Must-Read: Willem Buiter (2009): The Unfortunate Uselessness of Most ‘State of the Art’ Academic Monetary Economics:

If one were to hold one’s nose and agree to play with the New Classical or New Keynesian complete markets toolkit, it would soon become clear that any potentially policy-relevant model would be highly non-linear....

The interaction of these non-linearities and uncertainty makes for deep conceptual and technical problems. Macroeconomists... took these non-linear stochastic dynamic general equilibrium models into the basement and beat them with a rubber hose until they behaved.  This was achieved by completely stripping the model of its non-linearities and by achieving the transsubstantiation of complex convolutions of random variables and non-linear mappings into well-behaved additive stochastic disturbances. Those of us who have marvelled at the non-linear feedback loops between asset prices in illiquid markets and the funding illiquidity of financial institutions exposed to these asset prices through mark-to-market accounting, margin requirements, calls for additional collateral etc.  will appreciate what is lost by this castration.... Threshold effects, critical mass, tipping points, non-linear accelerators--they are all out of the window.  Those of us who worry about endogenous uncertainty arising from the interactions of boundedly rational market participants cannot but scratch our heads....

When you linearize a model, and shock it with additive random disturbances, an unfortunate by-product is that the resulting linearised model behaves either in a very strongly stabilising fashion or in a relentlessly explosive manner.  There is no ‘bounded instability’ in such models.  The dynamic stochastic general equilibrium (DSGE) crowd saw that the economy had not exploded without bound in the past, and concluded from this that it made sense to rule out, in the linearized model, the explosive solution trajectories.  What they were left with was something that, following an exogenous random disturbance, would return to the deterministic steady state pretty smartly. No L-shaped recessions.  No processes of cumulative causation and bounded but persistent decline or expansion.  Just nice V-shaped recessions....

The practice of removing all non-linearities and most of the interesting aspects of uncertainty from the models that were then let loose on actual numerical policy analysis, was a major step backwards.  I trust it has been relegated to the dustbin of history by now in those central banks that matter.... Charles Goodhart... once said of the Dynamic Stochastic General Equilibrium approach which for a while was the staple of central banks’ internal modelling: “It excludes everything I am interested in”. He was right.... The Bank of England in 2007 faced the onset of the credit crunch with too much Robert Lucas, Michael Woodford and Robert Merton in its intellectual cupboard.  A drastic but chaotic re-education took place and is continuing...

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