Home > Old Paradigm Economics, The Economics Profession > Why Wall Street shorts economists and their DSGE models

Why Wall Street shorts economists and their DSGE models

from Lars  Syll

Blogger Noah Smith recently did an informal survey to find out if financial firms actually use the “dynamic stochastic general equilibrium” models that encapsulate the dominant thinking about how the economy works. The result? Some do pay a little attention, because they want to predict the actions of central banks that use the models. In their investing, however, very few Wall Street firms find the DSGE models useful …

titanic-sinking-underwater

This should come as no surprise to anyone who has looked closely at the models. Can an economy of hundreds of millions of individuals and tens of thousands of different firms be distilled into just one household and one firm, which rationally optimize their risk-adjusted discounted expected returns over an infinite future? There is no empirical support for the idea. Indeed, research suggests that the models perform very poorly …

Why does the profession want so desperately to hang on to the models? I see two possibilities. Maybe they do capture some deep understanding about how the economy works … More likely, economists find the models useful not in explaining reality, but in telling nice stories that fit with established traditions and fulfill the crucial goal of getting their work published in leading academic journals …

Knowledge really is power. I know of at least one financial firm in London that has a team of meteorologists running a bank of supercomputers to gain a small edge over others in identifying emerging weather patterns. Their models help them make good profits in the commodities markets. If economists’ DSGE models offered any insight into how economies work, they would be used in the same way. That they are not speaks volumes.

Mark Buchanan/Bloomberg

[h/t Jan Milch]

Splendid article!

The unsellability of DSGE — private-sector firms do not pay lots of money to use DSGE models — is a strong argument against DSGE. But it is not the most damning critique of it.

In the basic DSGE models the labour market is always cleared – responding to a changing interest rate, expected life time incomes, or real wages, the representative agent maximizes the utility function by varying her labour supply, money holding and consumption over time. Most importantly – if the real wage somehow deviates from its “equilibrium value,” the representative agent adjust her labour supply, so that when the real wage is higher than its “equilibrium value,” labour supply is increased, and when the real wage is below its “equilibrium value,” labour supply is decreased.

In this model world, unemployment is always an optimal choice to changes in the labour market conditions. Hence, unemployment is totally voluntary. To be unemployed is something one optimally chooses to be.

The D Word

Although this picture of unemployment as a kind of self-chosen optimality, strikes most people as utterly ridiculous, there are also, unfortunately, a lot of neoclassical economists out there who still think that price and wage rigidities are the prime movers behind unemployment. DSGE models basically explains variations in employment (and a fortiori output) with assuming nominal wages being more flexible than prices – disregarding the lack of empirical evidence for this rather counterintuitive assumption.

Lowering nominal wages would not  clear the labour market. Lowering wages – and possibly prices – could, perhaps, lower interest rates and increase investment. It would be much easier to achieve that effect by increasing the money supply. In any case, wage reductions was not seen as a general substitute for an expansionary monetary or fiscal policy. And even if potentially positive impacts of lowering wages exist, there are also more heavily weighing negative impacts – management-union relations deteriorating, expectations of on-going lowering of wages causing delay of investments, debt deflation et cetera.

The classical proposition that lowering wages would lower unemployment and ultimately take economies out of depressions, was ill-founded and basically wrong. Flexible wages would probably only make things worse by leading to erratic price-fluctuations. The basic explanation for unemployment is insufficient aggregate demand, and that is mostly determined outside the labour market.

Obviously it’s rather embarrassing that the kind of DSGE models ”modern” macroeconomists use cannot incorporate such a basic fact of reality as involuntary unemployment. Of course, working with representative agent models, this should come as no surprise. The kind of unemployment that occurs is voluntary, since it is only adjustments of the hours of work that these optimizing agents make to maximize their utility.

To me, this — the inability to explain involuntary unemployment — is the most damning critique of DSGE.

  1. paul davidson
    January 22, 2014 at 7:11 pm

    In explaining why Samuelson’s “old” neoclassical synthesis Keynesianism and New Keynesianism theories have nothing to do with Keynes’s General Theory of Employment, I have continually quoted Keynes [from page 257 of The General Theory] who wrote “For the Classical Theory has been accustomed to rest the supposedly self-adjusting character of the economic system on the assumed fluidity of money-wages; and when there is rigidity, to lay on this rigidity the blame for maladjustment…My difference from this theory is primarily a difference of analysis”. This is in a chapter entitled “Changes in Money Wages” where Keynes explain why changes in money wages can not guarantee full employment.

    when in a published debate with Milton Friedman in the JPKE –later published as a book entitled MILTON FRIEDMAN’S MONETARY FRAMEWORK: A DEBATE WITH HIS CRITICS I pointed out this chapter of the General Theory to Milton his response was that Davidson refers to many chapters in the back of the General Theory that have some interesting and relevant comments –but are not part of Keynes’s theory, while fixity of wages and prices are essential to understanding Keynes..

    In a verbal discussion with Paul Samiuelson many years ago, I pointed out this chapter to Samuelson. His response was he found the General Theory “unpalatable” but liked the policy implications and therefore he [Samuelson] merely assumed the General Theory was a Walrasian system with fixity of wages and prices!

    And these two guys won Nobel Prizes in Economics and I can not even get any of my books reviewed in the Journal of Economic Literature!

    Paul

  2. Paul Schächterle
    January 22, 2014 at 7:52 pm

    Quote: “To me, this — the inability to explain involuntary unemployment — is the most damning critique of DSGE.”

    Amen to that!

  3. Jeff Z
    January 22, 2014 at 8:56 pm

    Lars Syll: “The classical proposition that lowering wages would lower unemployment and ultimately take economies out of depressions, was ill-founded and basically wrong. Flexible wages would probably only make things worse by leading to erratic price-fluctuations. The basic explanation for unemployment is insufficient aggregate demand, and that is mostly determined outside the labour market.”

    I agree with the basic thrust of the post. I am troubled by the idea that the state of aggregate demand is determined mostly ‘outside’ the labor market. For the U.S., the consumption component of the demand side measurement of GDP, personal consumption expenditures make up about 68% of Real Gross Domestic Product in the U.S. (www.bea.gov) Wages and salaries make up the vast majority of income for the vast majority of people.

    The basic story of people having to work for wages to buy consumer goods and services is based on the idea that wages and salaries are the prime source for consumption spending. Now, as a share of GDP, wages and salaries have been declining (http://research.stlouisfed.org/fred2/series/W270RE1A156NBEA) so we have seen a rise in consumer indebtedness overall that parallels this. In Keynes’ story governments could step in if there was a shortfall in AD, which arose primarily from investment (if I recall my GENERAL THEORY correctly – Paul will let me know if I haven’t. :) )

    The idea that a fall in real wages will restore unemployment, or that a fall in the real wage will really only make things worse, both rest on the assumption (observation?) that consumption spending is financed primarily out of wages, determined in the labor market.

    Heck, If I want to revisit the idea of the ‘paradox of thrift,’ the worker sets aside some portion of his current income (presumably earned in the labor market) which can also give rise to a shortfall of aggregate demand, throwing others out of work through the practice of an individual virtue.

    If you want to talk net exports, then we are reliant on the state of the labor market in other countries, either as a direct source of demand for out goods or as an indicator of strength letting firms import CAPITAL goods.

  4. January 23, 2014 at 10:35 pm

    I am obviously missing something. I have been missing it for a long time and at first I thought there was some error in what was being said, because it seemed to internally contradictory. But I keep reading the same thing, not least in this article. I am puzzled

    The article says:

    “when the real wage is higher than its “equilibrium value,” labour supply is increased, and when the real wage is below its “equilibrium value,” labour supply is decreased.”

    I take that to mean that when wages are lower than some particular value folk won’t take the jobs, and so unemployment increases. It is voluntary on the assumption that people say “I don’t take my jacket off for less than £20 an hour” or something of that sort.

    That is ridiculous on its face, and as often when reading what economists have to say, I tended to assume that it can’t be as stupid as that: they must mean something else.

    That view was reinforced then, as now, by the next bit

    ” lowering wages would lower unemployment ”

    We just said that lowering wages would increase unemployment. Now we say that lowering wages will decrease unemployment

    How can they have it both ways? Do they assume that eventually these workers will come to accept that the wages have fallen everywhere and therefore adjust their expectations and take low paid jobs and work just as hard? Why should they?

    There is said to be an old russian saying – “they pretend to pay us and we pretend to work”. It may be apocryphal but it says something about how human beings behave: and workers are indeed human beings.

  5. Jeff Z
    January 24, 2014 at 2:03 am

    Fiona,

    There is a duality in wages that I think some economists and some politicians need take more seriously than they do. You have captured both sides.

    Wages are a cost of production from one point of view of employers. If I am a business owner, and I see wages fall, that lowers my cost of production, and I might hire more workers. Especially if I think I can sell the resulting increase in output – say plasma TVs.

    On the other hand, wages are a producer’s primary source of demand in a capitalist economy. AS the owner of the plasma TV factory, I want wages overall to be higher so that as many people as possible can afford to buy my plasma TVs.

    If every business owner reasons the same way, they have split incentive – to keep wages as low as possible in their own factory, but to see that they are as high as possible everywhere else. That combination is typically in the best interest of factory owners everywhere, as that leads to large profits and income for the factory owner.

    Once I grasp this duality, it is easy to see that increases wages can lead to increased unemployment in some circumstances (increased demand) while in other you can see that decreases in wages might lead to increased unemployment (reduced cost to business owner).

    Of course, things like productivity play a role in real decisions, but in discussions such as this this duality is often operating in the background, and this is not often clear.

    Hope this helps.

  6. January 24, 2014 at 11:04 am

    Thank you for your response, Jeff Z.

    The first part sort of helps, but I fall at this hurdle

    “Once I grasp this duality, it is easy to see that increases wages can lead to increased unemployment in some circumstances (increased demand) while in other you can see that decreases in wages might lead to increased unemployment (reduced cost to business owner).”

    If increased wages = increased demand then I do not see why that should lead to increased unemployment. Increased demand means that the business owner can sell more, and on this reasoning it should lead to a fall in unemployment. That is what some economists who are opposing austerity argue and it is at odds with the first part of the sentence I have quoted above.

    If increased wages are characterised as increased cost then in one sense it follows that it will lead to increased unemployment, because the business owner will reduce the workforce. That is what some other economists argue in supporting austerity.

    It seems you reconcile this by splitting the response of business owners depending on what is important to them. It seems clear to me that neither response has anything at all to do with the decision of the employee – which is what the DGSE model is alleged to claim. If the ATL article is correct the locus of decision making is with the worker in that model, and that is quite clearly untrue. It is untrue in the real world and it is untrue in terms of the explanation you have just given. Unemployment is not “voluntary” at all.

    Nor is it clear to me why these two possible responses don’t balance out if the outcome is the product of decisions which tend in opposite directions, and both are reasonable. Economists are forever aggregating things, so it is not illegitimate to do that, in their own terms. But in order to do it they have to specify what particular circumstances will lead business owners to one thing rather than another. They also have to apply that understanding to real world businesses across the whole economy in order to predict the net outcome when some business owners put wages up because they need people to have income with which to buy their products; and others put them down because they wish to cut costs. I don’t see those parameters specified by either side: they both just tell a superficially plausible story and proceed as if it was self-evidently true. That is not science or even impartial analysis: it is woo.

    To me it is very simple. Economic activity does not stand alone and cannot account for behaviour in the real world all by itself. That is the fundamental presumption which renders the subject laughable. We are told in another part of the forest that business owners want to maximise profit (or return) all the time. Profit is not characterised as a cost of business though in one sense it is just that. There is no difference between cutting costs by cutting profit or cutting costs by cutting wages. It may be that the amount by which one can cut is different, but that will vary in different companies. A rational approach would consider the cost that is profit alongside the cost that is wages: but I never see that done. Profit appears to be defined in such a way that question is not even asked. “Sticky” wages are a problem but “sticky” profit is not even mentioned. Funny that. It tells you where the power lies, though. Over mighty or unrealistic workers and trade unions are a demon: but I never saw a workforce sack the board. Overmighty capitalists are, and always have been, the problem.

    It is for the state to control that. Pretending that it is all lawful in the same way as gravity is lawful is a great big lie. We can see who it serves and some of that is wilful: much depends on the stories told, however, and I assume that some who adopt such models actually believe they have captured some essential truth. They need look no further than their own behaviour to see that is rubbish. But that is in a different compartment in their heads. These people strike me as not being very bright. Yet I am invited to believe their fantasy and to admire their realism. In a pig’s eye!

  7. Jeff Z
    January 24, 2014 at 9:09 pm

    Fiona,

    I have read your comments, and my previous post, and it looks like I made a mistake. I wrote in comment #5:

    Once I grasp this duality, it is easy to see that increases wages can lead to increased unemployment in some circumstances (increased demand) while in other you can see that decreases in wages might lead to increased unemployment (reduced cost to business owner).

    No wonder it did not help – this is a confusing bit of gobbldygook.

    The duality is still there. Increased wages can lead to increased income, spurring demand for consumer goods, thus leading to employment gains. At the same time, from the point of view of the individual business owner, an increase in wages is an increase in cost, so the business owner may lay people off. I should have edited the sentence to read:

    Once I grasp this duality, it is easy to see that increases in wages can lead to increased employment in some circumstances (increased demand) while in others you can see that increases in wages might lead to increased unemployment (increased cost to business owner).

    It becomes an empirical question then about which of these predominates in any specific place and time. But there is a set of other factors that play a role. There is more than one industry. There are different types of workers with different levels of education and experience. Some industries use more workers to make things than others.

    But here is a set of circumstances in which an increase in wages can lead to increased employment. It is a hypothetical, and I concede that I can’t cover all the variations. Suppose San Francisco, California passes a so called ‘living wage’ law. It mandates that employers with over 50 employees pay these employees what is determined to be a ‘living wage’ (a problem in and of itself, but we will leave that aside for now). Assuming employees work the same number of hours as before, their income has gone up. On the face of it, so has the cost to employers. Over time, employers find that offering a higher wage does a couple of things. First, current employees are ‘happier,’ and they become slightly more productive. And they quit less often. Over time, employers find they are attracting a better pool of applicants than before; the new applicants are more productive to begin with than the old pool of applicants. Income for employees is up, they spend their new money in the community, and demand for goods and services in San Francisco has gone up, spurring possible employment gains in other sectors.

    What about employer cost? Yes, the outlay for wages has increased. But if productivity is up, and quits are down, then the savings from reduced cost for training and turnover can offset the increase in wages. Employers might find that cost has gone down.

    That is one pathway, but again it is an empirical question as to whether this plays out or not. Still, it does say that in order for the story to have any scientific meaning, you need to measure worker incomes, quit rates, the state of demand in local area, employment, productivity, and training and turnover costs. Now you might have a chance a determining the actual effect of a living wage ordinance.

    Profits should be counted as a cost of production, and you are right in that they often are not. You are also right in that this says something about the distribution of power.

    I happen to agree that for most people, the can not hold their labor back in the face of wage cuts. Most do not have any other way to make a living. The decisions of employees as people should be considered – for example they might have mortgages, and children to care for.

    Sorry about the length – there was a lot to cover. With any luck, I did not muddy the waters even more.

  8. January 25, 2014 at 2:14 am

    Thank you again, Jeff Z. I understand the duality as you have now explained it. It is largely a matter of “just so” stories, as I read it. The kind of in depth analysis which you specify, measuring incomes, quit rates etc is part of my point. A lot of that seems not to feature in the models we are discussing: but they are not irrelevant features to be discarded in simplifying a model: they are central. So are other such things as personal circumstance of both employer and worker, as you also observe. The worker is not homogeneous and if he does have a choice to quit if wages are reduced he is pretty rare: most folk are very few pay cheques away from poverty, and that truth goes quite far up the income scale.

    I appreciate the time you have taken to explain this to me. Length is good because the normal short posts full of unexplained assumptions and acronyms do little to educate folk like me who are trying to make sense of this stuff.

    Problem is that any time someone like yourself puts it into plain english it is revealed for the arrant nonsense it is. How notions such as these came to have any clout at all in the real world is a mystery and it tends to give rise to suspicions of conspiracy, because nothing that could tie its own shoelaces could believe anything like the proposition that unemployment is always voluntary. Blaming the victim usually suits someone: just not the victim

    • January 25, 2014 at 5:21 pm

      Quote Frederick Soddy, “So elaborately has the real nature of
      this ridiculous proceeding been surrounded with
      confusion by some of the cleverest and most
      skilful advocates the world has ever known, that
      it still is something of a mystery to ordinary
      people, who hold their heads and confess they
      are

      unable to understand finance “. It is not
      intended that they should. But if, instead of
      trying to puzzle it out along the lines of
      ” what
      you get for money “, these people will reverse
      the procedure, as in this book, and do so on the
      of
      ” what you give up for it “, the trick is clear
      enough.”
      Free download: “The Role of Money” by Frederick Soddy (written in 1926, 1931)
      http://archive.org/details/roleofmoney032861mbp

      Then read a fools interpretation:
      http://bit.ly/MlQWNs

      But always, ” ***** “Believe nothing merely because you have been told it…But whatsoever, after due examination and analysis,you find to be kind, conducive to the good, the benefit,the welfare of all beings – that doctrine believe and cling to,and take it as your guide.”- Buddha[Gautama Siddharta] (563 – 483 BC), Hindu Prince, founder of Buddhism.

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