You Like Me! You Really Like Me!! - part the second

During my earlier task of letting my fingers do the walking through the Yellow Googles on the topic of DSGE, the Yellow Googles failed me in a spectacular way. For many years, I have viewed Joe Stiglitz as the Godzilla of macro analysis, yet they didn't show me this paper. The Failing Yellow Googles.

In the discussion below, I shall illustrate the inadequacies of the DSGE framework by focusing on the 2008 crisis. Some advocates of DSGE models say these models were not meant to address "once in a hundred year floods." There are several responses to this defense. The first is by way of analogy: what would one think of a medical doctor who, when a patient comes with a serious disease, responded by saying, "I am sorry, but I only deal with colds."

You really should read that paper, if you care about macro quant. I'll offer a few more salient quotes.

Those readers with good memories will remember the Viagra graph:

[...] when house prices didn't increase as expected (and it should have been clear that they couldn't increase forever at those rates) and homeowners faced constraints in refinancing, the bubble broke, and the crisis ensued.

In a later footnote, he makes the same argument made here:

The Congressional inquiry into the 2008 crisis called itself the Financial Crisis Inquiry Commission and focused on aspects of the financial sector like credit rating agencies and the role of CDS's, derivatives, and other complex financial instruments. The standard DSGE models have nothing to say about either of these: these are failings related to its inadequate treatment of the financial sector.
[my emphasis]

Once again, with vigor, I give you Blythe Masters

One of the key reasons that representative agent models fail in enhancing understanding of macro-fluctuations is the pervasiveness of macroeconomic externalities -- the actions of each agent (in the aggregate) has macroeconomic consequences which they do not take into account.

Or give a shit about! Externalities, ignoring them, is where the profit is.

And, in a footnote to this part of the text, he Drops The Big One:

Complexity in financial structures may make it even impossible to ascertain whether a system is systemically stable.

Ooops.

The bete noir of my professional existence is the notion that macro-analytic structure is just the sum of some set of micro-structures.

The micro-economics of the basic competitive model—as formulated in Arrow and Debreu-- has been shown to be flawed by forty years of economic research. Why should we expect a macroeconomic model based on such micro-foundations to work?

Well, we don't.

And, finally

Defenders of DSGE models counter that other models did little better than the DSGE models. That is not correct. There were several economists (such as Rob Shiller) who, using less fully articulated models, could see that there was clear evidence of a high probability of a housing bubble. There were models of financial contagion (described earlier in this paper, developed further since the crisis), which predicted that the collapse of the housing bubble would likely have systemic effects.

What's that about history? Does it repeat itself, or just rhyme?