DSGE, the Standard Economic Paradigm, is Based on Bad Modeling

Yves here. The use, or one might say fetishization, of math-y models is how economists attempt to put a scientific veneer on their work and insulate it from criticism of the great unwashed. The fact that the most widely used economic model, the dynamic stochastic equilibrium model, fails in theory as wel as practice bizarrely has not dented their standing in policy circles. Some economists nevertheless fully recognize that the DSGE model is past its sell-by date and are advocating new approaches. Servaas Storm is one of our favorite writers; he’s not at all intimidated by orthodoxy and also does a
fine job of presenting technical issues in a layperson-friendly manner.

By Servaas Storm, Senior Lecturer of Economics, Delft University of Technology. Originally published at the Institute for New Economic Thinking website

Mainstream macroeconomics finds itself in a deeply unsatisfactory state, unable to make correct predictions and incapable of providing meaningful longer-term analyses and advice. It clearly needs a major rethink. Regrettably, the dominant response of mainstream macroeconomists so far has been to defend the accepted paradigm: some version of the New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model. People generally laugh when they hear that “after 1968 the restored communist regime required all Czech rock musicians to sit a written exam in Marxism Leninism” (Ferguson 2012, p. 248). But what they don’t know is that, in 2021, the Politburo of Correct Macroeconomic Thinking requires all Respectable Macroeconomists to frame their argument within the straightjacket of a DSGE model. Those who don’t, cannot be a member of the club.

Recognizing this deeply unsatisfactory state of mainstream macroeconomics, David Vines and Samuel Wills brought together a group of critical mainstream macroeconomists to explore the limitations and problems inherent in DSGE models and to consider future pathways for a more relevant macroeconomics. Professors Vines and Wills call their effort the ‘Rebuilding Macroeconomic Theory” project, with a second collection of papers coming out of this project recently published in the Oxford Review of Economic Policy 2020, volume 36 (3).

The two editors have to be admired for sticking out their necks and for arguing that mainstream macroeconomics needs a paradigm shift. They propose “a new multiple-equilibrium and diverse (MEADE) paradigm” as the future of macroeconomics. The way forward for macro, in their opinion, is “to start with simple models, ideally two-dimensional sketches, that explain mechanisms that can cause multiple equilibria. These mechanisms should then be incorporated into larger DSGE models in a new, multiple-equilibrium synthesis. All of this will need to be informed by closer fidelity to the data, drawing on lessons obtained from detailed work on policy models.”

Professors Vines and Wills are right in removing DSGE models from their pedestal, but they are quite wrong by keeping the same model approach at the center of macroeconomic analysis. In a new INET Working Paper, I argue that, paraphrasing Lance Taylor and Nelson Barbosa Filho (2021), the macroeconomics profession has to put DSGE models, once and for all, in the Museum of Implausible Economic Models. To help the visitors to this museum understand why DSGE models occupy such a central place in its Main Exhibition Hall, I revisit and scrutinize 10 untouchable dogmas of DSGE modeling, which make these models irreparably useless for macroeconomic policy analysis.

Irremediable Weaknesses

Quite a few of the 10 flaws have been recognized by DSGE practitioners themselves. For instance, DSGE practitioners are frantically trying to incorporate money in their otherwise money-less models. But so far, these attempts do not go beyond giving money a mere token role, which is not surprising, because money’s essentially macro-economic nature and role (under uncertainty) is inconsistent with micro-founded optimization (under rational expectations). Likewise, pithy attempts to incorporate money in DSGE models are bound to fail as long as DSGE practitioners continue to gloss over the role of money-creating commercial banks and remain wedded to models of a market for loanable funds provided by savers. Similarly, in today’s monetary production economies with substantial unemployment, the idea, central to all DSGE models, that inter-temporal trade-offs are the essence of economic decision-making is simply ridiculous. Households and firms do not face such trade-offs, because they can borrow from commercial banks, capable of creating new money to finance additional spending.

DSGE practitioners are also stumbling over more hurdles. To incorporate income distribution and inequality in their models, they are creating Two-Agent-New-Keynesian (TANK) or Heterogenous-Agents-New-Keynesian (HANK) DSGE’s. These HANKY-TANKY models, while challenging to solve, remain of very limited use in the classroom or as an input in policy institutions. This is completely unsurprising because these multi-agent DSGE’s can – at most – tell distributional Just So stories of how monetary policy decisions affect inequality. These stories are also rather one-sided: they consider the impact of exogenous shocks on inequality, but cannot – by construction – analyze the impact of (rising) inequality on longer-run growth.

The run-of-the-mill storyline is that one of the agents is for some unspecified reason credit- or cash-constrained, due to which this agent cannot adjust his/her/its consumption in response to changes in interest rates or variables other than current income. The attentive reader will understand that this is nothing less than the return of the much-maligned Keynesian assumption of a fixed marginal propensity to consume! Adding nominal rigidities and labor market frictions into the story plot, multi-agent DSGE’s may even be able to generate ‘endogenous unemployment risk’. Yes, indeed, with all this effort, HANKY-TANKY DSGE models are almost capable of generating ……… ‘quasi-Keynesian’ outcomes!

A further problem of DSGE models concerns the assumed dichotomy between demand-determined short-run fluctuations and supply-determined long-run potential growth. With this set-up imposed on the model, monetary policy and fiscal policy cannot have permanent effects on potential growth.

But the dichotomy is false. A large and growing body of empirical evidence shows that demand slumps do lead to permanentimpacts on potential growth (Girardi, Paternesi Meloni and Stirati 2020; Fontanari, Palumbo and Salvatori 2020; Kiefer, Mendieta-Muñoz, Rada and von Arnim 2020). And this is not happenstance but due to theoretically sound reasons and well-defined mechanisms. DSGE models, by construction, cannot capture any of the relevant mechanisms and, hence, missing the important part of the action, turn into Hamlet without the Prince of Denmark.

The Fallacy that Models Must Have ‘Rational Expectations’

DSGE agents endowed with ‘rational expectations’ know the ‘true economic model’ and understand that model outcomes that are being forecast do not differ systematically from the equilibrium growth path. By implication, model agents do not make systematic errors when predicting the future.

But one may wonder what the ‘true macro model’ is when even ‘saltwater’ U.S. macroeconomists disagree, as, for example, on the required size and shape of President Biden’s COVID19 relief package. Lawrence Summers, in an op-ed in the Washington Post, argues that the proposed $1.9 trillion COVID relief package is three times larger than the hole it needs to fill and ominously warns about “inflationary pressures of a kind we have not seen in a generation.” On the other hand, Paul Krugman (2021) and Jared Bernstein argue that Summers is “flat out wrong”. Both support Biden’s proposed relief package. If ‘saltwater’ economists cannot even agree amongst themselves, why would Trump Republicans and Coastal Democrats agree on the ‘true’ model of the U.S. economy?

It is no secret that the predictive power of rational-expectations DSGE models is a joke. Not one single DSGE model predicted the financial crisis of 2008 beforehand (but to be fair, most could do it, with great effort, afterwards). The predictive failure is far more general. European Central Bank economists Michal Andrle, Jan Brůha and Serhat Solmaz (2017) conclude that “the current vintage of DSGE models lacks a dominant demand shock that would explain the business cycle dynamics. This is no ado about nothing—most [DSGE] models fail to coherently explain up to 80% of key macroeconomic variables.” As Paul Krugman (2016) writes, “Were there any interesting predictions from DSGE models that were validated by events? If there were, I’m not aware of it. Yet even while failing to offer any measurable gains in insight, DSGE had the effect of crowding out the stuff that actually did work.”

‘Rational expectations’ have yet another – incurable – shortcoming: they are not rational at all. Why? Rational expectations ignore known unknowns. Inter-temporal optimization is possible only when DSGE agents have a complete probability distribution for every possible future state of the world – as in a complete (Arrow-Debreu) general equilibrium system of present and future markets. This means that the future is known (in a probabilistic sense) as well as ‘closed’ (since all possible future states have been described). DSGE agents behave ‘rationally’ by adapting to the already given future. But it is not rational to ignore known unknowns and fundamental uncertainty. Doing so is stupid and knowingly doing so is worse – as is tragically illustrated by the unpreparedness to the sudden, but not unexpected, arrival of SARS-Cov-2.

The Fallacy that Macro-Models Need Micro-Foundations

Macro-models allegedly need micro-foundations to ensure that these models satisfy the Lucas Critique and can be used for ‘policy-conditional’ forecasts. Models should be based on ‘deep’ or ‘structural’ parameters which reflect the fundamental, unchanging rules of individual behavior and hence, do not change when macro policy changes.

If we assume, for the moment, that Lucas-robust models can be built, the question is: how do we unearth the fundamental rules of individual behavior? In DSGE models, ‘micro-foundations’ are assumed to consist of individual optimization under conditions of risk. These axiomatic ‘micro-foundations’ are taken to be so self-evidently true, that they do not need to be justified. This is a truly astonishing act of self-deception because from the Sonnenschein-Mantel-Debreu (SMD) theorem we know that it is not possible to derive the characteristics of the aggregate market demand curve on the basis of individual rationality. The SMD theorem is actually quite unsurprising. After all, higher-order outcomes cannot be directly extrapolated from lower-order individual behavior, because the higher-order outcomes are most strongly determined by the interactions between individuals, rather than by the aggregation of individual rules of behavior of single individuals considered in isolation. Macro-economic phenomena are, in the language of complex systems theory, largely emergent (Keen 2017). Furthermore, much of individual decision-making is influenced, if not determined, by macro-economic factors – as I explain for the case of money and liquidity preference in the Working Paper.

The Fallacy that Macro-Models Must Pass the Lucas Critique

The Lucas critique targeted Keynesian macro-econometric models that used fixed behavioral parameters, such as the marginal propensity to consume or the parameters of the Phillips-curve. Lucas argued that the estimated ‘macro’ parameter values of these models are unstable and may change with shifts in policy regime because they depend on the economic policy pursued during the estimation period – and by implication, such macro-econometric models are useless for counter-factual policy analysis. Lucas’s point is, in fundamental ways, much ado about almost nothing.

A first way to interpret the Lucas critique is to see it as a positive statement concerning model application (Goutsmedt, Pinzon-Fuchs, Renault and Sergi 2016; Sergi 2016) – that is, as a critique of econometric models used for out-of-sample counter-factual analysis. Lucas’s positive point was long known, and it was also widely understood that the impact of changes in policy regime on model parameters is mostly negligible, and traditional macro-econometric models still perform well for policy evaluation (Sergi 2016).

The alternative is to interpret the Lucas critique in a prescriptive manner (Goutsmedt, Pinzon-Fuchs, Renault and Sergi 2016). In this interpretation, the Lucas critique represents a ‘purist’ methodological norm and a theoretical absolute: “no policy evaluations without deep parameters!” With ideology triumphing over common sense, micro-founded DSGE models are claimed to be Lucas-robust. The extreme ‘purist’ position is well expressed by Christiano, Eichenbaum and Trabandt (2017) who write: “The onlyplace that we can do experiments is in dynamic stochastic general equilibrium (DSGE) models”, adding that people “who don’t like dynamic stochastic general equilibrium (DSGE) models are dilettantes. By this we mean they aren’t serious about policy analysis.” (italics added). Using a standard rhetorical trick, Kehoe et al. (2018, p. 164) add: “[Macroeconomists] agree that a disciplined debate rests on communication in the language of dynamic general equilibrium theory”, while Chari (2010, p. 32) adds insult to injury, stating: “If you have an interesting and a coherent story to tell, you can do so within a DSGE model. If you cannot, it is probably incoherent.” Chari forgets to mention that one can also tell a lot of uninteresting and incoherent stories within a DSGE model.

But these specific claims do not logically follow from the general critique. The reasoning used is tautological:

Premise 1: Lucas-robust models feature deep model parameters which are invariant to changes in policy regime.

Premise 2: Only macro-models which are Lucas-robust, are useful.

Premise 3: Let us assume that the parameters of DSGE models are deep parameters.

Therefore: DSGE models are Lucas-robust and useful.

The conclusion is, to say the least, not very surprising. It is also wrong because premise 3 is incorrect: the parameters of micro-founded DSGE models are not deep enough, because DSGE preference and technology parameter estimates are found to be unstable in the face of changes in policy regime (Estrella and Fuhrer 2003).

This failure has strengthened efforts to identify even deeper and/or more ‘micro-foundations’ for DSGE models, but these efforts are pointless – driving macroeconomics further down a dead-end street. In reality, the estimated model parameters of economic systems are continuously changing and evolving and, as Boulding (1981) argued with deep insight, one “cannot predict the future without changing it.” This is the crux of the matter: Lucas-robust models do not exist, because – for reasons of performativity and reflexivity – individual rules of behavior may change in response to a change in policy regime. Human beings are, as far as I know, not mechanical robots or closed algorithms.

The bottom line is that it is not rational to insist that macro-models must be Lucas-robust. Is this a problem? No, not at all: the impact of changes in policy regime on parameters is generally negligible. What is needed, is an awareness that practitioners must be cautious drawing out policy conclusions when it could be reasonably expected that the estimated coefficients will be upset by policy change. But for all practical purposes, we may as well ignore the much over-hyped Lucas critique.

The Fallacy that Multiple Equilibria Are a Big Step Toward Greater ‘Realism’

In the MEADE paradigm, DSGE models should be rethought so that these models can generate different equilibria instead of one unique equilibrium path, around which the economy fluctuates. Martin Sandbu (2021), writing in The Financial Times (January 28, 2021), calls this proposal ‘revolutionary’. In his view, multiple-equilibria DSGEs will generate scenarios presenting multiple “central” outcomes, and enable “a discussion of the factors that could bring the economy to one or other equilibrium. Such a change would do wonders for an informed economic policy debate.” Sandbu writes that “a focus on multiple equilibria is transformative. […..] Once we acknowledge multiple equilibria, and that the economy can jump from a good to a bad state or vice versa, it becomes clear that by far the most important policy question is equilibrium selection: how to get the economy out of a self-reinforcing bad state, or prevent disruptions that tip it out of a good state.”

Sandbu’s claim that multiple-equilibria DSGEs would do wonders for an informed policy debate must be taken with not just one, but a few pinches of salt. First, adding more complexity to a flawed model will not improve the model, because the GIGO principle applies: ‘garbage in, garbage out’. There is simply no reason why ‘more complexity’ would mean ‘better suited’ for forecasting or policy advice.

Secondly, Sandbu’s emphasis on equilibrium selection is at odds with the logic of rational expectations. DSGE agents endowed with rational expectations know the ‘true’ model. If the ‘true’ model features multiple equilibria, agents will know this by assumption. Since these agents are capable of distinguishing a bad state from a good state, they will immediately opt for the good state. Hence, the only way in which to force the ‘all-knowing’ automatons populating the DSGE universe to settle in a bad state (rather than a good state), in response to some exogenous shock, is by imposing more ad-hoc restrictions, all inconsistent with the axiomatic ‘first-best’ micro-foundations of these models. It is also rather mysterious how governments are supposed to know how to bring an economy from a bad to a better state, when omniscient private agents cannot do this.

But don’t worry. One does not need ‘perfect foresight’ to know what will happen: never mind the inconsistencies, DSGE practitioners will think of new ad-hoc tweaks and squeezes to force their models to produce the desired (‘bad’, ‘better’, ‘best’) multiple equilibria. Hundreds of PhD theses will be written doing this, careers will be built, hundreds of journal articles on these tweaks will be published in Very Respectable Journals, prizes and awards will be bestowed on the most distinguished of these innovations, and after a decade or two and one or two non-trivial, unanticipated macroeconomic crises, it will finally dawn on the profession that multiple-equilibria DSGE’s were a cul-de-sac right from the start. But hey, nothing learned, but also nothing lost – and the Band of Respectable Macroeconomists will (again) move on to greener pastures.

The Way Forward

Progress is possible only if we abandon attempts to derive macroeconomics from the wrong end—that of the individual rather than the economy—and by proceeding from aggregate national accounting identities, which are true by definition, and then by disaggregating these statements to reflect the technological and institutional structures of the economy. In the Working Paper, I briefly review a few viable alternative macro-approaches.

Mainstream macroeconomics can only progress if it gets rid of the DSGE albatross around its neck. It is better to do it now than to wait for another 20 years because the question is not whether but when DSGE modeling will be discarded. DSGE modeling is a story of a death foretold. As Joseph Stiglitz (2018, p. 76) argues, “…most of the core constituents of the DSGE model are flawed – sufficiently badly flawed that they do not provide even a good starting point for constructing a good macroeconomic model.” DSGE models are thus unsuited to do what Vines and Wills want them to do, namely “to allow model builders to take a quick first pass at important questions.”

Getting rid of DSGE models is critical because the hegemonic DSGE program is crowding out alternative macro methodologies that do work, as was stressed by Krugman. DSGE practitioners, who with a mixture of bluff and bluster act as gatekeeper, judge, jury, and executioner in all macroeconomic matters, are a block on the road to progress. The roadblock has to be removed. The failed and failing DSGE models have to go if mainstream macroeconomics wants to become a force for the common good again.


Andrle, M., J. Brůha and S. Solmaz (2017) On the Sources of Business Cycles: Implications for DSGE models. ECB Working Paper Series No. 2058. Frankfurt: ECB.

Boulding, K.E. (1981) Evolutionary Economics. Beverly Hills, CA: Sage.

Chari, V.V. (2010) Testimony. In Building a Science of Economics for the Real World. US House of Representatives, House Committee on Science and Technology, Subcommittee on Investigations and Oversight.

Christiano, L.J., M.S. Eichenbaum, and M. Trabandt (2017) On DSGE Models. https://faculty.wcas.northwest…

Estrella, A. and J.C. Fuhrer (2003). Monetary Policy Shifts and the Stability of Monetary Policy Models. Review of Economics and Statistics 85 (1):94–104.

Ferguson, N. (2012) Civilization: The West and the Rest. London: Penguin Books.

Goutsmedt, A., E. Pinzon-Fuchs, M. Renault & F. Sergi (2016) Criticizing the Lucas Critique: Macroeconometricians’ Response to Robert Lucas. halshs-01364814.

Keen, S. (2017) Can We Avoid Another Financial Crisis? London: Polity Press.

Kehoe, P.J., V. Midrigan and E. Pastorino (2018) Evolution of Modern Business Cycle Models: Accounting for the Great Recession. Journal of Economic Perspectives 32 (1): 141-166.

Kiefer, D., I. Mendieta-Muñoz, C. Rada and R. von Arnim (2020) Secular Stagnation and Income Distribution Dynamics. Review of Radical Political Economics 52 (2), 189–207.

Krugman, P. (2016) The State of Macro is Sad (Wonkish). The New York Times, August 12.

Krugman, P. (2021) Stagflation Revisited: Did We Get the Whole Macro Story Wrong. https://paulkrugman.substack.c…

Sandbu, M. (2021) The Revolutions Under Way in Macroeconomics. The Financial Times, January 28.…

Schumpeter, J. A. (1947). The Creative Response in Economic History. Journal of Economic History 7 (2): 149–59.

Sergi, F. (2017) DSGE Models and the Lucas Critique. A Historical Appraisal. UWE Bristol Economics Working Paper Series 1806.

Stiglitz, J.E. (2018) Where Modern Macroeconomics Went Wrong. Oxford Review of Economic Policy 34 (1-2): 70-106.

Summers, L.H. (2021) Biden’s COVID stimulus is Big and Bold but It Risks Triggering Inflation. The Washington Post, February 4.

Taylor, L. and N.H. Barbosa-Filho (2021) Inflation? It’s Import Prices and the Labor Share! INET Working Paper 145. New York: INET.…

Vines, D. and S. Wills (2020) The Rebuilding Macroeconomic Theory Project Part II: Multiple Equilibria, Toy Models, and Policy Models in a New Macroeconomic Paradigm. Oxford Review of Economic Policy 36 (3): 427-497.

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  1. skippy

    Second last para got a giggle out of me … the forest of dead trees I’ve read just in the early days of NC to give me a base line on everything in the run up and post GFC – economic orthodoxy [neo/new Keynesian – neoclassical synergism] is an experience not unlike the RGR worm pit in winter …

    The drudgery of it, pseudoscience, long tortured laborious concocted vocabulary[tm], and at the end of it all the ideological a priori that presumes everything else from the backside of a movie screen in ones head – all deductive and not a whiff of a posteriori …

    Heck I’ll crack a fat about Marginalism alone before getting into some HS level debate about isms – ologys and their applications to humans and the orb and then getting sucked in to some DSGE convo … life is too short … imagine talking to a newly minted ism[tm] out of Uni and be authoritatively informed that psychology is refuted and DSGE models are reflective predictive powers of reality – en fin[.]

    This is why its strange to see Noahopinion being linked here of late, huge micro proponent back in the day and defender of the DSGE with some tweaks …. banned those that pointed out the above posts critiques of its weakness and pitfalls with emotional responses.

    I’ll leave with this …

    Very few Wall Street firms find the DSGE models useful … This should come as no surprise to anyone who has looked closely at the models. Can an economy of hundreds of millions of individuals and tens of thousands of different firms be distilled into just one household and one firm, which rationally optimize their risk-adjusted discounted expected returns over an infinite future? There is no empirical support for the idea. Indeed, research suggests that the models perform very poorly …

    Why does the profession want so desperately to hang on to the models? I see two possibilities. Maybe they do capture some deep understanding about how the economy works … More likely, economists find the models useful not in explaining reality, but in telling nice stories that fit with established traditions and fulfill the crucial goal of getting their work published in leading academic journals. – Mark Buchanan

    Bricoleurs by any other name …

    Lastly why is the model only two dimensional E.g. leaves out the customer which receives the out put of the two dimensional classic notion … oh yeah … economics is like a ****house hold**** in antiquity … now who would frame the topic as such …

    PS… YS thank you for posting this and putting the meat back on the bone as it were …

  2. skippy

    Law and contracts proceed all you mention, hence banks are just a subset of a larger issue.

    Longer form awaiting …

    1. Sound of the Suburbs

      What are banks supposed to do?
      It would be nice to know.

      Banks – What is the idea?
      The idea is that banks lend into business and industry to increase the productive capacity of the economy.
      Business and industry don’t have to wait until they have the money to expand. They can borrow the money and use it to expand today, and then pay that money back in the future.
      The economy can then grow more rapidly than it would without banks.
      Debt grows with GDP and there are no problems.
      The banks create money and use it to create real wealth.

    2. skippy

      GDP is non vector so why base your argument around it E.g. accrues at the top so base economic activity is suffering austerity in a high GDP environment.

      Even the author of the term argued against its use E.g. economic curiosity to be considered in the great scheme of things and not a standalone.

      I completely disagree with the Chicago school anything because of funding.

  3. vlade

    All models are wrong.

    Some models are useful.

    DSGE’s only use is as a self-licking ice cone.

    UBI for DSGE economists (conditional on them never doing any DSGE publishing/work/speaking etc. again) would be a net benefit to the world.

  4. BrianM

    My crude understanding from the last crisis was that DSGE models implicitly tend towards equilibrium over time anyway i.e. the E is the ultimate determinant. This means (a) they cannot predict crises, because these are large deviations, and (b) they underestimate the required policy response in a crisis because the model assumes its alright in the long-run. If my reading is right, I think this article almost supports my view, but is way more thorough.

    As an almost external observer, I’m kind of amazed that these models survived the big recession of a decade ago. In a rational world, this would have totally discredited them (ergo the rationality assumption is wrong??). But the idea of a universal model is appealing. At the moment we have a coherent critique of what is wrong with it, but not an alternative. Maybe we are better off without a single alternative, with a collection of smaller, state dependent models as capable of doing better. It could just be that physics envy: the latter look for their grand unified theory and economists want the same. I fear the desire for universal theory may be too strong.

    But the closed-mindedness is a concern too. I think the para towards the end, before “The Way Forward” title, gives another hint: science advances one death at a time, maybe even social sciences, so sadly the DSGE will be with a us a long time.

  5. c_heale

    Modern Chicago School economics is so bad it’s not even wrong. It’s worse than a medieval religion – telling the rich they are doing good and the rest of us to suffer. At least medieval religion gave people hope. It’s not science or math. Alchemy was more scientific than this garbage. Imo we should throw it all away and start again.

    1. skippy

      Concur and would add it was payed for E.g. intercultural capital went poof after that …

    2. SufferinSuccotash

      It’s worse than a medieval religion – telling the rich they are doing good and the rest of us to suffer.
      Feature, not bug.

  6. Synoia

    My crude understanding from the last crisis was that DSGE models implicitly tend towards equilibrium over time anyway…

    The economy does not tend to equilibrium, It appears chaotic.

    1. skippy

      Sargent basically said who cares … its eloquent … shades of Einstein at dead working on his last proof … the creator would have thingy …

  7. rob

    The first point of this paper actually dealt with a topic that is really the biggest elephant in the room that no one is talking about ,here.
    The fact that banks create money , as a result of making loans.
    What other industry is imbued with such a fantastic privilege?
    What other perversion, in our monetary framework, casts such a large shadow?
    How do economists try to pretend the economy is separate from the function of creating money; While directing whom that new money is given?
    All the hoopla over pretending we don’t have a privately controlled monetary system, that is the original sin, as far as the perversions of wall street, finance capitalism, the enduring NEED of “all growth, all the time”, mantra’s.. which really only are acceptance of the system we have where money is created as debt, and is removed after the debt is repaid, with a corresponding amout of debt that is left unpaid by the current system, except that those debts over the original sum are to be paid with newly created money. A system that will never end. This usury in the bankers hands, by a flawed model, allows the cartel like structure of the federal reserve .
    This has always been the criticism.
    And after the last 100 years where this latest banker version monetary system has prevailed, WE have PROOF that it doesn’t work well for anyone other than those at the top. Wealth concentration. this is the model to make it happen…. and it has… it is.
    the competing view of money is one where money is permanent. It is created as an asset. Like greenbacks. or continentals. Or how US dollars could be were the united states to abolish the federal reserve act, And write a new law ;like 112th congress HR 2990 “the NEED act”.

    Something like this could decouple the creation of a monetary system, as should be the role of the government, from deciding the winners and losers in the economy, and society.
    Then the whole of the financial world can use these US dollars to engage in any activity they see fit, in an actual competition. And if those wiz kids on wall street are so smart… then lets see what happens to their belief in absurd “models”

    1. Yves Smith Post author

      Banks face constraints in creating money:

      In recent years, some have claimed that banks create money ‘ex nihilo’. This column explains that banks do not create money out of thin air. From an economic viewpoint, commercial banks create private money by transforming an illiquid asset (the borrower’s future ability to repay) into a liquid one (bank deposits); they would quickly be insolvent otherwise. In addition to bank solvency representing a constraint on private money creation, banks require access to liquid reserves in order to be able to engage in money creation.

      1. vlade

        I think that technically the constraint is a bit more capital than liquidity, as CB’s are doing their damnedest to make sure that lack of liquidity doesn’t sink a bank. Of course, in theory they claim they are happy to lend to “healthy” banks but we have seen the “quality” collateral they were/are accepting.

        So practically the constraint is political, even if coated in the chocolate egg of regulation (why does it make me thing of MM Enterprises and chocolate-coated Egyptian cotton?)

      2. Mansoor H. Khan

        Banks performs at least the following two functions:

        1. Credit Analysis
        2. Clearing

        Credit analysis is finding appropriate investment opportunities in the economy and channeling resources to it.

        Clearing is where the banking system represents a huge ledger which keeps track of debit and credits for economic transactions in a very efficient manner.

        These two functions can be and should be separated. The “clearing” function should be performed by a government non-lending bank. A utility bank.

        If separated then banks can then be allowed to go bankrupt without causing loss of currency supply. We can then end money creation privilege’s for banks. But this is very difficult to achieve because we would also have to take away the “shadow” banking system’s ability to create bank deposits via fractionalizing.

        1. Procopius

          Errr… “loss of currency supply.” I think you meant “money supply,” because “currency” is the physical thing, notes and coins, that used to be called “specie.” It doesn’t go away when the bank goes bust. Of course, at one time banks issued their own currency, but we don’t allow that any more. What they do now is issue money. Actually, banks go bankrupt all the time, it’s just never mentioned in the media any more because the effect is minimal. Although there’s a facade of “insurance,” the Federal Deposit Insurance Corporation, when a bank goes bankrupt the government creates new money to make the depositors whole, so the money supply is preserved.

  8. lou strong

    The practical purpose of models like DSGE , output-gap and similars can be shown by the following.
    In Autumn 2018, the “sovereignist” Five Star Mov.-Lega government was arguing with the EU Commission for the budget manoeuvre,and asked to be allowed a 2.4 deficit.
    Commissioner Moscovici, whose aim was to keep austerity on and to give a denial to the government of the foes , put Italy digits in a kind of DSGE- branded machine.
    At the time,Italian growth rate was approximately 0.8 % , but the machine came out with the verdict that national economy was overheating, so he could justify the refusal .

  9. Nels Nelson

    Steve Keen has developed an economic model he calls Minsky that incorporates both money and energy as components of extreme importance. He calls for the abandonment of microfoundations and believes in starting with the macroeconomy and working back from there. He is cited in the article in the following sentence: “After all, higher-order outcomes cannot be directly extrapolated from lower-order individual behavior, because the higher-order outcomes are most strongly determined by the interactions between individuals, rather than by the aggregation of individual rules of behavior of single individuals considered in isolation. Macro-economic phenomena are, in the language of complex systems theory, largely emergent (Keen 2017).”

    Mason Gaffney in his book “Neo-classical Economics as a Stratagem Against Henry George” stated that NCE “is the paradigm that bends the twigs of young minds. Then it confines the florescence of older ones, like chicken-wire shaping shaping a topiary”. It was created to support the wealthy and powerful with beliefs like John Bates Clark’s Theory of Marginal Productivity. The rich deserve their vast fortunes because they are rewarded for the value they bring to society.

    Eugene McCarraher in his book “The Enchantments of Mammon” warns that when some new economic paradigm is said to be unrealistic what that means is it is not supported by the wealthy and powerful. They will say it is not practical or efficient. Economics as currently conceptualized is unrealistic and criticisms of neoliberal economics is being realistic.

  10. chuck roast

    Perhaps we are seeing Kuhn’s Scientific Revolutions in real time. As I recall, when he discussed the breakdown of the Ptolemaic System he posed the argument that in defending its increasingly fallacious nature, the Ptolemaic practitioners added more complexity to their cosmic model. The addition of epicycles to planetary motions the Geocentrics bolstered and discredited their model simultaneously. This is not to say that “Economics” is in any way a science. What is happening here is more like say, the development of Punctuated Equilibrium in Evolutionary Biology. By attempting to incorporate actual rather than theoretical economic change agents into their model, DSGE practitioners appear to be simply adding epicycles to formulation that needs a total overhaul.

    I like the idea of beginning at the beginning and attempting to add variables that are well grounded and see how it goes. Maybe it will lead back to the Political Economy from which it came. One can always hope.

    1. WobblyTelomeres

      “practitioners added more complexity to their cosmic model”

      In the software world, we call that spaghetti code.

  11. Peter Dorman

    I mostly agree with what Storm has to say here, but I’d like to harp on a technical detail that matters a lot to me. He is wrong to say that a multiple equilibrium framework is incompatible with rational expectations. RATEX, as we in the business like to call it, is really just adherence to a consistency criterion, that the forecasts made by the representative agent are consistent with the outcomes that eventuate from the agent’s choices. You could have multiple consistencies of this sort, and in fact a lot of the literature on this topic labors toward just this end — self-fulfilling prophecies of various sorts.

    In this context, my point is pretty close to irrelevant: all the other defects of DSGE are overwhelming and decisive. Simply establishing a representative agent, or even a small multiple of them, is a big no no, and the RATEX constraint is absurd.

    But the issue of multiple equilibria is really fundamental to any organized thinking about social questions, not only macroeconomics. It is the necessary outcome of widespread interaction between individuals, organizations and the goods and services they produce. It is a step forward to recognize that selecting “zones” (like zones of attraction for the mathematically inclined) is far more important in most circumstances that trying to optimize (or just engineer small improvements) within a given zone. This type of thinking should be encouraged and, of course, liberated from the pointless shackles that DSGE-type modeling demands.

  12. Dick Swenson

    I have read Prof Storm’s excellent dismemberment of DSGE over and over. His discussion is flawless but I am still uncomfortable. Why? I think it is because his use of the word “model” is contrary to its use in logic generally and mathematics.

    DSGE is a “theory.” All of the various attempts to prepare economics for mathematization are. Reality, such as it is, in the form of data is the “model.” If data cannot be fit into the theory and then used for prediction, then the theory is inadequate. If all the factors of reality don’t have a place in the theory, then the theory is incomplete. And when “reflexivity” (an idea well explained by Soros) is not considered, then why bother to continue using the theory?

  13. Ron

    I am not an economist but I’ve used and built models to predict the utility of electronic warfare systems in war games. If you build a model and it makes useful predictions people will soon pay attention to your model. So don’t complain about what does not work or what current models are missing, build a model that works. The political fight over model adoption will be a difficult one, but if you don’t have a working model to start with there can be no political fight.

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