Olivier Blanchard — The Need for Different Classes of Macroeconomic Models

So what should be done? My suggestion is that the two classes should go their separate ways.

DSGE modelers should accept the fact that theoretical models cannot, and thus should not, fit reality closely. The models should capture what we believe are the macro-essential characteristics of the behavior of firms and people, and not try to capture all relevant dynamics. Only then can they serve their purpose, remain simple enough, and provide a platform for theoretical discussions.

Policy modelers should accept the fact that equations that truly fit the data can have only a loose theoretical justification. In that, the early macroeconomic models had it right: The permanent income theory, the life cycle theory, the Q theory provided guidance for the specification of consumption and investment behavior, but the data then determined the final specification.

Both classes should clearly interact and benefit from each other. To use an expression suggested by Ricardo Reis, there should be scientific cointegration. But the goal of full integration has, I believe, proven counterproductive. No model can be all things to all people.

Like I have been saying. Separate theoretical from practical inquiry. They are separate fields, just as theoretical physics is separate from the various branches of engineering as applied physics.

However, engineers also require other knowledge and skill, such as materials science, and they must also take cost into account. Good design often includes aesthetics. Architecture is a combination of design and engineering.

Engineers are not interested in "the perfect bridge," but rather the bridge that will meet the design specifications most economically and reliably. Engineers realize that building in redundancy for safety is not inefficient, although it may appear to be "wasteful" duplication.

Theoretical economics requires specialization in applied math. Political economy requires knowledge of  systems dynamics, political science, sociology, history in addition to economics, accounting, and statistics.

There is nothing wrong with departments of theoretical economics looking like departments of theoretical physics or applied math. But departments of political economy should look more like business schools and engineering departments, which are oriented toward application and data-centric.

Peterson Institute for International Economics
The Need for Different Classes of Macroeconomic Models

Olivier Blanchard | Professor and Senior Fellow at the Peterson Institute for International Economics, and former chief economist at the International Monetary Fund
ht Lambert Strether at Naked Capitalism

  

Whither Economics?

Noah Smith speculates.

Noahpinion

A new age of econ imperialism is coming
Noah Smith | Assistant Professor of Finance, Stony Brook University

Jason Smith replies.

Information Transfer Economics
Economic imperialism?
Jason Smith

Jason cites this previous blog in his reply above. If you aren't familiar with it, I suggest reading it. It's short.

He concludes with:

In my link above, there are some other things that give us more information. For example, in a d-dimensional beehive with d >> 1, nearly all the bees are near the surface, not the interior ... as long as they are not coordinated to be in the interior (say, by the queen).

When this separation holds, then economics is more like physics. When it doesn't, economics is a social science.

If the details of the complexity of bee social structure strongly mattered, it would (likely) be impossible to figure out how much honey you could get from N bees [per capita real GDP]. Now humans are more complicated than bees, but the same principle -- that the macro properties are mostly governed by the bulk properties of the available state space -- has to apply if macro is tractable. And if it's not tractable (a possibility), then it really should just be moral and historical arguments.

I think that this probably puts a finger on the nub of it. Macro models work when trends are relatively stable but break down when they become unstable, that is, especially at cyclical turning points.  But turning points are what is most interesting and needs to be known for policy formulation.

This what Keynes meant when he said that in the long run will all be dead. What good does assuming equilibrium mean when a time series involving employment can persist in pattern in which the labor market doesn't clear for an extended period. Where there is debt, waiting it out is not a option.

Another way of putting it relying on mean reversion in markets may be a good strategy for those with deep pockets but many if not most participants don't have pockets that deep and the leveraged will become insolvent.

Macro can illuminate some consistencies in the behavior of aggregates, but experienced traders know the limitations of trend following.

One issue is that humans are not like atoms; they are subject to "animal spirits" that affect expectations and result in shifting preferences, in particular liquidity preference. The other issue is the influence of money. Conventional economics assumes that money is neutral "in the long run." Again, in the long run we are all dead, or deadbeats, since most households and firms are leveraged in one way other another.

Money as the unit of account is key in economics because economic aggregates are expressed in terms of the unit of account. To the degree that money is not neutral, it influences the system endogenously. This is something that conventional economics has not come to terms with, while Paleo and Post Keynesianism do.

Jason Smith — Empirical economics, a denouement

Nice quote about David Card.

Peter J. Walker profiles David Card, the economist who has questioned conventional wisdom on minimum wages, immigration, and education.

Is conventional economic theory a series of shibboleths?

Information Transfer Economics
Empirical economics, a denouement
Jason Smith