Why Wall Street shorts economists and their DSGE models
from Lars Syll
Very few Wall Street firms find the DSGE models useful … 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.
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 lifetime 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.
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 mainstream economists out there who still think that price and wage rigidities are the prime movers behind unemployment. DSGE models basically explain 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 were 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, etc.
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.
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Real-World Economics Review Blog 
I do not support DSGE models, but the arguments Lars Syll adopts against them are not well formulated.
Lars Syll:
It would be much easier to achieve that effect by increasing the money supply.
Is this remark correct? It seems Lars is arguing based on a very old theory of investment. When there is no prospect that demand for its product will increase, no firm seems to invest to increase their production capacity. It seems also that Lars is assuming that lower interest rates are associated with increased investment. However, this has been noted to be wrong soon after Keynes’s General Theory was published (Oxford Economists’ Research Group’s study in late 1930’s).
Actually many central banks in developing countries are adopting the quantitative easing policy and keeping interest rate near to zero (even negative for some countries). And yet investment level is very low. Is Lars observing what is happening in the real economy?
Citing Keynes’s phrases is not enough to fight back against mainstream economics. We must present more correct and plausible theories than mainstream ones. For that, building alternative theories is more urgent than denouncing mainstream economics. It is all right that Lars concentrates in methodological arguments, but he needs to study what is happening in the heterodox economics now.
I am sorry of a typo I have made.
The phrase “Actually many central banks in developing countries” should be written as
“Actually many central banks in developed countries”.
The following is the abstract to a paper by Engelbert Stockhammer and Paul Ramskogler (2009) which appeared ten years ago in Intervention. European Journal of Economics and Economic Policies 6(2):227-246 with the title “Post-Keynesian economics – how to move forward”.
Post-Keynesian Economics (PKE) is at the crossroads. Post-Keynesians (PKs) have become eff ectively marginalized; the academic climate at universities has become more hostile to survival and the mainstream has become more diverse internally. Moreover, a heterodox camp of diverse groups of non-mainstream economists is forming. Th e debate on the future of PKE has so far focussed on the relation to the mainstream. Th is paper argues that this is, in fact, not an important issue for the future of PKE. Th e debate has so far strangely overlooked the dialectics between academic hegemony and economic (and social) stability. In times of crisis the dominant economic paradigm becomes vulnerable. Th e important question is, whether PKE off ers useful explanations of ongoing socio-economic transformations. PKE has generated valuable insights on core areas such as monetary macroeconomics and medium-term growth theory, but it off ers little on important real world phenomena like the globalisation of production and social issues like precarisation and the polarization of income distribution or ecological challenges like climate change. It is these issues that will decide the future of PKE.
How can there be dynamic changes in equilibrium? It is
self-contradictory and appears to me to be a category error.
It is necessary, actually to deal with time to follow events in time.
It does indeed appear to be a hierarchy of categories of errors; error upon error as time goes by…
Is there a point in time when economists wake up to the reality that the collapse of democratic structures, of the so called “social contract” globally renders these models obsolete? I guess Keynes, a clever proponent of MANAGED capitalism, would now be able to guide his supporters.
DSGE models are a complete waste of time, unusable in practical economics and a potent source of miseducation of the young. Lars should tell the University of Chicago. I think he is preaching to the converted on this blog.
In such models a dynamic equilibrium is a constant-growth-rate path with stable relative prices and quantities from which no-one has any incentive to shift until there is an “exogenous” shock whereupon everyone jumps to the new optimal steady-growth path with different stable relative prices and quantities. A bit like Newton’s first law that a body remains in constant motion unless acted upon by a force. Don’t shoot the messenger – I know it’s hopelessly unrealistic.
In reply to Helen Sakho November, 19,2019 at 12:11 am
Helen in my opinion clearly states what I believe and that simply is, that a democracy restored, combined with Keynes ideas of a managed capitalism, could do a lot to restore a fair and just equal society.
My concern has always been that dumping a system that is run by greedy wealthy elite clowns, is likely to see the same wealthy clowns running the system the new system solely for their benefit. Therefor on this reasoning I think the public of all ages need to be encouraged to understand and take part in restoring their society to a equally just democratic society
Ted
Ted,
No system will ever be free from attempts to game it or regress it. Reforms will never last because they are shallow and incomplete actions, and hence regressive forces will eventually revert things to the “norm”.
A paradigm change is historically a permanent progression of knowledge and understanding that virtually everyone agrees is such because it resolves long standing problems and is temporally and personally experienced as essentially and dramatically better than the present/old paradigm and/or a new truth where the former paradigm was false. Hence only the unethical or deluded try to game or regress it.
Keynesianism got morphed into neo-liberalism as an example of reform. Helio-centrism forever changed cosmology as an example of a paradigm change.
Wall Street is about investing. To get a large return on money invested. There is no shortage of theories on what makes the markets tick or what a market movement means. Some of which influence investor decisions. The two largest factions on Wall Street are split between supporters of the efficient market theory and those who believe the market can be beaten. Although this is a fundamental split, many other theories attempt to explain and influence the market, as well as the actions of investors in the markets.
Efficient Market Hypothesis
Few people are neutral on the efficient market hypothesis (EMH). You either believe in it and adhere to passive, broad market investing strategies, or you detest it and focus on picking stocks based on growth potential, undervalued assets and so on. The EMH states that the market price for shares incorporates all the known information about that stock. This means that the stock is accurately valued until a future event changes that valuation. Because the future is uncertain, an adherent to EMH is far better off owning a wide swath of stocks and profiting from the general rise of the market. “Hedging one’s bets, so to speak.” Economists seem to like EMH. Mostly, it seems because it has little empirical support.
Opponents of EMH point to Warren Buffett and other investors who have consistently beaten the market by finding irrational prices within the overall market.
Fifty-Percent Principle
The fifty-percent principle predicts that (before continuing) an observed trend will undergo a price correction of one-half to two-thirds of the change in price. This means that if a stock has been on an upward trend and gained 20%, it will fall back 10% before continuing its rise. This is an extreme example, as most times this rule is applied to the short-term trends on which technical analysts and traders buy and sell.
This correction is thought to be a natural part of the trend, as it’s usually caused by skittish investors taking profits early to avoid getting caught in a true reversal of the trend later. If the correction exceeds 50% of the change in price, it is considered a sign that the trend has failed, and the reversal has come prematurely.
Greater Fool Theory
The greater fool theory proposes that you can profit from investing if there is a greater fool than yourself to buy the investment at a higher price. This means that you could make money from an overpriced stock if someone else is willing to pay more to buy it from you.
Eventually, you run out of fools as the market for any investment overheats. Investing according to the greater fool theory means ignoring valuations, earnings reports, and all the other data. Ignoring data is as risky as paying too much attention to it, and so people ascribing to the greater fool theory could be left holding the short end of the stick after a market correction.
Odd Lot Theory
The odd lot theory uses the sale of odd lots – small blocks of stocks held by individual investors – as an indicator of when to buy into a stock. Investors following the odd lot theory buy in when small investors sell out. The main assumption is those small investors are usually wrong.
The odd lot theory is a contrarian strategy based off a very simple form of technical analysis – measuring odd lot sales. How successful an investor or trader following the theory depends heavily on whether he checks the fundamentals of companies that the theory points toward or simply buys blindly.
Small investors aren’t going to be right or wrong all the time; so, it’s important to distinguish odd lot sales that are occurring from a low-risk tolerance from odd lot sales that are due to bigger problems. Individual investors are more mobile than the big funds and thus can react to severe news faster, so odd lot sales can be a precursor to a wider sell-off in a failing stock instead of just a mistake on the part of small-time investors.
Prospect Theory
The prospect theory can also be known as the loss-aversion theory. Prospect theory maintains that people’s perceptions of gain and loss are skewed. That is, people are more afraid of a loss than they are encouraged by a gain. If people are given a choice of two different prospects, they will pick the one that they think has less chance of ending in a loss, rather than the one that offers the most gains.
For example, if you offer a person two investments, one that has returned 5% each year and one that has returned 12%, lost 2.5%, and returned 6% in the same years, the person is more likely to pick the 5% investment because they put an irrational amount of importance on the single loss, while ignoring the gains that are of a greater magnitude. In the above example, both alternatives produce the same net total return after three years.
Prospect theory is important for financial professionals and investors. Although the risk/reward trade-off gives a clear picture of the risk amount an investor must take on to achieve the desired returns, prospect theory tells us that very few people understand emotionally what they realize intellectually.
For financial professionals, the challenge is in matching a portfolio to the client’s risk profile, rather than reward desires. For the investor, the challenge is to overcome the disappointing predictions of prospect theory and become brave enough to get the returns you believe are possible.
Rational Expectations Theory
The rational expectations theory states that the players in an economy will act in a way that conforms to what can logically be expected in the future. That is, a person will invest, spend, etc. according to what they rationally believe will happen in the future. By doing so, that person creates a self-fulfilling prophecy that helps bring about the future event.
Although this theory has become quite important to economics, its utility is doubtful. For example, an investor thinks a stock is going to go up, and by buying it, this act causes the stock to go up. This same transaction can be framed outside of rational expectations theory. An investor notices that a stock is undervalued, buys it, and watches as other investors notice the same thing, thus pushing the price up to its proper market value. This highlights the main problem with rational expectations theory: It can be changed to explain everything, but it tells us nothing.
Short Interest Theory
Short interest theory assumes that high, short interest is the precursor to a rise in the stock’s price and, at first glance, appears to be unfounded. Common sense suggests that a stock with a high short interest – that is, a stock that many investors are short selling—is due for a correction.
The thinking goes that all those traders, thousands of professionals and individuals scrutinizing every scrap of market data, surely can’t be wrong. They may be right to an extent, but the stock price may rise by virtue of being heavily shorted. Short sellers must eventually cover their positions by buying the stock they’ve shorted. Consequently, the buying pressure created by the short sellers covering their positions will push the share price upward.
The Bottom Line
I’ve covered a wide range of theories, from technical trading theories like short interest and odd lot theory to economic theories like rational expectations and prospect theory. Every theory is an attempt to impose some type of consistency or frame to the millions of buy and sell decisions that make the market rise and fall daily.
While it is useful to know these theories, it is also important to remember that no unified theory can explain the financial world. During certain time periods, one theory seems to hold sway only to be toppled soon after. In the financial world, change and uncertainty are the only constants. In these circumstances the DSGE is useless.