In one my favorite episodes of the TV show The Office (A Benihana Christmas), dim-witted accountant Kevin Malone faces a choice between two competing office Christmas parties: the traditional Christmas party thrown by Angela, or Pam and Karen’s exciting new party. After weighing various factors (double fudge brownies…Angela), Kevin decides “I think I’ll go to Angela’s party, because that’s the party I know.” I can’t help but see parallels between Kevin’s reasoning and some of the recent discussions about the role of DSGE models in macroeconomics. It’s understandable. Many economists have poured years of their lives into this research agenda. Change is hard. But sticking with something simply because that’s the way it has always been done is not, in my opinion, a good way to approach research.
I was driven to write this post after reading a recent post by Roger Farmer, which responds to this article by Steve Keen, which is itself responding to Olivier Blanchard’s recent comments on the state of macroeconomics. Lost yet? Luckily you don’t really need to understand the entire flow of the argument to get my point. Basically, Keen argues that the assumption of economic models that the system is always in equilibrium is poorly supported. He points to physics for comparison, where Edward Lorenz showed that the dynamics underlying weather systems were not random, but chaotic – fully deterministic, but still impossible to predict. Although his model had equilibria, they were inherently unstable, so the system continuously fluctuated between them in an unpredictable fashion.
Keen’s point is that economics could easily be a chaotic system as well. Is there any doubt that the interactions between millions of people that make up the economic system are at least as complex as the weather? Is it possible that, like the weather, the economy is never actually in equilibrium, but rather groping towards it (or, in the case of multiple equilibria, towards one of them)? Isn’t there at least some value in looking for alternatives to the DSGE paradigm?
Roger begins his reply to Keen by claiming, “we tried that 35 years ago and rejected it. Here’s why.” I was curious to read about why it was rejected, but he goes on to say that the results of these attempts to examine whether there is complexity and chaos in economics were that “we have no way of knowing given current data limitations.” Echoing this point, a survey of some of these tests by Barnett and Serletis concludes
We do not have the slightest idea of whether or not asset prices exhibit chaotic nonlinear dynamics produced from the nonlinear structure of the economy…While there have been many published tests for chaotic nonlinear dynamics, little agreement exists among economists about the correct conclusions.
Barnett and Serletis (2000) – Martingales, nonlinearity, and chaos
That doesn’t sound like rejection to me. We have two competing theories without a good way of determining which is more correct. So why should we rigidly stick to one? Best I can tell, the only answer is Kevin Malone Economics™. DSGE models are the way it has always been done, so unless there is some spectacular new evidence that an alternative does better, let’s just stay with what we know. I don’t buy it. The more sensible way forward in my opinion is to cultivate both approaches, to build up models using DSGE as well as alternatives until we have some way of choosing which is better. Some economists have taken this path and begun to explore alternatives, but they remain on the fringe and are largely ignored (I will have a post on some of these soon, but here is a preview). I think this is a huge mistake.
Since Roger is one of my favorite economists in large part because he is not afraid to challenge the orthodoxy, I was a bit surprised to read this argument from him. His entire career has been devoted to models with multiple equilibria and sunspot shocks. As far as I know (and I don’t know much so I could very well be wrong), these features are just as difficult to confirm empirically as is the existence of chaos. By spending an entire career developing his model, he has gotten it to a place where it can shed light on real issues (see his excellent new book, Prosperity for All), but its acceptance within the profession is still low. In his analysis of alternatives to standard DSGE models, Michael De Vroey writes:
Multiple equilibria is a great idea that many would like to adopt were it not for the daunting character of its implementation. Farmer’s work attests to this. Nonetheless, it is hard to resist the judgement that, for all its panache, it is based on a few, hard to swallow, coups de force…I regard Farmer’s work as the fruit of a solo exercise attesting to both the inventiveness of its performer and the plasticity of the neoclassical toolbox. Yet in the Preface of his book [How the Economy Works], he expressed a bigger ambition, “to overturn a way of thinking that has been established among macroeconomists for twenty years.” To this end, he will need to gather a following of economists working on enriching his model
De Vroey (2016) – A History of Macroeconomics from Keynes to Lucas and Beyond
In other words, De Vroey’s assessment of Roger’s work is quite similar to Roger’s own assessment of non-DSGE models: it’s not a bad idea and there’s possibly some potential there, but it’s not quite there yet. Just as I doubt Roger is ready to tear up his work and jump back in with traditional models (and he shouldn’t), neither should those looking for alternatives to DSGE give up simply because the attempts to this point haven’t found anything revolutionary.
I’m not saying all economists should abandon DSGE models. Maybe they are a simple and yet still adequate way of looking at the world. But maybe they’re not. Maybe there are alternatives that provide more insight into the way a complex economy works. Attempts to find these alternatives should not be met with skepticism. They shouldn’t have to drastically outperform current models in order to even be considered (especially considering current models aren’t doing so hot anyway). Of course there is no way any alternative model will be able to stand up to a research program that has gone through 40 years of revision and improvement (although it’s not clear how much improvement there has really been). The only way to find out if there are alternatives worth pursuing is to welcome and encourage researchers looking to expand the techniques of macroeconomics beyond equilibrium and beyond DSGE. If even a fraction of the brainpower currently being applied to DSGE models were shifted to looking for different methods, I am confident that a new framework would flourish and possibly come to stand beside or even replace DSGE models as the primary tool of macroeconomics.
At the end of the episode mentioned above, Kevin (along with everybody else in the office) ends up going to Pam and Karen’s party, which turns out to be way better than Angela’s. I can only hope macroeconomics continues to mirror that plot.