Macroeconometrics is fundamentally an attempt to turn different time periods (say, the 1970's and the 1990's) into controlled experiments.

From Arnold Kling:

"Menzie Chinn writes,

A key reason for the academic disenchantment with these types of models included the view that the identification schemes used were untenable (e.g., why is income in the consumption function but not in the investment?). Another source is the combined impact of the inflationary 1960's and 1970's, and the Lucas Critique.

Chinn ignores the critique of structural macroeconometric models that most influenced me. In this regard, he is like many young macroeconomists today, including some who have taken shots at my blog posts (I don't feel personally insulted, just bothered by the wrong-headed view of people who think that the only problem you need to solve in macroeconometrics is the Lucas critique). The American Economic Association has a new Journal of Macroeconomics containing no less than three articles that reflect this misguided view. My anger at these articles prompted me to begin an essay called "The Lost History of Macroeconometrics." When I finish, I may submit it to the journal. In any case, I will post it here, because I really think that younger economists have failed to learn some key lessons. Below, I elaborate on my views.

[update: Mark Thoma adds color.]

Macroeconometrics is fundamentally an attempt to turn different time periods (say, the 1970's and the 1990's) into controlled experiments. There are many challenges to overcome. One is that the size of the economy differs across time periods. There is more income and more consumption in 1990 than in 1970, for reasons having nothing to do with fiscal policy or monetary policy.

How can we make data from different time periods truly comparable? One approach would be to adjust data for trend factors that affect the scale of the economy--population growth and trend productivity growth. Unfortunately, these trend adjustments fail, as is demonstrated by the high coefficients of serial correlation that remain in the de-trended data. In layman's terms, no matter how hard you try to adjust for trends, macro data still send out strong signals saying that time periods far apart are not really comparable.

The next thing that you can try is to "difference" the data. That is, instead of focusing on the level of consumption in the fourth quarter of 2003, you take the difference between consumption in the fourth quarter and consumption in the third quarter. In fact, given the high degree of serial correlation, failure to difference the data, or at least semi-difference the data, would be utterly unsound practice.

Once you difference the data, however, you greatly amplify noise in the data relative to signal. At this point, if you know anything about the conceptual problems and implementation issues that the statistical agencies have in constructing the data to begin with, you realize how reckless a project it is to simply turn a computer loose trying to find patterns in this noise, which is what vector autoregressions are all about. Instead, you filter out the noise in differenced or quasi-differenced data using "priors" about economic structure. In other words, you bring a point of view about key macroeconomic relationships to the data, and you force your statistical estimates to conform to those relationships. This is the structural approach.

The structural approach is nothing but a roundabout way of communicating the way you believe the economy works. The estimated equations are not being used to inform the investigator about how the economy works. Instead, the equations are being used by the econometrician to communicate to others the econometrician's beliefs about how the economy ought to work. To a first approximation, using structural estimates is no different from creating a simulation model out of thin air by making up the parameters.

This "making up out of thin air" critique is logically distinct from the Lucas critique. Telling me that a structural model is robust with respect to the Lucas critique only tells me that you made it up out of thin air in a way that satisfies a particular set of beliefs about how the economy ought to work. It does not tell me that you have found reliable relationships in the data. The relationships are in your own head, and you have used the data as a calibration tool.

In my day, the leading macro model, which was the antecedent to the Federal Reserve model, was abbreviated FMP. This stood for Fed-MIT-Penn, but a common joke was that it stood for "Franco Modigliani's Priors," meaning his beliefs about the economy. The FMP model was a showcase for Modigliani's life-cycle consumption function (one of the ideas cited in his Nobel award). However, his collaborator Albert Ando appeared to me to be the main force behind the FMP model. It would better be termed "Albert Ando's priors." For over thirty years, Flint Brayton at the Fed has been custodian of the model, so today it reflects his priors, which in turn have evolved in response to changes in opinions elsewhere in the profession.

Once again, the second critique of macroeconometrics is this. Structural models do not extract information from data. Instead, they are a method for creating and calibrating simulation models that embody the beliefs of the macroeconomist about how the economy works. Unless one shares those beliefs to begin with, there is no reason for any other economist to take seriously the results that are calculated."

Me:

Don the libertarian Democrat writes:

"Macroeconometrics is fundamentally an attempt to turn different time periods (say, the 1970's and the 1990's) into controlled experiments."

Where any human behavior is involved, I don't see it as possible to denude your investigation of the actual social and historical context of the particular time. For instance, in the 30s, many people assumed that capitalism was dying and that fascism or communism were the future. It's hard for me to believe that the methods tried then were not only influenced by these presuppositions, but had an influence upon how they worked out.

"In other words, you bring a point of view about key macroeconomic relationships to the data, and you force your statistical estimates to conform to those relationships. This is the structural approach."

A major problem here would be confirmation bias. Indeed, in many of the discussions of the 30s, people seem to be looking for any verification that they can find of their views,they then pronounce their evidence valid, and ignore or exclude contrary findings or explanations. I know that you've tried to downplay this, but, from the outside, it does look political.

From my point of view, this is how the world actually works. Keynes provides a map or narrative for our current situation, and, centering on that central narrative, people start offering either assent or dissent, even as people try anything that seems plausible in the real world.

I do the same thing in my own views. For instance, I really enjoy the book called "The Calculus Of Consent". I have a link to it on my blog/diary. I find that it largely confirms my own views of political economy. However, I hesitate to quote it much because, if I'm not mistaken, Gordon Tullock is still around, and I've a bad feeling that he wouldn't agree with some of my uses of that book. I fear a McLuhan in Annie Hall moment on some blog I suppose.

All of this debate seems healthy, assuming you can accept criticism. I can't, but I'm not an academic.

"Our macroeconomic problems require major public investments"

I wrote a fairly positive assessment of Jeffrey Sachs international aid plan, but this post scares me:

He starts with a tour more like a parody of a tour. Even if I wanted to follow his map, it is decidedly lacking in landmarks. It's just a general statement of biases, but go ahead and read them:

"Here is a quick tour of our macroeconomic miseries, with roots that go back 40 years."

Axiomatically, this must follow in Sachs' universe:

"America will sooner or later have to overcome its extreme allergy to taxation at a time when the government is hemorrhaging in deficits and when urgent public needs go unfulfilled."

"Our macroeconomic problems require major public investments in new technologies, infrastructure, public education, and poverty reduction. At some point soon, Americans will have to start paying for these investments themselves, rather than borrowing heavily from abroad. We are experiencing the structural shift from an economy relying on easy money and seemingly endless international borrowing to an economy that is gradually realizing that ultimately we will have to pay our way, especially if the United States wants to be a leading power. There are pressing domestic and global investment needs, and the money has to come from somewhere. The only place it can come from is an increased tax base, which requires abandoning the Reagan-Bush mythology."

So, what bothers me so much about this post? It's light on specifics, which I can handle as I am, and very heavy on a philosophy of high taxes and high government spending, which I need a xanax to handle. That seems to be his main point in this post, he wants higher taxes and more government spending. Period.

He does glancingly address issues and problems, like poverty, the environment, infrastructure, etc., to daringly call them issues and problems. I agree with his list, but have no clear idea to what extent higher taxes or more government spending would help. Show me the programs and needs, then I might be able to address these issues and problems. But as a statement of general principles, I sure hope President Obama ignores him, for the good of the country.

"While Reagan was crudely ideological, Clinton mildly reformist, and Bush simply crude in the application of these small-government doctrines, none of the recent approaches will do. It's time to stop talking about who can give away more to the public in rebates and start talking about investing in our future in a way that can save the poor, sustain the rest, and build a decent world for our children. Those are the real family values."

Come now, you're not talking about anything. Forget mythology, Sachs deals only in nostrums. One way to invest in our future would be to actually offer a specific and assessable plan. Try that next time, and I might not need a xanax.

G-7 Finance Ministers and Central Bank Governors Plan of Action

Via Across The Curve:

October 10, 2008
HP-1195

G-7 Finance Ministers and Central Bank Governors Plan of Action

Washington-- The G-7 agrees today that the current situation calls for urgent and exceptional action. We commit to continue working together to stabilize financial markets and restore the flow of credit, to support global economic growth. We agree to:

1. Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure.
2. Take all necessary steps to unfreeze credit and money markets and ensure that banks and other financial institutions have broad access to liquidity and funding.
3. Ensure that our banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources, in sufficient amounts to re-establish confidence and permit them to continue lending to households and businesses.
4. Ensure that our respective national deposit insurance and guarantee programs are robust and consistent so that our retail depositors will continue to have confidence in the safety of their deposits.
5. Take action, where appropriate, to restart the secondary markets for mortgages and other securitized assets. Accurate valuation and transparent disclosure of assets and consistent implementation of high quality accounting standards are necessary.

The actions should be taken in ways that protect taxpayers and avoid potentially damaging effects on other countries. We will use macroeconomic policy tools as necessary and appropriate. We strongly support the IMF's critical role in assisting countries affected by this turmoil. We will accelerate full implementation of the Financial Stability Forum recommendations and we are committed to the pressing need for reform of the financial system. We will strengthen further our cooperation and work with others to accomplish this plan.

-30-

Again, I think we're there.