Faust, Keynes and the DSGE Approach to Macroeconomics

DSGE models have been the subject of much attention recently on the blogs. Simon Wren-Lewis suggests that DSGE modelers made a Faustian bargain and offers a partial defense.  David Glasner is distinctly uneasy with the DSGE approach and although Paul Krugman remains eclectic he wants to retain the IS-LM model as part of his portfolio.

Like it or not, DSGE models are here to stay. I made the following argument in the First Edition of The Macroeconomics of Self-Fulfilling Prophecies in 1993.
In this book I take a point of view that is becoming less controversial but is by no means universally accepted. I will argue that the future of macroeconomics is as a branch of applied general equilibrium theory. 
Believe it or not; twenty one years ago, that was a controversial statement. I argued then that the problem with DSGE models is not the assumption that the economy is in equilibrium. The problem with DSGE models is the implication of some of these models that the equilibrium is optimal. Since then, I have consistently argued that the way forward is to reformulate Keynesian ideas with modern mathematics; that is what the DSGE agenda is all about.

For example, I have constructed a DSGE model where 25% unemployment is an equilibrium. That model does not use, or need, the concept of sticky wages or sticky prices to explain why high unemployment  persists; persistence is implicit in the notion of an equilibrium. Unlike classical or new-Keynesian DSGE models, my work explains why 25% unemployment is a very bad thing from the point of view of society.

The use of multiple equilibrium models to understand Keynesian economics is part of a research agenda that began at the University of Pennsylvania in the 1980s. That agenda has accelerated recently and the use of multiple equilibrium models to understand data has become mainstream. Jim Bullard uses the work of Benhabib-Schmitt-Grohé and Uribe to understand the liquidity trap. Narayana Kocherlakota applies my work on incomplete factor markets to understand unemployment and the top economics journals are routinely publishing research on the importance of animal spirits as a driver of economic activity. We have moved past the IS-LM model as the true guardian of Keynesian thought.

So what’s wrong with middle brow theorizing? The IS-LM model made the best use of techniques available in 1936 when Hicks introduced it as a way of making logical sense of the General Theory. We’ve moved on since then and we now have tools for bringing dynamics into the picture and for understanding how expectations interact with realized outcomes in ways that respect the methods that have proven successful in so many other branches of economics.

The IS-LM model says nothing about inflation. It says nothing about the passage of time and it does not account for the inability of firms and workers to engage in apparently mutually beneficial trades. We now have the tools to put all of those pieces together and, despite Paul’s claims to the contrary, the result is not a simple regurgitation of 1950s macroeconomics. If a smart theorist like Krugman struggles with formalizing his intuition the problem is not with the mathematics; the problem is with the intuition.

Mathematical formalism is an indispensable tool that has been with us since the late nineteenth century. There was a major leap forward in 1947 with Samuelson’s Foundations of Economic Analysis and a further methodological surge in 1989, when Stokey-Lucas released Recursive Methods in Economic Dynamics. With the publication of Stokey-Lucas, the bar for becoming a practitioner of economics became significantly higher than it was when Adam Smith wrote The Wealth of Nations.

Some in the blogging community hearken for the days when an economist could slap together a verbal argument and publish the result in the Quarterly Journal of Economics. Paul Krugman for example, wants his…
ad hockery back — not as an exclusive approach, but as a permissible one. And that’s not a small thing, given the almost total exclusion of middlebrow modeling from academic macro for the past three decades.
The use of ‘ad hockery’ has not been acceptable in economics for quite a while. And for good reason. As Marshall argued in his 1906 letter to Bowley, mathematics is a language; nothing more. I drew attention to Marshall’s instructions in an earlier post but they are worth repeating;
  1. Use mathematics as shorthand language, rather than as an engine of inquiry. 
  2. Keep to them till you have done. 
  3. Translate into English. 
  4. Then illustrate by examples that are important in real life. 
  5. Burn the mathematics.
  6. If you can’t succeed in 4, burn 3. This I do often
Bloggers and researchers have each ignored Marshall’s dictum; but in different ways. Ph.D. economists have published a huge amount of mathematical junk that bears little or no relevance to any real world problem.1  Some, but not all, economic bloggers have ignored the call to check the logic with mathematics before writing down a verbal argument.

The research community ignored points (3) and (4). Paul would have us ignore points (1) and (2) and that is at least as bad.

The IS-LM model is static. It cannot explain inflation and it has no well developed theory of expectations. DSGE models are a huge methodological advance that gives us logical tools to integrate all of these pieces. There is simply no substitute for the use of mathematics to make sure that an argument hangs together.
1. Don’t get me wrong; mathematics for mathematics sake does play a role in economics journals.  Sometimes, the real world examples come later.  A good example of this process is Lloyd Shapley’s work on stable matches that was used by Al Roth to create markets for kidney exchanges. But the best and most enduring economics papers use the mathematics to explain real world phenomena.