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.

"it would be a major mistake to seriously hamper a worldwide competitive market engine that has brought so many benefits to the world's population."

I can't really disagree with Gary Becker's main point:

"For many years economists and central bankers have congratulated themselves on the remarkable stability of US economy. Since the early 1980s, inflation has been under excellent control, and business cycle fluctuations in real GDP have been modest. For example, in no year since 1955 was US average unemployment as high as 10 percent. The highest annual rate was 9.7 percent in1982 during the recession then, and the next highest was 8.5 percent during the recession related to the first oil price boom. Moreover, many economists attributed the quite high average rate growth rate of American GDP in large part to the low rate of inflation and the stability of the economy.

Stable prices and mild business cycles were in turn explained not only by the underlying strength of the American economy, but also in an important way by policies learned by the Fed and other major central banks. Inflation targeting explicitly guided the European Central Bank, the New Zealand Bank, and a number of other central banks. It was also important to the Fed. Through such targeting, central banks would raise their interest rates and tighten up access to credit when inflation exceeded say 2 per cent. Inflation has been remarkably mild for the past quarter century. Japan experienced deflation, not inflation during its stagnant 1990s.

To control real business cycles, central banks relied on formal or informal versions of generalized inflation targeting to include real output changes. In these Taylor-type rules, central banks responded not only to inflation rates, but also to slowdowns in the growth of GDP relative to what was estimated as their long-term trend values. When the growth rate slowed relative to trend, central banks would loosen up their interest rates and access to credit. They would tighten when growth rates were above trend values. By "leaning against the wind" in this fashion, steps were taken to dampen the magnitude of fluctuations in real output.

In light of the severity of the recession that the world economy is now experiencing, for example in the US, Europe, and the UK, can this widespread confidence in our knowledge of how to tame the business cycle through central bank policy be called "a Grand Illusion"? In answering this question, one does have to recognize that the Fed and other central banks learned major lessons from the Great Depression about the value of loosening its purse strings when times were bad. And no one can deny that the past 25 years was a remarkable, and perhaps unprecedented, good run for the American, British, Chinese, Indian, and the world economy.

Clearly, however, central bankers and we economists were unprepared for the magnitude of the present financial crisis, and even less for its large effects on the real economy through the drying up of credit for mortgages and business investments. This recession is still ongoing, but it appears as if it will be the most severe recession since 1982, when American unemployment peaked in some months at about 10.5 percent. One year into the recession according to the NBER dating, unemployment has reached 6.7 percent, and it is still rising at a fast pace.

Central banks, especially the Fed, did respond rather rapidly to the unfolding of the financial crisis, even before it had a large impact on the economy. The Fed employed all the weapons in its traditional arsenal, such as lowering interest rates and easing access to the discount window. It also innovated beyond traditional approaches by allowing investment banks access to its credit, and by helping to arrange for the takeover or elimination of weak investment banks, such as Bears Stern and Lehman brothers."

I believe that investors also believed that the Fed could cure a serious malady should one arise.

"In contrast to the Fed, the US Treasury took a series of actions with dubious merit, including bailouts and a fiscal stimulus, that had few consistent principles. The latest as reported in the NY Times and Wall Street Journal is to use Fannie Mae and Freddie Mac to encourage banks to drop mortgages to 4.5 percent in order to raise housing prices and encourage home building. Yet Freddie and Fannie and their government guarantees contributed to the housing mess by encouraging excessive building of residential dwellings. Any effect of this proposed price ceiling on housing prices on mortgage rates would be small, but the damage to adjustments in the housing market would be major. The goal of policy should be to reduce, not increase, the power and distortions caused by these two institutions."

I tend to agree with him about all of this. He finds my main remedy, taking over the banks and then privatizing them, objectionable. But this Hybrid was the only real alternative. As I talked about beliefs in my last post, he seems not to believe that investors felt that they had the government to bail them out, and should it not, there was not going to be some free market resolution to this crisis. The choices aren't going to include hands off in this crisis. No way.

"In any case, the Fed and Treasury's actions combined obviously were not sufficient to greatly contain the damage to the real sector. The retreat from risk has been so large that treasury bills and bonds are selling at very low interest rates, other measures of risk are way up, and lenders are reluctant to lend, even when expected rates of return on their investments are high. Not surprisingly, the confidence of central bankers and economists that we have learned how to moderate greatly the real business cycle has been shattered. It is revealing how many leading macroeconomists have been silent during the unfolding of this crisis. Perhaps the prudent approach is to go back to the drawing board before offering an interpretation of what happened, and how to combat it."

Try a Human Agency approach, that involves real people. The models are useful tools, but only that. They are not reality.

"Despite the seriousness of the present crisis, we should not forget that the past quarter century has been a great period of growth and stability for most of the world. Hundreds of millions of men, women, and children were pulled out of extreme poverty in China, India, and elsewhere by the rapid growth of their economies, due in considerable measure to the steep expansion in world trade, and the stability of the world economy. Even with two years of a rather deep world recession added in, the period since the early 1980s would look good by historical standards."

I agree completely, which is why I don't want this to happen. But as I tried to explain to Nick Rowe, opposing labor unions in this crisis might make some economic sense, but it will not help the attempt to retain this system we believe to have proven its value over this time span. Not everyone finds this as obvious as we do.

"True, as I argued in prior posts on our blog, additional regulations of financial institutions are desirable, and the Fed has to think deeply about how to expand its arsenal of weapons. Yet it would be a major mistake to seriously hamper a worldwide competitive market engine that has brought so many benefits to the world's population."

Every political choice I've been advising has been meant to assure that what you and I desire comes about.

And, once again, forget the drawing board, and get a notebook.