Unlike now wary reader, whenever I see DSGE I read "Dirigisme" which, if schoolboy French is up to the task, means state directed capitalism, a whole different topic.
I mentioned in last week's "Nassim 'Black Swan' Taleb Is a....[fill in blank]" that Professor Smith seemed to be getting funnier and more agreeable as he got older. Here's another example, using what could have been a very contentious and frankly tedious subject.
From Noapinion:
The most damning critique of DSGE
If DSGE models work, why don't people use them to get rich?
When I studied macroeconomics in grad school, I was told something along these lines:
"DSGE models are useful for policy advice because they (hopefully) pass the Lucas Critique. If all you want to do is forecast the economy, you don't need to pass the Lucas Critique, so you don't need a DSGE model."
See also his earlier "What can you do with a DSGE model?".This is usually what I hear academic macroeconomists say when asked to explain the fact that essentially no one in the private sector uses DSGE models. Private-sector people can't set economic policy, the argument goes, so they don't need Lucas Critique-robust models.
The problem is, this argument is wrong. If you have a model that both A) satisfies the Lucas Critique and B) is a decent model of the economy, you can make huge amounts of money. This is because although any old spreadsheet can be used to make unconditional forecasts of the economy, you need Lucas-robust models to make good policy-conditional forecasts.
Let me explain. An unconditional forecast is when you say "GDP growth will be 2.4% next year", or "inflation will be 1.7% next quarter". For this kind of thing, any old spreadsheet will do.
A policy-conditional forecast is when you say "If the Fed tapers, inflation will fall by 0.5% next year." To get these forecasts as good as possible, you need to know how policy affects the economy. and if your model is not Lucas-robust, then you will not be able to know how policy affects the economy, so you will react sub-optimally to a policy change.
For example, suppose the Fed suddenly lowers interest rates substantially. Most people, using their silly spreadsheets with their 70s-vintage Phillips Curves, will forecast a rise in GDP growth, so they will pay a lot for stocks, expecting higher profits from the increased growth. But wise DSGE modelers, using the Nobel-winning and ostensibly Lucas-robust Kydland-Prescott 1982 model, know that the Phillips Curve is not structural. They know that the promised growth will not occur, so as soon as stocks become overpriced, they short the S&P. When the hoped-for growth does not materialize and stocks fall, the DSGE modelers reap a huge profit at the expense of the spreadsheet modelers.
Now that's a bit of an old example, so let's take a more modern one. Suppose the Fed launches a new program of QE. Clever DSGE modelers, armed with Steve Williamson's 2013 QE paper, know that QE will be deflationary rather than inflationary (as most people think). This allows them to take other investors, who are armed only with spreadsheets, for a ride, shorting TIPS and buying Treasuries. Voila - instant riches. Williamson himself endorses this idea, writing:
[I]f it does anything, QE will lower the inflation rate over the long run. And the long run comes sooner than you might think, i.e. if QE gives you a short-run increase in inflation, then if it's like typical monetary easing, then that effect lasts only a year or two. More to the point, there are other forces post-financial crisis that will cause the real interest rate on safe assets to rise, and inflation to fall further, so long as the Fed keeps short nominal rates at or near the zero lower bound. And there are good reasons to think that the Fed will be stuck at the zero lower bound indefinitely. Conclusion: expect less inflation rather than more. That has to matter for your portfolio choices. (emphasis mine)So as we see, a Lucas-robust DSGE model has the potential to make its wielders a LOT of money. This is especially true in the current environment, where correlations are high and macro events have become much more important to investors' performance....MORE
Older readers (octo or spry nonagenarians) will recognize in the first half of the headline the plaint attributed to President Truman:
Give me a one-handed economist! All my economists say, On the one hand on the other...
