Has the Market Moved Beyond DSGE?

A Summary of the Recent DSGE Discussion at Bruegel

by Dirk Ehnts, Econoblog101

Bruegel has a nice blogs review on DSGE models and their strengths and weaknesses. Discussing the Euler equation, which is at the heart of the intratemporal optimization, the authors note that empirical evidence refutes the theory. The problem that intertemporal equilibrium is assumed and therefore it is not possible to discuss any of the issues that arise from it not being true has been discussed before.

Here is the abstract of a model by Mazzocchi, Tamborini and Trautwein:

The current consensus in macroeconomics, as represented by the New Neoclassical Synthesis, is to work within frameworks that combine intertemporal optimization, imperfect competition and sticky prices. We contrast this “NNS triangle” with a model in the spirit of Wicksell and Keynes that sets the focus on interest-rate misalignments as problems of intertemporal coordination of consumption and production plans in imperfect capital markets. We show that, with minimal deviations from the standard perfect competition model, a model structure can be derived that looks similar to the NNS triangle, but yields substantially different conclusions with regard to the dynamics of inflation and output gaps and to the design of the appropriate rule for monetary policy.

The other interesting issue regards the question of whether the theory is used by practitioners (the “market test”). I would be very careful here. Remember the Li formula? Here’s an extract from that Wired article:

For five years, Li’s formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched-and was making people so much money-that warnings about its limitations were largely ignored.

Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li’s formula hadn’t expected. The cracks became full-fledged canyons in 2008-when ruptures in the financial system’s foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.

So, the market test must be taken tongue in cheek. The blogosphere apparently believes that DSGE models failed it. Let me add to that. It would be quite interesting to know what people like Jan Hatzius, chief economist of Goldman Sachs, actually is using. As you can see at Business Insider, his most popular chart is based on Post-Keynesian economics.  Interesting.

Goldman Sachs