Posted by: Dirk | October 7, 2016

DSGE vs the balance sheet approach – clash of the paradigms

Olivier Blanchard has distilled two assumptions that either make DSGE the prominent tool for macroeconomic research or they don’t. However, before this paragraph he writes that there are three propositions with wide agreement:

  1. Macroeconomics is about general equilibrium.
  2. Different types of general equilibrium models are needed for different purposes. For exploration and pedagogy, the criterion should be transparency and simplicity, and for that, toy models are the right vehicles. For forecasting, the criterion should be forecasting accuracy, and purely statistical models may, for the time being, be best. For conditional forecasting, i.e. to look for example at the effects of changes in policy, more structural models are needed, but they must fit the data closely and do not need to be religious about micro foundations.
  3. Partial equilibrium modelling and estimation are essential to understanding the particular mechanisms of relevance to macroeconomics. Only when they are well understood does it become essential to understand their general equilibrium effects. Not every macroeconomist should be working on general equilibrium models (there is such a thing as division of labor).

I do not agree with these positions, and many others don’t. Macroeconomics is about examining the causes for unemployment first. As secondary objectives, it is about economic growth and distribution, both of which already play a role when examining unemployment. Macroeconomics is not about general equilibrium. Blanchard confuses the method with field. When it comes to method, I would argue for a balance sheet approach. Equilibrium means that balance sheets have to be balanced, not necessarily at full employment. I have a book chapter for publication in 2017 sitting on my desk of which a first draft already exists (ResearchGate). Anybody interested in it is invited to comment on that draft.

I think that DSGE has shown itself to be useless when you need the macroeconomist – in times of macroeconomic crisis. Even worse, it can be used to give bad policy advice and analysis (see here) that is hard to falsify because the models do not lend themselves to empirical tests. It is a bit like trying to prove that dragons do not exist. Common sense is more helpful than a mathematical model that shows that a dragon is possible. The DSGE model shows that a very particular world is possible where wishes to save always trigger investment so that the economy is self-regulating. However, we can clearly see in the real world that it’s not. DSGE should be allowed to die.

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