An excellent little spot by Noah Smith on who uses what sort of economic model to do their forecasting:
Suppose you’re a macro investor. If all you want to do is make unconditional forecasts — say, GDP next quarter – then you can go ahead and use an old-style SEM model, because you only care about correlation, not causation. But suppose you want to make a forecast of the effect of a government policy change — for example, suppose you want to know how the Fed’s taper will affect growth. In that case, you need to understand causation — you need to know whether quantitative easing is actually changing people’s behavior in a predictable way, and how.
This is what DSGE models are supposed to do. This is why academic macroeconomists use these models. So why doesn’t anyone in the finance industry use them? Maybe industry is just slow to catch on. But with so many billions upon billions of dollars on the line, and so many DSGE models to choose from, you would think someone at some big bank or macro hedge fund somewhere would be running a DSGE model. And yet after asking around pretty extensively, I can’t find anybody who is.
One unsettling possibility is that the academic macroeconomists of the ’70s and ’80s simply bit off more than they could chew. Modeling a big thing (like the economy) as the outcome of a bunch of little things (like the decisions of consumers and companies) is a difficult task. Maybe no DSGE is going to do the job. And maybe finance industry people simply realize this.
And at this point we might be able to work out what’s wrong with academic macroeconomics. It’s not quite economics to simply shout “Follow the money!” but we can adapt that very useful idea of revealed preferences to tell us what’s going on here. That useful idea being that we shouldn’t look at what people say they’ll do but rather at what they actually do. And we can argue that academic economists are trying to successfully predict what is going to happen as a result of changes in government policy if we should so wish to. But combine that with that follow the money idea and we’d expect the financial markets economists to have been subjecting their models to more rigorous testing. After all, real money is at stake, not just whether you manage to get published in one or another journal.
We should admit that this does rather play to our prejudices here. We’re not great fans of macroeonomics at all, agreeing with Keynes that in the long run we’re all dead but adapting that to insist that in the long run it’s all microeconomics. Get incentives and the price system right and pretty much all other economic problems will either solve themselves or shrink to their not being problems that we want or need to worry about.
This of course enrages macroeconomists but as we don’t get invited to their parties anyway we can shoulder this burden well enough.
Underneath that jollity though there is a much more serious point. Macroeconomics is really a very under developed approach of looking at the world. We rather take the Hayekian line that it always will be, given the dispersed nature of information and the impossibility of having enough of it in real time to be able to do anything useful with it. But that there’s pretty much no one macro theory that you could get all macroeconomists to sign up to is another indication that it’s really just not ready for prime time yet.
And if it’s not ready for prime time then we really shouldn’t be using it to try and guide our actions on the economy. We should, therefore, concentrate our efforts on those areas where we do know we’ve largely got the appropriate and necessary knowledge, about those incentives and that price structure.