I've been remiss in not providing links to my last two Bloomberg pieces. Active web surfers may have run across them, but if not -- below is the full text of this essay from January. It looks at the question -- first raised here by Noah Smith -- of why, if DSGE models are so useful for understanding an economy, i.e. for gaining insights which can be had in no other way, no one on Wall St. actually seems to use them. Good question, I think:
In 1986, when the space shuttle Challenger exploded 73 seconds after
takeoff, investors immediately dumped the stock of manufacturer Morton
Thiokol Inc., which made the O-rings that were eventually blamed for the
disaster. With extraordinary wisdom, the global market had quickly
rendered a verdict on what happened and why.
remind us that markets, by pooling information from diverse sources, do a
wonderful job of valuing companies, ideas and inventions. So what does
the market think about economic theory itself? The answer ought to be
Blogger Noah Smith recently did an informal survey
to find out if financial firms actually use the “dynamic stochastic
general equilibrium” models that encapsulate the dominant thinking about
how the economy works. The result? Some do pay a little attention,
because they want to predict the actions of central banks that use the
models. In their investing, however, very few Wall Street firms find the
DSGE models useful.
I heard pretty much the same story in
recent meetings with 15 or so leaders of large London investment firms.
None thought that the DSGE models offered insight into the workings of
This should come as no surprise to anyone who has
looked closely at the models. Can an economy of hundreds of millions of
individuals and tens of thousands of different firms be distilled into
just one household and one firm, which rationally optimize their
risk-adjusted discounted expected returns over an infinite future? There
is no empirical support for the idea. Indeed, research suggests that the models perform very poorly.
may object that the field has moved on, using more sophisticated models
that include more players with heterogeneous behaviors. This is a
feint. It isn’t true of the vast majority of research.
the profession want so desperately to hang on to the models? I see two
possibilities. Maybe they do capture some deep understanding about how
the economy works, an “if, then” relationship so hard to grasp that the
world’s financial firms with their smart people and vast resources
haven’t yet been able to figure out how to profit from it. I suppose
that is conceivable.
More likely, economists find the models
useful not in explaining reality, but in telling nice stories that fit
with established traditions and fulfill the crucial goal of getting
their work published in leading academic journals. With mathematical
rigor, the models ensure that the stories follow certain cherished
rules. Individual behavior, for example, must be the result of
optimizing calculation, and all events must eventually converge toward a
benign equilibrium in which all markets clear.
economist colleague of mine told me that his papers have often been
rejected from leading journals not for being implausible or for
conflicting with the data, but with a simple comment: “This is not an
Knowledge really is power. I know of at least one financial firm in London
that has a team of meteorologists running a bank of supercomputers to
gain a small edge over others in identifying emerging weather patterns.
Their models help them make good profits in the commodities markets. If
economists’ DSGE models offered any insight into how economies work,
they would be used in the same way. That they are not speaks volumes.
of course, aren’t always wise. They do make mistakes. Maybe we’ll find
out a few years from now that the macroeconomists really do know better
than all the smart people with “skin in the game.” I wouldn’t bet on it.