If I am honest, I found Solow’s attack on DSGE a little strange, and fairly inconsistent. Here is why:
Update: (Before saying why I think this, I should say) This initially came from an Arnold Kling post, and the lingo regarding biology has moved into some of Brad’s negative writing about economists he disagrees with (ht Economist View). My own view is that these authors are attacking a straw man when they attack DSGE’s (the straw man I’m talking about is the 1980’s RBC model, as I discuss later) – instead of attacking the inappropriate assumptions of some of the practitioners they have decided to attack the method. This disappoints me.
Yes – all models have weaknesses. But it is about seeing what to use and where. And contrary to Brad’s language he is being far from objective in his attack on this type of modeling.
Now, back to the post as it was a few days ago 😉
On unemployment and “the model”
In one paragraph he states that we have frictions such as rigid prices for goods and labour – then in the following paragraph he says that there is no such thing as unemployment in a DSGE model, which is obviously false from the first point.
However, this is merely a small point compared to what I see as his broad critique of DSGE’s, which is that they treat the economy like a couple of decision makers acting optimally, when the economy isn’t like that.
This is a strange criticism. A DSGE model does have few agents, often with infinitely long lives. However, these are simplifying assumptions – and many of the results can be generalised to heterogeneous agents who have finite lives (but over-lapping generations of people who value their descendants). There is definitely value in researching the impact of heterogeneity and the such – and that is exactly what macroresearchers appear to be doing – at least judging by the mailing lists I’m on for macro papers.
Furthermore, what is Solow’s alternative. Is he suggesting that me model each individual in society? I don’t see how that could provide tractable results, or even if it is remotely possible.
On the use of the model
What ultimately kicks me is the conclusion, which is absolutely at odds with what people use DSGE models for!
The point I am making is that the DSGE model has nothing useful to say about anti-recession policy because it has built into its essentially implausible assumptions the “conclusion” that there is nothing for macroeconomic policy to do
This is abjectly false. The scope for policy intervention relies on the assumption of “rigidities” which are implicitly proxies for the very market failures he is begging for from economic models. There are a swath of papers coming out of universities every year using DSGE modeling to justify all sorts of policy interventions, and justifying all sorts of responses to economic events.
The problem isn’t that the model always tells us to do nothing – the issue is trying to fish through the differing assumptions that are being made about the aggregate economy, and trying to find which assumptions we think are most appropriate for discussing the real economic situation.
You seem confused
I am a touch confused – as Solow was effectively the godfather of this form of modeling. His long-run growth theories were one of the major building blocks of what has become DSGE models. As a result, the man does know what he is talking about.
But his critique of DSGE models that
- They don’t allow for unemployment and
- They immediately dictate that there is no role for stabilisation policy,
Doesn’t seem to follow from the current set of DSGE modeling, but instead from critiques of old school Real Business Cycle theories from the 1980s.
Is there a lot of work still to be done on DSGE models to ensure that we have a clearer description of the economic situation, yes. Do practitioners need to be mindful of the limitations of DSGE models when forming policy, yes. But in no way does DSGE modeling act like all unemployment is voluntary and that there is no role for government.
Now, I am assuming that the critique is about the use of DSGE models to form policy and describe the economy – if the critique is actually about the predictive power of DSGE models I think the case is even weaker, as predictive weakness is an issue that holds for the entire discipline – and it is not a game killer.