the most damning critique of dsge

7/25/2019 The Most Damning Critique of DSGE

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The most damning critique of DSGE

Author: Noah Smith

If DSGE models work, why dont !eo!le use them to get rich"

#hen I studied macroeconomics in grad school, I was told something along these

lines:

$DSGE models are useful for !olicy ad%ice &ecause they 'ho!efully( !ass the

)ucas *ritique+ If all you want to do is forecast the economy, you dont need to

!ass the )ucas *ritique, so you dont need a DSGE model+$

This is usually what I hear academic macroeconomists say when asked to e!lain

the fact that essentially no one in the !ri%ate sector uses DSGE models+ -ri%ate.sector !eo!le cant set economic !olicy, the argument goes, so they dont

need)ucas *ritique.ro&ust models+

The !ro&lem is, this argument is wrong+ If you ha%e a model that &oth A( satis/es

the )ucas *ritique and 0( is a decent model of the economy, you can make huge

amounts of money+ This is &ecause although any old s!readsheet can &e used to

make unconditional forecasts of the economy, you need )ucas.ro&ust models to

make good policy-conditional forecasts+

)et me e!lain+ An unconditional forecast is when you say $GD- growth will &e1+23 net year$, or $in4ation will &e 5+63 net quarter$+ 7or this kind of thing,

http://www.blogger.com/profile/09093917601641588575

http://www.slate.com/blogs/moneybox/2013/12/18/freshwater_macroeconomics_has_failed_the_market_test.html

http://noahpinionblog.blogspot.com/2012/07/the-lucas-critique-and-hard-money.html


http://noahpinionblog.blogspot.com/2012/07/the-lucas-critique-and-hard-money.html




any old s!readsheet will do+

A policy-conditional forecast is when you say $If the 7ed ta!ers, in4ation will fall

&y 8+93 net year+$ To get these forecasts as good as !ossi&le, you need to know

how !olicy aects the economy+ and if your model is not )ucas.ro&ust, then you

will not &e a&le to know how !olicy aects the economy, so you will react su&.o!timally to a !olicy change+

7or eam!le, su!!ose the 7ed suddenly lowers interest rates su&stantially+ ;ost

!eo!le, using their silly s!readsheets with their 68s.%intage -hilli!s *ur%es, will

forecast a rise in GD- growth, so they will !ay a lot for stocks, e!ecting higher

!ro/ts from the increased growth+ 0ut wise DSGE modelers, using the No&el.

winning and ostensi&ly )ucas.ro&ust <ydland.-rescott 5=>1 model, know that the

-hilli!s *ur%e is not structural+ They know that the !romised growth will not

occur, so as soon as stocks &ecome o%er!riced, they short the S?-+ #hen the

ho!ed.for growth does not materiali@e and stocks fall, the DSGE modelers rea! ahuge !ro/t at the e!ense of the s!readsheet modelers+

Now thats a &it of an old eam!le, so lets take a more modern one+ Su!!ose the

7ed launches a new !rogram of E+ *le%er DSGE modelers, armed with Ste%e

#illiamsons 185B E !a!er, know that E will &e de4ationary rather than

in4ationary 'as most !eo!le think(+ This allows them to take other in%estors, who

are armed only with s!readsheets, for a ride, shorting TI-S and &uying Treasuries+

Coila . instant riches+ #illiamson himself endorses this idea, writing:

If it does anything, E will lower the in4ation rate o%er the long run+ And thelong run comes sooner than you might think, i+e+ if E gi%es you a short.run

increase in in4ation, then if its like ty!ical monetary easing, then that eect lasts

only a year or two+ ;ore to the !oint, there are other forces !ost./nancial crisis

that will cause the real interest rate on safe assets to rise, and in4ation to fall

further, so long as the 7ed kee!s short nominal rates at or near the @ero lower

&ound+ And there are good reasons to think that the 7ed will &e stuck at the @ero

lower &ound inde/nitely+ *onclusion: e!ect less in4ation rather than more+ That

has to matter for your portfolio choices. 'em!hasis mine(

So as we see, a )ucas.ro&ust DSGE model has the !otential to make its wielders a

)FT of money+ This is es!ecially true in the current en%ironment, wherecorrelations are high and macro e%ents ha%e &ecome much more im!ortant to

in%estors !erformance+

0ut not necessarily+ 0eing )ucas.ro&ust is necessary for making o!timal !olicy.

contingent forecasts, &ut it is not sufcient + ou also need the model to &e a good

model of the economy+ If your !arameters are all structural, &ut you%e assumed

the wrong microfoundations, then your model will make &ad !redictions e%en

though its )ucas.ro&ust+

So now lets get to the !oint of this !ost+ As far as Im aware, !ri%ate.sector /rmsdont hire anyone to make DSGE models, im!lement DSGE models, or e%en scan

http://www.minneapolisfed.org/research/prescott/papers/timetobuild.pdf

http://www.artsci.wustl.edu/~swilliam/papers/qe2.pdf


http://noahpinionblog.blogspot.com/2013/12/freshwater-vs-saltwater-divides-macro.html?showComment=1386982371681#c7425215041708420526

http://noahpinionblog.blogspot.com/2013/12/i-love-microfoundations-just-not-yours.html





http://noahpinionblog.blogspot.com/2013/12/freshwater-vs-saltwater-divides-macro.html?showComment=1386982371681#c7425215041708420526





the DSGE literature+ There are a lot of /rms that make macro &ets in the /nance

industry . in%estment &anks, macro hedge funds, &ond funds+ To my knowledge,

none of these /rms s!ends one thin dime on DSGE+ I%e called and emailed

e%eryone I could think of who knows what /nancial.industry macroeconomists do,

and theyre all unanimous . they%e ne%er heard of anyone in /nance using a

DSGE model+

If you know someone who does, !lease re!ly in the comments+ Im sure theres

someone out there+ 0ut e%en if there is, they ha%ent soared to fame and fortune

on the &ack of their DSGE model+

So may&e theyre Hust using the wrong DSGE models" ;ay&e theyre

using#illiamson '1851( instead of #illiamson '185B(+ I mean, after all, there is a

huge, %ast, unending array of DSGE models out there, most of which !ur!ort to

e!lain the entire macroeconomy, and most of which are thus mutually eclusi%e

at any !oint in time+ ;ay&e two or three of them are right at any gi%en !oint intime, &ut may&e this set switches around as conditions change+ -erha!s /nance.

industry !eo!le are sim!le una&le to !ick out the right DSGE model to use on any

gi%en day+

0ut if /nance.industry !eo!le cant know which DSGE model to use, how can

!olicymakers or !olicy ad%isors"

In other words, DSGE models 'not Hust $7reshwater$ models, I mean the whole kit

? ca&oodle( ha%e failed a key test of usefulness+ Their main selling !oint .

satisfying the )ucas critique . should make them %ery %alua&le to industry+ 0utindustry shuns them+

;any economic technologies !ass the industry test+ *om!anies !ay !eo!le lots

of money to use auction theory+ *om!anies !ay !eo!le lots of money to

use %ector autoregressions+ *om!anies !ay !eo!le lots of money to

use matching models+ 0ut com!anies do not, as far as I can tell, !ay !eo!le lots

of money to use DSGE to !redict the eects of go%ernment !olicy+ ;ay&e this will

change someday, &ut its &een B1 years, and no ones touching these things+

As I see it, this is currently the most damning critique of the whole DSGE!aradigm+

!dates:

;att glesias comments+

Tony ates comments, at greater length+

The anonymous deni@ens of EJ;K discuss DSGE and the !ri%ate sector+Interesting !ost:

http://ideas.repec.org/a/aea/aecrev/v102y2012i6p2570-2605.html


http://en.wikipedia.org/wiki/Vickrey_auction

http://en.wikipedia.org/wiki/Vector_autoregression

http://en.wikipedia.org/wiki/Gale%E2%80%93Shapley_algorithm

http://www.slate.com/blogs/moneybox/2014/01/10/dsge_is_useless_in_the_private_sector.html

http://longandvariable.wordpress.com/2014/01/10/why-the-lack-of-private-sector-dsge-models-is-weak-evidence-of-the-worth-of-dsge-models/

http://www.econjobrumors.com/topic/dsge-in-the-private-sector

http://ideas.repec.org/a/aea/aecrev/v102y2012i6p2570-2605.html


http://en.wikipedia.org/wiki/Vickrey_auction

http://en.wikipedia.org/wiki/Vector_autoregression

http://en.wikipedia.org/wiki/Gale%E2%80%93Shapley_algorithm

http://www.slate.com/blogs/moneybox/2014/01/10/dsge_is_useless_in_the_private_sector.html

http://longandvariable.wordpress.com/2014/01/10/why-the-lack-of-private-sector-dsge-models-is-weak-evidence-of-the-worth-of-dsge-models/

http://www.econjobrumors.com/topic/dsge-in-the-private-sector



Insider in a small, &outique !ri%ate equity /rm+ #e do not use DSGE models, &ut

we do use DSGE models as a screening de%ice, in the same s!irit as graduate

!rograms use real analysis+ It turns out that we can get these guys chea!er than

;0As, and they ha%e similar le%els of /re!ower+

So DSGE does function as a kind of signaling . the a&ility to make DSGE models is%alua&le to com!anies e%en if the models themsel%es arent, &ecause they

indicate general intelligence, com!uter skills, creati%ity, andLor work ethic+ That

makes sense+

*hris Mouse, my old /rst.year macro instructor and a !rof at the ni%ersity of

;ichigan, has A( started a &log, which you should read, and 0( attem!ted to

re&ut this !ost+ *heck it out 7un fact: The argument in quotes at the to! of this

!ost is actually !ara!hrased from stu *hris Mouse said to me, which is %ery

similar to what he now writes in his !ost+ I must say, though, I think *hris !ost

actually reiterates and strengthens the !oint I make in my !ost+ The dierence&etween !olicy.conditional and other forecasts is key here+ If the a%erage

!olicymaker can use a DSGE model to im!ro%e her !redictions of the results of

her !olicies, then the a%erage /nancial trader can use the same model to

im!ro%e her !redictions of the results of the !olicymakers !olicies+

Tyler *owen thinks Im too quick to dismiss DSGE, and that instead, critiques like

this one should merely make us $downgrade$ DSGE+ This is a %ery 0ayesian

a!!roach, and I like it+ 0ut notice that 0ayesian &eliefs de!end on your !riors+ If

you started out thinking that DSGE was totally awesome, then critiques like this

one should make you tem!er your enthusiasm+ 0ut if you started out thinkingthat DSGE was hocus.!ocus, then critiques like this should tend to strengthen

your &elief somewhat+

-osted at 5:59 A;

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5B2 comments:

5+

Andrew Lilley5:12 A;

I can con/rm the e!ectation, Australian in%estment &anks and hedge funds do

not use DSGE models+ Cery few who are em!loyed to forecast would know what

they are+

Ke!ly

1+

Dimitar1:98 A;

http://en.wikipedia.org/wiki/Signalling_(economics)

http://orderstatistic.wordpress.com/2014/01/11/noah-smiths-not-so-damning-critique-of-dsge-models/



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http://en.wikipedia.org/wiki/Signalling_(economics)




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0ut++ markets are eOcient so wise DSGE modellers will not make money+ The

DSGE !aradigm wins again

Ke!ly

B+

AnonymousB:1B A;

DSGE models historically ha%e com!letely ignored /nance+ 7inance is sim!ly

re!lying in kind+

Ke!ly

2+

Will 2:28 A;

Arent DSGE models !rimarily used in !olicy institutions in order to !ro%ide a

narrati%e as to what has &een occuring within the economy" ;ainly &ecause at

some!oint economists need to talk to non.economists who desire to ha%e some

form of structuredLcausal e!lanation of why things are the way they are"

Fut of interest what macro models do /nancial institutions use" CAKs"

Ke!ly

9+

Robert 9:8= A;

Sometimes I &ore myself+ In fact when I read $)ucas critique$ I usually &ore

myself+ I will &ore you too+ I fear I cant resist discussing the meaning of $)ucas

ro&ust$+ It is quite dierent from the meaning of $ho!efully )ucas ro&ust$+

#e can go &ack to the source of the )ucas critique to a%oid the word $)ucas$+ That source was named Jaco& ;arshack

htt!:LLen+wiki!edia+orgLwikiLJaco&P;arshak ')ucas cited him(+ Me was also a

minister in a ;enshe%ik go%ernment once+ Me introduced the word $structural+$

Ah thats the ticket+ They !hrase $)ucas.ro&ust$ can &e translated to $your

!arameters are all structural+$

F< so what does $structural$ mean in this contet " It is currently often used to

mean $ha%ing something to do with o!timi@ing$ &ut it originally meant !olicy

in%ariant+ Now it is not necessary to write down a model in which agents o!timi@e

to ha%e !olicy in%ariant !arameters .. the Newtonian model gra%ity gi%es !olicyin%ariant close enough to &e useful e%en if we do not discuss the utility function















of !lanets+

Similarly the fact that one writes down a model in which a !arameter a!!ears in

a utility function does not make em!irical estimates of that !arameter !olicy

in%ariant+ that would &e true if the model were reality+ The fact that the model /ts

a%aila&le data F< tells us no more than it would if no techniques of o!timi@ationwere not used in sol%ing the model+ The relationshi! &etween our conditional

forecasts and conditional !ro&a&ility distri&utions cant de!end on whether we or

not we consider the regression coeOcient of consum!tion growth on the real

interest rate the estimate of a !arameter of a utility function or Hust an ad hoc

regression coeOcient+

The argument that models with micro foundations are )ucas.ro&ust makes no

sense at all+ I think it has !recisely eactly @ero merit of any kind+

Ke!ly

Ke!lies

5+

Noah Smith=:B6 A;

Sure+ 0ut I say Qe%en grantingQ )ucas.ro&ustness to a su&set of dsge models,

they fail+the market test+

Reply

R+

Robert 9:51 A;

0y the way, I &ore myself &ut you dont &ore me+ This is a &rilliant !ost+ The

eam!les are %ery con%incing+

Ke!ly

Ke!lies

5+

Noah Smith=:B6 A;

Ma+ Thank you, sir+

Reply
















6+

Dr DSGE9:5= A;

I cant hel! noticing that MS0* )ondon is currently looking to hire a DSGE e!ert+

Ke!ly

Ke!lies

5+

Anonymous9:BB A;

I &elie%e they are also used in 00CA

'see, eg+htt!:LLser%iciodeestudios+&&%a+comL<ETDLf&inLmultLEuro!ePEconomicP#atchP5=8

655PtcmB2>.1RB285+!df"ts5511855 (

1+

Noah Smith=:5= A;

That is good info Thanks

Reply

>+

Anonymous9:B8 A;

I would !oint to an alternati%e e!lanation+ -eo!le use CAKs in !art &ecause there

are software !ackages that do almost all the estimation work for them 'E%iews,

etc+(+ #hile DSGE models ha%e eisted for B1yrs it is only during the last 58yrs

that software to sol%e them has emerged 'Im thinking of Dynare(, and only

during the last 9 years or so that the software has &een ca!a&le of estimatingthem+

I would therefore argue that it is only now that they are &eginning to &e a realistic

alternati%e to CAK for $real.time$ analysis of the macroeconomy+ Since $real.time$

analysis is where money is to &e made it is not sur!rising that DSGE models are

not yet widely used in macro./nance+ It will howe%er &e &ad news for DSGE if

they do not &egin to &e used in macro./nance o%er the net decade+

'In short, until a tool is easy to use it will not &e widely used, regardless of

whether or not it might &e a good tool(

http://www.econ-jobs.com/economics-jobs/senior-quantitative-economist-9571






http://www.econ-jobs.com/economics-jobs/senior-quantitative-economist-9571








Ke!ly

Ke!lies

5+

foosionR:8> A;

The %alue of a &etter model is high enough to many /nancial institutions that it

would &e worthwhile de%elo!ing a software !ackage+

1+

Gene allahan1:15 A;

Kight foosion+ I was !aid to code u! my com!anys own !ro!rietary o!tion model,

e%en though we could ha%e Hust &ought o%er.the.counter stu with a standardmodel+









Reply

=+

!onathan9:BB A;

#hile !ri%ate sector economists may not use DSGE models to forecast 'at least,

not yet( QunderstandingQ such models may well &e ad%antageous to them:

5L *entral 0anks clearly take DSGE seriously 'whether they should or not is

another question(+ So understanding DSGE models may hel! your understanding

of a *entral 0anks reaction function+ A !ri%ate sector economist in 188> who had

read and understood Eggertson and #oodford '188B( would ha%e &een much

&etter a&le to !redict the 7eds actions once the fed funds rate hit @ero+

7or eam!le, see Ga%yn Da%is 'former chief economist at GS( discuss the !a!ersof Janet ellen and the im!ortance of ha%ing done the same with 0ernanke:

htt!:LL&logs+ft+comLga%ynda%iesL185BL58L5BLthe.economics.of.Hanet.l.yellenL

1L If not DSGE, then what" Kelying on em!irics without theory can &e dangerous .

Hust ask an in4ation forecaster in the 5=68s+ If you acce!t this 'I know many

might not, &ut Hust for the sake of argument( . the question is what theory"

As you yourself note here:

htt!:LLnoah!inion&log+&logs!ot+co+ukL185BL82La.world.without.macroeconomists+html

There are many cra@y theories out there 'ho!!ed onto @erohedge recently"( and

DSGE, while not !erfect, is a disci!lining de%ice that hel!s you get rid of the cra@y

ones+

The common theme here is thinking in terms of modern macro . forward thinking,

general equili&rium etc is im!ortant for !ri%ate sector economists, e%en if they

arent !rogramming u! model economies on Dynare Hust yet+

Ke!ly

58+

i"ansml 9:2= A;

#ell, according to most DSGEs, !ri%ate sector !eo!le already ha%e rational

e!ectations, so they dont need to study DSGEs+ -ro&lem sol%ed

;ore seriously . you raise some good !oints, &ut heres a !ossi&lecounterargument: At this stage, DSGE models are not %ery good at making










!recise quantitati%e forecasts 'in the conditional sense you descri&ed(, sim!ly

&ecause macro is tough . so there would &e no !oint in constructing a !ri%ate

DSGE model to get !recise E.conditional !ro/t.maimi@ing !ortfolio weights, or

whate%er+

0ut models can still !ro%ide qualitati%e insights . if ha!!ens and assum!tionsA,0,* are a!!roimately true, then will increaseLdecreaseLstay the same+ At the

same time, theres a natural di%ision of la&or . academic economists generate

new insights with DSGE models, industry economists a!!ly these insights '!assed

to them through tet&ooks or sur%ey !a!ers( when analy@ing s!eci/c questions

they face, according to their &est Hudgement a&out which insights are most

rele%ant for their situation+

Do industry !eo!le use modern macroeconomic theory in this way" I dont know+

If they dont, there could &e se%eral reasons . may&e DSGE are worthless+ 0ut in

that case, what kind of theory !eo!le QdoQ use" Fld.style <eynesian models"Intuition" Keciting !ages from ;ises" That would &e interesting to know+

Fn the other hand, may&e it Hust takes time for theory to trickle down from

research frontier to tet&ooks, and !eo!le will use them more in the future+ Fr

may&e most DSGE models dont actually &ring that much new insights . e+g+ the

whole New.<eynesian research !rogram seems to &e mostly a&out deri%ing

standard undergraduate <eynesian macro with intertem!oral o!timi@ation 'which

I think is %alua&le, &ut it wont change !eo!les decision %ery much(+

Ke!lyKe!lies

5+

#nlearnin$econ6:B9 A;

I agree with this . economics should not run &efore it can walk, and e!laining the

general, stylised &eha%iour of the economy is surely the &est starting !oint we

can ho!e for+

F&%iously theres still the issue of whether DSGE does this suOciently+ I think it

still suers from the e.ante choice of model !ro&lem the Noah references here+

1+

%r&ys B:16 -;

The !ro&lem with this argument is that some DSGE models ha%e %ery dierent

qualitati%e !rediction from the market mo%ements+ In other words, sim!le

directional trades should make you money, &ut they dont+












B+

Gene allahan1:1B A;

$Keciting !ages from ;ises"$

:.( *alled the $-eter Schi methodology+$

Reply

55+

hris 'rownR:9= A;

A %iew from a /nance guy in )ondon+ No one I%e met uses DSGE or e%en has it

on their radar+ Fnly interest would &e from &anks 'like MS0* mentioned a&o%e(

trying to understand central &anks decision making !rocess+











This is o&%iously not an endorsement: they would try to understand Scottish

rainfall models &etter 'say( if they thought this was !art of the central &ank

!rocess+

Ke!ly

51+

Ste"e 'annister6:81 A;

*hris Sims:

Sims, *hristo!her A+ U;acroeconomics and Keality+V Econometrica 2>, no+ 5'January 5=>8(: 5W2>+ doi:58+1B86L5=51856+

ntil this is satisfactorily answered 're!ly here if you think it is(, this issue should

ha%e &een settled in 5=>8+ Kemem&er Sims, Doan, and )itterman were at

;innesota, either the or the 0ank, or &oth+

Ke!ly

5B+

(eter( >:28 A;












;ore generally the industry doesnt hire new <eynesians, freshwater !eo!le or

market monetarists+ Ftoh they !ay &ig &ucks for ;;T.related analysis ';c*ulley

at -imco, retired rich, Mat@ius at GS(+

Ke!ly

Ke!lies

5+

Won)s Anonymous5:58 -;

I thought Mat@ius was su!!osed to &e rather mainstream in his economics, rather

than ha%ing any association with ;;T+

1+

%r&ys B:1= -;

7unny, Mat@ius endorsed ;; a year and a half ago+

B+

*an)' 2:1= -;

-I;*F ne%er used ;;T in its &ond trading decisions+ ;c*ullley only looselystarted discussing some -ost.<eynesian elements of economics in the latter years

of his career+

And Jan Mat@ius sometimes uses #ynne Godleys sector /nancial &alances+ Me

doesnt $do ;;T$ in any meaningful sense and is actually much more

sym!athetic to ;arket ;onetarism than ;;T+

2+

(eter( 58:51 -;

XMank0

htt!:LLwww+economonitor+comLlrwrayL1851L8RL19L!aul.mcculley.mmt.won.

declare.%ictory.&ut.&e.magnanimous.a&out.itL

X<r@ys,

7unny, &ut he didnt+ Me likes NGD- targeting a la #oodford who said+++ he ne%er

heard of ;arket ;onetarists and doesnt read their &logs+ Mat@ius also doesnt

&elie%e in standard ;; idiocies like monetary !olicy always osetting /scal+





http://guggenheim.com/















9+

*an)' 55:58 -;

Mi -eter-,

I think that 1855 ;;T %ictory la! was a &it !remature+ Some ;;T economists

!redicted the Euro was $doomed and would colla!se+

htt!:LLwww+le%yinstitute+orgL!u&sLhiliP55Ba+!df

htt!:LL&il&o+economicoutlook+netL&logL"!5=126

0ut Euro!e is now seeing economic acti%ity at BR month highs and the E*0

seems to ha%e contained the crisis+ It looks like ;;Ts dooms day !redictions

were actually wrong+

R+

%r&ys 51:5R A;

-eter,

Gi%en that NGD- targeting is the central idea of ;;, who reads whose &logs is

irrele%ant+

6+

AnonymousR:B> A;

X Mank0,

;;T was correct in !redicting the demise of the Euro+ It has already failed and is

continuing to fail+ The consequences of mass unem!loyment, out!ut lost fore%er

and a youth undergoing hysteresis will waste an entire generation+ If that doesntqualify as failure Id like to know what does+

It is my &elief that the Euro will &e continued out of &lind !olitical dogmatism+ It

was &orn as a !olitical construct and the sooner it is formally a&andoned the

&etter+

&ill28

>+

Anonymous>:19 A;

















E%en the out.going 0en 0ernanke re%eals himself as an ;;T #anna&e:.

htt!:LLwww+theguardian+comLcommentisfreeL185BLdecL5=L&en.&ernanke.legacy.

calling.out.congress

which kind of &rings him into line with the Jan Mat@ius Godleyian %iew of the worldand of course Sectoral 0alances Analysis are core to ;;T:.

htt!:LLwww+&[email protected].&alances.1851.

51Yi@@1K<TBFN2I

htt!:LLwww+realclearmarkets+comLdocsL1851L51L551>51Pusecs+!df

htt!:LLwww+&usinessinsider+comLthe.&ull.case.for.1852.185B.51

Reply

52+

Anonymous=:81 A;

#ell, a DSGE !ro!onent would sim!ly counter that the industry is run &y a &unch

of herd.following idiots, surely"

Ke!ly

Ke!lies

5+

%r&ys B:22 -;

This comment has been removed by the author.

Reply

59+

Anonymous=:58 A;

I trade with econometric models+ I ha%e tried+ Fr rather, my research associate

'fresh out of a school(, tried hard+ Me is con%inced that DSGE models are su!erior+

0ut &acktesting !ro%ed to &e a rather frustrating eercise for him+ Not that I was

sur!rised+ 0ut sometimes the only way to learn is to fail yourself+

This &rings u! another issue+ If the 7F;* were to look at their models as

something they were trading with, 'trade unem!loyment and in4ation(, theywould see they ha%e terri&le real time results+ That should tell them something+












Ke!ly

Ke!lies

5+

Noah Smith=:15 A;

This is great info+ Thanks

Reply

5R+

Daniel 'achman=:51 A;

I%e &een doing forecasting in the !ri%ate sector since 5==1+ I%e worked on teams

that sold forecasting models and forecasts to lots of maHor industrial and /nancial

com!anies+Mad to relearn what I thought I had learned in grad school in the

5=>8s+ There no+++re!eat no+++com!etition to traditional <lein.ty!e

macroeconometric modeling+ Ne%er has &een+ 'Its not done in s!readsheets, &y

the way, its done in ECiews or something similar(+

This is also true of the !u&lic sector+ Dont let the central &ank thing fool you+

They may look at DSGEs, &ut when it comes to to create the forecast that the

F!en ;arket *ommitttee looks at, the sta goes to 7K0LS, which is more or lessan u!dated traditional model+ And they use addfactors when necessary+ Just like

in 5=R=+ ;eanwhile, *0F and *EALF;0 mainly use traditional models for their

forecasts..and to answer questions from !olicy !rinci!als+ So e%en in the !olicy

world, DSGE is really more of a curiosity than a serious tool+ Fh, and Euro!eans

actually use more structural modeling and know more a&out it than in we do in

the +S+

Incidently, I%e ne%er heard of any&ody using CAKs in a commercial contet+ Too

diOcult to e!lain to decision makers+ ;ay&e some /nance !eo!le do this, &ut I

ha%ent seen it+

I wrote a !a!er a&out this long ago, &ut ne%er could /gure out where to !u&lish

it+ htt!:LLwww+col&y+eduLeconomicsLfacultyLmrdonihuLmcsL&achman+!df+

Ke!ly

Ke!lies

5+

Noah Smith=:1R A;













7inance !eo!le use CE*;s, which are &ased on CAKs+++

1+

Anonymous=:2B A;

I ha%e seen CAKS integrated into a neo.classical synthesis ty!e model to account

for some /nancial %aria&les+ 0ut it was 5 'B or 2 %aria&le( CAK a!!ended to a

<lein.style model of >88Z equations+

I ha%e alos see a num&er of industry models and can con/rm what Daniel says

from my more limited e!osure+

B+

!e+topia=:22 A;

I took a forecasting class in undergrad where we used CAKs and CE*;s 'among

other tools(, QandQ used E%iews, which is hella ugly+ *ouldnt /nd a Ho& in

forecasting, so may&e theres more to ;r+ 0achmans statement after all+++

2+

!ohn 58:22 A;

Noah, in my e!erience, if someone is !ro%iding some !roHection to management

'which is !erha!s dierent from a trading situation(, they ha%e to e!lain it in a

way that one manager can e!lain it to his &oss and so on u! the later+ ou ha%e

to &e a&le to say whats dri%ing things+ There is a clear !reference away from

CAKs since it is hard to say what is dri%ing what+ #hile I ha%e a !reference for

CE*; %s+ CAK, it doesnt sol%e the underlying communication issue+

9+

'rian51:5B -;

I also work in industry !roducing forecasts+ I agree with the sentiment that

standard <lein.ty!e macro models are still the &read and &utter of our trade+

Theres relati%ely sim!le and ha%e a long track record, and in the daily grind of

dealing with clients, data, etc+, you dont ha%e a lot of time left to kee! re/ning

and trying new models+

That said, I think some of the attitudes here a&out DSGEs are too dismissi%e+ No, I

dont cali&rate or estimate them myself, &ut we still look at the modern macro

literature to get a good handle on the current thinking in terms of !olicy analysis,

how the macroeconomy &eha%es, etc+ #hile doing our forecasts, we certainly !ay

some attention to academic work 'often &ased on DSGEs(, and well mani!ulate
















our forecasts using add factors to re4ect that+

In short, we dont directly use DSGEs to forecast, &ut we do !ay attention to what

they tell us a&out macro and incor!orate that information into our traditional

forecasting tools using add factors and o%errides+ Just &ecause we dont use the

latest tools to !roduce forecasts doesnt mean were stuck in the 68s in ourthinking and su&Hecti%e outlook+

R+

Daniel 'achman5:2B -;

0rian, I agree that current <lein.ty!e models ha%e ado!ted quite a &it from macro

research of the !ast 28 years+ And, yes, you can learn useful things from the

recent literature+

Mowe%er, the question is really tied u! in how the academic world %iews &usiness

and go%ernment forecasting+ )ucas and Sargent !redicted that <lein style models

were on their way out 'in the 5=68s( and that didnt ha!!en+ #ould &e worth

understanding why that forecast didnt !an out, no" 0ut the usual %iew in

academia is that this re4ects a 4aw on the !art of those of us in the industry

rather than a 4aw in the academic research agenda+

Just as an eam!le, right now I am dealing with the fact that it is im!ossi&le to

/nd some&ody trained at school in using <lein.style models+ The only way you

can learn this is %ia a!!renticeshi!+ et these models remain the worlds maintools for using economics in &usiness 'and go%ernment, too(+ I ha%e to untrain

!eo!le &efore I can train them+ #hy isnt there any academic !rogram that takes

!roducing this ty!e of forecast seriously"

Reply

56+

Anonymous=:B5 A;

Ask Ste%e #illiamson to trade with his own models+ ;ay&e we will !air him u!

with Tale&+ Should &e a killer com&ination to raise A;+ And hedging each others

tails+

Ke!ly

Ke!lies

5+

Anonymous=:95 A;









*all it the Dynamic ;acro 0S -artners ))-

Reply

5>+

(hilip Glandon58:B> A;

I !ro!ose the following a corollary $CE*; 'or SCAK or whate%er /nance !eo!le

actually use( models are unconditionally &etter for forecasting than DSGE

models$

I still think thats not the same thing as saying that DSGE models dont work+

Fne !ossi&ility is that CAK is as good or &etter than DSGE for forecasting as long

as things are mostly normal 'ie no /nancial crisis and the monetary !olicy rulehasnt changed much(+ I think that descri&es most of the last B1 years+

Ke!ly

5=+

!ohn *. ochrane58:9> A;

Though no fan of DSGE models in their current form, I think you ha%e two &asicfacts wrong+

7irst, &usiness economists who use macro models are not using them !rimarily to

s!eculate on asset markets+ The main task is for indi%idual &usinesses to !lan

in%estment, in%entories, etc+ So they really want !lain %anilla unconditional

forecasts, $whats your &est guess of GD- net quarter"$ -eo!le who want to

make money in asset markets dont use macro models at all+

Second, you are assuming that &etter !olicy conditional forecasts will !roduce

&etter unconditional forecasts+ ou make money o unconditonal forecasts in theend+ 0ut the &itter truth of economic modeling is that this sim!ly is not true+

;odels that make good !olicy !redictions are necessarily clean, trans!arent,

sim!li/ed, and thus dont e!loit all the little correlations in the data to make

&etter unconditional forecasts+ And %ice %ersa, models that do e!loit correlations

in the data fall a!art on making conditional forecasts .. the &ig lesson of the

shifting !hilli!s cur%es of the 5=68s+

ou are wishing this fact away+ Surely good conditional forecasts should hel! us to

construct some sort of melange model that does &oth, you suggest+ 0ut so far

that is a wish not a fact+ The fact is, unstructural use of correlations !roduces&etter unconditional short term forecasts, and sim!le micro founded models











!roduce &etter conditional forecasts+

0y the way we are not alone+ -ure $structural$ weather models dont do as well in

making actual forecasts as statistical a!!roaches which com&ine dierent

structural models, sim!le correlations in the data, and forecaster Hudgement+

Ke!ly

Ke!lies

5+

Anonymous55:2> A;

-rofessor . it would &e really interesting to see you e!and on why you arent a

fan of DSGE models in their current form, and if you ha%e any thoughts on howthe !rofession could try to remedy the failings youre thinking of+

I know youre &usy, &ut !erha!s something to consider for a future &log !ost"

1+

hris 'rown55:98 A;

Fn your /rst !oint: there are !lenty of economist ty!es em!loyed at macro hedge

funds and &ond funds who would lo%e to ha%e an edge o%er the market on theim!act of fed !olicy on GD-, in4ation etc+ There is a lot of money at stake here

'the -imco Total Keturn 0ond funds A; [\198&n( and these !eo!le 'to my

knowledge( ignore DGSE so for me Noahs !oint stands+

B+

Won)s Anonymous5:5B -;

Keaders might &e interested to know that *ochrane !re%iously discussed

conditional %s unconditional forecasts at *ato n&ound, touching on Tetlocks$foes %s hedgehogs$: htt!:LLwww+cato.un&ound+orgL1855L86L59LHohn.h.

cochraneLdefense.hedgehogs

2+

Noah Smith1:98 -;

Mey, John

Though no an o DSGE models in their current orm















Id say that itself deser%es a Grum!y Economist !ost+++ ].(

First business economists who use macro models are not using them primarily to

speculate on asset mar!ets.

I know, thats my !oint ;y !oint is that if DSGE models worked, /rms could&edoing this+ The fact that theyre not is %ery informati%e+

"ou are wishing this act away. Surely good conditional orecasts should help us

to construct some sort o melange model that does both you suggest. #ut so ar

that is a wish not a act.

Im not really wishing, Im saying that, F<, su!!ose theres a 7ed !olicy change,

and &uy.side /rms want to know how to &et on the eects+ They &ase their &et on

a model that is aZ&Zc^, where is a weighted com&ination of all a%aila&le

reduced.form models, is a weighted com&ination of all a%aila&le non.DSGEostensi&ly.structural models 'such as sCAKs(, and ^ is a weighted com&ination of

all a%aila&le DSGE models+

#e o&ser%e c8+ oud think that if DSGE models as a class had any %alidity, wed

see c[8, howe%er small+

9+

!e+topiaB:22 -;

Seconding Noah here+ No one is $#ishing the fact away$ 'Id rather like to know,

$why is this fact the case"$(+

$So they really want !lain %anilla unconditional forecasts$

;ay&e Im missing something here, &ut why would &usiness owner assume that a

GD- forecast should &e !olicy in%ariant" If the &est forecast is conditional,

wouldnt e%eryone !refer that forecast, ceteris !ari&us"

$-eo!le who want to make money in asset markets dont use macro models atall+$

And were &ack where we started+

R+

%r&ys B:2R -;

ou can easily enhance returns &y using conditional forecats in entry and eit+ If

the models cant do it, they are sim!ly false+












6+

Som Das$upta2:22 -;

$-eo!le who want to make money in asset markets dont use macro models atall+$

I dont agree with this+ De!ends on which model you use+ 7or eam!le the sim!le

static ISL); model !redicted no in4ation and therefore falling yields 'real and

nominal(+ -eo!le who used this insight made a lot of money+

The 7ed is trying to aect the real economy through wealth eects+ Does this not

im!ly that getting the model right gi%e one &etter information a&out !ositioning

on assets"

>+

Ray Lope&51:98 -;

John M+ *ochrane se@: $ -ure $structural$ weather models dont do as well in

making actual forecasts as statistical a!!roaches which com&ine dierent

structural models, sim!le correlations in the data, and forecaster Hudgement+ $ .

&ut taking your analogy one ste! further: the really im!ortant stu for !lanet

Earth is in fact structural weather models of *)I;ATE as o!!osed to whether it

is going to rain this weekend #EATMEK forecasts+Reply

18+

Anonymous55:2> A;

-rofessor . it would &e really interesting to see you e!and on why you arent a

fan of DSGE models in their current form, and if you ha%e any thoughts on how

the !rofession could try to remedy the failings youre thinking of+

I know youre &usy, &ut !erha!s something to consider for a future &log !ost"

Ke!ly

Ke!lies

5+

Anonymous55:2= A;

Sorry, this was for -rof *ochrane 'a&o%e(+















Reply

15+

%eith 5:85 -;

0y Noahs own standard, then, seat !ants %ersions of neo.Austrian theories of the

&usiness cycle ha%e !assed the market test, gi%en their !o!ularity among his

quantitati%e /nance colleagues, and among non.academic #all Street

economists+

I mean, Hee@, is it really so hard to &elie%e that go%ernment committments to

!urchase assets and !eg interest rates could induce andLor eacer&ate strategic

com!lementarities in /nancial asset markets"

Ke!ly

Ke!lies

5+

!e+topia5:B= -;

Assum!tion: $neo.Austrian$ theories are !o!ular on #all Street+

They Hust &ark loudly+

1+

Noah Smith1:92 -;

#y $oah%s own standard then seat pants versions o neo-&ustrian theories o the

business cycle have passed the mar!et test

es, &ut dont fall for the fallacy of the con%erse+

%alidity ..[ use

thus use ..[ %alidity

0ut use ..[ %alidity

B+

%eith R:81 -;

Mmmm, whilst I admire your mastery of freshman sym&olic logic, you &etter let)arry Summers in on that whole fallacy of the con%erse thing:





















$0ut a growth strategy that relies on interest rates signi/cantly &elow growth

rates for long !eriods %irtually ensures the emergence of su&stantial /nancial

&u&&les and dangerous &uildu!s in le%erage+$

htt!:LLwww+washington!ost+comLo!inionsLlawrence.summers.strategies.for.sustaina&le.growthL1852L85L89L=52BB5Bc.62&=.55eB.>&Bf.

&5RRR689caB&Pstory+html

Not to mention John )andon.)ane:

#e show that UlooseV monetary !olicy W that is ha%ing an interest rate &elow the

target rate or ha%ing a growth rate of money a&o%e the target growth rate W does

!ositi%ely im!act asset !rices and this corres!ondence is heightened during

!eriods when asset !rices grew quickly and then su&sequently suered a

signi/cant correction+

htt!:LLwww+n&er+orgL!a!ersLw5=9>9

Reply

11+

Anonymous5:98 -;

Id suggest se%eral reasons for this+ 7irstly, /nancial com!anies are run &y !eo!lewho dont ha%e a %ery good intuition for 'macro(economics+ 7or eam!le, a lot of

hedge funds ha%e started assuming that interest rates are not %ery %olatile+

Anyone with a modicum of economics knowledge knows that this is an artefact of

the ^)0: ma'natural rate,83( is always going to &e less %olatile than natural

rate near 83+ Fnce we lea%e the ^)0 these com!anies will &e a &it stued+

DSGEs will only really &e acce!ted if they match these managers intuitions,

which will only ha!!en if they are also &roken and useless+

Secondly, on the other hand, DSGEs tend to ignore a lot of conce!ts like $hotmoney$ that are demonstra&ly %ery signi/cant from a /nancial !ers!ecti%e+ 7or

eam!le a lot of the current &oom in the 0KI*s is !artially dri%en &y highly.liquid

in%estors from Euro!e chasing yield+ The 4ow of hot money into and &ack out of

third.world economies is a maHor cause of their crashiness+

Thirdly, academic DSGEs are normally set u! as toy systems that only handle one

or two economies and a handful of economic indicators+ Ke.tooling them as fully.

4edged world models is !ossi&le &ut non.tri%ial+

7ourthly, and relatedly, with DSGEs I get the im!ression were still in a situationwhere the maths dictates the model+ 7inding closed.form solutions to DSGEs+++





well, e%eryones got to ha%e a ho&&y, &ut it really shouldnt &e necessary to make

!rogress, and models with no closed.form solution shouldnt &e ecluded from

consideration+

Also, for some reason, the $glo&al macro$ community of hedgies seems to &e

dominated &y [email protected] technical analysis ty!es+ ;ay&e theres a ga! in themarket here"

Ke!ly

1B+

Stephen Williamson1:B6 -;

Mi Noah,

Thats not what those models were &uilt for+ Its well.known that you do not need

economic theory to forecast+ 7or the *EF of General ;otors, its !ossi&le to set u!

an in.house forecasting grou!, &ut its lower cost, and !ro&a&ly a &etter !roduct,

to sim!ly &uy the ser%ice from ;acro Ad%isors 'a /ne /rm, located here in

*layton ;F(+ 0ut I would not use the ;acro Ad%isors model for !olicy analysis+

Thats what the $DSGE$ models are intended for+ #hether any models currently in

use at the 7ed, the E*0, the *0F, or whate%er, are any good is another question+

Ke!ly

Ke!lies

5+

Noah Smith1:9B -;

That%s not what those models were built or.

Ff course not+ #ho cares" As you yourself !ointed out, they should ha%e

rami/cations for !ortfolio choices+

't%s well-!nown that you do not need economic theory to orecast.

nconditional forecasts, yes+ -olicy.conditional forecasts, NF+ That is the !oint of

my !ost+

1+

Stephen WilliamsonB:5= -;

It seems the !oint of the !ost is that $DSGE$ models are no good, &ecause

!ri%ate industry doesnt use them+ So, Im saying its clear why !ri%ate industry















doesnt use them+ Thats &ecause the models were not designed to sell to !ri%ate

industry+ No one is suggesting that those !eo!le should /nd them useful+ #e

design the models for !olicy analysis, and for !ure scienti/c !ursuits . lets try to

understand how the world works+

;ay&e you could write us a !ost a&out how a gold/sh is no good to take on aduck hunt+

B+

Daniel 'achmanB:1> -;

Ah, &ut Treasury and *EA do use ;acro Ad%isors for !olicy analysis+ '*0F uses its

own in.house structural model(+ 0ecause theres no real alternati%e when the

Treasury Secretary or -resident want an answer+ ou might not want that, &ut the

!oint of the original !ost is that...fact...DSGE models arent used much in the$!ractical$ world+ ;y challenge to the academic world is to ask why instead of

sim!ly asumming that we &usinessLgo%ernment ty!es are wrong+

And its not true that &usiness forecasting doesnt need economic theory+ ;uch of

it takes !lace in the medium.term, non/nancial &usiness world, where you need

theory to e!lain 'e+g+( your auto or housing forecast+ Thats theory+

Ste!hen, you are welcome to set u! a com!any to com!ete with the <lein ty!e

models+ <lein did it, after all+ So did )arry ;eyer+ #hy has no&ody from the KE

world e%er come u! with any com!etition in this market"

2+

%r&ys B:95 -;

If the industry doesnt use them, &ut the models actually are &etter then the

currently used in forming conditional forecasts, then its a clear &usiness

o!!ortunity+ The DSGE modeled should form their little hedge fund and !roduce

su!erior returns for a while+ As always, they need to !ut money where their

mouths are+

9+

Noah Smith2:89 -;

So '%m saying it%s clear why private industry doesn%t use them. That%s because

the models were not designed to sell to private industry. $o one is suggesting

that those people should (nd them useul. )e design the models or policy

analysis and or pure scienti(c pursuits - let%s try to understand how the world

wor!s.














The !oint of my !ost is that i DSGE models are indeed useful for !olicy, they

must &e useful for trading as well, e%en if that is not what they were designed for+

See"

And the Ste%e #illiamson quote I !osted says much the same thing Kead whatyou wrote

R+

Daniel 'achman2:55 -;

$Those !eo!le$" I missed that+ Ste!hen, may I suggest that you might not know

that much a&out how the !ri%ate sector use economics if you ha%ent worked in

the industry+ ;y Ho& is not really to su!!ly a &unch of num&ers..it is $to try to

understand how the world works$ so I can e!lain it to decision.makers+ Themodel and forecast are tools to that end+

So if DSGEs really hel!ed me understand &etter $how the world works$ I would

use them+ I dont use them+ #hich is a fact+ And I think thats an im!ortant !oint

to understand+

6+

Stephen Williamson9:5B -;I think were running into a !ro&lem here as to what we mean &y $DSGE+$

5+ Noah seems to think that what I do is somehow re!resentati%e of $DSGE,$ &ut

Im a monetary theorist+ In my academic work, I dont construct large quantitati%e

models that I /t to data+ That said, with reference to the quote from my &log

a&o%e, some of my theoretical work . and things I &log a&out . are suggesti%e of

successful !ortfolio strategies+ Indeed, if I were working on #all St+, I think I could

hel! someone make some money+

1+ #hat ;acro Ad%isers does is Hust /ne+ -eo!le want stories, and that stu can&e used to tell a story, e%en if it means a&solutely nothing+ 0ut there is a market

for stories, a!!arently+

B+ $So if DSGEs really hel!ed me understand &etter $how the world works$ I

would use them+ I dont use them+ #hich is a fact+ And I think thats an im!ortant

!oint to understand+$

So, you dont use them+ 0ut can you tell me what they are"

>+









Stephen Williamson9:B= -;

Meres another o&ser%ation+ Gary Gorton makes, and has made, a lot of money on

#all Street+ 0ut I dont think Gary knows any more than I do 'ask him what he

thinks, if you want(+ Therefore, I think I could get !aid %ery well to work on #all

St+ )arry *hristiano, who I think we could more accurately call a DSGE guy, has a%ery dierent skill set from Gary and me+ Im willing to assert that he could also

make a lot of money on #all St+ if he wanted to+

So, I think !eo!le schooled in modern economics ha%e marketa&le skills+ E%en as

academics, we get !aid ecellent salaries relati%e to what most academics get

'and theyre always com!laining a&out it(+ So, thats the market test+ #hat would

you &e doing with a -hysics -hD, Noah"

=+

Noah Smith=:8R -;

$oah seems to thin! that what ' do is somehow representative o *DSGE* but '%m

a monetary theorist. 'n my academic wor! ' don%t construct large +uantitative

models that ' (t to data.

es, yes, I know+ Technically those models arent dynamic and stochastic+ 0ut I

think the same argument a!!lies to all of the ostensi&ly.)ucas.ro&ust

microfounded modern macro models in use today, and $DSGE$ is Hust a term

!eo!le recogni@e+ Its a &u@@word, sure+

,arry hristiano who ' thin! we could more accurately call a DSGE guy has a

very dierent s!ill set rom Gary and me. '%m willing to assert that he could also

ma!e a lot o money on )all St. i he wanted to.

Im sure he !ro&a&ly could, &eing a smart guy+ 0ut could he do it using the same

kind of model that he makes to try to answer !olicy questions 'i+e+ the kind we

saw him !resent at St+ )ouis(" Thats really the question+

So ' thin! people schooled in modern economics have mar!etable s!ills.

No question a&out that] this !ost wasnt a&out Ho& markets for DSGE.trained

economists+

)hat would you be doing with a /hysics /hD $oah0

Thats a question I%e often asked myself, &ut I guess well ne%er know now

58+

%r&ys 51:8R A;
















es, some economists can make some money on the street, mainly &y talking to

other economists, called regulators, or to customers selling them stories+ Its

mainly -K and litigation hedging+ No academic c economist would &e allowed

close to a trading &ook 'or e%en a strategy team(+

55+

%r&ys 51:B8 A;

Ste!hen,

Some of your results suggest !ortfolio strategies" ou dont e%en reali@e how

funny that sounds+ ou remind me of a classic eam!le of a #all Street quant

who thinks they understand the marketLeconomy &ecause they understand

' their( model &est+ Now, it ha!!ens etremely infrequently that said quant is

actually right+ They do know something &etter+ et, its etremely unlikely+

If you want to see how little of the economy you understand, try and !ut some

trades on+ Mey try e%en !a!er trading, &ut not e !ost &ut going forward+ ou will

%ery quickly disco%er how little you know+

I think e%ery wanna &e regulator, central &anker and so on, should &e forced to

actually to test their su!!ositions &y actually making decisions, I+e+ -utting trades

on in whate%er their /eldLmarket is+ That will teach them humility really quick+

51+

Stephen Williamson1:25 -;

$Its mainly -K and litigation hedging+$

ou dont reali@e how funny that sounds+ I know !lenty of economists who ha%e

&een full.time academics, and who ha%e worked full time on #all St+, at Goldman

Sachs, 0ear Stearns, AIG+ Fthers are full.time academics and ha%e #all St+

retainers or short.term consulting contracts+ Those !eo!le arent Hust there for

window dressing, they are doing hea%y lifting+

5B+


$es, yes, I know+ Technically those models arent dynamic and stochastic+ 0ut I

think the same argument a!!lies to all of the ostensi&ly.)ucas.ro&ust

microfounded modern macro models in use today, and $DSGE$ is Hust a term

!eo!le recogni@e+ Its a &u@@word, sure+$

Actually, Im not sure what you know+ ;y models indeed are dynamic andstochastic, though theres not always aggregate uncertainty in there+ #e could
















talk a&out the $GE$ too+ Some of the models I work with are not GE in the sense

of com!etiti%e equili&rium, as there can &e strategic com!onents in there+ So,

when you say $ostensi&ly )ucas.ro&ust micro.founded,$ it seems youre talking

a&out the whole /eld of macroeconomics+ So its not clear where your argument

is going+ ou want to argue that all that stu is useless &ecause some !eo!le in

the !ri%ate sector dont want to think a&out it"

52+

Noah SmithB:55 -;

es, all+ ;y critique is of the whole !aradigm+ Theres so damn QmuchQ of this

stu out there that its quite !ro&a&le that a few of the models would in fact &e

%ery useful to industry+ 0ut industry cannon /nd them+ #hy not" 0ecause the

macro !rofession has no way of Hudging models in%alid and throwing them out+ So

whate%er works . if any of the models work . gets lost in the massi%e Hunk !ile,and we kee! Hust adding and adding to the Hunk !ile+

QThatsQ what Im critici@ing+ Its really not e%en a&out the models as much as its

a&out the scienti/c standards of the !rofession that allows all these models to

li%e+ I will write another &ig !ost a&out this fairly soon+++

59+

Stephen Williamson2:1> -;$+++ its a&out the scienti/c standards of the !rofession that allows all these

models to li%e+++$

oure e!ecting something of economic science that it can ne%er deli%er+ This is

Hust the nature of the &east+ I%e learned to lo%e it, &ut o&%iously you ha%e a hard

time with it+ 7irst, in macro, there will ne%er &e one model for e%ery !ro&lem+

#ere trying to understand the world, so the models ha%e to &e sim!le+ ou ha%e

to &reak down this massi%e !ro&lem into little !arts so that we can come to gri!s

with what is going on+ So, there are going to &e a lot of models+ Thats %ery

democratic, dont you think" #e can e%en ha%e %ery dierent models of the same!henomenon, and one might &e as useful as another+ I can like ;o@art, and I can

like Kadiohead too+

The models are all wrong+ ;any !eo!le ha%e em!hasi@ed that !oint 'most

recently )ars Mansen, though I cant remem&er where I read it(+ Thats what

makes economics dierent+ These things are all in%alid, &ut we work with wrong

models &ecause they are sim!le, and . of course . &ecause they are useful+

5R+











Noah Smith6:58 -;

"ou%re e1pecting something o economic science that it can never deliver. This is

2ust the nature o the beast. '%ve learned to love it but obviously you have a hard

time with it.

I guess thats true+

' can li!e 3o4art and ' can li!e 5adiohead too.

A( F<, &ut this isnt art+ ou Hust !ointed out that we 'i+e+ ta!ayers( !ay

macroeconomists relati%ely generous amounts of money to do this stu+ If its all

a matter of taste, what are the ta!ayers getting for that money"

0( #eirdly, I dont like either ;o@art or Kadiohead+ I know, Im strange+

The models are all wrong...That%s what ma!es economics dierent.

I ho!e you dont hate me if I dont eactly /nd that fact encouraging+++

These things are all invalid but we wor! with wrong models because they are

simple and - o course - because they are useul.

seful for what"

And arent sim!le models, like little F)G models, more useful for storytelling thanthese &ig in/nitely.forward.looking monstrosities"







56+

Sam Lichtenstein6:18 -;

7T7

0( #eirdly, I dont like either ;o@art or Kadiohead+ I know, Imstrange+_M_M_M_M_M_M_M wrong

5>+

%r&ys =:1R -;

They are not window dressing" They are doing $hea%y lifting$" ;eaning they

direct trading strategies and get a cut of a trading &ook" )et me assure you that

!retty much ne%er ha!!ens+ es, some e Econ academics do work on the street,

&ut that has nothing to do with their Econ &ackground+ They are many more emath or !hysics academics than Econ ones working close to front oOce+ E%en












they are mainly window dressing+ I hired lots of -hDs o%er the years, and as a

rule I would not hire Econ -hDs+ Their skills were sim!ly wrong for front oOce

work+

Anyway, dont take my word for it+ Try and trade on your models+ ou will quickly

disco%er how little your models are worth+

5=+

Noah Smith=:B1 -;

Thanks, Sam+

18+

%r&ys 58:85 -;

0y the way+ )et me mention that &asic economics is actually quite useful for

understanding certain &asc regularities in the markets+ Mowe%er, the analytical

richness is !retty much ehausted once you go &eyond some &asic undergrad

con+ The moment you start !laying with more com!leL so!histicated models

they o%er/t data almost instantaneously and you end u! !laying with noise+

15+

Noah Smith51:56 A;

Not sure I &uy that, <sr@yksryk@+ ;c7addens models famously !redicted 0AKT

ridershi!, and theres a lot of stu &ased on those, right"

11+

Stephen Williamson55:1B A;

$And arent sim!le models, like little F)G models, more useful for storytellingthan these &ig in/nitely.forward.looking monstrosities"$

Now youre actually getting down to &usiness+ If you claim to &e condemning all

of modern macro, then thats essentially damning all of modern economics to

hell, as its now im!ossi&le to say where micro sto!s and macro &egins+ So now I

think youre saying that $storytelling$ might &e useful+ That seems a &it on the

!eHorati%e side, &ut to !ut a nice s!in on it, we could &roaden our notion of

storytelling &y saying that we ha%e some little models that gi%e us some s!arks

of insight into how the world works+

-ossi&ly the area of agreement we can /nd here is the following+ I /nd %arious

models useful, sometimes for quite dierent reasons+ ;ay&e they tell me




















something a&out how monetary !olicy works] may&e they !ro%ide some insight

into why some !eo!le in the world are so !oor and some are so rich] may&e this

Hust !ro%ides me with another tool . Im going to learn how this thing works, and

Im going to /le that away for later use when Im struggling with some !ro&lem+

So, I ha%e a toolkit . its some array of neoclassical growth modelLsearch andmatchingLmechanism designLinformation economicsLFG modelL)agos.#rightLetc+

etc+ And then I use that for e%erything I do, whether Im writing academic !a!ers,

&logging, writing tet&ooks, gi%ing ad%ice to !eo!le who make !olicy+

0ut there is a class of monster models, which started with 5=R8s )awrence <lein

ty!e 288.equation macroeconometric models+ Those were the models )ucas was

critiquing+ And theres a tendency for more contem!orary models like what came

out of Schmets.#outers and *hristiano.Eichen&aum.E%ans to grow into monsters

that really look much like the )awrence <lein models+ And those monsters are

really quite useless, I think, though the !eo!le who construct those things andwork with them will argue otherwise, of course+

1B+


<r@ys,

Im not sure that were e%en discussing the same thing+ Two questions for you:

5+ #hat eactly is the line of &usiness youre in+

1+ #hy are you reading Noahs &log, anyway"

12+


0( #eirdly, I dont like either ;o@art or Kadiohead+ I know, Im

strange+_M_M_M_M_M_M_M wrong

Didnt say I liked them these characters either+ I assure you that my tastes are

soooo cool that no one likes what I do+

19+

Noah Smith1:29 -;

' you claim to be condemning all o modern macro then that%s essentially

damning all o modern economics to hell as it%s now impossible to say where

micro stops and macro begins.















No+ 7alse+ Not e%en slightly true+ 7irst of all, e%en if the techniques used are

similar, the questions they try to answer are dierent and the data and em!irical

methods they use to %alidate their theories are com!letely dierent+

So now ' thin! you%re saying that *storytelling* might be useul.

-eo!le do enHoy stories Id rather models make usa&le quantitati%ely accurate

!redictions a&out stu, &ut stories are &etter than nothing+ Meck, thats all

cosmologists and a lot of e%olutionary &iologists get from their models+

&nd there%s a tendency or more contemporary models li!e what came out o

Schmets-)outers and hristiano-Eichenbaum-Evans to grow into monsters that

really loo! much li!e the ,awrence 6lein models. &nd those monsters are really

+uite useless ' thin! though the people who construct those things and wor!

with them will argue otherwise o course.

I sus!ect youre !ro&a&ly right+ ou should write this &log !ost $;onster models$

is a great title+ I will link a!!ro%ingly+ :.(

1R+

Noah Smith1:26 -;

Also:

7. )hy are you reading $oah%s blog anyway0

#ell gee, thanks ].(

' assure you that my tastes are soooo cool that no one li!es what ' do.

NF# I ;ST <NF#

16+

%r&ys B:B1 -;

Ste!hen,

5+ I do quant commodity trading+

1+ I like Econ for its qualitati%e insights+ Its always a useful check+ -lus I always

look around for stu I might &e missing+

1>+

%r&ys R:92 -;

















Noah,

Thank you, although you forgot a cou!le of @s+

Anyway, the cases you quote corres!ond to situations in which the economic

structure is %ery trans!arent, the o!timi@ation does not interact with the

'estimation( noise and the underlying DG- is stationary and %ery sta&le and youclearly control the rules of the game+ Thats why mechanism design a!!lication

'like auctions( work well+ In actual markets, where the fundamentals are not %ery

trans!arent, your a&ility to /lter noise away are %ery limited, econ models will

ty!ically fail+

)et me gi%e you a !erfect eam!le from commodities+ Around 58.59 years ago,

GE was marketing a great !roduct: GE ma!s+ It was great since it !erfectly

ca!tured the fundamentals in the local electricity market in -ennsyl%ania: -J;+

Mow !erfectly" GE ma!s was used &y the system o!erator to actually dis!atch

the system in real time+ So, they knew the underlying su!!ly and demandstructure !retty much with !erfect !recision+ et, they couldnt !redict or e%en

e!lain !ast !rices+ Neither le%els nor %olatilities+ *onsider how strange that is+

Electricity is the sim!lest commodity+ No storage, hence 'almost( no inter.

tem!oral o!timi@ation in the underlying !roduction decision+ 7undamentals as

trans!arent as could &e+ et, no success+

1=+

Noah Smith58:26 -;

That%s why mechanism design application 8li!e auctions9 wor! well.

e!+

So of course I was &eing etremely tongue.in.cheek with my eam!les+++naturally

you cant do what I descri&ed, which is why !eo!le dont+ ].(

Reply

12+

Anonymous1:26 -;

I feel as though the !ost already went o%er the ground &eing co%ered in se%eral

!laces a&o%e+ 0eginning with:

$DSGE models are useful for !olicy ad%ice &ecause they 'ho!efully( !ass the

)ucas *ritique+ If all you want to do is forecast the economy, you dont need to

!ass the )ucas *ritique, so you dont need a DSGE model+ + + + The !ro&lem is, this

argument is wrong+ + + + )et me e!lain+$









It would &e interesting to hear some more in.de!th res!onses to the e!lanations

oered in the !ost+

Ke!ly

19+

AnonymousB:59 -;

I think a factor has got to &e the dierence &etween the ethos of the /nance

sector and that of academia+ F&%iously, there is often quite a di%ergence of

o!inion &etween academic economists and /nanciers 'think of /gures like -eter

Schi(+ E%ery industry and occu!ation comes with its own ideological &aggage,

determined in large !art &y the kind of !eo!le it attracts

Ke!lyKe!lies

5+

Daniel 'achmanB:BB -;

Sorry to &e re!etiti%e here, &ut an awful lot of &usiness forecasting takes !lace in

the non/nancial sector+ It might &e more fruitful to think of how a cor!orate

!lanner in an auto or ca!ital goods com!any uses economic forecasts+

1+

Anonymous2:1> -;

Fkay, &ut I think the same still a!!lies

Reply

1R+

Som Das$upta2:1R -;

Mi Noah,

#hy is the )ucas *ritique 'I admit I ha%e not read his original( right" Is it

something like the Meisen&erg -rinci!le" *ould it !ossi&ly &e that a consistent

theoretical model sim!ly has time %arying !arameters instead"

Ke!ly

Ke!lies













5+

Noah Smith2:BR -;

)ucas *ritique is right &ecause there is no reason to &elie%e that the !arametersof any model you decide to write down are /ed !arameters+ They could change

when !olicy changes+

1+

Som Das$upta2:9R -;

Fk I see the !oint 'and as much as I thought a&out models ha%ing time %arying

!arameters(+

Its interesting and !erha!s the *ritique does not a!!ly uni%ersally 'only to macro

!olicy models !erha!s"(+ The reason I say this is for eam!le we kow that the

0lack.Scholes model with constant %olatility !arameter does not do a great Ho&+

#hich is why im!lied %ols are constantly u!dated and traded+ 0ut that hardly

refutes a model &ased on the no.ar&itrage conditions+

B+

Noah Smith9:51 -;

Some form of the critique a!!lies to most things+

Reply

16+

*an)' 2:B5 -;

Noah, does anyone really $use$ economics to get rich" Mow useful is economics

in actual market a!!lication" Does anyone actually utili@e a macroeconomica!!roach to making money in the markets" I work for a large hedge fund and I

dont know anyone who relies solely on economists and economic analysis for

their market decisions+

Thoughts"

Ke!ly

Ke!lies

5+




















Noah Smith2:B= -;

De!ends on what you de/ne as $economics$+ A lot of /rms use time.series

statistics to get rich+ Some time.series techniques were de%elo!ed &y

economists+

Also, there are lots of other industries where !eo!le use game theory to get

rich+++thats why all those tech startu!s are hiring auction theorists like cra@y+

1+

Anonymous2:21 -;

Does any&ody in the &usiness use macro models to inform their trading

decisions"

B+

Anonymous2:2R -;

In other words, does your statement that $if DSGE models are indeed useful for

!olicy, they must &e useful for trading as well,$ not also a!!ly to other ty!es of

models as well, and do they all fail the market test"

2+

Noah Smith2:2R -;

es+ 0ridgewater Associates su!!osedly does this a lot+

9+

Noah Smith2:91 -;

Sure, some other models fail the market test 'as Id e!ect, since I &elie%e

humanity is mostly ignorant a&out macro due to !oor data(, &ut macro hedgefunds and &anks use a lot of non.DSGE models+

Reply



















1>+

Syed ,a&en9:8= -;

This comment has been removed by the author.

Ke!ly







1=+

Syed ,a&en9:55 -;

i need to understant that,has indi%idual weaken the en%ironment due to

industriali@ation"adams smith freemarket theory !layed any role in it,i tried to

analyse it in %ery short in my &log+++!lease comment in it,though this is

com!letely dierent to!ic &ut i would lo%e to recie%e comments

htt!:LLsyedma@enquddusi+&logs!ot+inL1852L85Lside.eect.of.ca!italistmy.

%iew+html

Ke!ly

B8+

Tom9:5= -;

#hile its true as John *ochrane says that traders dont rely on or usually e%en

much understand models, they generally ha%e analyst su!!ort who do

understand and use models+ And it does mean something that those guys ne%er

ado!ted DSGE, though may&e not as much as Noah thinks it means+

Its not a %ote of con/dence in traditional models+ Its more a case of why change









if the newer is more com!licated without &eing &etter+ Neither ty!e of model

!roduces actiona&le !redictions+ If you dig into 0loom&erg you can /nd data on

how often the a%erage forecast of the economists they sur%ey get right the

direction of this or that macro !arameter, and the track records are all %ery close

to 983+ Some !articular economist &eat that, others do worse, &ut thats

generally %iewed as the natural dis!ersion of the random+

0ut e%ery research team has to take a stand on macro, and clients dont like to

hear that youre Hust kind of guessing+ If old models are as good as any, why toss

them out"

So the more !om!ous !romises made for DSGE indeed fell through, &ig sur!rise+

0ut the /nance industrys $meh$ at DSGE was more a&out con%enience of the

!rocess than the quality of the results+

Ke!ly

Ke!lies

5+

%r&ys 51:B2 A;

Same thing as always+ The &eauty of the street is that if you think you ha%e an

edge that other traders are ignoring, then you trade against them and take their

money+ If you think they are la@y, well, sim!le solution, dont &e la@y yourself and

form the hedge fund already+ ntold riches await+

Reply

B5+

Eric -al)enstein58:2> -;

I was an economists at two &anks way &ack, in 5=>6.>=, and in 5==2.9+

Economists were used for -K, talking a&out econ stats, and sometimes settingthe ta&le for discussions a&out the economy+ The real decisions were made &y

guys winging it a&out macro forecasts+ So, no DSGE, &ut really no macro at all, in

terms of any graduate le%el stu from any thread+

Note they also dont use Stochastic Discount 7actors++++

Ke!ly

Ke!lies

5+












Noah Smith55:12 -;

Nowadays there are lots of !eo!le doing formal macro modeling at &ig &anks,

right" Just not structural, microfounded, DSGE.ty!e stu+

1+

Eric -al)ensteinR:59 -;

The a!e of !ri%ate sector economists was the 5=68s, when e%eryone was

o!timistic a&out large scale macro models+ 0y the time I Hoined a &ank in 5=>6

our &ig &ank had a&out 52 economists, and they would get misty remem&ering

the good old days when there was 98Z !rofessionals de%oted to economics+ After

demonstrating they didnt ha%e any %alue, their ranks slowly dwindled, so when I

was at a &ank in 5==2 we had one economist and me his assistant, and he was

Hust to res!ond to !ress requests are inter!reting macro releases: the &ank liked

getting their name in the !ress+

#hen I was at ;oodys no one inside listened to the com!any economist though

again, he was often quoted in the !ress and inter%iewed, and so remained

%alua&le for that reason+ Needless to say, these -K economists ha%e <eynesian

causal mechanisms &ecause they are more intuiti%e than %ague su!!ly shocks,

regardless of whether they were em!irically &etter, and the whole !oint is to &e

!o!ular with Joe si.!ack+

Fnce, &ack in 5==2, I was sent to )odi Fhio, and was s!eaking to a room full of&ank clients a&out our 'ie, my &osses( macro forecast+ I was &asically a !ro! for

sales !itches &y local &ankers to their clients to sell ser%ices+ I had a lot of

reasons why interest rates would rise, in4ation would rise, etc+ Ff course, if that

was really good info 'it wasnt(, they would ha%e wanted it at our Asset and

)ia&ility *ommittee meeting 'A)*F(, and !erha!s not want to share it+ Fur A)*F

committee couldnt care less what our economist said+ I reali@ed this was dum&,

and got into risk management 'forecasting !ortfolio %olatility(, and later !ortfolio

management, &ecause when done well, they are actually useful+ None of this

uses any macro models+

Reply

B1+

%aleber$51:1R A;

If #Iki!edia is to &e &elie%ed, a DSGE model requires a !roduction function and a

utility function+ That is, you ha%e to ha%e a theory a&out what !eo!le are a&le to

sell and what !eo!le want to &uy+ That seems to &e !ro&lem+ If you can de%elo!

either of those two functions, or e%en &etter, &oth, you can make money withoutin%oking DSGE+ Its sort of like !utting the &ell on the cat+















The other !ro&lem is the E, equili&rium+ The way you make your money in the

/nancial sector is when the equili&rium changes, and when the equili&rium

changes the market is, &y de/nition, not in equili&rium+ All told, Im not sure Hust

what DSGE adds to a /nancial actors usa&le knowledge+

Ke!ly

BB+

Doc ,erlinR:19 A;

This isnt limited to macroeconomics+ -hysics &ased models in s!ace and solar

!hysics also tend to &e far worse than historical &ased 'regressions, looku!.

ta&les, neural nets, etc( models+ Mowe%er, the !hysics &ased models allow us to

learn a&out the su&Hect &y e!loring what is otherwise an o!aque system+

Ke!ly

Ke!lies

5+

Noah Smith58:59 A;

0ut thats &ecause you know the !hysics itself is right+ In econ, if we had goodmicrofoundations . i+e+, a good understanding of how consumers and /rms make

decisions . we could do something similar to what youre talking a&out+

Reply

B2+

Dr. Tufte=:99 A;

Two additions in two comments] /rst addition:

A&out 18 years ago, GewekeQ had a !iece on the scale of innaccuracy caused &y

5( modeling with the )ucas critique &ut ha%ing an unaddressed aggregation

!ro&lem &uilt into your model, %ersus 1( not modeling with the )ucas critique &ut

a%oiding the aggregation !ro&lem 'essentially a <lein model(+ Me concluded that

the scale of the innaccuracies from the two !ro&lems was a&out equal+

This is consistent with the %iew of some in this thread that !ri%ate sector

forecasters may not use DSGE models &ecause that would require an in%estment

of time and eort without any im!ro%ement in outcomes+

Q I think it was Geweke 'in the AEK-?-(+ I couldnt /nd it online on Saturday















morning+ If the thread kee!s u!, I can /nd the cite in my hard co!y in my oOce

on ;onday+

Ke!ly

B9+

Dr. Tufte=:9R A;

Second addition:

Some of the discussion here &rings to mind *anner, ;ankiw and #eils 5==6 $An

Asset Allocation -u@@le$+ They argued that in%estment ad%ice a&out how to s!lit

u! your !ortfolio was inconsistent with how theory said it should &e done+ The

end result was that the ad%ice that de%iated from theory wasnt %ery costly, so it

could &e regarded as near.rational+ Essentially, !ortfolio managers could engagein chea! talk that de%iated from the theory without doing much harm+

I wonder if this is what is going on with the of macro models in the !ri%ate sector+

#e all know that the dierences in !erformance &etween a <lein model, a

CAKLCE*;, and a DSGE 'while there( Hust arent that large: they all miss so much

stu that their &ottom.line results arent that dierent+ In this case, there isnt

much cost in using something that you%e already got 'like a <lein model( instead

of something that might &e &etter 'a DSGE(+ So !erha!s what we are o&ser%ing is

that the latitude a%aila&le for chea! talk is %ery large+

Ke!ly

BR+

#n)nown5:2= -;

Noah, when you talk a&out B1 years that is not fair to dsge models+ #e learned

how to eOciently estimate them may&e 58 years ago or e%en less+ Just com!are

the dates when CAK s!ftware &ecame a%aila&le and when dynare &ecame

a%aila&le+

I think one &ig reason for focus on CAKs is they%e &een aorund much longer and

theyare sim!ler+ DSGe will get there as well, youll see+

Not that I disagree with your other !oints+

Ke!ly

Ke!lies

5+

Noah SmithB:85 -;















#hat, cali&ration isnt good enough" ].(

Reply

B6+

%1:B6 -;

The whole article and almost all the comments are a&o%e my !ay grade"

Two questions:

If DSGE model is not usa&le 'in /nancial and in%estment decisions(, why s!end so

much ink on it"

#hy are so many !eo!le cogni@ant of it"

Ke!ly

Ke!lies

5+

%r&ys =:21 -;

Same as with string theory in !hysics: the internal logic takes o%er, the

&ureaucratic logic assures re!lication, r and !eo!le will always /nd a good reason

not to confront their models with data to kee! their Ho&s+

Reply

B>+

%ent Willard58:55 A;

7rom what I%e seen, in%estment decisions are &ased on a !lausi&le narrati%e of

what will ha!!en and why+ If you cant tell that story within 58 minutes and B.!ages, then it wont 4y at the to! le%els+ And that narrati%e had &etter /t the

!olitical %iew, !ersonal e!erience, and rule of thum& of the to! guy+

*om!le models tend to o&scure the narrati%e, so no one is going to stake their

fortune on it+ Nor should they, since too many !rogramming mistakes can &e

made and too many %aria&les arent measured timely or !recisely+ Fnce the

narrati%e has &een chosen, then may&e models will &e used to quantify the

magnitude and timing of the e!ected outcome+ The com!le models are often

used for showmanshi! rather than strategic decisions+

In%estors e!ectations of in4ation for the !ast 2.years were sim!ly &ecause





http://www.kentwillard.com/





http://www.kentwillard.com/




;0As didnt know the dierence &etween the monetary &ase and the money

su!!ly, and that the latter was created &y commercial &ank lending more than

central &anks+ It was a confusion of terms, they didnt really rely e%en on sim!le

s!readsheet models+

Ke!ly

B=+

daniels5:BR -;

Noah, I think a lot of this is a case of &ig mental adHustment costs+ -ri%ate sector

macro to me still seems dominated &y !eo!le who got most of their training in

the 68s and >8s, at a time when DSGE models were rudimentary+ The state of

the art DSGE modeling with e%erything from /nancial sectors, to search frictions

to all sorts of im!erfect informationLlearning are !ro&a&ly too recent for many!eo!le to &e aware of outside academia and central &anks+ And I think switching

from the simultaneous equations model with all %aria&les o&ser%a&les, to a state

s!ace framework where you aknowledge the im!ortance of latent,uno&ser%ed

state %aria&les and try to measure them is a &ig im!ro%ement in !ers!ecti%e

a&out the macroeconomy+ 0ut things like <alman /ltering are still not !art of the

standard training of most ;asters in economics students I think, so the technical

&aggage required for using DSGE models may &e missing sometimes 'though its

!ro&a&ly there in some quantL/nance a!!lications. e+g for stochastic %olatility

modeling+(+

;acro forecasting is not eactly a &usiness with a great re!utation for accuracyeither in conditional or unconditional forecasting, so while you cant clearly !ro%e

their forecasts and scenario analysis would im!ro%e with using DSGE models, its

hard to argue that they couldnt im!ro%e if they di%ersi/ed their toolkit+

A lot of DSGE models are a&out gi%ing insight, shar!ening intuition &y taking a

more theoretical !ers!ecti%e, which then you can com!lement %ia your

HudgementLadd factors Zstatistical models like CAKs to get a /nal forecast+ Its

not meant to &e the single forecast !roducer, and neither should a large old style

model 'forecast com&ination o%er se%eral models almost always dominates

indi%idual model forecasts(+ And much of the insight can also &e o&tained &y

going o%er all sorts of DSGE modelsL!a!ers, without necessarily using one as akey forecasting tool+

Ftherwise, I sus!ect things like 0ayesian CAKs or dynamic factor models or

sometimes Hust uni%ariat AKI;As will always dominate in !ure forecasting at 5.1

years hori@on+ The more rele%ant question is whether DSGE models can &e useful

in riskLscenario analysis+ ou seem to suggest no, &ecause the microfoundations

are wrong, &ut thats a &it of a straw man+ After all, its not like the ty!ical

consum!tion or in%estment function in a &ig old style models are true either+

Theyre also surely missing many %aria&les 'that must &e the case since theyre

limited to thinking only of o&ser%a&le %aria&les or using %ery rough !roies for

uno&ser%a&le things like !otential out!ut(, using the wrong linear functional form,too hasty in assuming error terms are IID and dont contain richer dynamics, and







in general often seeming to ignore key su!!lyLdemand considerations that should

matter &eyond the shortest forecasting hori@on+ And the notion that they take

into account &ounded rationality isnt %ery serious to me &eyond the fact that

they include lags of %aria&les '&ut so do !olicy oriented DSGE models, and its

hard to know you%e really se!arately identi/ed ha&it formation, from adHustment

costs, from ada!ti%e e!ectations when you add lags of consum!tion foream!le(+ And I dont see anything re4ecting !ros!ect theory or other state of

the art !sychological theory in old style macro models either+ So any model you

use is false, &ut we can disagree a&out whether it contains enough reality to &e

useful 'Id say a modi/ed %ersion of the !ermanent income consum!tion model

that allows for some demogra!hic factors, a !ro!ortion of households who Hust

consume all their income and some discount factor shocks isnt so &ad+ oud

!ro&a&ly disagree(+

Ke!ly

Ke!lies

5+

Daniel 'achman1:1= -;

The !oint a&out !eo!le in the !ri%ate sector &eing old is !recisely the red herring

that academics ha%e clung to since the KE re%olution+ I was trained in the 5=>8s

in KELreal &usiness cycles and had to relearn quite a &it to &ecome an eecti%e

&usiness analyst in the =8s+ This is still the case+ Its not a question of age, it

really is a question of DSGEs not &eing useful in the &usiness en%ironment+

The !oint of the original !ost is that the !ri%ate sector doesnt use DSGEs 'or, for

that matter much of the structure of !ost.5=R8s macroeconomics(+ And this is

also true for go%ernment &y the way+++when !ush comes to sho%e the discussion

will &e understanda&le &y any&ody who took intermediate undergraduate

macroeconomics in the 5=68s+

This is a fact, which has &een dri%ing !eo!le cra@y for a long time+ It doesnt

necessarily in%alidate DSGEs or real &usiness cycles as a tool for analysis, &ut it

does raise some serious questions+ It also suggests that the e!erience of

analysts in the go%ernmentL&usiness world might &e useful for de%elo!ing

theoretical a!!roaches+ 0ut instead I ty!ically see some %ariant of $&usiness

economists are ignorant+$

Sorry for the mini.rant+ I quite agree that a toolkit is useful, and, of course,

no&ody sane gi%es a decision.maker a !urely model.&ased forecast+ #hich is the

ty!e of thing that should gi%e us all !ause+ Ece!t 'I ha%e to get this in( the <lein.

ty!e model system recogni@es this formally, with addfactors, while the DSGE

a!!roach+++well I dont see it in the literature+

Same thing with risk+ If DSGEs are &etter for scenario analysis, why dont ;acro







Ad%isors and ;oodys Economy+com ha%e com!etition from this direction in

su!!lying tools for stress testing+ 0ecause Im not aware of any&ody su!!lying a

DSGE &ased tool for stress testing+ It does seem like a !otentially lucratu%e

market niche+

1+

daniels2:1B -;

Actually I think ;oodys has started looking at DSGE models as !art of their credit

risk scenarios modeling recently+ 5 !ossi&le ad%antage with DSGE models, is that

with current software such as dynare its quite easy to do for eam!le a Brd order

Taylor a!!roimation of the dynamics, so you can &etter ca!ture the im!ortant

nonlinearities that may matter if youre trying to simulate a more etreme

scenario+ Im not aware of anything equi%alent in the <leinL*owles comission style

models+Im not im!lying &usiness economists are ignorant, though there is a general lack

of con/dence in &usiness economists forecasts 'eem!li/ed for eam!le in the

cha!ter on economic forecasting in Nate Sil%ers recent &ook the $Signa and the

Noise$(. to &e fair forecasting the economy either as a !oint forecast or with

scenariosLwell cali&rated con/dence &ands is going to &e hard whate%er you do+

In academic a!!lications, you ne%er see add factors, &ecause thats not !art of

what you want to do in a Hournal article where the goal is to see how far a model

or theory can go &efore failing without add factors 'I dou&t To&in or Solow or

;odigliani used add factors in any way when writing an academic article using

some ISL); model(+ 0ut in !olicy en%ironments, DSGE models use %ariants of addfactors quite a lot either through the shock !rocesses or %ia e!licit model

com&ination 'treat the DSGE model as a core model, then add etra

dynamicsLadHustment %ia a non.core &lock(, and !resuma&ly youd do the same in

!ri%ate sector macro consulting+ In some cases, the add factorsL/es from the

!ers!ecti%e of one DSGE model can &e Husti/ed as com!ensating for missing

factorsLmechanisms that are !resent in other auiliary DSGE models that are

richer in some dimensions &ut may &e harder to work with+ The &est e!osition I

know of is the recent 0oE e!lanation of their forecasting framework,

htt!:LLwww+&ankofengland+co+ukLresearchLDocumentsLworking!a!ersL185BLw!265

+!df +

The coreLnon core a!!roach is also gi%en a good e!osition &y the 0oE as !art of

their !re%ious model,

htt!:LLwww+&ankofengland+co+ukL!u&licationsLDocumentsLotherL&eqmL&eqmfull+!d

f

+

Fther central &anks may &e using similar !rocedures, &ut are less trans!arent+

Reply

28+







!. Dubois>:16 A;

Noah: $0ut notice that 0ayesian &eliefs de!end on your !riors$

It may &e so, &ut your !riors may &e wrong and you should !unish yourself more

the more con/dent you were in these mistaken !riors+ I had this discussion withScott Sumner and god, it is frustrating+

Fk, lets ha%e this eam!le: you ha%e B theories that may e!lain some

!henomena+ ou need to &e more than 983 con/dent in order for you to !u&licly

su&scri&e to a theory+ Imagine that your !riors are as follows: 953 for theory A,

2>+=========== for theory 0 and 8+88888888885 3 for odd theory * that you

deem almost im!ossi&le+

Now new e%idence comes u! that makes you u!date your !riors as in the

following 1 scenarios:

5( New e%idence su!!orting theory 0 a!!ears so that the !osterior !ro&a&ilities

are as follows: A . 2=3 ] 0 . 95+===========3 and * . 8+88888888885 3

Since it is now theory 0 that !assed the threshold you make !u&lic

announcement that eecti%e now you are $com!letely$ changing your o!inion

and now su!!ort theory 0+ Mowe%er from 0ayesian !oint of %iew it is not

com!lete change of o!inion+ ou reduced !ro&a&ility of theory A and 0 &y

a!!roimately 23+ #e may say that it is not a large change+ ou made a mistake,

&ut not a large one+

1( New e%idence su!!orting theory * a!!ears+ Now it looks like this: A . 953 ] 0 .

2R+===========3 and * . 1+88888888885 3

Now your !u&lic $o!inion$ did not change much+ No &old statements, you still

su!!ort theory A, right" 0ut this is MGE, really MGE from &ayesian !oint of

%iew+ ou Hust ele%ated something from &eing la&eled as $really, really incredi&ly

not likely$ to Hust $not likely$+ ou made a huge change in your &ayesian scoring

scale+ ou should really &erate yourself for ha%ing such terri&le !riors+

So 0ayesian is something else from what you think+ The most useful conce!t here

is that of information entro!y, a conce!t from information theory+ This conce!t

can hel! you measure how $sur!rising$ a change in !ro&a&ility was, how much

new information you gained with a new e%idence+ The !oint &eing that the lower

the !ro&a&ility of a sur!rise the larger the information %alue it has+ -romoting low

!ro&a&ility e%en &y orders of magnitude means a lot of information was gained+

And &y this account the scenario 1 has a much larger im!act then scenario 5+

Ke!ly

25+







Daniel 'achman>:BB A;

This is interesting+ I quite agree a&out the lack of con/dence in &usiness

economists forecast..this is well demonstrated in the literature, as well as &y

Nate Sil%er+ At this !oint, no&ody in the economics world really e!ects much

a&ility in forecasting turning !oints 'educating our customers is another matter(+ This is, of course, where we really need a good tool+ I dont &elie%e DSGEs did

that well in the last downtown+ 0ut how could any econometric model !redict that

the )ehman would fail when it did"

So the question is whether DSGEs !ro%ide another useful tool+ As the original

!ost !oints out, so far this has not !ro%en to &e the case+ 'Again kee! in mind

that while *entral &anks ha%e DSGEs, they also use <lein.ty!e models+ The 0ank

of England, as far as I can tell from what they show on their we& site, ha%ent

re!laced the uarterly ;odel with a DSGE+(

#e had a session on models a cou!le of years ago at AEA 's!onsored &y NA0E, so

it was relegated to an incon%enient location(+ Fne of the 7ed !eo!le at that

session made an interesting !oint: That central &anks 'and es!ecially the 7ed

0oard( ha%e a lot more resources than the !ri%ate sector, so they sim!ly &uy

more of all ty!es of forecasting, without necessarily making strict cost.&ene/t

analysis of what they are &uying+ A nicer way to !ut it might &e that central

&anks are more willing to &uy new, risky technology than the !ri%ate sector+

In any e%ent, I welcome the !ossi&ility that DSGE models could !ro%ide a useful

tool+ I am currently a !urchaser of a traditional model, &ut would welcome a salescall from some&ody who could con%ince me that their DSGE model would &e a

&etter tool+

Any takers" If not, I think the original !ost stands+

Ke!ly

Ke!lies

5+

danielsB:B= -;

I dont get what youre saying a&out a&out the 0oE" The core of their old

forecasting framework was a DSGE model+ The dierence relati%e to a CE*; is

that instead of Hust ha%ing con%ergence to some long run static E, their error

correction terms are res!onding to the de%iation &etween a dynamic equili&rium

model 'a DSGE model, or may&e rather a DGE since it seems the 0E; core is

non stochastic(+ Their new core model is a DSGE model similar to an o!en

economy %ersion of Smets and #outers modelZsome credit constrained

households+ The !ost says this has not !ro%en to &e the case so far %ery frequently in the









!ri%ate sector+ 0ut I dont know that <lein ty!e models were useful in the !ri%ate

sector in the 5=98s either, which didnt mean theyre not useful today+ If I

understand correctly the leaders in using large macro models were a macro

consulting /rm esta&lished &y <lein himself and the 7ed through ;odiglianis ;-S

model+ At the time it must ha%e &een much easier !ro&a&ly to gain clients Hust &y

showing u! with a model when there was nothing com!ara&le+ Nowadays, themarket is still oligo!olistic &ut more crowded, and it would &e harder for someone

like )arry *hristiano to o!en u! a macro consultancy &usiness at the same le%el

as say Fford Economics or IMS: it wouldnt &e enough for him to quit his

uni%ersity Ho&, hed need to /nd do@ens of other like minded economists,

coordinate them, hire secretaries and &usiness de%elo!ment managers+++in short

there are &arriers to entry into the /eld, and like in other 'semi( scienti/c /elds

its not always o&%ious to con%ince non e!ert clients that a new method can do

&etter than something thats &een around for decades and seemed to !ro%ide a

satisfactory though highly im!erfect ser%ice+ 0ut who knows, may&e 0ernanke

and Gertler will get &ored with academia 'not sure what 0ernankes !lans arenow( and theyll team u! to !ro%ide macroeconomic ad%ice &ased on their New

<eynesian DSGEZ7inancial accelerator model" I !ersonally wouldnt mind

listening to 0ernankes macro ad%ice+

0y the way, Nate Sil%er and my comment werent a&out how come the !oint

forecast from &usiness economists didnt !redict )ehman &rothers or other

recessions+ The !oint is that ty!ical !ri%ate sector forecasts seem to &e &adly

cali&rated: their con/denceLuncertainty &ands around the forecast 'e+g in the S-7

density forecasts( are too narrow and underestimate the risks facing the

economy 'and its true this was also an issue for DSGE models estimated on great

moderation sam!les when the /nancial crisis hit( . and why is e%eryone so/ated on the !oint forecast when you know its an 'almost( !ro&a&ility @ero

e%ent" #ith all the uncertainty around, its the con/dence &ands and the

scenarios which should &e more im!ortant+

1+

Daniel 'achman9:88 -;

Daniels:

7irst, I Hust want to thank you for ha%ing such a reasoned discussion+ I a!!reciate

learning from you a&out some as!ects of DSGEs I didnt know+

Fn the 0FE: I got this from looking at their we&site, so may&e I am wrong" 0ut it

does seem to im!ly that they still use their quarterly model, which looked a lot to

me like a small.scale traditional model+ I know for a fact that, at the 7ed 0oard,

the stas main tool remains 7K0LS 'I ha%e a cha!ter on 7orecasting in the

7ederal Go%ernment coming out in a &ook soon'"(, so I%e s!oken to !eo!le there

a&out it(+ Not that DSGEs arent used, &ut when it comes to organi@ing all the

!ieces of the toolkit, the <lein.ty!e model is still at the core+





I dont think you are correct a&out the IF characteristics of the economic

forecasting industry+ There ha%e certainly &een new entries o%er the years...

Dismal ScientistLEconomic+com came out of nowhere to !ick u! a signi/cant

market share in the 5==8s, for eam!le+ And the &ig /rms are always u!dating

their models anyway+ If there was a market ad%antage to &e gained from using a

new methodology, I think it would ha%e &een ado!ted+ I know this &ecause I%e&een there 'and !ushed successfully for the ado!tion of error correction in

estimation, among other things(+ In fact, I heard that one of the large /rms hired

a DSGE modeler at one !oint, &ut they !arted ways after a cou!le of years when

it &ecame e%ident that the /rms in%estment wasnt worthwhile+

It doesnt take $do@ens$ of economists+ Three -h+D+s and may&e one full.time

manager could !ro&a&ly get it started+ Theres !lenty of turno%er among &usiness

economists, so lots of o!!ortunity to /nd !eo!le who are ready for something

new and dierent that they can sell to their users as more u!.to.date than what

others are using+

Agree a&out the cali&ration issue..and es!ecially the !oint forecasts+ 0ut that

leads to the diOculty of getting users to see &eyond the !oint forecast+ Ma%ing

&een there a lot, I can assure you that its non.tri%ial+

ou see, I would like to get &eyond the idea that DSGEs arent acce!ted &ecause

of market failures, or ignorance, or whate%er, and look more closely at how and

why decision.makers use information..and how economics su!!lies it to them+ I

think thats a really worthwhile area of thought that ought to !lay a role in dri%ing

the research agenda+ And I think the sur%i%al of <lein.style models is a reallyinteresting data !oint in that contet+

Reply

21+

Anonymous58:B9 A;

I can s!eak from the model &ased macro hedge trading !ers!ecti%e+

5( ;ost of the &iggest macro funds are fundamental, NFT technical+ And I meanthe ones that are running models+

1( This is a case of ha%ing no faith in the DSGE or 7ed models+ S!eaking from

!ersonal e!erience 'o%er 18 years(, I can say that a lot of the traditional theory

is sus!ect+ Kecent eam!les &eing . no &alance sheet or de&t %iew of the

economy has led to in4ation and growth &eing lower than forecast+ Interest rates

do not work in the real economy as ad%ertised in traditional models+ #hy should I

use them if they do not work" It is clear to us in the real world that the world

does not work like the 7ed descri&es+

B( Dont e%en get me started on currency trading+ The fact that academic models

ha%e such a &ad track record should tell the macro guys something+2( ltimately, the continual denial &y the 7ed that asset !rices do not swing





your !osts, although this is now the second time I ha%e tried to do so and failed+

Not sure what is u!+

Ke!ly

29+

Robert >:21 A;

Someone Hust clicked a link here which sent him or her to my &log 'thanks(+ So I

re read the !ost+ It is &rilliant .. a&solutely wonderful

Ke!ly








,onday1 ,ay 231 2456

#hat can you do with a DSGE model"

Author: Noah Smith

#hen the 0ank of England in%ited me to gi%e a talk at their worksho! on

macroeconomics, I wasnt sure if they wanted me to !ro%oke 'i+e+ troll( them with

the kind of ske!tical stu I usually write on this &log, or to talk a&out my ownresearch on arti/cial markets and e!ectations+ So I did &oth+ Now, this is a

central &ank e%ent, which means secrecy !re%ails . so I cant tell you what the

reaction was to my talk, or what other !eo!le said in theirs+ 0ut I thought Id

re!roduce !art of my talk in a &log !ost . the !art where I talked a&out DSGE

models+ 'In other words, the !ro%ocati%e !art+(

$DSGE$ is a loose term+ It usually im!lies much more than dynamics, stochastics,

and general equili&rium] colloquially, to &e $DSGE$ your model !ro&a&ly has to

ha%e things like in/nitely far.sighted rational e!ectations, ra!id clearing of

goods markets, certain sim!le ty!es of agent aggregation, etc+ So when I talka&out $DSGE models$, Im loosely referring to ones whose form is &ased on

the 5=>1 <ydland ? -rescott $K0*$ model+

In recent times, of course, K0* models themsel%es ha%e fallen out of fa%or

somewhat in the mainstream &usiness.cycle.modeling community, and ha%e

gone on to coloni@e other /elds like asset !ricing, international /nance, and la&or

econ+ As of 185B, the most $mainstream$ DSGE models of the &usiness cycle are

$New <eynesian$ models+ The most im!ortant of these is the Smets.#outers

model, which has gained a huge amount of attention, es!ecially from central

&anks, for seeming to &e a&le to forecast the macroeconomy &etter than certain!o!ular alternati%e a!!roaches+ If you know only one DSGE model, Smets.



http://www.ecb.int/pub/pdf/scpwps/ecbwp722.pdf








#outers is the one you should know+

Anyway, my talk asked the question: $#hat can you do with a DSGE model"$

;ost !eo!le who e%aluate the DSGE !aradigm dont focus on this question] they

either trace the historical reasons for the ado!tion of DSGE 'the )ucas *ritique,

etc+(, or they discuss the ways DSGE models might &e im!ro%ed+ Instead, in mytalk, I wanted to take the !ers!ecti%e of an alien econ !rof who showed u! on

Earth in 185B and tried to e%aluate what human macroeconomic theorists were

doing+

A DSGE model is Hust a tool+ Its a gi@mo, like a fork lift or a lithium.ion &attery+

The +S+ and Euro!e ha%e in%ested an enormous amount of intellectual ca!ital .

thousands of !erson.years of our &est and &rightest minds . in creating, testing,

and using these tools+

So what can you do with these tools"

5. -orecast the economy7

Fne thing you might want to do with a &usiness cycle model is to forecast the

&usiness cycle+ DSGE models ha%e im!ro%ed enormously in this regard+ Though

early K0* models were notoriously &ad at forecasting, more recent, com!le

DSGE models ha%e !ro%en much &etter, and are now considered slightly &etter

than %ector autoregressions, and a&out as good as the 7eds own forecasts+

0ut as Kochelle Edge and Kefet Gurkaynak show in their seminal 1858 !a!er,

e%en the &est DSGE models ha%e %ery low forecasting !ower+ *heck out these

ta&les from that !a!er:

http://www.federalreserve.gov/pubs/feds/2011/201111/201111pap.pdf

http://ideas.repec.org/p/nbp/nbpmis/74.html



http://ideas.repec.org/p/nbp/nbpmis/74.html




These ta&les show the forecasting !erformance for the Smets.#outers model

'which, remem&er, is the $&est in class$( from 5==1 through 188R+ The /rst ta&leis for in4ation forecasts, the second is for growth forecasts+ )ook at the K.squared

%alues+ These num&ers loosely descri&e the amount of the actual macroeconomic

aggregate 'in4ation or growth( that the model was a&le to !redict+ An K.squared

of 5 would mean that the forecasts were !erfect+ oull notice that most of the

num&ers are %ery, %ery low+ The Smets.#outers model was a&le to !redict a &it of

in4ation one quarter out 'though the 7eds internal forecasts were much &etter at

that hori@on(, and not at all after one quarter+ As for growth, the DSGE model had

%ery low forecasting !ower e%en one quarter ahead+

Now, this doesnt necessarily mean that DSGE models are su&.o!timalforecasters+ These things might Hust &e %ery %ery hard to !redict Mumanity may

sim!ly not ha%e any good tools 'yet( for !redicting macroeconomies, Hust like we

arent yet a&le to !redict earthquakes+

0ut theres also some e%idence that we could &e doing &etter than we are+ In this

185B !a!er, Gurkaynak et al+ test the $forecast eOciency$ of DSGE models, and

/nd that their forecasts are not o!timal forecasts+ Also, they /nd that sim!le

uni%ariate AK models are often signi/cantly &etter at forecasting things like

in4ation and GD- growth than the &est a%aila&le DSGE models This is not an

encouraging /nding for the DSGE !aradigm, since AK models are Hust a&out thesim!lest thing you can use+

Also, in this discussion of forecasting, remem&er that the deck has already &een

stacked in fa%or of DSGE models+ #hy" 0ecause of !u&licity &ias and o%er/tting+

If DSGE models dont do well at forecasting, researchers will add features until

they do &etter+ As soon as they do well enough to look good, researchers will

!u&lici@e the success+ This is a !erfectly a!!ro!riate thing to do, of course . its

like im!ro%ing any machine until its good enough to sell+ 0ut it means that the

!u&lici@ed models will ha%e a tendency to o%er/t the data, meaning that their

out.of.sam!le !erformance will usually &e worse than their in.sam!le and!seudo.out.of.sam!le !erformance+

http://econ.upf.edu/~brossi/GKR2013_April20.pdf






'!date: Cia a commenter, heres a good sur%ey of DSGE models forecasting

a&ility, including how they did in the Great Kecession+ See my new !ost for

more+++(

In other words, DSGE models are !ro&a&ly not %ery good as forecastingtools+++yet+ 0ut theyre a&out as good as anything else we ha%e+ And they ha%e

im!ro%ed considera&ly com!ared to their early incarnations+

2. Gi"e policy ad"ice7

This is what DSGE models are $su!!osed to do$ . in other words, most academics

will tell you that this is the !ur!ose of the models+ Actually, a model can &e

!erfectly good for !olicy ad%ice e%en if its &ad at forecasting+ This is &ecause

forecasts ha%e to deal with lots of dierent eects and noise and stu thats allha!!ening simultaneously, while !olicy ad%ice only requires you to understand

one !henomenon in isolation+

0ut heres the !ro&lem: To get good !olicy ad%ice, you need to know which model

to use, and when+ So how do you choose &etween the %arious DSGE models"

After all, theres a million and one of them out there+ And theyre usually mutually

contradictory] since theyre /tted using many of the same macroeconomic time.

series 'e+g+ +S+ !ost.##1 GD-, em!loyment, and in4ation(, one of them &eing a

good model 'e%en Hust in one s!eci/c situation( means the others must then not

&e good models+

So how do you choose which model to use to gi%e you ad%ice" Fld methods like

$moment matching$, which were used to $%alidate$ the original K0* models, are,

sim!ly !ut, not %ery hel!ful at all+

#hat a&out hy!othesis testing" Again, not %ery hel!ful+ If you make the model

itself the null, then of course youll reHect it, &ecause any model will &e too

sim!li/ed to e!lain e%erything thats going on in the economy+ If you make the

null the hy!othesis that the DSGE model !arameters equal @ero, youll almost

always reHect that null, e%en if the model is grossly miss!eci/ed+

In !rinci!le, I think you should use some kind of goodness.of./t criterion, like an

K.squared, using out.of.sam!le data and adHusted to fa%or !arsimonious models+

At the macro conferences and seminars I%e attended, I ha%ent see !eo!le

saying $)ook at the out.of.sam!le adHusted K.squared of this model #e should

use this one for !olicy$ ;ay&e they do say this, though, and I Hust ha%ent seen

it+ '!date: Mere, some !eo!le, including Smets and #outers, do e%aluate the /t

De/nitely check out this !a!er if youre into macro modeling+(

0ut anyway, theres a few more !ro&lems here+ Fne is the lack of clearly de/nedsco!e conditions] macro theorists rarely work on the diOcult !ro&lem of when to

http://www.ssc.upenn.edu/~schorf/papers/hb_forecasting.pdf


http://noahpinionblog.blogspot.com/2013/05/dsge-financial-frictions-macro-that.html

http://www.ssc.upenn.edu/~schorf/papers/dssw2007.pdf



http://noahpinionblog.blogspot.com/2013/05/dsge-financial-frictions-macro-that.html

http://www.ssc.upenn.edu/~schorf/papers/dssw2007.pdf



sto! using one model and start using another 'see net section(+ Another is the

nonlinearity !ro&lem] most DSGE models are lineari@ed, which makes them

easier 'i+e+ !ossi&le( to work with, &ut means that their !olicy recommendations

often dont e%en match the model+

'As an aside, many !eo!le say $F<, we dont know which DSGE model is right, so Hust com&ine a &unch of models, with some weights+$ 7ine+++&ut the weights arent

structural !arameters, so &y doing this you gi%e u! the su!!osed $structural.

ness$ of DSGE models, which is the main reason !eo!le use DSGE models instead

of a s!readsheet in the /rst !lace+(

So to sum u!, DSGE models could oer !olicy ad%ice if you used an a!!ro!riate

model selection criterion, and dealt carefully with a &unch of other thorny issues,

AND ha!!ened to /nd a model that seemed to /t the data decently well under

some clearly de/ned set of o&ser%a&le conditions+ 0ut I dont think we seem to

&e there yet+

6. ,ap from DSGE models to policy ad"ice7

F<, so its really hard to gi%e de/niti%e !olicy ad%ice with DSGE models+ ;ay&e

you could instead use DSGE models as ma!s from !olicymakers assum!tions to

!olicy ad%ice" I+e+, you could say $Mey, !olicymaker, if you &elie%e A and 0 and *,

then here are the im!lications for !olicies and and ^+$ In other words, since

DSGE models are internally consistent, may&e they can hel! tell !olicymakers

what they themselves think can &e done with regards to the macroeconomy+'Another way of saying this is that may&e we can lea%e model selection u! to the

!riors of the !olicymaker+(

Theres Hust one !ro&lem with this+ DSGE models are highly styli@ed, meaning

that its often not possible even to (gure out whether you &uy an assum!tion or

not+

)et me demonstrate this+ )ets take a look at a DSGE model . say, *hristiano,

Eichen&aum, and E%ans '1889(+ This New <eynesian model is %ery similar to the

Smets.#outers model mentioned a&o%e+ Mere is a CEK truncated list of theassum!tions necessary for this model to work:

• -roduction consists of many intermediate goods, !roduced &y mono!olists,

and one single consum!tion good$ that is a *ES com&ination of all the

intermediate goods+

• 7irms who !roduce the consum!tion good make no !ro/ts+

• 7irms rent their ca!ital in a !erfectly com!etiti%e market+

• 7irms hire la&or in a !erfectly com!etiti%e market+

• New /rms cannot enter into, or eit from, markets+

http://noahpinionblog.blogspot.com/2013/03/the-swamp-of-dsge-despair.html


http://www.benoitmojon.com/pdf/Christiano%20%20Eichenbaum%20Evans%202005%20JPE.pdf








• All ca!ital is owned &y households, and /rms act to maimi@e !ro/ts 'no

agency !ro&lems(+

• 7irms can only change their !rices at random times+ These times are all

inde!endent of each other, and inde!endent of anything a&out the /rm,

and inde!endent of anything in the wider economy+ 'This is $*al%o !ricing$+ The magic entity that allows some /rms to change their !rices is called the

$*al%o 7airy$(+

• The wage demanded &y households is also su&Hect to *al%o !ricing 'i+e+ it

can only &e changed at random times(+

• Mouseholds !urchase /nancial securities whose !ayos de!end on

whether the household is a&le to reo!timi@e its wage decision or not+

0ecause they !urchase these odd /nancial assets, all households ha%e the

same amount of of consum!tion and asset holdings+

• Mouseholds deri%e utility from the change in their consum!tion, not from

its le%el '$ha&it formation$(+ Mouseholds also dont like to work+

• Mouseholds are rational, forward.looking, and utility.maimi@ing+

F<, Ill sto!+ )ike I said, this is a CEK truncated list] the full list is may&e two or

three times this long+

Mow many of these assum!tions do you &elie%e" Im not sure thats e%en !ossi&le

to answer+ 7ormally, most of these are false+ Some are %ery o&%iously false+ The

question is how good an a!!roimation of reality they are+ 0ut how do we know

that either"" Is it a good a!!roimation of reality to say that households !urchase

/nancial securities whose !ayos de!end on whether the household is a&le to

reo!timi@e its wage decision or not" Mow would I e%en know"

In !rinci!le, you could look at the micro e%idence and see which of these

assum!tions looks kinda.sorta like real micro &eha%ior+ Some !eo!le ha%e tried to

do that with a few of the assum!tions of the Smets.#outers model] their results

are not eactly encouraging+ 0ut if you tried to go ask a !olicymaker $#hich of

these things do you &elie%e"$, youd get a &lank stare+

So DSGE models dont make a clear ma! from assum!tions to conclusions+ 0ut

how a&out using them Hust to e!lore the ro&ustness of models to %ariations in

assum!tions" A central &ank 'or the academic macro community( could make a

&unch of DSGE models and com!are their results, Hust to see how dierentmodeling assum!tions aect conclusions+ In fact, thats !ro&a&ly what the

http://www.minneapolisfed.org/research/wp/wp664.pdf






academic macro community has &een doing for the !ast B8 years+ This seems

somewhat useful to me, &ut theres a !ro&lem+ DSGE models are not %ery

tracta&le, so its !ro&a&ly the case that nearly all of the modeling assum!tions

usa&le in DSGE models are !oor a!!roimations of reality+ In that case, well &e

stuck searching net to the lam!!ost+

8. ommunicate ideas7

DSGE models can de/nitely &e used as a language in which to communicate

ideas a&out how the economy works+ 0ut they are !ro&a&ly not the &est such

language+ Sim!ler econ models, like F)G models, or e%en !artial.equili&rium

models, are much more 4ei&le, and can &e understood much more quickly &y an

interlocutor+ DSGE models ha%e a ton of mo%ing !arts, and its generally %ery

hard to see which assum!tions end u! causing which results+ The &etter a model

matches data or forecasts future data, the more mo%ing !arts it will generally

ha%e+ This is called the $realism.tracta&ility tradeo$+

So if you only work with DSGE models, and if you try to understand e%erything in

terms of DSGE models, youll ha%e a hard time communicating with other

economists+ I can see this &eing a !ro&lem in a central &ank, where !eo!le needto communicate ideas %ery quickly in times of crisis+

So1 what else would you ha"e us do7

There are a num&er of alternati%es that ha%e &een !ro!osed to DSGE models+

Dierent alternati%es are generally !ro!osed for the dierent !ur!oses listeda&o%e+

7or communicating ideas, the most !o!ular alternati%es are sim!ler, F)G.ty!e

models 'which are, technically, DSGE, though not what we ty!ically call $DSGE$(,

and !artial.equili&rium models 'suggested &y Ko&ert Solow(+ I%e seen some

!eo!le use these at seminars, es!ecially the F)G ty!e, so I think this alternati%e

may &e catching on+

http://en.wikipedia.org/wiki/Streetlight_effect

http://web.archive.org/web/20110204034313/http:/democrats.science.house.gov/Media/file/Commdocs/hearings/2010/Oversight/20july/Solow_Testimony.pdf

http://en.wikipedia.org/wiki/Streetlight_effect

http://web.archive.org/web/20110204034313/http:/democrats.science.house.gov/Media/file/Commdocs/hearings/2010/Oversight/20july/Solow_Testimony.pdf



7or forecasting, the common alternati%es are $s!readsheet$ ty!e models '*hris

Sims dismissi%e term( that dont assume structural.ness+ This is the kind of

model used &y the 7ed 'the 7K0LS( and &y some !ri%ate forecasting /rms

like ;acroad%isers+

-olicy ad%ice is the thorniest question, since you need your model to &e

structural+ 7or this, the main alternati%e that has &een !ut forth is called $agent.

&ased modeling$+ I dont know too much a&out this, and the name is weird,

&ecause DSGE models are also agent.&ased+ 0ut &asically what it seems to mean

is to s!ecify a set of microfoundations '&eha%ioral rules for agents(, and then do

a &ig simulation+ The &ig dierence &etween this and DSGE is that with DSGE you

can write down a set of equations that su!!osedly go%ern the macroeconomy,

and with A0; you cant+

So are we wastin$ our time ma)in$ all these DSGE models1 or not7

;y answer is: Im not sure+ So far, we dont seem to ha%e gotten a heck of a lot of

a return from the massi%e amount of intellectual ca!ital that we ha%e in%ested in

making, e!loring, and a!!lying these models+ In !rinci!le, though, theres no

reason why they cant &e useful+ They ha%e 4aws, &ut not any clear $fatal 4aw$+ Theyre not the only game in town, and reali@ation of that fact seems to &e slowly

s!reading, though cultural momentum may mean that the more recently

in%ented alternati%es 'A0;( will take decades to catch u! in !o!ularity, if they

e%er do+

-osted at 2:89 -;

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RB comments:

5+

!E 2:B1 -;

as larry summers said: stick to &agehot, minsky and kindle&erger

Ke!ly

1+

tuneconomist2:92 -;

http://macroadvisers.blogspot.com/2010/06/emperor-has-no-clothes-ma-on-state-of.html

http://en.wikipedia.org/wiki/Agent-based_model


http://noahpinionblog.blogspot.be/2013/05/what-can-you-do-with-dsge-model.html








http://noahpinionblog.blogspot.com/2013/05/what-can-you-do-with-dsge-model.html?showComment=1369686770899#c7005631595321394012

http://tuneconomics.wordpress.com/


http://macroadvisers.blogspot.com/2010/06/emperor-has-no-clothes-ma-on-state-of.html



http://noahpinionblog.blogspot.be/2013/05/what-can-you-do-with-dsge-model.html








http://tuneconomics.wordpress.com/




This is a %ery good !ost

;y only memory of DGSE models, dates dating &ack to my master degree

courses a few years ago, is that they are %ery elegant o&Hects through which I

learned how to com!ute using ;at)a&

As for your /rst !oint 'forecasting( I, generally, think that:

'i( if the %aria&le is inherently diOcult to forecast 'for eam!le in4ation(than you

will not gain much from com!le models 'including DGSE(+ So, the &est strategy

would &e to kee! it, as ^ellenr once said, $so!histically sim!le$+

'ii( now, if the %aria&le is relati%ely sim!le to forecast, than adding some

com!leity !ro&a&ly will lead to some forecast im!ro%ement '&ut not that

much(+

I dont ha%e much to say a&out 1(, B( etc+

Ke!ly

B+

Ale9 9:55 -;

Firms can only change their prices at random times. These times are allindependent o each other and independent o anything about the (rm and

independent o anything in the wider economy. 8This is *alvo pricing*. The

magic entity that allows some (rms to change their prices is called the *alvo

Fairy*9. The wage demanded by households is also sub2ect to alvo pricing 8i.e. it

can only be changed at random times9.

h+++whaa+++I had no idea+

Ke!ly

2+

neuroecolo$y9:5R -;

$Another is the nonlinearity !ro&lem] most DSGE models are lineari@ed, which

makes them easier 'i+e+ !ossi&le( to work with, &ut means that their !olicy

recommendations often dont e%en match the model+$

F<, I know net to nothing a&out DSGE, &ut if youre looking for !olicy

recommendations, why e%en &other with making them analytically tracta&le"

#hats the draw&ack of Hust doing the simulations"




http://neuroecology.wordpress.com/




http://neuroecology.wordpress.com/




Ke!ly

Ke!lies

5+

Nathanael9:81 A;

$if youre looking for !olicy recommendations, why e%en &other with making

them analytically tracta&le" #hats the draw&ack of Hust doing the simulations"$

No draw&ack+ Its Hust $!retty math worshi!$ which causes the idiotic

lineari@ations+

Reply

9+

!*a&ell 9:5R -;

Mi Noah, I was wondering if when you dimiss the forecasting success of DSGE

models, you ignore Nick Kowes thermostat !ro&lem+ S!eci/cally, wouldnt a

!erfect DSGE model !erfectly eliminate all forecasta&le shocks, so that !redicted

%aria&les and realised %aria&les would &e !erfectly uncorrelated" In this case any

K.squared ty!e test is worse than useless, and says nothing a&out the

!erformance of DSGE models in general+ Gurkaynak tends to &ring this u! quite alot, &ut always worth mentioning

Ke!ly

Ke!lies

5+

Noah Smith9:18 -;

I dont ignore it, I know it+ Its Hust not rele%ant to the $forecasting$ section of my!iece+

Note that I do not claim that models that are &ad at forecasting must &e &ad at

gi%ing !olicy ad%ice+

If a model cant forecast, it cant forecast+ -eriod+ #hether it can gi%e good !olicy

ad%ice is a se!arate and also im!ortant question+

1+














Nic) Rowe58:5> A;

This is what Gurkaynak and Edge say:

$0ut what does that say a&out the use of DSGE models in central &anks] &oth as

a tool for !olicy analysis as well as a tool for forecast generation" #e argue thatin &oth cases the answer is UnothingV+ The /nding that in4ation is not

forecasta&le o%er the Great ;oderation !eriod is consistent with the !redictions

of the DSGE model gi%en the strong monetary !olicy rule estimated for this

!eriod+ S!eci/cally, since under this rule the !olicymaker will alter the interest

rate to counter forecasta&le de%iations of in4ation from the target, the rule will

eliminate forecasta&le mo%ements in in4ation and lea%e only unforecasta&le

shocks to dri%e 4uctuations+ Thus, our /nding of low forecast !erformance is not

necessarily e%idence against the %alidity of the model+$

B+

Nic) Rowe58:26 A;

)ets !ut it another way: if a central &ank is targeting in4ation, the only model

that could forecast in4ation would &e a model the central &ank didnt know

a&out, or was too stu!id to use+

Since in4ation targeting central &anks know a&out DSGE models, and use them,

we can conclude that DSGE models wont &e a&le to forecast in4ation+

2+

RAstudent55:12 A;

According to this logic, CAKs shouldnt work either, yet they do+

9+

Nic) Rowe2:91 -;

KA student: good !oint+ I dont know why CAKS should work+

;ay&e its easier to datamine and o%er/t CAKS than DSGEs"" Is it Hust like those

%iolations of the E;M that disa!!ear as soon as they are !u&lished""

Ff course, if a central &ank is trying to target in4ation at a 1.year hori@on, it may

still &e !ossi&le to forecast in4ation at a less than 1 year hori@on+

R+

Noah Smith2:9B -;





















Since in:ation targeting central ban!s !now about DSGE models and use them

we can conclude that DSGE models won%t be able to orecast in:ation.

Not necessarily] that conclusion also requires that we &elie%e that in4ation

targeting is feasi&le+ Some dont &elie%e this+

Kegardless, this !oint is really com!letely &eside the !oint+ If a model cant

forecast, it cant forecast+ That doesnt mean the model is &ad] for instance, it

could &e good for !olicy ad%ice+ #hich is why I considered $forecasting$ and

$!olicy ad%ice$ in two se!arate sections of this &log !ost+

6+

Noah Smith9:81 -;

Also, Nick:

5+ ECEKFNE GETS FK -FINT a&out the $thermostat$+ Its a cute !oint,

!ro&a&ly not a!!lica&le to the real ni%erse in which we li%e, &ut cute

nonetheless+ 0ut its %ery easy to gras!, and we all gras! it already

1+ F%er/tting wont gi%e you &etter out.of.sam!le forecast !erformance+++

>+

waltB:5> A;

Nick, youre aware of the fact that there are $%iolations of the E;M$ that ha%e

!ersisted for like 28 years, right" 'I !ut in scare quotes, since they may turn out

to ha%e rational e!lanations+( I swear to God, I get the im!ression that the last

!a!er in /nance anyone in economics has read was in 5=68 or so+

=+

'arry 51:B9 -;

#ouldnt the thermostat !ro&lem a!!ly only if the model was actually &eing

used to adHust the economy"

Reply

R+

!Seydl 9:16 -;

I actually think they do ha%e a fatal 4aw, which is that they all rely onmicrofoundations+ There are many good reasons why we should not ha%e







http://www.jseydl.com/












microfoundations in macro models, and to that end, Id encourage e%eryone to

read, $Does ;acroeconomics Need ;icrofoundations,$ &y <e%in Moo%er+

Ke!ly

6+

laudia9:BB -;

Noah, sounds like you ga%e a useful talk+ uestions +++ rather than lectures are an

ecellent frame+ A few comments +++ !urely my o!inion and understanding of

some related stu+

At the 0oard, there are se%eral forecasting L !olicy e%aluation tools that the sta

use+ I am a /rm &elie%er in many models, many tools 'none dominate across all

settings(+ In the near term a&out a three quarter window, the sta nowLforecast is

data translationLsignal etraction and su!er weedy stu+ The economists are

s!ecialists in their areas+ 'I ha%e done consum!tion and now am learning

in%entories(+ That same grou! does conditional !artial equili&rium forecasts out

for 1.B years+ Judgment also gets layered on, stu not in the models or quirks of

the models corrected+ The conditional !art is that many of the eogenous in!uts

stock !rices, echange rates, multi!liers come from elsewhere, including 7K0LS,

the stas workhorse macro model+ A coordinator economist !ulls all the -E

forecasts together and makes sure it is sensi&le from the to! down+ And 7K0LS

with some adds takes o%er for the long term+ So its com!licated, &ut we can

e!lain where it is coming from+

Ff course, the 0oard has DSGE models and along with 7K0LS gets used for

altsims and !olicy analysis+ -E models or s!readsheets are not ideal for

sensiti%ity analyses in equili&rium +++ es!ecially if you want risks quanti/ed+ And

e%en though DSGE model out!ut might not &e a easy way to do communication

!olicy, they are a tool for macroeconomists to talk and e!lore structure+

As I understand it, no *0 has a !ure model.&ased sta forecast+ Another

interesting question is where there Hudgment comes from and how do they

e%aluate that !iece o%er time+

Ke!ly

>+

rs/ >:8B -;

*urious why central &ank meetings need to &e $secret$+ Seems like these

institutions need to &e as trans!arent as !ossi&le+

Ke!ly












=+

perfectlyGood:n)5:81 A;

For this the main alternative that has been put orth is called *agent-basedmodeling* ... #ut basically what it seems to mean is to speciy a set o

microoundations 8behavioral rules or agents9 and then do a big simulation. The

big dierence between this and DSGE is that with DSGE you can write down a set

o e+uations that supposedly govern the macroeconomy and with &#3 you can%t.

7rom what little I understand, an alternate way to say this is that A0; has the

!otential to model relationshi!s and &eha%ior that are not mathematical in

nature+ 7or eam!le, !henomena with !ositi%e feed&ack loo!s andLor those that

do not tend towards equili&rium andLor those that are nondeterministic+

Also, under rational e!ectations, !eo!les !references and e!ectations cannot

aect each others !references and e!ectations, which is !articularly

!ro&lematic 5( for a social science and 1( in modeling &u&&les and herd.&eha%ior+

I would ask 0arkley Kosser, though+ I%e only read a&out it+

Ke!ly

Ke!lies

5+

RAstudent9:1R -;

I dont think this is true+ ;athmatical rules Hust go%ern the &eha%ior of agents+

A&m has a lot of game thery ty!e math+ -ro&lem is cali&ration Hust like in dgse+

0oth a!!roaches if they could &e made to work, ha%e many ad%antages+ I am Hust

ske!tical they can e%er forecast %ery well+ Small changes in the rules can lead to

huge changes in glo&al &eha%ior+ I would say that in the world of s!orts s!orts,

A0; has !ro%en to !roduce !retty good !redictions+ Think of EA s!orts for the

N7) or Accuscore+ Still seems like econmetic models are &etter &ut A0; has comea long way

1+

perfectlyGood:n)9:8= -;

As I understand A0;, you can model emergent &eha%iors where the system

&eha%es %ery dierently from its !arts, rather like how the &eha%ior of molecules

does not follow the same rules of &eha%ior go%erning that of atoms, which is why













chemistry is a se!arate /eld from !hysics+ So that the agents &eha%e according

to mathematical rules does not mean the system has to+

Reply

58+

William AllenB:26 A;

Noah, in your scheme of classi/cation, where would you !lace the stock 4ow

consistent -ost <eynesian models of #ynne Godley and Staord *ri!!s 'New

*am&ridge school(" I /nd these far more 4ei&le than DSGE ty!e models+

Ke!ly

Ke!lies

5+

Noah Smith=:5R A;

#hat does $stock 4ow consistent$ mean" Are DSGE models $stock 4ow

inconsistent$" *an you show me how this is the case" I am curious+++

1+

walt5:9> -;

DSGE models are stock.4ow consistent+ An eam!le of a non stock.4ow

consistent model is ISL);+

B+

#n)nownB:B5 -;

ou are right, what distinguishes so.called !ost.keynesian stock.4ow consistentmodels from DSGE models is not stock.4ow consistency++++ &ut &asically two

general features: 5+ the treatment of micro &eha%ior &y means of aggregati%e

&eha%ioral equations &ased on certain !riors 'which can &e em!irically

estimated( rather than dynamic o!timi@ation .. say, an aggregate consum!tion

function, an aggregate in%estment function, a loan su!!ly function, a to&inian.

ty!e asset demand function, etc]

1+ the adHusting %aria&les 'or model closures( are also dierent .. out!ut adHusts

'instead of !rices( to aggregate demand] asset !rices 'including the interest rate(

adHust to su!!ly and demand in market of stocks of assets, rather than 4ows 'as

in a loana&le funds theory of the interest rate for instance,among other things]















the /nancial system creates money endogenously+++ S7* are also &eing com&ined

with A0; models &y a few !eo!le+

Reply

55+

!onathanB:92 A;

Mi,

weLyou ha%e to &etter understand the main !ur!ose of DSGE modeling:

com!uting, simulating and estimating a microfounded model 'and thus micro

%aria&lesLshocks( with interlinked 'structural( shocks and %aria&les in a stochastic

framework+ This is the main goal and we know that DSGE modeling is unique for

that !ur!ose+

So I ha%e some comments:

5+ 7orecast the economy"

*om!aring to other methods, DSGE forecasting is the youngest 'a&out > or 58

years old( and e%en if it is not $the &est$, it is mainly &etter than what I call $old

methods$+ )et us time

1+ Gi%e !olicy ad%ice's("

It is working %ery well, &ut in a qualitati%e manner 'in a sense that it gi%e us

useful information a&out trends, shocks and dynamic roles of %aria&les( rather

than for a quantitati%e !ur!ose+ It is still hard to !redict the 'eact( %alue of one!oint 'after two or more !eriods(, &ut it is now easy, with a structural

microfounded model, to !redict a trend with res!ect to other structural 'or not(

shocks+

The !ro&lem of the huge amount of models is not s!eci/c to DSGE models+ It is

more related to the research !rocesses and it is a%aila&le for all modeling

methods+++

I am agree with the fact that we need more goodness.of./t statistics &ut we ha%e

already other great tools: mean of estimated shocks, con%ergence statistics,student tests, IK7s, long run and short run %ariance decom!ositions, shared

growth !ath, model &ased detrending, etc+++ the list is may&e as long as your list

in Section B ].(

B+ ;a! from DSGE models to !olicy ad%ice"

ou should ask the following question: what is 'economic( modeling " Assuming

se%eral and acce!ta&le hy!otheses in order to o&tain a light %ersion of the

'economic( fact you want to model+ Again, assuming hy!othesis is not s!eci/c to

DSGE modeling+ *ontrariwise, assuming fatal 4aw's( is common in se%eral other

modelingLestimation methods+++2+ *ommunicate ideas"





Totally agree, we need to im!ro%e the communication channels+ S!eci/cally, we

need to etract more information from a DSGE model and e!lain this more with

words, and less with num&ersLequationsLfunctional forms+++

So are we wasting our time making all these DSGE models, or not"

Ff course not and we need to mo&ili@e more $human ca!ital$ in order to im!ro%e

DSGE modeling+

Fther remarks for all !re%ious !oints:

. Ff course we need to focus on second and third order DSGE models, &ecause

sim!le lineari@ation !ro%ide materials to Noah ].(

. #hat is research " 7rom my o!inion, it is to &uild little ad%ances in order to /nd

one &ig /nding+ Ff course my remark is not s!eci/c to DSGE modeling, &ut it

includes it

Ke!ly

51+

-rederic ,ari 2:5= A;

*om!ared to some of the commentators a&o%e, I am a &ar&arian+ I &elie%e that

macro.economics ought to &e sim!le, like an a to the head+++

htt!:LLthered&anker+&logs!ot+comL1851L8BLrefreshing.macro.economics.!art.

5+html

htt!:LLthered&anker+&logs!ot+comL185BL81Lrefreshing.macro.economics.!art.

1+html

htt!:LLthered&anker+&logs!ot+comL185BL8BLin4ation.or.de4ation.refreshing.

macro+html

htt!:LLthered&anker+&logs!ot+comL185BL8BLrefreshing.macro.!art.2.!ro/t.

matters+html

That &eing said, I think an interesting macro.question right NF# is why is the Seconomy reco%ering 'a!!arently(" I would /nd that su&Hect worthy of macro.

economic analysis Is it the $loose$ 'less tight( monetary !olicy" If so, which

channels worked" Is it /scal e!ansion" Mow, with sequester and stu"

#hat is going on" And if macro models cannot answer that, what good are they"

Ke!ly

5B+

!or$e 'ielsa2:19 A;










The hiatus has made wonders on ou+ This !ost is the &est I ha%e read in this

&log+ Thank ou %ery much+

I ha%e only a little $&ut$, in the way you conclude your ecellent !ost:

$in%ented alternati%es 'A0;( will take decades to catch u! in !o!ularity, if they

e%er do+$

)ooking at the s!eed the times are changing, I ne%er had used the term$decades$ for &etter or worse+ Anyway, I think you made a risky &et, s!ecially

after showing the DSGE cards in such a clear and enlightening way+

Ke!ly

Ke!lies

5+

!or$e 'ielsa2:96 A;

I ha%e Hust read your !re%ious !ost and I can not hel! to ask you:

Ma%e you some no.monetary !ay.os for your last &et"

Reply

52+

Tom 2:91 A;

$They ha%e 4aws, &ut not any clear $fatal 4aw$+$

Not sure why you &elie%e models that neither contain defaults nor &anks are not

fatally 4awed+ Suggest you look at Goodhart and 0orios work+

Ke!ly

59+

Nathanael9:85 A;

our conclusion is weak, and frankly you need to ha%e the courage of your

intellectual con%ictions+

our e%idence shows conclusi%ely that DGSE models are a dead line of research

and a waste of time, at least for this generation+

'If some other analytical tool is de%elo!ed in 18 years which allows us to make

DSGE models which work, then we can re%isit them in 18 years+(

Ke!ly


http://www.creditcapitaladvisory.com/










5R+

DimitarR:8= A;

$So are we wasting our time making all these DSGE models, or not" ;y answer is:Im not sure+ So far, we dont seem $

B8 years of macro research+ This is nothing &ut failure+ *om!are with the B8

years of research &efore+ DSGE is a sunk cost+

Ke!ly

56+

Dan =:B1 A;

Is it fair to re!eat what you say &y saying you told a grou! of central &ankers that

it is not !ossi&le to forecast the future"

I trust they res!onded &y saying, &ut no one can !redict the future+

I am going to make a forecast, in fact I would e%en make a &et+ ;y !rediction is

that in no time !rior to July 1859 will economists learn how to !redict the future+

Strangely this is true e%en though we are told that Mistory re!eats itself which

would suggest an AK model should work, e%en though you cant !redict thefuture which is strange &ecause+++

Ke!ly

5>+

Rothosen=:BB A;

This is &eyond me e%en though Im sure its good stu+ #ill you &e thinking of

doing something in the future on macro.economic eects of a further 183weakening of the en"

Ke!ly

Ke!lies

5+

a&mytheconomics9:B1 -;

http://lazyfairyecon.tumblr.com/






http://azmytheconomics.wordpress.com/


http://lazyfairyecon.tumblr.com/









Dont reason from a !rice change, or in other words, it de!ends why the yen

de!reciates as to the consequences+ In general, it would &e good for Ja!anese

e!orts and increase their in4ationLaggregate demand+

1+

-rederic ,ari B:8R A;

I am not sure itll &e so good for their e!orters: 7irst, it relies on none of their

com!etitors reacting+ Two, what a&out in!ut !rices" 0ut, yes, if someone should

&ene/t, it should &e e!orters+

I am !retty sure it will also &oost their in4ation 'if only %ia higher im!orted

!rices(+

Mows that going to do anything 7FK AD, though, I wonder"

Reply

5=+

RAstudent55:8B A;

5+( I do not think its true any ty!e of DGSE has out!erformed 0ayesian %ariants of

CAKs+

1+( Mow is it that DSGEs can !erform &etter than CAKs &ut worse than AK'5(s

when AKs are sim!ly s!ecial cases of CAKs"

B+( )ooking at K_1s is a terri&le way to e%aluate forecast !erformance, so why

focus on that"

Ke!ly

Ke!lies

5+

RD 55:9> A;

5+( See htt!:LLwww+%oeu+orgLarticleLfailed.forecasts.and./nancial.crisis.how.

resurrect.economic.modelling

1+( F%er/tting+

1+

RAstudent51:5= -;





http://updatedpriors.blogspot.com/












5+ nless I am missing something this does not say how the 0CAK did %is a %is the

others+ It sim!ly says model &ased forecasts werent that great at !redicting the

recession+

1+ Good !oint &ut wouldnt a good !ractitioner then colla!se to the AK model

rather than rely on an o%er/t model"

B+

Noah Smith2:2= -;

;nless ' am missing something this does not say how the #<&5 did vis a vis the

others. 't simply says model based orecasts weren%t that great at predicting the

recession.

See here:htt!:LLecon+u!f+eduL`&rossiLG<K185BPA!ril18+!df

2+

RAstudent=:56 A;

Touche ;r Smith+ *onsider my mind oOcially &lown+ In all honesty though, these

results make no sense to me+ I really cannot understand how its !ossi&le that an

AK could out !erform a CAK, 0CAK, and KCAK 'what they call K#(+

9+

Noah Smith55:86 A;

F%er/tting, is my guess+

htt!:LLen+wiki!edia+orgLwikiL7ile:F%er/t+!ng

Reply

18+

Anonymous51:86 -;

the ultimate yardstick for any model in my o!inion, is its out of sam!le

forecasting !erformance

I am not an economist, &ut my guess is, the way to go is write down assum!tion

and do a giant simulation . sort of what they do to !redict weather nowadays

Ke!ly















15+

(aul Se$al 5:86 -;

Keally nice !ost+ I learned a lot+ 0ut Im confused &y what a!!ear to &econtradictory statements a&out forecasting:

A+ $more recent, com!le DSGE models ha%e !ro%en much &etter, and are now

considered slightly &etter than %ector autoregressions, and a&out as good as the

7eds own forecasts+$

0+ $sim!le uni%ariate AK models are often signi/cantly &etter at forecasting

things like in4ation and GD- growth than the &est a%aila&le DSGE models$

*+ $DSGE models are !ro&a&ly not %ery good as forecasting tools+++yet+ 0ut

theyre a&out as good as anything else we ha%e+$

Doesnt 0 contradict A and *" Fr did I misunderstand something"

Also, Id like to know your real answer to #illiam Allens question: regardless of

the !hrase stock.4ow consistent, do you ha%e a %iew on the #ynne Godley and

Staord *ri!!s.ty!e models" A!!arently Goldman Sachs use their a!!roach as

!art of their tool &o+ 'If youre Hust not familiar enough with the model, thats ok

too+(

Ke!ly

Ke!lies

5+

Noah Smith2:2> -;

Doesn%t # contradict & and 0 =r did ' misunderstand something0

*heck out this !a!er:htt!:LLecon+u!f+eduL`&rossiLG<K185BPA!ril18+!df

do you have a view on the )ynne Godley and Staord ripps-type models0

No!e

Reply

11+

a&mytheconomics9:2R -;
















Its not a good sign that I%e ne%er heard a DSGE model mentioned in !olicy

de&ates, e%en amoung highly technically skilled economists+

As to forecasting, nothing can &eat a futures market+ If you want to make money

in the futures market and use a DSGE model to do so, /ne, &ut for the !ur!oses

of a central &ank, any model is strictly second &est+ 7urthermore, it makes no

sense for a central &ank to forcast a targeted %aria&le+ If the forecast is dierentfrom the target, change your actions until they match+

ou might &e interested in this !ost &y Adam Gurri which notes the mismatch

&etween central &ankers academic work and their actual !olicy decisions+

Technical macroeconomics has had %ery little im!act on !olicy, DSGE or not+

Ke!ly

Ke!lies

5+

Noah SmithR:8= -;

't%s not a good sign that '%ve never heard a DSGE model mentioned in policy

debates even amoung highly technically s!illed economists.

Agreed+

&s to orecasting nothing can beat a utures mar!et.

Not necessarily true, since the 7ed has inside info 'note that according to Edge

and Gurkaynak, the 7eds short.term in4ation forecasts are ;*M &etter than any

models, and in fact ha%e an K.squared of 8+2>, which is huge(+

Reply

1B+

danielsR:B2 -;

. !oint forecast accuracy is far from e%erything e%en in forecasting+ 7or decisionmaking it may &e im!ortant to accurately characterise !ro&a&ility of %arious

inter%als or more generally multi%ariate regions for the %aria&les we care a&out+

The &est model for that !ur!ose may tell you theres a lot of un!redicta&le stu

going gi%en the small num&er of o&ser%a&le %aria&les you ha%e+ 0ut it may &e

&etter at quantifying the uncertainty you face than a model that tries to

maimise the accuracy of the !oint forecast at the cost of distorting !ro&a&ility

&ands+

. Fld style large macro models 'what you call s!readsheet models( ha%e tons of

hidden assum!tions hidden in all the @ero coeOcient restrictions they im!ose in

their &eha%ioural equations+ Theyre Hust hidden and harder to unco%er+ And to&oot, its not e%en clear they res!ect the resource constraints and &udget

http://theumlaut.com/2013/05/27/the-dogma-of-central-banking/





http://theumlaut.com/2013/05/27/the-dogma-of-central-banking/







constraints of anyone in the economy+

. ;any of the assum!tions you mention are a!!roimations of the kind you make

in any econometric s!eci/cation 'e+g loglinearity or constant elasticity of

su&stitution, ignoring distri&utional eects , the mono!olistic com!etition

assum!tion that !rices are inde!endent of the num&er of com!etitors in the

market etc+++(+ #e couldnt !ossi&ly e%er &uild a model as a sim!lifying frameworkfor organising our thoughts in such a messy reality if we didnt ha%e to make

these assum!tions+ As we get &etter, we &uild more com!le models with more

realistic assum!tions 'e+g heterogeneous households and /rms, more realistic

wage &argaining etc+++(

. If you end u! seriously working with DSGE models and see many models you

start to get a feel for which model is a!!ro!riate in which situation, and how to

mentally com&ine dierent models each of which may &e missing im!ortant &its

of reality to get a more com!rehensi%e understanding of the economy '&ut isnt

this the same with micro models"(+ ou dont this Hust from the core macro

sequence or ocasionally reading a&out them+. There are ways to classify dierent clusters of models into a smaller num&er of

more general ty!es 'e+g models of /rm le%el credit constraints often ma! into

models of in%estment taesLwedges, other models are &asicaly a&out

taesLwedges on em!loyment, others microfound changes in total factor

!roducti%ity etc+++(+ Some !eo!le at the 0oE should ha%e a lot of interesting stu

to say a&out this+ )ook u! &usiness cycle accounting and an etension &y Kichard

Marrison and co+++also the 0oEs new forecast methodology com&ining a core

DSGE model with a suite of other models 'DSGE or otherwise( is well documented

in a recent working !a!er on their we&site+

. To say DSGE models are not useful in !olicy analysis &egs the question: notuseful in com!arison to what" ;ost of the criticisms that ha%e &een made could

&e made Hust as well a&out the large scale macro models that are su!!osed to &e

useful in !olicy analysis &y !ractioners+ )ucas and Sargent made some good

!oints in the 5=68s+ )ooking at the current s!eci/cation of e+g the ;oodys

macro model or the Fford models most of these !oints ha%e not &een

addressed+

. A signi/cant com!onent of a model &ecoming useful for !olicy analysis is

e!erience in using it+ Theres a reluctance I think on the !art of !eo!le trained in

the old style macroeconomics to switch from simultaneous equations systems

'often estimated &y F)S des!ite the endogeneity &ias( to the more modern states!aceLlatent %aria&les !ers!ecti%e that underlies the DSGE a!!roach+ As more

central &anks and other agencies like the Euro!ean *omission work with DSGE

models, they should &ecome &etter at communicating their insights and using

the etra structure that allows you to see !eo!le, /rms and markets in these

models 'as you said, theyre in that sense similar to agent &ase models( to satisfy

your o&Hecti%e 1(,B( and 2( &etter+

Ke!ly

12+



ameron ,urray>:5= -;

;ate, I lo%e that you are an honest outlet for how economists reason and model

the economy+ 0ut it is a %ery !oor sign a&out the state of the disci!line that you,

a freshly minted star -hD, knows all these limitations to the main modelling

techniques 'since you are o&%iously well trained in them( yet are &asicallyignorant of other a!!roaches that seem to oer quite useful insights+

I am not accusing you of &ias+ ou clearly think things through %ery clearly and

are honest a&out what economists are u! to+ 0ut it seems like economists in

general wont try anything else ece!t tweaking their current tool till it works a

little &etter+

I guess my analogy is that economists are trained in using a hammer to work on

a !ro&lem+ The hammer doesnt seem to work, &ut they wont e%en try a s!anner

or a screwdri%er+ They must modify the hammer until it works a tiny &it &etter+;eanwhile a whole /eld of !eo!le is out there testing other tools and getting

really interesting results+

7rom your writing it seems you are well aware of this+ 7or eam!le you refer to

agent &ased models, &ut dont really know enough to say whether they might &e

useful+ Then a commenter asked a&out #ynne Godley, and again you ha%ent

had much e!osure to this a!!roach+

If you are interested in learning a&out #ynne Godleys a!!roach, his tool&o if

you will, I recommend this &ookhtt!:LLwww+ama@on+comL;onetary.Economics.Integrated.A!!roach.

-roductionLd!L81B8B85>2B

I am also studying an economic -hD and /nd the rather inward looking nature of

the /eld quite distur&ing+ Es!ecially when it comes to macro 'there are many

microeconomists ha!!y to learn from !sychology, sociology etc(+

In any case, when you do read u! on some alternati%e macro a!!roaches I would

really like to read your o!inion 'in my %iew many ha%e similar !ro&lems, some

ha%e dierent !ro&lems(+

Ke!ly

Ke!lies

5+

Noah Smith58:82 -;

Actually, I know a &it a&out agent.&ased models in /nance+++not in

macroeconomics 'remem&er, Im a /nance !rof, I Hust took macro in grad school(+ There are a )FT of dierent things that agent.&ased macro models could &e











doing+ I can think of a lot of these things+ 0ut I dont know which ones !eo!le are

actually doing+ Mowe%er, the word on the street is that A0; is getting more and

more attention+ So Ill look into it at some !oint+

As for #ynne Godley and his a!!roach, Im not going to order a &ook &efore

reading some free -D7s+++got any good links"

I agree that the macro !rofession is way, way, way too concentrated on the DSGE

a!!roach+

1+

Noah Smith58:58 -;

So, are you talking a&out this kind of model"

htt!:LLwww+le%yinstitute+orgL!u&sLw!P2=2+!df

This is Hust a system of linear equations for macro aggregates, with the

coeOcients assumed to &e structural !arameters+

B+

RAstudent=:19 A;

;ust say I am unfamiliar with #ynne Godley &ut as for A0;, Ko& Atells 'and

Joshua E!steins( work to &e the most fascinating+ In !articular:

htt!:LLwww+&rookings+eduLESLdynamicsL!a!ersL/rmsL/rms+!df

htt!:LLwww+creati%eclass+comLrfcgd&LarticlesLEmergentP*ities+!df

and the seminal work

htt!:LLwww+ama@on+comLGrowing.Arti/cial.Societies.Science.

Ada!ti%eLd!L81R199819B

2+

ameron ,urray58:82 -;

e!+ Though note that the equations include some deri%ates of macro aggregates

and at all time !eriods the accounting identities hold+

I thought you might Hust get the &ook from the li&rary to get a feel for why there

eists this grou! who want to reHect DSGE and use other tools+ And of course,may&e outline a &it of a !rosLcons list of DSGE %s monetary models %s A0; &ased













on your reading 'you seem to &e a&le to !ro%ide good clear un&iased %iews on

such things(+

I guess my !ersonal %iew is that there wont &e an a!!roach that forecasts well+

The economy is a com!le system and we know that the !ath it takes is sensiti%e

to initial 'and all time !eriod( conditions+ Add a s!rinkling of !olitics and you dontha%e much to work with

Reply

19+

marcel 58:82 -;

'n recent times o course 5# models themselves have allen out o avor

somewhat in the mainstream business-cycle-modeling community and havegone on to coloni4e other (elds li!e asset pricing international (nance and labor

econ

*an you !oint me to some of the eam!les in la&or" I ha%e an idea I want to

e!lore and it would &e useful for me to ha%e some idea of whats gone &efore+

Thanks

Ke!ly

Ke!lies

5+

Noah Smith58:5R -;

htt!:LL!ress+!rinceton+eduLtitlesL=156+html

#hen Shimer says $neoclassical growth model$ he means $K0*$+

Reply

1R+

daniels 5:88 A;

. I%e looked into many eam!les of old style macro models and A0;s+ The old

simultaneous equations models Hust strike me as documenting a set of

correlations that were found in the data set they used without much structure+

This doesnt matter if you Hust want the &est !oint forecast 'though its &etter

than to Hust use a statistical model like a CAK or e%en uni%ariate AK;Aequations(+ 0ut it does matter if the goal is to answer things like whats the eect

















of !olicy or structural shock + As for A0;s I constantly get the im!ression that

the rationality in them is much too &ounded indeed in terms of re4ecting

moti%ations for human actions, and the market !rocesses they model also strike

me as too !rimiti%e+ I a!!reciate the %alue in trying to &uild things from the

&ottom u!, &ut I feel you may end u! with models descri&ing a market !rocess

from hundreds of years ago instead of the so!histicated markets of the 15stcentury+ Theres !ro&a&ly a middle way where A0;s contain more dynamic

&eha%iour considerations and use more so!histicated matching and search

!rotocols+ I can see how such a hy&rid would &e &oth micro founded and contain

more realistic heterogeneity than most DSGE models+ 0ut I dont see anyone

working on this from the A0; !a!ers I%e seen, and a model with millions of

agent ty!es is &ound to oer more com!licated and hard to understand insights

than a DSGE model with 1.2 agent ty!es+

. K0* models ha%e &een a&andoned in the central &ank monetary !olicy

community+ Theyre still used a lot in economic growth,de%elo!ment and taation

analysis+ If it seems they must &e tri%ially wrong &ecause the real world hasnominal !rices that dont mo%e all the time, you should look u! the 0arro critique+

The &asic intuition is that sticky !rices dont necessarily ha%e a &ig

macroeconomic eect if theyre attached to sticky quantities 'and when

quantities mo%e !rices are 4ei&le(+ As for the com!arison of /t: sticky !rice and

wage models ha%e more com!licated equations with du&ious assum!tions a&out

the frequency of wage adHustment+ K0* models ha%e fewer equations,so if you

want &etter forecsting !erformance its easier to s!ecify them with more

com!licated 'realistic"( shock !rocesses to im!ro%e /t+ Its not always clear which

route is more realistic+ 0ut its im!ossi&le to discuss this seriously in &log

comments+++.

Ke!ly



16+

Gene allahan=:B8 A;

$ I dont know too much a&out this, and the name is weird, &ecause DSGE models

are also agent.&ased+$

Not in the com!uter science sense they arent+

Ke!ly

1>+

Luis Au$usto51:B1 -;

I dont understand why you say:

i( #e know the assum!tions are not e%en closed to correctly outlining how !eo!le

&eha%e+

ii( Their !redicti%e !ower is fairly low+

0ut then you conclude $I dont know$+ Keally" I know youre !hysicist, and I cant

imagine you saying the same a&out an atomic theory such that:











i( The theory !ostulates that atoms &eha%e in certain way, we !ut it at test, and

we found thats not the case+

ii( The theory !redicts certain results in thermodynamics, and the correlation

&etween !rediction and reality is low+

and that you dont know whether is true or false+

I do understand that youre Hudging it as a $tool$, &ut its a theoretical model and

if its mostly false why should we e!ect it to ha%e correct !redictions"

Ke!ly

Ke!lies

5+

Noah Smith9:56 -;

See my more recent !ost:

htt!:LLnoah!inion&log+&logs!ot+comL185BL89Ldsge./nancial.frictions.macro.

that+html

Reply

1=+

Lei$h Tesfatsion5:8= -;

Kegarding agent.&ased modeling 'A0;(++++

I, too, am delighted to see the o!en and honest discussion occurring in this &log

regarding the current state of macroeconomic theory, and the ad%antages and

disad%antages of alternati%e modeling a!!roaches for macroeconomics such as

DSGE and agent.&ased modeling 'A0;(+

7or a com!rehensi%e set of introductory materials on agent.&asedmacroeconomics, agent.&ased /nance, and agent.&ased com!utational

economics 'A*E( more generally, !lease check out the following highly acti%e

sites:

A*E Mome!age: Growing Economies from the 0ottom !

htt!:LLwww1+econ+iastate+eduLtesfatsiLace+htm

Agent.0ased ;acroeconomics

htt!:LLwww1+econ+iastate+eduLtesfatsiLamulmark+htm

Agent.0ased 7inancial Economics



http://www.econ.iastate.edu/tesfatsi/




http://www.econ.iastate.edu/tesfatsi/




htt!:LLwww1+econ+iastate+eduLtesfatsiLa/nance+htm

A*E Introductory ;aterials

htt!:LLwww1+econ+iastate+eduLtesfatsiLaintro+htm

;any annotated !ointers to additional sites are linked at the a&o%e A*Ehome!age, including !ointers to A*ELA0; introductory slide !resentations,

teaching resources 'A*ELA0; coursesL!rograms(, software resources 'A*ELA0;

com!utational la&s, software, and toolkits(, and ongoing A*E research focusing

on: %eri/cation ? em!irical %alidation] agricultural ? natural resources,

automated markets, &usiness and management, economic !olicy, electricity

markets, e%olution of institutions and social norms] industrial organi@ation] la&or

markets] market design] network formation] organi@ations] !arallel e!eriments

with real and com!utational agents] !ath de!endence] !olitical economy]

technological change and economic growth+

In short, the amount of ongoing acti%ity related to A*E is ra!idly growing, and the

a&o%e sites attem!t to gi%e newcomers a &road o%er%iew of this acti%ity+ I ho!e

that the readers of this &log who are not currently familiar with this modeling

a!!roach will &e interested enough to read at least some of the introductory

materials at these sites+

*onstructi%e comments for im!ro%ing the !resentation of materials at these sites

would &e most welcome+

Ke!lyKe!lies

5+

Noah Smith5:98 -;

Thanks, )eigh Ill de/nitely take a look+ I%e &een meaning to read a lot more

a&out A0;+

Reply

B8+

tom$rey 58:8= A;

$In !rinci!le, though, theres no reason why they cant &e useful+$

Mow a&out this !rinci!le: Any model that is successful in !redicting macro

economic &eha%ior, will &e useful only if it allows !olicy makers to change !olicy

decisions &ased on the !rediction+ Such !redicta&le !olicy changes will allowsome market !artici!ants to make money &y !redicting the !olicy changes and



http://tomgrey.wordpress.com/









results+ The success of the successful !redictors will result in so much &eha%ior

change that it in%alidates the model+

Id say that $success leads to &eha%ior change and then failure$ of a model is the

kind of !rinci!le that DFES !ro%ide a reason that such models wont &e long term

useful for !rediction+

Ke!ly

B5+

,olly (er)ins55:2R A;

;y &rother does something with &usiness forecasting models+ #hat eactly is

that"

Dynamic Stochastic General E;uilibrium ,odels in ,acroeconomics

<DSGEs=

>? @un 7>AB >?CBA



http://mycompanymodel.com/



http://mycompanymodel.com/



-retend that the national economy consists of a single !erson, the

$re!resentati%e agent$+ This agent owns all the goods, es!ecially all the ca!ital

goods, and does all the work in the economy+ The agent is greedy for material

consum!tion, and la@y+ To consume, which it likes, it must !roduce, which is amatter of indierence, ece!t that to !roduce it must work, which it dislikes+ If it

!roduces more now than it consumes, it can sa%e the dierence as ca!ital goods,

which make its future la&or more !roducti%e+ There are also shocks to

$technology$, i+e+, to how eecti%ely it can use ca!ital to turn la&or into

consum!tion goods] rather &i@arrely, these shocks are &oth negati%e and

!ositi%e, which means that it regularly forgets !roducti%e technologies, and not

&ecause &etter re!lacements ha%e come along+

In addition to &eing greedy and la@y, the agent is is determined to act now so as

to maimi@e not !resent utility, &ut the discounted future stream of utility at all

times 'since it is also immortal(+ 7ortunately, it is incredi&ly foresighted, and

knows the eact distri&ution of future shocks to technology+ 'This distri&ution is

not changed &y anything the agent does] or, if you like, it always acts in such a

way that its e!ectations are eactly ful/lled+( -ossessing unlimited cogniti%e

resources, it is easy for the agent to sol%e the resulting dynamic !rogramming

!ro&lem o!timally+ This will not lead to a smooth !attern of !roduction,

in%estment and consum!tion] if, for instance, there is a &ig negati%e shock to

technology, and shocks are !ersistent, it &ecomes rational to slack o now, and

enHoy leisure] etra work will &e more rewarded later when the agent will ha%e

remem&ered how to do stu+ These 4uctuations are, su!!osedly, the 4uctuations

of the macroeconomy, the &usiness cycle+

I ha%e sketched this sort of model in a deli&erately hostile way, &ecause I think

such things are remarka&ly silly+ 0ut many %ery eminent economists regard them

%ery highly indeed+ ;ostly I think this re4ects &adly on the disci!line of

macroeconomics, &ut it does raise some interesting technical !ro&lems, like:

• Mow do !eo!le e%aluate the /t of these models"

• Do those e%aluation methods make any sense"

• Mow many of the !arameters of these models are actually identi/a&le"

• Mow much data would it take to estimate one of these models to a gi%en

degree of !recision"

• Mow much data would it take to detect that one of these models was

wrong"

• Mow well would these models /t in.sam!le if they were wrong a&out the

structure of the economy"

'ou might well ask $where is the equili&rium, let alone the general equili&rium, ina model with one agent and no trade"$ ou might %ery well ask that+(

http://vserver1.cscs.lsa.umich.edu/~crshalizi/notabene/sequential-decisions.html






Kecommended, eam!les and tet&ooks:

• 0ent Jes!er *hristensen and Nicholas ;+ <iefer, Economic 3odeling and

'nerence Ke%iew: An F!timal -ath to a Dead End+

• Da%id N+ DeJong and *hetan Da%e, Structural 3acroeconometrics Ke%iew

• 7inn E+ <ydland and Edward *+ -rescott, $Time to 0uild and Aggregate

7luctuations$, Econometrica >4 '5=>1(: 5B29..5B68 JSTFK+ -retty much

the origins of the a!!roach, and of $real &usiness cycle theory$+

• 7rank Smets and Kafael #outers, $Shocks and 7rictions in S 0usiness

*ycles: A 0ayesian DSGE A!!roach$, &merican Economic

5eview ?3'1886(: 9>R..R8R -erha!s the &est.regarded current DSGE of

the S economy+ -re!rint %ersion

Kecommended, statistical as!ects 'in addition to the &ooks &y *hristen and

<iefer, and &y DeJong and Da%e(:

• 7a&io *ano%a and )uca Sala, $0ack to square one: identi/cation issues in

DSGE models$ -D7 !re!rint

• ;arco Del Negro, 7rank Schorfheie, 7rank Smets and Kafael #outers, $Fn

the 7it of New <eynesian ;odels$, @ournal o #usiness and Economic

Statistics 2> '1886(: 51B..5R1 Including discussion and re!ly

• Kochelle ;+ Edge and Kefet S+ Gurkaynak, $Mow seful are Estimated DSGE

;odel 7orecasts"$, ssrnL5>58869 Kecommended for actually going

through the eercise of com!aring out.of.sam!le forecasts, and including

sim!le &aseline models+ 0ut the methodological ideas here are sus!ect+ It

is true that there is not much to !redict a&out an in.control system, and

what is ha!!ening is largely random and so un!redicta&le, so that e%en

the true model would show low forecasting a&ility+ The question howe%er is

why we are su!!osed to think that the DSGE does gi%e us good

information a&out counterfactuals+ If you could show that it had much

&etter !redicti%e !erformance than &aselines like constants or random

walks during out-o-control !eriods, that would &e something] &ut they

dont+

• )ars -eter Mansen and James J+ Meckman, $The Em!irical 7oundations of

*ali&ration$, @ournal o Economic /erspectives 54 '5==R(: >6..582 Fr,

rather, the lack thereof+ JSTFK

• <atarina Juselius and ;assimo 7ranchi, $Taking a DSGE ;odel to the Data

;eaningfully$, Economics 5 '1886(: 2 There are !laces where Juselius and

7ranchi write as though a CAK, or co.integrated CAK, were automatically

asuOcient statistic for any time series+ This I think is mere minor

carelessness] the general strategy here, of seeing what im!lications the

generati%e model has for !henomenological models, and testing thoseim!lications, is quite sound 'its o&%iously close to indirect inference(+ It is

http://vserver1.cscs.lsa.umich.edu/~crshalizi/reviews/christensen-kiefer/

http://vserver1.cscs.lsa.umich.edu/~crshalizi/weblog/algae-2011-01.html#dave-and-dave

http://www.jstor.org/stable/1913386

http://ideas.repec.org/p/ecb/ecbwps/20070722.html

http://www.econ.upf.edu/docs/papers/downloads/927.pdf

http://dx.doi.org/10.1198/073500107000000016

http://dx.doi.org/10.1198/073500107000000016

http://dx.doi.org/10.1198/073500107000000016

http://dx.doi.org/10.1198/073500107000000016

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1810075


http://dx.doi.org/10.5018/economics-ejournal.ja.2007-4



http://vserver1.cscs.lsa.umich.edu/~crshalizi/notabene/sufficienct-statistics.html

http://vserver1.cscs.lsa.umich.edu/~crshalizi/notabene/indirect-inference.html

http://vserver1.cscs.lsa.umich.edu/~crshalizi/reviews/christensen-kiefer/

http://vserver1.cscs.lsa.umich.edu/~crshalizi/weblog/algae-2011-01.html#dave-and-dave


http://ideas.repec.org/p/ecb/ecbwps/20070722.html

http://www.econ.upf.edu/docs/papers/downloads/927.pdf

http://dx.doi.org/10.1198/073500107000000016

http://dx.doi.org/10.1198/073500107000000016

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1810075



http://vserver1.cscs.lsa.umich.edu/~crshalizi/notabene/sufficienct-statistics.html

http://vserver1.cscs.lsa.umich.edu/~crshalizi/notabene/indirect-inference.html



!articularly interesting to try to translate speci(c !ieces of the generati%e

model to s!eci/c o&ser%a&le hy!otheses+ The fact that the DSGE model

is a misera&le failure at matching the data is, of course, Hust a &onus+

• I%ana <omunHer and Serena Ng, $Dynamic Identi/cation of DSGE ;odels$

-re!rint a%aila&le %ia -rof+ <omunHer

• ;ark #atson, $;easures of 7it for *ali&rated ;odels$, @ournal o /olitical

Economy 545 '5==B(: 5855..5825

Kecommended, criticisms:

• #illem 0uiter, $The unfortunate uselessness of most bstate of the art

academic monetary economics$, Financial Times B ;arch 188= The !oint

a&out needing to impose the trans%ersality condition is !articularly

interesting

• Kicardo J+ *a&allero, $;acroeconomics after the *risis: Time to Deal with

the -retense.of.<nowledge Syndrome$, SSKNL5R>BR56

• Da%id *olander, -eter Mowitt, Alan <irman, Ael )eiHonhuf%ud and -erry

;ehrling, $0eyond DSGE ;odels: Towards an Em!irically.0ased

;acroeconomics$ -D7 !re!rint

• Alan <irman, $#hom or #hat Does the Ke!resentati%e Indi%idual

Ke!resent"$, @ournal o Economic /erspectives @ '5==1(: 556..5BR Answer:

No one and nothing] accordingly it $deser%es to &e &uried$+ JSTFK

• James ;orley, $The Em!eror Mas No *lothes$, 3acro Focus >2 ';arch

1858( -D7

• Ko&ert Solow, $The State of ;acroeconomics$, @ournal o Economic

/erspectives 22 '188>(: 12B..12= $the claim that bmodern macro

somehow has the s!ecial %irtue of following the !rinci!les of economic

theory is tendentious and misleading+++ The other !ossi&le defense of

modern macro is that, howe%er s!ecial it may seem, it is Husti/ed

em!irically+ This too strikes me as a delusion+$

•

)awrence M+ Summers, $Some Ske!tical F&ser%ations on Keal 0usiness*ycle Theory$ 5=>R] -D7

Kecommended, miscellaneous:

• James <+ Gal&raith, Fli%ier Gio%anni and Ann J+ Kusso, $The

7eds 5ealKeaction 7unction: ;onetary -olicy, In4ation, nem!loyment,

Inequality and -residential -olitics$ Not directly a&out DSGEs, &ut since

so many of them incor!orate some %ersion of the Taylor rule, it amuses me

to think a&out writing one using this instead+ ni%ersity of Teas Inequality

-roHect working !a!er 21, 1886

http://econ.ucsd.edu/~ikomunje/respaper.htm

http://blogs.ft.com/maverecon/2009/03/the-unfortunate-uselessness-of-most-state-of-the-art-academic-monetary-economics/




http://ssrn.com/abstract=1683617

http://www.aeaweb.org/annual_mtg_papers/2008/2008_545.pdf

http://www.jstor.org/pss/2138411

http://artsci.wustl.edu/~morley/Main/Home.html

http://artsci.wustl.edu/~morley/emperor.pdf

http://dx.doi.org/10.1257/jep.22.1.243




http://www.minneapolisfed.org/research/QR/QR1043.pdf

http://utip.gov.utexas.edu/


http://utip.gov.utexas.edu/papers/utip_42.pdf

http://econ.ucsd.edu/~ikomunje/respaper.htm




http://www.aeaweb.org/annual_mtg_papers/2008/2008_545.pdf

http://www.jstor.org/pss/2138411

http://artsci.wustl.edu/~morley/Main/Home.html

http://artsci.wustl.edu/~morley/emperor.pdf



http://www.minneapolisfed.org/research/QR/QR1043.pdf



http://utip.gov.utexas.edu/papers/utip_42.pdf



• Mer&ert Gintis, $The Dynamics of General Equili&rium$, The Economic

@ournal 553 '1886(: 51>8..5B8= -D7 re!rint courtesy of -rof+ Gintis

• Aa!o My%rinen, <un ^hang, Shohei Shimi@u, -atrik F+ Moyer, $Estimation

of a Structural Cector Autoregression ;odel sing Non.Gaussianity$, @ournal

o 3achine ,earning 5esearch 55 '1858(: 568=..56B5

• James ;orley and Jeremy -iger, $The Asymmetric 0usiness *ycle$, The

5eview o Economics and Statistics ?8 '1851(: 18>..115

To read:

• George.;arios Angeletos and Jennifer )aF, $Animal S!irits$ -D7+ 7rom a

quick eamination, e!i.cycle adding ... or, rather, shock.adding+

• Koger 0ackhouse and ;auro 0oiano%sky, Transorming 3odern

3acroeconomicsC E1ploring Dise+uilibrium 3icrooundations A?--7>>

• Jean 0oi%in and ;arc -+ Giannoni, $DSGE ;odels in a Data.Kich

En%ironment$ -D7 !re!rint

• Da%id *olander 'ed+(, /ost )alrasian 3acroeconomicsC #eyond the

Dynamic Stochastic General E+uilibrium 3odel

• Fli%ier *oi&ion and uriy Gorodnichenko, $Strategic Interaction among

Meterogeneous -rice.Setters in an Estimated DSGE ;odel$, The 5eview o

Economics and Statistics ?6 '1855(: =18..=28

• -edro Garcia Duarte and <e%in D+ Moo%er, $F&ser%ingShocks$,ssrnL5>28689

• Koger E+ A+ 7armer, E1pectations Employment and /rices

• Ko&ert J+ Gordon, $Is ;odern ;acro or 5=6>.era ;acro ;ore Kele%ant to the

nderstanding of the *urrent Economic *risis"$ -D7 !re!rint %ia -rof+

Gordon

• )ance Taylor, 3aynard%s 5evengeC The ollapse o Free 3ar!et

3acroeconomics

To write:

• *o.cons!irators to &e named later Z *KS, $our 7a%orite DSGE Sucks$

http://www.umass.edu/preferen/gintis/General%20Equilibrium.pdf

http://jmlr.csail.mit.edu/papers/v11/hyvarinen10a.html




http://dx.doi.org/10.1162/REST_a_00169




http://econ-www.mit.edu/files/5322

http://cambridge.org/9781107023192


http://neumann.hec.ca/pages/jean.boivin/mypapers/dsgedr.pdf








http://www.oup.com/us/catalog/general/subject/Economics/Labor/?view=usa&ci=9780195397901

http://faculty-web.at.northwestern.edu/economics/gordon/GRU_Combined_090909.pdf


http://www.hup.harvard.edu/catalog.php?isbn=9780674050464


http://www.umass.edu/preferen/gintis/General%20Equilibrium.pdf





http://econ-www.mit.edu/files/5322



http://neumann.hec.ca/pages/jean.boivin/mypapers/dsgedr.pdf






http://www.oup.com/us/catalog/general/subject/Economics/Labor/?view=usa&ci=9780195397901







DSGE models B empirically irrele"ant and lo$ically incoherent

July >, 185BEditor)ea%e a commentGo to comments

from Lars Syll

Something a&out the way economists construct their models doesnt sit right+

Economic models are often acknowledged to &e unrealistic, and 7riedmanite

assum!tions dont matter style arguments are used to Hustify this a!!roach+ The

result is that internal mechanics arent really closely eamined+ Mowe%er, when it

suits them, economists are !re!ared to hold u! internal mechanics to em!irical

%eri/cation W usually in order to !reser%e key !ro!erties and mathematical

rele%ance+ The result is that models are constructed in such a way that, instead

of trying to e!lain how the economy works, they deli&erately a%oid &oth

diOcult empirical and diOcult logical questions+ This is !articularly noticea&le

with the Dynamic Stochastic General Equili&rium 'DSGE( models that are

commonly em!loyed in macroeconomics

The fact is that DSGE models themsel%es are not Uem!irically rele%antV+ They

assume that agents are o!timising, that markets tend to clear, that the economy

is an equili&rium time !ath+ They use log linearisation, a method which doesnt

e%en !retend to do anything other make the equations easier to sol%e &y forci&ly

eliminating the !ossi&ility of multi!le equili&ria+ Fn to! of this, they

generally dis!lay !oor em!irical corro&oration+ F%erall, the DSGE a!!roach is

structured toward !reser%ing the use of microfoundations, while at the same timein%oking %arious W often unrealistic W !rocesses in order to generate something

resem&ling dynamic &eha%iour+

Economists tacitly acknowledge this, as they will usually say that they use this

ty!e of model to highlight one or two key mechanics, rather than to attem!t to

&uild a com!rehensi%e model of the economy+ Ask an economist if !eo!le really

maimise utility] if the economy is in equili&rium] if markets clear, and they will

likely answer Uno, &ut its a sim!li/cation, designed to highlight !ro&lem V+ et

when questioned a&out some of the more surreal logical consequences of all of

the sim!li/cations made, economists will a!!eal to the real world+ This is not acoherent !ers!ecti%e+

https://rwer.wordpress.com/author/editorrwerblog/

https://rwer.wordpress.com/2013/07/08/dsge-models-empirically-irrelevant-and-logically-incoherent/#respond

https://rwer.wordpress.com/2013/07/08/dsge-models-empirically-irrelevant-and-logically-incoherent/#comments

http://unlearningeconomics.wordpress.com/2013/02/08/against-friedman-why-assumptions-matter/

http://en.wikipedia.org/wiki/Dynamic_stochastic_general_equilibrium


https://rwer.wordpress.com/author/editorrwerblog/


https://rwer.wordpress.com/2013/07/08/dsge-models-empirically-irrelevant-and-logically-incoherent/#comments

http://unlearningeconomics.wordpress.com/2013/02/08/against-friedman-why-assumptions-matter/

http://en.wikipedia.org/wiki/Dynamic_stochastic_general_equilibrium




Neoclassical economics uses an aiomatic deducti%e a!!roach, attem!ting to

logically deduce theories from &asic aioms a&out indi%idual choice under

scarcity+ Economists ha%e a stock of reasons to do this: it is rigorous] it &ases

models on !olicy in%ariant !arameters] it incor!orates the fact that the economy

ultimately consists of agents consciously making decisions, etc+ If you were to

suggest internal mechanics &ased on sim!le em!irical o&ser%ations, con%entionalmacroeconomists would likely reHect your a!!roach+

;odern DSGE models are constructed using these ty!es of aioms This allows

macroeconomists to draw clear mathematical im!lications from their models,

while the assum!tions are Husti/ed on the grounds of em!iricism et the model

as a whole has %ery little to do with em!iricism, and economists rarely claim

otherwise+ #hat we end u! with is a clearly unrealistic model, constructed not in

the name of em!irical rele%ance or logical consistency, &ut in the name of

!reser%ing key conclusions and mathematical tracta&ility

A consequence of this methodological dance is that it can &e diOcult to draw

conclusions a&out which DSGE models are !otentially sound+ Fne eam!le of this

came from the &logos!here, %ia Noah Smith+ Though Noah

has !re%iously criticised DSGE models, he recently noted W a!!ro%ingly W that

there eists a DSGE model that is quite consistent with the &eha%iour of key

economic %aria&les during the /nancial crisis+ This increased my res!ect for DSGE

somewhat, &ut my immediate conclusion still wasnt Ugreat That model is my

new mainstayV+ After all, so many DSGE models eist that its highly !ro&a&le

that some sim!listic cur%e /tting would make one seem !lausi&le+ Instead, I was

concerned with whats going on under the &onnet of the model W is it

re!resentati%e of the actual &eha%iour of the economy"

Sadly, the answer is no+ Said DSGE model includes many unrealistic mechanics:

most of the key &eha%iour a!!ears to &e determined &y eogenous shocks to

risk, in%estment, !roducti%ity etc without any e!lanation+ This includes the oft.

mocked *al%o fairy, which imitates sticky !rices &y assigning a !ro&a&ility to

/rms randomly changing their !rices at any gi%en !oint+ -resuma&ly, this

&eha%iour is Husti/ed on the grounds that all models are unrealistic in one way or

another+ 0ut if we ha%e constructed the model to a%oid key !ro&lems how can

we Hustify using something as &latantly unrealistic as the *al%o 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 !art of economics,

and many economists agree that DSGE W at least in its current form W is yielding

no fruit 'although these same economists may still &e hostile to outside

criticism(+ Ne%ertheless, I wonder if this !ro&lem etends to other areas of

economics, as economists can sometimes seem less concerned with e!laining

economic !henomena than with utilising their !referred a!!roach+ I &elie%e

internal mechanics are im!ortant, and if economists agree, they should e!ose

e%ery as!ect of their theories to em!irical %eri/cation, rather merely those areas

which will !rotect their core conclusions+

nlearning Economics

http://larspsyll.wordpress.com/2013/06/14/what-is-neoclassical-economics-a-rejoinder-to-noahpinion/

http://noahpinionblog.blogspot.co.uk/2013/05/what-can-you-do-with-dsge-model.html

http://noahpinionblog.blogspot.co.uk/2013/03/the-swamp-of-dsge-despair.html

http://noahpinionblog.blogspot.co.uk/2013/05/dsge-financial-frictions-macro-that.html

http://www.newyorkfed.org/research/staff_reports/sr618.pdf

http://en.wikipedia.org/wiki/Curve_fitting

https://en.wikipedia.org/wiki/Deus_ex_machina

http://blogs.ft.com/economistsforum/2010/01/the-stimulus-plan-unemployment-and-economic-theory-why-i-dont-believe-in-fairies/

http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/03/dsge.html

http://noahpinionblog.blogspot.co.uk/2012/11/econ-grad-students-and-macro-wars.html

https://twitter.com/jjreade/status/350623200863977473

http://unlearningeconomics.wordpress.com/2013/07/06/the-dsge-dance/

http://larspsyll.wordpress.com/2013/06/14/what-is-neoclassical-economics-a-rejoinder-to-noahpinion/

http://noahpinionblog.blogspot.co.uk/2013/05/what-can-you-do-with-dsge-model.html

http://noahpinionblog.blogspot.co.uk/2013/03/the-swamp-of-dsge-despair.html

http://noahpinionblog.blogspot.co.uk/2013/05/dsge-financial-frictions-macro-that.html

http://www.newyorkfed.org/research/staff_reports/sr618.pdf

http://en.wikipedia.org/wiki/Curve_fitting

https://en.wikipedia.org/wiki/Deus_ex_machina

http://blogs.ft.com/economistsforum/2010/01/the-stimulus-plan-unemployment-and-economic-theory-why-i-dont-believe-in-fairies/

http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/03/dsge.html

http://noahpinionblog.blogspot.co.uk/2012/11/econ-grad-students-and-macro-wars.html

https://twitter.com/jjreade/status/350623200863977473

http://unlearningeconomics.wordpress.com/2013/07/06/the-dsge-dance/



To me this con/rms what I ha%e &een arguing for years now W neoclassical

economic theory is in the story.telling &usiness+

Neoclassical economics has since long gi%en u! on the real world and contents

itself with !ro%ing things a&out thought u! worlds+ Em!irical e%idence only !lays

a minor role in economic theory, where models largely function as a su&stitute forem!irical e%idence+ 0ut Ufacts kickV, as Gunnar ;yrdal used to say+ Mo!efully

hum&led &y the manifest failure of its theoretical !retences, the one.sided,

almost religious, insistence on aiomatic.deducti%ist modeling as the only

scienti/c acti%ity worthy of !ursuing in economics will gi%e way to methodological

!luralism &ased on ontological considerations rather than formalistic tracta&ility+

;odern macroeconomics &uilds on the myth of us knowing the Udata.generating

!rocessV and that we can descri&e the %aria&les of our e%ol%ing economies as

drawn from an urn containing stochastic !ro&a&ility functions with known means

and %ariances+

In the end this is what it all &oils down to+ #e all know that many acti%ities,

relations, !rocesses and e%ents are genuinely uncertain+ The data do not

unequi%ocally single out one decision as the only UrationalV one+ Neither the

economist, nor the deciding indi%idual, can fully !re.s!ecify how !eo!le will

decide when facing uncertainties and am&iguities that are ontological facts of the

way the world works+

Some macroeconomists, howe%er, still want to &e a&le to use their hammer+ So

they decide to !retend that the world looks like a nail, and !retend that

uncertainty can &e reduced to risk+ So they construct their mathematical models

on that assum!tion+

If macroeconomic models W no matter of what ilk W &uild on

microfoundational assumptions of re!resentati%e actors, rational e!ectations,

market clearing and equili&rium, and we !now that real !eo!le and markets

cannot &e e!ected to o&ey these assum!tions, the warrants for su!!osing that

conclusions or hy!othesis of causally rele%ant mechanisms or regularities can &e

&ridged, are o&%iously non.Husti/a&le+ Incom!ati&ility &etween actual &eha%iour

and the &eha%iour in macroeconomic models &uilding on re!resentati%e actors

and rational e!ectations.microfoundations is not a sym!tom of UirrationalityV+ It

rather shows the futility of trying to re!resent real.world target systems with

models 4agrantly at odds with reality+



A gadget is Hust a gadget W and &rilliantly silly DSGE models do not hel! us

working with the fundamental issues of modern economies+

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*ategories: The Economics -rofession

*omments '9()ea%e a comment

5. paul da"idson

July >, 185B at B:5B !m

Ke!ly

<eynes e!licitly stated this argument on !age 5R of the General Theory when henoted that

Uclassical economists resem&le Euclidean geometers in a non.Euclidean world

who, disco%ering that in e!erience re&uke these lines for not kee!ing straightW

as the only remedy for the unfortunate collisions which are occurring+ et , in

truth , there is no remedy ece!t to throw o%er the aiom of !arallels and to work

out a non.Euclidean geometry+ Something similar is required today in

economicsV+

The unfortunate collisions were unem!loyment] re&uking the lines was re&uking

those who ke!t !rices /ed or sticky

The aioms <eynes o%erthrew, as I ha%e continually argued , were 5 the

neutrality of money aiom, 1 the gross su&stitution aiom &etween liquid assets

and real dura&le ca!ital assets] and B the ergodic aiom+

The /rst two aioms <eynes e!licitly s!eci/es as not in his General Theory and

therefore he has o%erthrown the third aiom follows from his de/nition of

uncertainty and his criticism of ;r+ Tin&ergens method+

<eynes ke!t, and we can kee!, the aioms that '5( !eo!le are self.interested and

try to !rotect their income and wealth] and that '1( /rms try to maimi@e !ro/ts

for surely we can assume that most /rms are not charita&le institutions, andmost !eo!le look out for what they &elie%e is their own self.interest W 'e%en if in a

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world of uncertainty they may make decisions which turn out to &e against their

self interest(t

2. paul da"idson

July >, 185B at B:5> !m

Ke!ly

Sorry &ut somehow a few words got dro!!ed from my quote from <eynes+ The

correct !art of the sentence is] U++Euclidean geometers in a non.Euclidean world

who, disco%ering that in e!erience straight lines a!!arently !arallel often meet,

re&uke these lines for not kee!ing straight+V

6. -red Caman

July >, 185B at 58:8= !m

Ke!ly

Tomorrow, or !erha!s the day after, I will argue on the thread UAdam Smith, 7+

^amans K#EK !a!er and the ==3 mo%ementV that <eyness a!!lication of the

Euclidean %s, non Euclidean analogy in economics is critically 4awed and %ery

misleading in regard to what ha!!ens in the real.world economy+ A more realistic

understanding of this analogy in economics will further illuminate the su&Hect of

what the ==3 mo%ement is in !rinci!le+

o da"etaylor5

July =, 185B at =:22 am

Ke!ly

0ut 7red, <eynes was eactly right In Euclidian geometry, if one kee!s on going

in the same direction 'i+e+ doing the same thing( the same things ha!!en+ In the

non.Euclidian geometry of the surface of a s!here, the law of diminishing returns

ha!!ens: the further you get away from your starting !oint the nearer you get to

&eing &ack where you started+ So we%e tamed Natures Hungle and enHoyed its

fruits] &ut &eing stu!id, mankind has not &een grateful for small mercies+ It has

laughed at Schumachers USmall is 0eautifulV criterion of adequacy and continuesto &elie%e Umore is &etterV, des!ite the manifest e%idence that we%e gone o%er

the to! and are reducing a &eautiful and 'when cared for( fruitful world to a few

oases in an industrial desert+

Just &ecause forests are &eing &urnt on the other side of the world where we

cant feel their heat and see their de%astation doesnt mean they are not &urning,

nor make a few oil !alms worth more than the Hungles natural function W

a&sor&ing the suns heat and lifes wastes to cool, calm, cleanse and regenerate

the air and water su!!lies we need to li%e+

USomething a&out the way economists construct their models doesnt sit rightVwhen they dont draw attention to crucial issues like this+









8. ,acrocompassion

July 55, 185B at B:9> !m

Ke!ly

E%en the DSGE models are unsatisfactory &ecause they do not include the wholeof the social system+ They are im!ro%ements on what was a%aila&le in <eynes

time, &ut until some&ody takes Menry Ma@litt suOciently seriously and follows his

UFne )essonV to include the whole she&ang, there will always &e some dou&t+ In

!articular the models &eing used today ha%e still not !ro!erly caught u! with

Adam Smiths claim a&out !roduction de!ending on B factors and yeilding B

returns to these factors 'ground.rent, wages and interest or di%idends(, through

sale of the !roduce+ The signi/cance of natural resources !articularly land is %ital

here &ut Hust a&out e%ery&ody misses it out

I sus!ect the reason for this is that the mono!olists who control the access toland ha%e decided that our uni%ersities should not tell students all a&out what is

going on within the social system and sinces these august &odies !ay the !i!er,

they certainly can call the tune that is !layed through our education system+ The

signi/cance of land within the macro.economy was e!lained &y many of the

classic economists like Da%id Kicardo, &ut the last one to show its im!ortance

was Menry George 5B8 years ago and no&ody cares to read u! his ideas today+

• #ithout ha%ing a com!lete model in hand there is little ho!e that the

e!erts will &e allowed to realise what is the real &raking source on

economic !rogress, and so go%ernments will continue to &e limited in their

attem!ts to / the situation, thank to the interference and sel/shness of

those owning and cont0enelu

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