Tuesday, July 27, 2010

Equilibrium Economics & DSGE

Many thanks to Greg Mankiw for posting the link on his blog to Robert Solow's prepared statement to the House Committee on Science and Technology Subcommittee on Investigations and Oversight - “Building a Science of Economics for the Real World."

I didn't realize it at the time, but I was introduced to the field of DSGE (Dynamic stochastic general equilibrium modeling) economics in part last year at the "Stimulus SmackDown: Can Deficit Spending Save the Economy?" hosted at the University of California - Davis where Michele Boldrin expressed his view from the vantage point of equilibrium economics, of which DSGE is a branch.

Why is does this matter?

Along with other explicit reasons to mistrust DSGE as a viable economic theory, Solow explains:
The only way that DSGE and related models can cope with unemployment is to make it somehow voluntary, a choice of current leisure or a desire to retain some kind of flexibility for the future or something like that. But this is exactly the sort of explanation that does not pass the smell test.
Much of today's political approach to economic cures focuses on reviving the Keynesian/government intervention approach. Robert Solow developed the Solow Eocnomic Growth Model (yes, that Solow...) and his economic standpoint falls on the opposite end of spectrum from Keynesians and New Keynesians.

It's reasonable to generalize about economic conditions and accept that there will be gaps and holes in describing how economic events and policies affect each individual participant. There's certainly no accounting for taste (as microeconomists often state) and how participants respond or are affected by each new macroeconomic condition may in fact change each time because of amultitude conscious and sub-conscious factors weighing decisions. While noble, the notion that modeling macroeconomic activity as a construct of measured individual decisions emits a certain arrogance that individual human behavior can be predicted and subsequently controlled through economic policy.

Solow, Friedman and scores of other free market economists have long shown the positive effects of less government intervention and empowering individuals to make their own economic decisions. While some will choose poorly and even irrationally, the aggregate optimizes their situation with any set of given constraints. Most importantly, I simply want the liberty to make such decisions. It's just not possible to predict how the individual, on an individual basis, will respond to conditions at any one point in time.

The complexities of individual choice border on infinite and have long been articulated. Nobel prize winner Hebert Simon published his paper "A Behavioral Model of Rational Choice" back in 1955 (and even used the housing market to illustrate his point...).

I'm not suggesting that DSGE economists are seeking to control behavior, but a general Keynesian approach that includes modeling nearly infinite variations for individual players just doesn't seem right.

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