Noah Smith — The most damning critique of DSGE

If DSGE models work, why don't people use them to get rich?

When I studied macroeconomics in grad school, I was told something along these lines:

"DSGE models are useful for policy advice because they (hopefully) pass the Lucas Critique. If all you want to do is forecast the economy, you don't need to pass the Lucas Critique, so you don't need a DSGE model."

This is usually what I hear academic macroeconomists say when asked to explain the fact that essentially no one in the private sector uses DSGE models. Private-sector people can't set economic policy, the argument goes, so they don't need Lucas Critique-robust models.
The problem is, this argument is wrong. If you have a model that both A) satisfies the Lucas Critique and B) is a decent model of the economy, you can make huge amounts of money. This is because although any old spreadsheet can be used to make unconditional forecasts of the economy, you need Lucas-robust models to make good policy-conditional forecasts….

So now let's get to the point of this post. As far as I'm aware, private-sector firms don't hire anyone to make DSGE models, implement DSGE models, or even scan the DSGE literature. There are a lot of firms that make macro bets in the finance industry - investment banks, macro hedge funds, bond funds. To my knowledge, none of these firms spends one thin dime on DSGE. I've called and emailed everyone I could think of who knows what financial-industry macroeconomists do, and they're all unanimous - they've never heard of anyone in finance using a DSGE model….

But if finance-industry people can't know which DSGE model to use, how can policymakers or policy advisors? 

In other words, DSGE models (not just "Freshwater" models, I mean the whole kit & caboodle) have failed a key test of usefulness. Their main selling point - satisfying the Lucas critique - should make them very valuable to industry. But industry shuns them.
Many economic technologies pass the industry test. Companies pay people lots of money to useauction theory. Companies pay people lots of money to use vector autoregressions. Companies pay people lots of money to use matching models. But companies do not, as far as I can tell, pay people lots of money to use DSGE to predict the effects of government policy. Maybe this will change someday, but it's been 32 years, and no one's touching these things.

As I see it, this is currently the most damning critique of the whole DSGE paradigm.

Noahpinion
The most damning critique of DSGE
Noah Smith | Assistant Professor of Finance } Stony Brook University