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A bit more about Bad Models


So, there were warnings about the DSGEs in 2008.

http://www.econstor.eu/dspace/bitstream/10419/27466/1/dp2008-30.pdf

Tovar, Camilo Ernesto (2008) : DSGE Models and Central Banks, Economics Discussion Papers / Institut für Weltwirtschaft, No. 2008-30, http:// hdl.handle.net/10419/27466

"From a more technical point of view there are important concerns related to the degree of misspecification of current DSGE models. Well-known economists have argued that DSGE models are too stylized to be truly able to describe in a useful manner the dynamics of the data. Sims (2006), for instance, considers DSGE models to be only story-telling devices and not hard scientific theories. He argues that there is no aggregate capital or no aggregate consumption good, and that the real economy has a rich array of financial markets, which have not been included so far in a wide and successful manner into these models."

"Others have also warned about the "principle of fit" (ie models that fit well should be used for policy analysis, and models that do not fit well should not be used)."

"For instance, data transformations, such as detrending and the elimination of out- liers, together with the selection of appropriately stable periods, or the elimination of structural breaks, are common prerequisites to take these models to the data (Canova (2007))."

I take those quotes (go read the paper if you think I took them out of context) as solid evidence for my assertions that: (1) There weren't banks (in any meaningful sense) in the DSGEs being used until recently. (2) People using the models were trying to smooth things out and throwing away data that indicated disruptive changes.

Honestly, by saying "there is no aggregate capital", this author is saying an even stronger version of "there are no banks" than I thought.

I'm all in favor of simulation models, even DSGEs in helping central bankers make decisions. But this was a clear error of over-simplification that directly contributed to blindness in advance of the bust on the part of policy makers.