the futility of trying to represent real-world target systems with models flagrantly at odds with reality.

A gadget is just a gadget – and brilliantly silly DSGE models do not help us working with the fundamental issues of modern economies.