Submitted by Richard Alford, a former economist at the New York Fed. Since them, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.
The fault, dear Brutus, is not in our model, but in ourselves–apologies to W Shakespeare
The economics profession is in disarray. Internecine warfare has broken out as proponents of various models/schools of thought are attacking and being attacked by each other. The battle between the different camps has been increasingly fought in the open e.g. The Economist and blogosphere. Despite the credentials of the combatants, there is a definite “My model can beat up your model’ air to the contretemps. The best outcome would be for policymakers to avail themselves of the models while losing the modelers.
Given the complexity of the financial markets and the economy, macro policymakers must operate on the basis of either implicit or explicit model(s). Furthermore, an explicit and transparent model subject to outside examination continuous testing is preferable to implicit poorly specified models that can serve as quasi-intellectual cover for policies based on solely belief systems.
However, macroeconomic models have been oversold again, the great moderation was fleeting. While economic models are necessary, both the recent experience and well-known limitations of the models themselves indicate that models alone will not be sufficiently robust to perform as well as many including investors and the general public have been led to expect. The underlying markets and the real economy are not stable. The models by definitions are incomplete. The responses of economic agents in times of stress and crisis may differ dramatically from the behavior reflected in parameters estimated on the basis of data collected in normal times. Goodhart’s law suggests that policy changes will induce changes in the statistical relationships on which the policy is based.
In defense of the current class of models (DSGE), some economists have spoken out saying that the models evolved as they did in response to questions raised by economists. But isn’t that the problem? Macro-economic models have become more formal and mathematically elegant, but all the while the modelers both ignored important drivers of economic performance, e.g. the workings of the financial markets, and failed to communicate the limitations of the models. The models evolved reflecting the economists‘desire for elegance and tractability, but with insufficient weight given to concerns such as financial stability or external balance.
Macro-economic policy is now being executed by the same people who devised the models. At times it has appeared that some of them sought policy making positions in order to be able to demonstrate the value of the model that they created or to which they made a contribution. These model builders were quick to take credit for the great moderation, but slow to see/ blind to the risk building up in the financial system and the imbalances. This type of behavior is to be expected. There is no reason to assume that the next set of policymaker/model builders will react any more positively to “warnings” that risks not central to the model pose real threats.
The role of model builders and policymakers should be split. Given the necessity of models in the policy formation process, it would be best, if the policymakers’ judgments about which model to use or when diverge from it are not clouded by previous involvement in the development of one or another of the models that might be employed.