Home > Uncategorized > The blatant absence of empirical fit of macroeconomic models

The blatant absence of empirical fit of macroeconomic models

from Lars Syll

Some months ago sorta-kinda ‘New Keynesian’ Paul Krugman argued on his blog that the problem with the academic profession is that some macroeconomists aren’t “bothered to actually figure out” how the ‘New Keynesian’ model with its Euler conditions — “based on the assumption that people have perfect access to capital markets, so that they can borrow and lend at the same rate” — really works. According to Krugman, this shouldn’t be hard at all — “at least it shouldn’t be for anyone with a graduate training in economics.”

aimage.pngBut if people — not the representative agent — at least sometimes can’t help being off their labour supply curve — as in the real world — then what are these hordes of Euler equations that you find ad nauseam in these ‘New Keynesian’ macro models going to help us?

Yours truly’s doubts regarding the ‘New Keynesian’ modelers’ obsession with Euler equations is basically that, as with so many other assumptions in ‘modern’ macroeconomics, the Euler equations don’t fit reality.

In a classic paper by Hansen and Singleton (1982) only very little support for the Euler equations was found, and in later paper by Canzoneri, Cumby, and Diba (2006) it was confirmed that there is vanishing little support for real people acting according to the Euler equations.

In the standard neoclassical consumption model — underpinning ‘New Keynesian’ microfounded macroeconomic modelling — people are basically portrayed as treating time as a dichotomous phenomenon – today and the future — when contemplating making decisions and acting. How much should one consume today and how much in the future?

The Euler equation implies that the representative agent (consumer) is indifferent between consuming one more unit today or instead consuming it tomorrow. This importantly implies that according to the neoclassical consumption model that changes in the (real) interest rate and the ratio between future and present consumption move in the same direction.

So good, so far. But how about the real world? Is the neoclassical consumption as described in this kind of models in tune with the empirical facts? Not at all — the data and models are as a rule inconsistent!

In the Euler equation we only have one interest rate, equated to the money market rate as set by the central bank. The crux is that — given almost any specification of the utility function – the two rates are actually often found to be strongly negatively correlated in the empirical literature.

Theories are difficult to directly confront with reality. Economists therefore build models of their theories. Those models are representations that are directly examined and manipulated to indirectly say something about the target systems.

But being able to model a ‘credible world,’ a world that somehow could be considered real or similar to the real world, is not the same as investigating the real world. Even though all theories are false, since they simplify, they may still possibly serve our pursuit of truth. But then they cannot be unrealistic or false in any way. The falsehood or unrealisticness has to be qualified.

If we cannot show that the mechanisms or causes we isolate and handle in our models are stable, in the sense that what when we export them from are models to our target systems they do not change from one situation to another, then they only hold under ceteris paribus conditions and a fortiori are of limited value for our understanding, explanation and prediction of our real world target system.

But how do mainstream economists react when confronted with the monumental absence of empirical fit of their macroeconomic models? Well, they do as they always have done — they use one of their four pet strategies for immunizing their models to the facts:

(1) Treat the model as an axiomatic system, making all its claims into tautologies — ‘true’ by the meaning of propositional connectives.

(2) Use unspecified auxiliary ceteris paribus assumptions, giving all claims put forward in the model unlimited ‘alibis.’

(3) Limit the application of the model to restricted areas where the assumptions/hypotheses/axioms are met.

(4) Leave the application of the model open, making it impossible to falsify/refute the model by facts.

Sounds great doesn’t it?

Well, the problem is, of course, that ‘saving’ theories and models by these kind of immunizing strategies are totally unacceptable from a scientific point of view.

If macroeconomics has nothing to say about the real world and the economic problems out there, why should we care about it? As long as no convincing justification is put forward for how the inferential bridging between model and reality de facto is made, macroeconomic modelbuilding is little more than hand waving.

The real macroeconomic challenge is to face reality and still try to explain why economic transactions take place – instead of simply conjuring the problem away by assuming rational expectations, or treating uncertainty as if it was possible to reduce it to stochastic risk, or by immunizing models by treating them as purely deductive-axiomic systems. That is scientific cheating. And it has been going on for too long now.

  1. December 10, 2015 at 10:27 am

    i looked up euler equation in econ. (there are alot of equations named after euler in different fields of physics, which i find confusing). according to some econ dictionaries, a euler equation is basically just a first order difference equation ie x(t+1) = f( x(t) )—a system at time t depends on its state the previous time (one can consider even more periods in the past). . . . f can be anything—so it doesnt imply anything about rational expectations. representative agents if any, utility functions etc. Its just a dynamic system. I think that may be fairly noncontroversial as a part of a theory—assuming one wants to mathematizer it for various reasons—eg for measurement prediction and confirmation. Perhaps you are referring to the euler equation in the cited paper.

    I guess my view the questions are a) is there any reason to write down an equation (i dont need one to go shopping, nor to support policies to protect the environment and improve social justice) and b) if we want an equation what is it. (sometimes equations can be useful to make the case for social policies—sometimes because they are ‘scientific’ (ie are true) and sometimes just because they are influential rhetoric (‘dress to impress’), Equations are used to compress information. Words tend to be longer. But systems of equations can also get very lengthy, so one needs some balance.

    I personally am not aware of much real use in econ for math, apart from accounting (eg planning a budgte for a large government project using nonlinear optimization) i so its really mostly an aesthetic excercize. I guess its used to set interest rates (though that to me looks like it could be done with a calculation on the back of an envelope.)

    Aniother question is whether recursions are the way to go. There are quite a few ideas around for alternative formalisms (eg mirowski poromtes one i think named after himself, and there exist similar theories elsewhere—-i dought einstein called it ‘einstein’s theory of relativity’). I tend to think most of the dynamic and more abstract alternatives are basically convertible, a view increasingly held in computer science —there’s just one big theory, but it can be viewed from different perspectives (possibly what Nzietche meant by perspectivism). (Of course people do tend to promote certain perspective as priviledged or more correct for various reasons, and they ,may be from their perspective).

  2. December 10, 2015 at 10:45 am

    The problem is not the Euler equations or otherwise a mathematical. The problem is simple: GDP produces credit and credit generates GDP. It is a self-referential system. This must be in the modeling to be found – otherwise the matter has already failed in the approach. And right there is the weak point: economists refuse to recognize this immediate reciprocal relationship. In the mathematical modeling that only works with a coupled system of differential equations. One can even make a Euler like approach if you want, it’s not the problem (see e.g. http://arxiv.org/abs/1407.6334 page 74 ff.) . It is only expected that you model this immediate interdependence between money/credit and GDP and backwards. It’s also denied by economics that the Investment market is dependent with the GDP, but it is – what counts is the whole of the financial market as it always influences the exchange of savings/credit with GDP due to substitutional effects. And by the way, with using just one equation for Output, and choosing Capital just as an external, the model does not work from the outset regardless where your equations come from.

    • December 12, 2015 at 6:23 am

      Thats a very interesting paper on arxiv—-its possible i’ve seen it before since someone (possibly you) linked to it on rwer awhile back (but i lost the reference). Its too long and detailed for me to digest (at least now, if ever) but i think its taking the right approach .

      (Some people might get upset with treating the economy as a conservative system—noether’s theorem, though i’m not sure you do, and that formalism actually can be extended to nonconservative systems — eg Landau and Lifshtiz discussed this in their classic book on statistical physics from the 30’s. (lev landau must have been an interesting person—see wikipedia—especially operating in the USSR in that period, which in history of math and physics, was known to be a den of thieves, and current academia actually has some similarity with that).

      As an aside, I’m not sure about precedence but that book (or one in the series on physics) also discussed what became known as ‘path integrals’ (feynman, but they may have gotten that from the famous footnote in dirac’s book on quantum theory—someone stole my copy) and had the beginning of nonequilibrium thermodynamics in one chapter—later developed by prigogine and going on to this day. (I only know the path integral reference due to a paper by Frank Tipler who is a total kook but also a very good and interesting physicist http://www.arxiv.org/abs/1007.4592 —you have to seperate the wheat from the chaff)

      one could add a few footnotes on related work if you are familiar with it—eg noether’s theorem applied to economics, and the lotka-volterra equations. There are also a few (if not many more) attempts to formalize economics using the standard euler-lagrange formalism (and some forms of that go into the mathematical stratosphere —reimann geometry, guage theory etc.). (I personally tinker with the idea of getting rid of the euler-lagrange formalism since in some cases you end up adding up alot of zero terms which is counterintuitive.)

      I also dont quite know what problem you are solving—i guess the relationship between GDP and economic growth, and role of banks, etc. I think you are correct this should be viewed as a self-organizing system (nonlinear, like general relativity). Its very much like biology—it creates itself, but is embedded in an open system (ie it has a source, and uses that to create negentropy or order). I’m more interested in the structure of the ecosystem (eg the job market, supply chains, etc.) One nowadays does this using statistical mechanics (and they use it toO in biology)—though it is a formalism, not an explanation. One can write it down as a set of field equations too, but i think this is basically ‘state of the art’ so there is no accepted recipe for doing it.

      I also think you have to include diffusion of ideas too—one of the earliest approaches to this is in ‘Genes, Mind, and Culture’ by C J Lumsden (who gave me that book) and E O Wilson (a fairly welll known ant biologist/environemtnal advoacte/sociobiologist). The equations in that book were taken from elsewhere (with attibution) and to this day people keep writing them down ). brian arthur of standford/santa fe institute used them to deal with ‘non erogdic economics’ or ‘path dependence’ –qwerty—and more recently the ‘neutral theory of evolution’ has reprinted them, not to mention all the papers in ‘econophysics’. On the other hand, i dought very few kindergardeners have discovered anything new when solving arithmatic equations. (the equations in Lumsden and Wilson are correct, but their interpretation of them is not—due to bias i think. Its almost like they didnt read their own book. I ran across this also with paul cockshott of UK —eg his writings on atatistical mechanics and economics (‘laws of chaos’—machover. ) i asked him about some of the equations in his book, and he explained he hadn’t read that part—someone else wrote that chapter. . .

    • December 12, 2015 at 4:29 pm

      Comment on Heribert Genreith

      You are perfectly right: the Euler equation is ultimately irrelevant for the question on hand. The crucial point is the interrelation of change of private/public debt (= new credit/redemption), profit/loss, employment and real output. For the formally correct representation see (2014).*

      Kakarot-Handtke, E. (2014). Economics for Economists. SSRN Working Paper Series, 2517242: 1–29. URL http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2517242

      * See also cross-references New curriculum
      and cross-references Debt

  3. Peretz
    December 10, 2015 at 5:53 pm

    The problem is to wonder where is the reality ? For an example, when do you think that quantities of things becomes quality ? When do you say that so many threads makes a broom ? How many pieces of small silicium make sand ? That means the reality is what every people feel at each time. So it is impossible to predict any economy reality, because it is not an Euler theory but a live one, because money is always moving and quantities too.

  4. John McDonald/mcbockalds
    December 10, 2015 at 7:06 pm

    It took about 1400 years before Copernicus replaced Ptolemy’s astronomical model which was (as we now say) designed to ‘save the appearance’ of the earth at the center of our solar system.

    Does the following quote sound like it applies to neoclassical economists? Quote, “That Ptolemy could place Earth at the center of the universe and still predict the planets’ positions adequately was a testament to his ability as a mathematician. That he could do so while maintaining the Greek belief that the heavens were perfect—and thus that each planet moved along a circular orbit at a constant speed—is nothing short of remarkable.”

    Perhaps it won’t take 1400 hundred years to replace neoclassical economics since, unlike Ptolemaic astronomy, neoclassical economics does not “predict the {equilibrium} positions adequately….”

    Cheers John McDonald

  5. December 10, 2015 at 9:04 pm

    Be careful : there is ONLY ONE Euler equation – the first order conditon of maximisation by the ONLY ONE representative agent. This is the principal caracteristic of “new keynesians”models (DSGE).

  6. Peretz
    December 11, 2015 at 8:45 am

    Yes monetarism is the only one economic system. And the law of any system is coming from the second principle of thermo-dynamism. Mainly it proves that there are deviants when it is working for transformation. That is why I wrote that you cannot predict what becomes after a long time. And why Keynes was right too, when he said he could not have a mathematical theory of economics : it is human, so a psychological one too.

  7. December 11, 2015 at 12:08 pm

    How economists became the scientific laughing stock
    Comment on ‘The blatant absence of empirical fit of macroeconomic models’

    The brief explanation for the failure of macroeconomics is that economists from Adam Smith onward have been incompetent scientists.

    This is not recognizable for the layperson and therefore, what the genuine scientist Feynman identified as cargo cult science* is taken by the general public as the real thing. Needless to emphasize that the public perception is hallucinatory, but because it is widely shared it constitutes social reality. In general, most of what is called reality is a social construct.

    But not only laypersons have a rather superficial intuition of what science is, the representative economist, too, has no real grasp. What should be abundantly clear is that science deals with the relation between theory and fact. A good theory tells one how certain realms of reality work. Logically and empirically hardened theory is the highest and most extensive form of knowledge that is humanly possible. As Kant said: “There is nothing so practical as a good theory.” The good theory puts an end to common sense.

    The theory of fire, for example, explains fire as an interaction of certain materials and oxygen and the laws of energy conservation/transformation. The theory is general, that is, it holds in all cases but neither predicts nor describes a historically concrete case “We are very far from being able to predict, even in physics, the precise results of a concrete situation, such as a thunderstorm, or a fire. (Popper, 1960, p. 139)

    There are TWO concepts of reality here. The crucial point to notice is that science looks for what remains unchanged in time, i.e. the eternal laws, history in marked contrast looks at how the concrete situation changes and evolves over time. Science is not concerned with individual historical events except as a singular manifestation of a general law. A concrete historical event can either corroborate or refute a theory. So there are touching points where the two realities become one. An empirical test is case in point, unsought experience is another.

    Accordingly, there is a division of labor among scientists. In physics for example we have the distinction between theoretical and applied physicists. The T-scientist searches for the laws that govern a certain realm of reality, and the A-scientist uses these laws for the solution of practical problems. For the T-scientist a theory embodies pure knowledge and nothing else.

    Here is the classical case that shows the different mind-sets of the T- and the A-type: “At one point in that 100 years, Lord Ernest Rutherford was visited by a minister of the Queen. He proudly and busily demonstrated what he had learned about radio. The minister said, that’s all very good, but what is it good for. Lord Rutherford replied that he did not know, but he guaranteed that at some point the government would tax it.”**

    With regard to theory the T-type asks is it true or false, the A-type asks what is it good for. The pure practitioner as a limiting case of the A-type is guided by a self-made informal ‘theory’ and resorts to trial and error and experience. In the strict sense only the T-type is a scientist because he is guided by the criteria of material and formal consistency which ultimately define scientific truth.

    In economics it is similar. The theoretical economist tries to find out which laws govern the economy. The applied economist uses this knowledge for a purpose. Adam Smith, for example, told the political sovereign and the public how to make their nation wealthy. He was at the same time a theoretical and a political economist. Political economists are agenda pushers; in marked contrast, theoretical economists are knowledge pushers and nothing else. What Ricardo, Malthus, Marx, Keynes, Hayek or Friedman as obvious agenda pushers had in common was that they produced much opinion and little knowledge.

    As a rule, in economics the A-type claims to push the welfare of humankind, the wealth of their nation, the cause of capitalists/landowners/workers or other social subgroups, the profit of his employer, or he simply tries to get rich on the stock market. The A-type is interested in theoretical economics only so far as it serves his agenda. What he is content with is a simple model that works in his specific domain for the time being. Eternal laws, the concern of the T-type, is not the concern of the A-type. The latter’s relationship to science is instrumental, parochial, and dilettantish.

    The A-type is dependent on the T-type. If the T-type fails, the model of the A-type is hanging in the air. This is the case in economics (in contrast to the engineer). No Walrasian, Keynesian, Marxian, or Austrian economic policy advice has a sound theoretical foundation.

    The blatant problem of economics is that the agenda pushers — political economists in particular — have no consistent economic theory to works with. And the ultimate reason is the scientific incompetence of the theoretical economists of the Walrasian, Keynesian, Marxian, or Austrian sect.

    Presently, economics consists of a heap of special purpose models which are either partial/commonsensical/idiosyncratic or provably false if generalized. A materially and formally consistent theory of how the monetary economy works is lacking until this very day.

    The distinctive mark of incompetence is that the profit theory is false since Adam Smith, that is, economists have no idea of the central phenomenon of their subject matter. And this is how they became the scientific laughing stock.

    Methodologically, the ultimate reason for the overall scientific failure is that the foundational propositions, aka axioms, of economics are false.*** This explodes the whole theoretical superstructure.

    Therefore, the one and only task of theoretical economics is to rectify the axiomatic foundations of economics. The clueless multiplication of hanging-in-the-air models is pointless. It did not work in the past and it will not work in the future.

    Theoretical economics, which has to satisfy the criteria of material and formal consistency, has to be put on sound axiomatic foundations (2014). From this then follows the correct formula of overall monetary profit**** and the correct employment formula***** and so on to distribution and growth theory.

    The exemplary formulas contain nothing but measurable variables, which means that their empirical fit can be readily established. This ultimately leads from valueless political economics and model bricolage to economics as a science.

    Egmont Kakarot-Handtke

    Kakarot-Handtke, E. (2014). Objective Principles of Economics. SSRN Working Paper Series, 2418851: 1–19. URL
    Popper, K. R. (1960). The Poverty of Historicism. London, Henley: Routledge and Kegan Paul.

    * Wikipedia https://en.wikipedia.org/wiki/Cargo_cult_science
    ** Source http://www.philsoc.org/2007Fall/2225minutes.html
    *** See ‘Scientific Cave men with a daunting message’
    and ‘The ur-blunder of economics and its rectification’
    **** https://commons.wikimedia.org/wiki/File:AXEC09.png
    ***** https://commons.wikimedia.org/wiki/File:AXEC07.png

    • Goku, Kakarot
      December 14, 2015 at 12:30 pm

      Once again, you kioll the discussion by utter nonsense.
      We definitely need more of your trade-marked “science” to understand economics.

    • December 15, 2015 at 12:32 am

      Well, not exactly nonsense, Goku, but – irritatingly here – ending by simply repeating his, in my experience mistaken, view of science without advancing it in response to criticism. (Which can draw attention off the attempts of those who are trying to help him advance it). The following is not nonsense, but Egmont’s subsequent argument for the difference between Theoretical and Applied science fails with it.

      “There are TWO concepts of reality here. The crucial point to notice is that science looks for what remains unchanged in time …history in marked contrast looks at how the concrete situation changes”.

      Surely, if the concrete situation CAN change, what remains unchanged in time must contain something unchangeably changing that can change it? Arguably, science having discovered the Big Bang, it has discovered the possibility of change in energy radiating symmetrically in all directions; but at that level the best that can be done theoretically to differentiate it is to apply Cartesian coordinates (differentiated by Feynman’s “symmetry”) to Hubble’s expanding bubble, which merely tells us where to look. This four-fold (quaternion) differentiation can then be used to differentiate the four phases of waves, the four types of stable subatomic particles, the possible none to three dimensional forms of atomic progress from atoms to molecules etc right up to four types of life, four types of family members, successive activation of four types of brain functions and so to the abstract theory of control systems with no to three levels of control, i.e. PID servo systems. This brief history of time has thus generated four possible fundamental theories of current economics: as either not a control system or with present (Smith), present and past (Keynes) or three (Keynes plus entrepreneurial avoidance of problems in the foreseeable – near – future). This fundamental theory of reality, like a map, merely tells you what to look for, but has already predicted the evolution of physical control into information-based control and thus the possibility of controlling information rather than physical force.

      My fundamental theory of economics is that this universal scientific theory [of dynamic logic] applies, with money as information. As an applied scientist myself I have learned that fundamental science has two different uses. The technician needs to understand the workings and reasons for not working of what we have, but the applied scientist needs to discover how to control externalities so that particular types of application can be engineered to work reliably; as in insulating electrical conductors.

      In any case, I’m agreeing with Egmont that economics (and indeed social science generally) is not theoretical in his sense, but nor is it applied science as against data-gathering to define practical problems. In my view the dominant orthodoxy trains technicians to play with mathematical models. A bit more kindly than Egmont, I think our heterodox economists at least try to be applied scientists, though as long as they start from the orthodox models they were taught they won’t haven’t a scientific theory to apply.

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