DSGE Dilettantes v. ADM God Devotees

By William K. Black

December 18, 2017     Bloomington, MN

The truly exceptional thing about ‘modern macroeconomics’ devotees is not that they are so consistently and horrifically wrong or that they persist in their errors – but their exceptional combination of arrogance and disdain for those who have dramatically better records and broader and more relevant expertise.  Kartik Athreya, the Richmond Fed’s Research Director, led the modern macro parade on June 17, 2010 with his blog (which he later withdrew in embarrassment) when he announced the Athreya Axiom of Absolute Arrogance.

So far, I’ve claimed something a bit obnoxious-sounding: that writers who have not taken a year of PhD coursework in a decent economics department (and passed their PhD qualifying exams), cannot meaningfully advance the discussion on economic policy. Taken literally, I am almost certainly wrong. Some of them have great ideas, for sure. But this is irrelevant. The real issue is that there is extremely low likelihood that the speculations of the untrained, on a topic almost pathologically riddled by dynamic considerations and feedback effects, will offer anything new. Moreover, there is a substantial likelihood that it will instead offer something incoherent or misleading.

Modern macro devotees suffered far worse substantive embarrassment than Athreya’s personal embarrassment.  After Athreya (briefly) published his Axiom, a flurry of the world’s top economists issued devastating critiques of modern macro’s foundational myths in their dynamic stochastic general equilibrium (DSGE) models.  The takedowns enraged and humiliated modern macro devotees, and because they are incapable of staying embarrassed, they doubled-down on Athreya’s Axiom by announcing the Dilettante Doctrine.

People who don’t like dynamic stochastic general equilibrium (DSGE) models are dilettantes.  By this we mean they aren’t serious about policy analysis.

Lawrence J. Christiano, Martin S. Eichenbaum, and Mathias Trabandt, authored “On DSGE Models on November 9, 2017.  Christiano and Eichenbaum are freshwater modern macro devotees trained largely at the University of Minnesota, and now holding prominent positions at Northwestern.  Trabandt is a German modern macro devotee.

A dilettante is a person who cultivates an area of interest, such as the arts, without real commitment or knowledge.  The Dilettante Doctrine takes modern macro’s arrogance to a new pinnacle.  Only their model is legitimate, and it is illegitimate to criticize their DSGE models, even though they repeatedly fail.  Instead, we must all “like” their models.  We cannot make any statements about macroeconomics unless we “like [DSGE] models.”  The Dilettante Doctrine is a sure-fire means of winning academic disputes.  You demand that your critics endorse your views, or you dismiss them as dilettantes unworthy of respect.

Readers may recall that the scientific method works in the opposite direction of the Dilettante Doctrine.  Modern macro proposes a theory (DSGE) and tests its predictive ability.  The DSGE models fail recurrently, on the most important macro events, and the failures are massive.  The scientific method requires the theorist of the failed model to declare it falsified.  Economists who “like” repeatedly falsified DSGE models are, as Paul Romer famously declared, engaged in “pseudoscience.”

Athreya then inadvertently compounded modern macro’s failures by putting in writing a bit too many of modern macro’s darker secrets in his 2013 book about macroeconomics.  Athreya confirmed many of the most fundamental criticisms of modern macro devotees, revealed additional failures that were even more devastating, and illustrated perfectly the blindness of modern macro’s devotees to their dogmas and logic.  Athreya did recognize clearly one dogma that made modern macro devotees unable to spot even the world’s largest bubble – but treated that failure as if it were a virtue.  Modern macro devotees train macroeconomists to be unable to identify warn against, or take action to end even the most destructive bubbles.  This is like training surgeons to believe that shock cannot occur and they should ignore shock in treating patients.

I will return to these errors in subsequent columns, but in this initial column, I introduce Athreya’s most embarrassing and devastating admission.  Athreya goes on for over 100 pages on how wondrous his fellow modern macro devotees are.  They are brilliant specialists who are the world’s top practitioners of ultra-rigorous logic and ultra-sophisticated mathematics skills that make it impossible for them to be anything other than transparent and scrupulously honest.  In particular, Athreya tells the reader that the paramount problem in macro and microeconomics is recognizing, understanding, and countering deceit, the defining element at law of fraud.  (Actually, he does that only in an exceptionally opaque manner.)  On p.103, however, Athreya admits that modern macro devotees know that their vaunted DSGE models rest on a fatal premise that is so preposterous and embarrassing that they dare not state it.  “A silent assumption of the ADM model” is that “the ADM God” perfectly prevents all crimes, predation, and deceit – at no cost.  Note that this means that modern macro devotees (silently) designed their DSGE models to be incapable of recognizing, understanding, measuring, or countering deceit, which they admit is their paramount and fatal failure.

It is never good to be arrogant.  It is always dangerous and limiting to be (proudly) ignorant of fields that are likely to have superior understanding of issues such as deceit, fraud, and predation.  Athreya’s book displays his pride in both of these faults.

The authors of the Dilettante Doctrine inadvertently revealed another embarrassing modern macro failure of great importance.  It is the combination of repeated, devastating failure and unfailing arrogance that defines (and dooms) modern macro as pseudoscientists.  In fairness to the authors, they announced their Dilettante Doctrine in the context of an article admitting catastrophic errors in modern macro.  They also unintentionally admit the non-scientific nature of their enterprise.  Consider this passage:

For [IMF’s leader] to take DSGE model-based recommendations seriously, the economic intuition underlying those recommendations has to be made in compelling and intuitive ways.

Yes, they actually wrote that for anyone to take DSGE models “seriously” their “economic intuition” must “be made … intuitive.”  Wow, who knew science could be so ‘intuitive?’  Not satisfied with announcing their new “intuitive method” as a substitute for the scientific method, the authors double-down on the concept that ‘intuition’ is the secret sauce of economics declaring that the super-secret is to keep that ‘intuition’ “simple.”

To be convincing, it is critical for a DSGE modeler to understand and convey the economic intuition behind the model’s implications in simple and intuitive terms.

Notice that the authors are not stating the conditions required to make the DSGE models ‘correct.’  They are only interested in what practices will make the models’ results “convincing” to the bosses.

The bosses decide “actual policymaking.”  The Dilettante Doctrine authors declare policymaking to be even less scientific than relying on ‘simple’ ‘intuition’ to convey DSGE model results.  It turns out that DSGE models are the ‘canvas’ on which modern macro devotees “see the combined effect of the different colors” of their “art.”

Inevitably, actual policymaking will always be to some extent an art. But even an artist needs a canvas to see the combined effect of the different colors.  A DSGE model is that canvas.

These passages are not simply embarrassing, they are revealing.  DSGE is a substantive farce that repeatedly fails because modern macro devotees shaped their models from the beginning to embrace laissez faire dogmas.  The ‘simple’ ‘intuitions’ underlying DSGE models are the most destructive laissez faire dogmas.  Narayana Kocherlakota’s sly use of the word “almost” reveals his agreement with this point.                

[A]lmost coincidentally—in these [early DSGE] models, all government interventions (including all forms of stabilization policy) are undesirable.

The authors of the Dilettante Doctrine agree with Kocherlakota’s observation about the original DSGE models.

The associated policy implications are clear:  there was no need for any form of government intervention. In fact, government policies aimed at stabilizing the business cycle are welfare-reducing.

Modern macro is proud that its ‘freshwater’ and ‘saltwater’ factions have achieved a grand fusion.  The saltwater types agreed to use DSGE models and the freshwater types agreed that the freshwater types could add ‘frictions’ to the DSGE models that would allow the models to at least purport to address some of the actual macroeconomic problems.  There is a misleading view that because the ‘saltwater’ types often call themselves “New Keynesians” they must have views sympathetic to Keynesian thought.  The Dilettante Doctrine authors make the useful point that “New Keynesian” dogma is actually Milton Friedman’s core laissez faire dogmas.

Prototypical pre-crisis DSGE models built upon the chassis of the RBC model to allow for nominal frictions, both in labor and goods markets. These models are often referred to as New Keynesian (NK) DSGE models. But, it would be just as appropriate to refer to them as Friedmanite DSGE models. The reason is that they embody the fundamental world view articulated in Friedman’s seminal Presidential Address….

The Dilettante Doctrine authors admit that DSGE models failed at the most fundamental level – they could not even spot that the economy was becoming progressively more dangerous and harmful.

Pre-crisis DSGE models didn’t predict the increasing vulnerability of the US economy to a financial crisis.

The authors go badly wrong in multiple ways when they attempt to explain the DSGE models failures and their implications for economic theory and policy.

There is still an ongoing debate about the causes of the financial crisis. Our view, shared by Bernanke (2009) and many others, is that the financial crisis was precipitated by a rollover crisis in a very large and highly levered shadow-banking sector that relied on short-term debt to fund long-term assets.19

The trigger for the rollover crisis was developments in the housing sector. U.S. housing prices had risen rapidly in the 1990’s with the S&P/Case-Shiller U.S. National Home Price Index rising by a factor of roughly 2.5 between 1991 and 2006. The precise role played by expectations, the subprime market, declining lending standards in mortgage markets, and overly-loose monetary policy is not critical for our purposes. What is critical is that housing prices began to decline in mid-2006, causing a fall in the value of the assets of shadow banks that had heavily invested in mortgage-backed securities. The Fed’s willingness to provide a safety net for the shadow banking system was at best implicit, creating the conditions under which a roll-over crisis was possible. In fact a rollover crisis did occur and shadow banks had to sell their asset-backed securities at fire-sale prices, precipitating the Great Recession.

In sum, the pre-crisis mainstream DSGE models failed to forecast the financial crisis because they did not integrate the shadow banking system into their analysis.

I begin with the most fundamental failure – the failure to ask the right questions.  Two prominent examples are why didn’t the DSGE models warn us decades ago that the economy was systematically misallocating assets and creating the largest bubble in world history and what should we do to change the perverse incentives harming the economy and economic stability?  Kocherlakota, in the same article from which I quoted above, emphasized that modern macro failed to warn about the coming financial crisis and the Great Recession and failed to provide effective policies to respond to them.

The dilettante article only uses the word ‘bubble’ once – to describe the tech bubble.  It never labels the vastly larger housing bubble a ‘bubble.’  The dilettante article’s authors claim it is not relevant for their purposes to know how the bubble arose, why it continued to inflate for over a decade, why it burst, or why it triggered the global financial crisis and the Great Recession.  Only a dilettante could make or believe that claim.

Recall that Athreya emphasizes that deceit is the key factor that screws up economies – and that DSGE models “silently” assume “the ADM God” makes deceit impossible.  I have explained in scores of columns why deceit, fraud, and predation were the central causes of the housing bubble hyper-inflating, the financial crisis, and the creation of the Great Recession.  The dilettante authors refusal to call the housing bubble a bubble does not change the fact that they claim that the dramatic fall in housing values after 2005 was the paramount “trigger” of the financial crisis and the Great Recession.

The dilettante authors create a fiction about what “precipitat[ed] the Great Recession.

In fact a rollover crisis did occur and shadow banks had to sell their asset-backed securities at fire-sale prices, precipitating the Great Recession.

The dilettante authors then make their twin ‘mea culpa’ on behalf of modern macro.

Against this background, we turn to the first of the two criticisms of DSGE models mentioned above, namely their failure to signal the increasing vulnerability of the U.S. economy to a financial crisis. This criticism is correct. The failure reflected a broader failure of the economics community.

The failure was to allow a small shadow-banking system to metastasize into a massive, poorly-regulated wild west-like sector that was not protected by deposit insurance or lender-of-last-resort backstops.

We now turn to the second criticism of DSGE models, namely that they did not sufficiently emphasize financial frictions.  One reason why modelers did not emphasize financial frictions in DSGE models is that until the recent crisis, post-war recessions in the U.S. and Western Europe did not seem closely tied to disturbances in financial markets. The Savings and Loans crisis in the US was a localized affair that did not grow into anything like the Great Recession. Similarly, the stock market meltdown in the late 1980’s and the bursting of the tech-bubble in 2001 only had minor effects on aggregate economic activity.

At the same time, the financial frictions that were included in DSGE models did not seem to have very big effects.

The dilettante authors have no idea how important their concessions are.  Their premise is that it was government regulation, deposit insurance, and the central bank’s ‘lender of last resort’ function that prevented prior epidemics of accounting control fraud from causing anything worse than “minor effects on aggregate economic activity.”  The obvious problem is that since its inception 30 years ago modern macro ideologues have claimed the opposite is true – that governmental action is unnecessary and harmful.  They constructed their DSGE models to valorize their Friedmanite dogmas.

The less obvious problem is that freshwater modern macro has claimed that the lesson of the financial crisis is the opposite.  Athreya and the Richmond Fed have preached for years that the federal safety net caused the housing problem, the financial crisis, and the Great Recession.  The Richmond Fed claims that the key policy response to future financial crises is allowing the shadow sector to collapse in an orgy of “rollover cris[e]s.”

The broader problem is why the dilettante authors are so wedded to their failed models, which at their core assume out of existence the institutions and events they say are most critical to explaining the catastrophic failures of their models.  Why, for example, start with a general equilibrium model based on absurdly utopian assumptions (stated and unstated) that invariably produces equilibrium when the things we most need to study involve the failure of markets to function?  It is nonsensical to make contradictory assumptions in different parts of your model about human behavior.  Modern macro models keep failing and their devotees’ response is to add (over time) dozens of fudges that posit that humans typically act in a manner that contradicts to the explicit and unstated assumptions of the DSGE model about human behavior.   DSGE models increasingly resemble Borg constructs.  The Borg also claim that there is no alternative to assimilation into their collective.