We’ve heard it before: Beware of PhD economists. Don’t ask them too many questions; just let them talk. Let them talk about that one thing they spent 6 years writing a dissertation about, and only that thing. Don’t try to argue, don’t try to think. They’ve already done that. They know it. You know it. Just let them do what they’re supposed to do. After all, PhD economists are the people whom we rely on to create macroeconomic policy and teach us about macroeconomics.
Maybe that was a little harsh. But the flaw in macroeconomics comes with the self referential, inward-looking distractions that are the beliefs of macroeconomists, especially those of the New Classical and New Keynesian schools, and especially in reference to the Efficient Markets Hypothesis. The parameters of this hypothesis claim trading that spans all possible outcomes in which budget constraints are always satisfied by assumption, keeping in mind that default, bankruptcy and insolvency are impossible. Because of this, questions of illiquidity and insolvency can’t be asked OR answered. They don’t even exist! Right? Wrong. The hypothesis also includes the assumption that there is some power in the universe that makes sure nothing unexpected happens with long term price expectations. The basis of this hypothesis alone is a major “empirical fatality” of the 2008 financial crisis.
So what does this have to do with DSGE models? Consider the way in which macroeconomists view the EMH—a model that is so doctored to display perfect, unrealistic conditions in an imperfect, realistic world. What do we think they did with DSGE models? In the words of William Buiter: “They took these non-linear stochastic dynamic general equilibrium models into the basement and beat them with a rubber hose until they behaved.”
The problem with macroeconomics is the lack of a powerful desire to understand how the economy works, in good times and in bad. Macroeconomists have a stronger desire to fiddle with their unrealistic models and try to convince people that yes, that really is how the economy works, and no, there is no other way.
To lighten the mood, here’s a picture of my dog in the bathtub: