Two reasons DSGE models are such spectacular failures

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Lars Pålsson Syll
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Two reasons DSGE models are such spectacular failures

The unsellability of DSGE models — private-sector firms do not pay lots of money to use DSGE models — is one strong argument against DSGE.

But it is not the most damning critique of it.

To me the most damning critiques that can be levelled against DSGE models are the following two:
 
(1) DSGE models are unable to explain involuntary unemployment

In the basic DSGE models the labour market is always cleared – responding to a changing interest rate, expected life time incomes, or real wages, the representative agent maximizes the utility function by varying her labour supply, money holding and consumption over time. Most importantly – if the real wage somehow deviates from its ‘equilibrium value,’ the representative agent adjust her labour supply, so that when the real wage is higher than its ‘equilibrium value,’ labour supply is increased, and when the real wage is below its ‘equilibrium value,’ labour supply is decreased.

In this model world, unemployment is always an optimal choice to changes in the labour market conditions. Hence, unemployment is totally voluntary. To be unemployed is something one optimally chooses to be.

Although this picture of unemployment as a kind of self-chosen optimality, strikes most people as utterly ridiculous, there are also, unfortunately, a lot of neoclassical economists out there who still think that price and wage rigidities are the prime movers behind unemployment. DSGE models basically explains variations in employment (and a fortiori output) with assuming nominal wages being more flexible than prices – disregarding the lack of empirical evidence for this rather counterintuitive assumption.

Lowering nominal wages would not  clear the labour market. Lowering wages – and possibly prices – could, perhaps, lower interest rates and increase investment. It would be much easier to achieve that effect by increasing the money supply. In any case, wage reductions was not seen as a general substitute for an expansionary monetary or fiscal policy. And even if potentially positive impacts of lowering wages exist, there are also more heavily weighing negative impacts – management-union relations deteriorating, expectations of on-going lowering of wages causing delay of investments, debt deflation et cetera.

The classical proposition that lowering wages would lower unemployment and ultimately take economies out of depressions, was ill-founded and basically wrong. Flexible wages would probably only make things worse by leading to erratic price-fluctuations. The basic explanation for unemployment is insufficient aggregate demand, and that is mostly determined outside the labour market.

Obviously it’s rather embarrassing that the kind of DSGE models ‘modern’ macroeconomists use cannot incorporate such a basic fact of reality as involuntary unemployment. Of course, working with representative agent models, this should come as no surprise. The kind of unemployment that occurs is voluntary, since it is only adjustments of the hours of work that these optimizing agents make to maximize their utility.
 
(2) In DSGE models increases in government spending leads to a drop in private consumption

In the most basic mainstream proto-DSGE models one often assumes that governments finance its current expenditures with current tax revenues.  This will have a negative income effect on the households, leading — rather counterintuitively — to a drop in private consumption although both employment an production expands. This mechanism also holds when in more elaborated DSGE models the (in)famous Ricardian equivalence is added.

Ricardian equivalence basically means that financing government expenditures through taxes or debts is equivalent, since debt financing must be repaid with interest, and agents — equipped with rational expectations — would only increase savings in order to be able to pay the higher taxes in the future, thus leaving total expenditures unchanged.

Why?

In the standard neoclassical consumption model — used in DSGE macroeconomic modeling — people are basically portrayed as treating time as a dichotomous phenomenon – today and the future — when contemplating making decisions and acting. How much should one consume today and how much in the future? Facing an intertemporal budget constraint of the form

c_t + c_f/(1+r) = f_t + y_t + y_f/(1+r),

where c_t is consumption today, c_f is consumption in the future, f_t is holdings of financial assets today, y_t is labour incomes today, y_f is labour incomes in the future, and r is the real interest rate, and having a lifetime utility function of the form

U = u(c_t) + au(c_f),

where a is the time discounting parameter, the representative agent (consumer) maximizes his utility when

u'(c_t) = a(1+r)u'(c_f).

This expression – the Euler equation – implies that the representative agent (consumer) is indifferent between consuming one more unit today or instead consuming it tomorrow. Typically using a logarithmic function form – u(c) = log c – which gives u'(c) = 1/c, the Euler equation can be rewritten as

1/c_t = a(1+r)(1/c_f),

or

c_f/c_t = a(1+r).

This importantly implies that according to the neoclassical consumption model changes in the (real) interest rate and consumption move in the same direction. And — it also follows that consumption is invariant to the timing of taxes, since wealth — f_t + y_t + y_f/(1+r) — has to be interpreted as present discounted value net of taxes. And so, according to the assumption of Ricardian equivalence, the timing of taxes does not affect consumption, simply because the maximization problem as specified in the model is unchanged. As a result — households cut down on their consumption when governments increase their spendings. Mirabile dictu!

As one Nobel laureate had it:

Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense.

Joseph E. Stiglitz, twitter 

And as one economics blogger has it:

DSGE modeling is taught in every graduate school in the country. It is also sheer nonsense.

Lars Syll, twitter