Economist's View: 'DSGE + Financial Frictions = Macro that Works?': This is a brief follow-up to this post from Noah Smith….
In my last post, I wrote:
So far, we don't seem to have gotten a heck of a lot of a return from the massive amount of intellectual capital that we have invested in making, exploring, and applying [DSGE] models. In principle, though, there's no reason why they can't be useful.
One of the areas I cited was forecasting. In addition to the studies I cited by Refet Gurkaynak, many people have criticized macro models for missing the big recession of 2008Q4-2009. For example, in this blog post, Volker Wieland and Maik Wolters demonstrate how DSGE models failed to forecast the big recession, even after the financial crisis itself had happened…
This would seem to be a problem.
But it's worth it to note that, since the 2008 crisis, the macro profession does not seem to have dropped DSGE like a dirty dishrag…. Why are they not abandoning DSGE? Many "sociological" explanations are possible…. But… maybe DSGE models, augmented by financial frictions, really do have promise as a technology. This is the position taken by Marco Del Negro, Marc P. Giannoni, and Frank Schorfheide…. The model they use is a combination of two existing models: 1) the famous and popular Smets-Wouters (2007) New Keynesian model that I discussed in my last post, and 2) the "financial accelerator" model of Bernanke, Gertler, and Gilchrist (1999). They find that this hybrid financial New Keynesian model is able to predict the recession pretty well as of 2008Q3!… I don't want to downplay or pooh-pooh this result…. But this does look really good….
However, I do have an observation…. The Bernanke et al. (1999) financial-accelerator model has been around for quite a while…. Why was the Bernanke model not widely used to warn of the economic dangers of a financial crisis?… It seems to me that it must have to do with the scientific culture of macroeconomics. If macro as a whole had demanded good quantitative results from its models, then people would not have been satisfied with the pre-crisis finance-less New Keynesian models, or with the RBC models before them…. [P]eople in the macro field were probably content to use DSGE models for storytelling purposes, and had little hope that the models could ever really forecast the actual economy. With low expectations, people didn't push to improve the existing models as hard as they might have…
My take on why these models weren't used is a bit different. My argument all along has been that we had the tools and models to explain what happened, but we didn't understand that this particular combination of models -- standard DSGE augmented by financial frictions -- was the important model to use… part of the reason was empirical… but the bigger problem was that our arrogance caused us to overlook the important questions…. We could have put the model described above together before the crisis, all of the pieces were there, and some people did things along these lines. But this was not the model most people used. Why? Because we didn't think… financial frictions were an important feature of modern business cycles because technology and deregulation had mostly solved this problem. If the banking system couldn't collapse, why build and emphasize models that say it will?…
We have the tools and techniques to build all sorts of models, but they won't do us much good if we aren't asking the right questions. How do we do that? We must have a strong sense of history, I think, at a minimum…. And we also need to have the humility to understand that we probably haven't progressed so much that it (e.g. a financial collapse) can't happen again.