Saturday, July 26, 2014
Comment on Noah Smith
Noah Smith wrote an easy to read version of his thoughts on why DSGE models aren't used by the private sector. It is, of course, an excellent article. He includes some conventional history of 1970s macrieconomic thought. I object strongly. My comment. 1) "The Keynesian SEMs predicted that when the Federal Reserve lowered interest rates, it should have given the economy a boost; instead, all it did was create useless, harmful inflation. " Definitely false. In particular around 1980 Volcker demonstrated that he had the power to make the GDP turn on a dime. The data show a huge correlation of short term interest rates and growth (with the well known roughly 6 month lag). 2) Robert Lucas,“We tried (stupid) inflation! It didn’t (dang) work!” . Did we really ? Whose idea was that ? Why are the Keynesian inflation advocates never named or and their advocacy never cited ? The simple reason is that they are straw men. 3) The SEMs could have been tweaked to fit the data. Two things. They were tweaked to give no long term inflation unemployment tradeoff. Second, the old SEMs fit the data from the 70s fine. The evidence available in 1973 and in 1980 doesn't fit the then leading new classical model at all. It fits the old Keynesian models from 1971 very well. The tweak to old Keynesian models (replacing an old 1960-70s Phllips relationship in which wage inflation depends on a few lags of price inflation and unemployment with one where the change in inflation depends on unemployment) replaced models which fit the then and now available US data with models which don't. 4) As Lucas explained in "Econometric Policy Evaluation: a Critique." his argument was not at all original having been made by the developers of SEMs while they were developing SEMs. There is no mystery why people with money on the line don't use DSGEs. It is a complete mystery how they took over academic macro (I was there not then but soon after). The candiate explanations you present in this post are not valid. The stylized facts on which they depend are falsehoods.