In a recent paper, Ricardo Reis offers an interesting insight in the debate on dynamic stochastic general equilibrium that has taken place in macroeconomics since the 2008 financial crisis. While some economists argue that DSGE modeling is fundamentally flawed, others maintain that because the crisis was unexpected, it is inappropriate to blame such modeling.
Reis admits that DSGE modeling is not perfect and that there is certainly room for improvement. However, he argues, macroeconomics is much more than DSGE modeling. Even if critiques of DSGE modeling are correct, those critiques do not extend to macroeconomics as a field. Reis pushes further the defense of macroeconomics by arguing that it is not the job of macroeconomists to predict crises.
His argument is based on an analogy. Imagine, he invites the reader, going to your doctor and asking the doctor to forecast whether you’ll be alive two years from now. Your physician says you are more than 50 percent likely to be alive. However, within that time frame you suffer a fatal heart attack. Reis asks, “Should there be outrage at the state of medicine for missing the forecast, with such deadly consequences?” Reis concludes that the economist’s job, just like that of the physician, is not to predict someone’s heart attack but to understand why it happened and learn from this deadly event. A more sophisticated version of this argument recognizes that predictions are conditional. Given the life choices of the patient, the physician can update his or her forecast. So does the economist.
I’m afraid Reis’s analogy is mistaken for two reasons. First, during the financial crisis it wasn’t just one bank that had a heart attack: most banks were under financial distress. It is not as if one particular physician missed one particular heart attack. It is more like if the World Health Organization missed a massive spate of heart attacks around the world.
Second, the economist is not like the physician, at least in the context of Reis’s discussion. The difference is that banks, as economic agents, need to abide by central bankers’ regulations and are subject to their monetary policy. Economists in government regulate banks and dictate monetary policy. Unlike the physician in Reis’s example, the economist is not an impartial observer. The economist is, rather, a key player. If my physician tells me that, following World Health Organization regulations and policies, he or she is forcing me into a lifestyle with an unhealthful diet and no physical activity, I not only have the right to ask for a forecast, I also have the right to be concerned and ask for an explanation if I observe a spate of heart attacks among people subject to the WHO regulations and policies. Physicians, especially the ones working at the WHO, cannot avoid their responsibility by claiming their job is to understand what happened ex post.
It is true, as Reis points out, that there can be unexpected shocks. But no one is disappointed at economists being unable to predict the unpredictable. The issue is that crises can also occur because of mistaken policies designed by economists and enforced through central banks and regulators. Reis does not seem to entertain the idea that central bankers can commit very costly mistakes. And DSGE modeling, for better and for worse, is an important component of policy design.
If macroeconomists want to be more like physicians and be able to claim no responsibility for crises, then they should move away from advocating monetary institutions built on central banks and toward those based on competitive markets. The extensive academic literature on free banking shows that a free market in money and banking is not to be feared. Experts’ mistakes can in fact be more damaging.