Monday, September 12, 2016

More on policy models of mass destruction

  1. This is good old shoe


    1 "A model that includes a lot of institutional detail is not a virtue in itself: indeed if at the end of the day these institutions do not matter too much it is an unnecessary and distracting feature. A useful way to think about modelling approaches is in terms of the validity of simplifications or short-cuts. It is for this reason that my method of theoretical deconstruction outlined and demonstrated here for large models is so important. By trying to relate large model properties to simpler models, you find out where additional detail is important or unnecessary. And of course, the answer to that problem may be context specific.
  2. I hope I never said SFC modes were “accounting, not economics”, because that statement makes no sense. Any behavioural model contains some kind of theory. What I think I said was that these models often seemed ‘light on theory’, which means that they talk a great deal about the accounting and rather little about theory.

    For example, to say that consumers have a desired wealth to income ratio is light on theory. Why do they have such a ratio? Is it because of a precautionary motive? If it is, that will mean that this desired ratio will be influenced by the behaviour of banks. The liquidity structure of wealth will be important, so they may react differently to housing wealth and financial assets. Now the theory behind the equations in the Bank’s paper may be informed by a rich theoretical tradition, but it is normal to at least reference that tradition when outlining the equations of the model.
  3. It is true that stock-flow accounting is important in modelling, in the sense that doing it stops you making silly errors. But it is not dissimilar to identities or market clearing conditions in this respect. You would never call a class of models ‘National Income Identity models’. [1] If the point is to emphasise that stocks matter to behavioural decisions about flows, then that is making a theoretical point. As Jo says, DSGE models are stock-flow consistent, but in the basic model consumers have no desired wealth ratio: it is the latter that matters. So when Jo says this absence should ring alarm bells, he is making a theoretical statement.

    I think Jo is right that the SFC name is unfortunate, but you can make a similar case for the name DSGE. It only matters when some people believe that stock-flow consistency is some kind of heterodox invention. Equally the label DSGE becomes a problem when economists start thinking that macroeconomists cannot do partial equilibrium any more, a point that Blanchard makes in hisdiscussion of DSGE models.
  4. When Jo tries to connect the unimportance of stocks in DSGE to the return to full employment I think he is painting with too broad a brush. Let’s take a simple example. In the baseline small open economy model of mainstream macro, a temporary shock that leads to a current account deficit will permanently reduce welfare because net assets permanently fall. The trade balance has to improve, and consumption is therefore lower. A permanent depreciation worsens the terms of trade. In that case what happens to stocks has a permanent effect. Indeed, if you alter the model by replacing the consumption function with one based on Blanchard/Yaari consumers, there would be a feedback from wealth to consumption which would mean this shock would no longer have a permanent effect.
  5. In using the quote of mine about ‘not their field’ from a previous post he is rather unfair. As I go on to say, mainstream macro was at fault in neglecting finance. Pretty well every mainstream macroeconomist will say the same. The point I wanted to make was that it is not true that they all did this because they were sure it didn’t matter, the sector would regulate itself etc etc. What I have argued in this paper is that macroeconomists might well have not neglected the financial sector if they had allowed more traditional aggregate (i.e. non-microfounded) models to continue to be a legitimate area of academic research. Some might want to argue that this neglect of the financial sector reflected that mainstream macroeconomists were inherently neoliberal and believed financial markets looked after themselves. Perhaps some were, but plenty of others were not.
  6. I also think it is a bit unfair to suggest that I was criticising the model in the Bank’s paper. As it represents an alternative to DSGE models it should be welcomed. (Especially so for the Bank. Many public institutions, like the Fed, have maintained their aggregate models alongside DSGE models: the Bank of England has not.) What I was criticising was (a) the emphasis in the paper on the accounting at the expense of theoretical discussion (b) that the paper ignored the non-DSGE non-Post Keynesian modelling tradition.