Economists, Incentives, Judgment, and the European CVAR Approach to Macroeconometrics

Abstract

The primary aim of the paper is to place current methodological discussions in macroeconometric modeling contrasting the ‘theory first’ versus the ‘data first’ perspectives in the context of a broader methodological framework with a view to constructively appraise them. In particular, the paper focuses on Colander’s argument in his paper “Economists, Incentives, Judgement, and the European CVAR Approach to Macroeconometrics” contrasting two different perspectives in Europe and the US that are currently dominating empirical macroeconometric modeling and delves deeper into their methodological/philosophical underpinnings. It is argued that the key to establishing a constructive dialogue between them is provided by a better understanding of the role of data in modern statistical inference, and how that relates to the centuries old issue of the realisticness of economic theories.

Full text

Page 1

“Economists, Incentives, Judgment, and the European  
CVAR Approach to Macroeconometrics” 
 
By 
 
David Colander 
 
August, 2009 
 





MIDDLEBURY COLLEGE ECONOMICS DISCUSSION PAPER NO. 09-12








DEPARTMENT OF ECONOMICS
MIDDLEBURY COLLEGE
MIDDLEBURY, VERMONT 05753

http://www.middlebury.edu/~econ

Page 2

Economists, Incentives, Judgment, and the European CVAR Approach to
Macroeconometrics1
David Colander
Abstract: This paper argues that the DSGE approach to macroeconometrics is the
dominant approach because it meets the institutional needs of the replicator dynamics of
the profession, not because it is necessarily the best way to do macroeconometrics. It
further argues that this “DSGE-theory first” approach is inconsistent with the historical
approach that economists have advocated in the past and that the alternative European
CVAR approach is much more consistent with economist’s historically used
methodology, correctly understood. However, because the European CVAR approach
requires explicit researcher judgment, it does not do well in the replicator dynamics of the
profession. The paper concludes with the suggestion that there should be an increase in
dialog between the two approaches.
Keywords: methodology, macroeconometrics, general to specific, DSGE, VAR,
judgment, incentives
JEL classification: C10. A1
1. Introduction

To tell an economist that he chooses that type of work and that viewpoint
which will maximize what his income is, he will hotly say, a studied insult.
Such market-oriented behavior will be characterized not with our
customary phrases such as consumer sovereignty, but in terms as harsh as
"intellectual prostitution". To adapt one's views to one's audience is hardly
to be distinguished from the falsification of evidence and other disreputable
behavior.—George Stigler

Specific Approach to Empirical Macro (Hendry, 1995, Johansen, 1976 and Juselius, 2006)
had only limited success in the competition for ideas for doing applied macroeconomic
policy in the U.S.? As an illustration of the General-to-Specific approach I shall discuss
the cointegrated vector auto regression (CVAR) approach, primarily developed in Europe
and used by many of the contributors of this special issue, and compare it to the Dynamic
Stochastic General Equilibrium (DSGE) approach, primarily developed in the U.S. where
it is considered the correct approach to doing macroeconometrics.
In this opinion paper I ask a simple question: Why has the European General-to-

approach is he talking about? We haven’t heard of the CVAR approach; it must be a
minor approach by some out-of-the-mainstream economists.” Given the lack of
The initial reaction to this question by most U.S. economists likely will be: “What

1 I would like to thank Peter Kennedy, Katarina Juselius, Lawrence Boland, Kevin Hoover, Casey
Rothschild, Aris Spanos, and Tomas Mayer for important suggestions on earlier versions of this paper. I
have definitely not taken all their advice so only I am responsible for the arguments here.

Page 3

Economists, Incentives and Empirical Work
familiarity of many economists with this approach, I will discuss in Section 2 what I
mean by the European CVAR approach, why I call it European, and how it differs from
the DSGE approach. In Section 3 I shall discuss some hypotheses explaining why the
European CVAR approach is not winning out in the competitions of ideas and methods
and relate these to the notion of a representative researcher and the invisible hand of truth.
In Section 4 I take a historical look at the evolution of macroeconomic theory and how
that evolution is related to incentives; I argue that there is little historical foundation for
the pre-eminence of theory approach as interpreted by DSGE advocates, and in fact, there
is a historical evidence suggesting that their approach is an approach that earlier
economists would have strongly condemned. In Section 5 I characterize the policy
implications of the two approaches and discuss the role of theory and judgment in the
CVAR versus the DSGE approach. In section 6 I combine the arguments in the above
sections, and argue that given the current replicator dynamics of the academic economics
profession, there is a bias against methods, such as the European CVAR method, that
explicitly require the use of researcher intuition and judgment in the analysis.
2. The European CVAR and the U.S. DSGE Approach to Econometrics

the Walrasian approach, sees the macro economy as a system that can we can best
understand through the lens of formal micro-founded theory, based in carefully specified
micro foundations. Most recently, it is an approach associated with the DSGE model. It is
the dominant approach taught in U.S. graduate schools and held by U.S. macro
economists. It is a formal theory first approach. As Campos, Eriksson and Hendry (2005)
point out this approach “insists on a complete theoretical model of the phenomena of
interest prior to data analyses.” (pg 1)
There are two ways of thinking about the macroeconomy. The first, which I call

with, sees the macro economy as more complex than that and does not see a rigid
microeconomicly grounded theory as especially helpful in shedding light on most
macroeconomic problems. This approach, which elsewhere I have called the Post
Walrasian approach (Colander, 2006), has also been nicely described by Campos,
Eriksson and Hendry. It sees the economy as “a complicated, dynamic, nonlinear,
simultaneous, high-dimensional, and evolving entity [in which] “social systems alter over
time; laws change and technological innovations occur.” (pg. 1) This alternative approach
can be found in small pockets throughout the world, but tends to be more prevalent in
Europe, which until recently did not buy into the DSGE approach anywhere near as
completely as did the U.S.
The alternative approach, which I see the European CVAR approach as consistent

macroeconometrics. The DSGE theory-first approach to macroeconometrics tends to
dominate in the U.S. while in Europe there has been, until recently, a more eclectic
approach, and it is within these eclectic approaches that one finds the CVAR approach.
There tends to be a similar divide between the U.S. and Europe in
2.1. Methodology of the Two Approaches
10/7/2009 2

Page 4

Economists, Incentives and Empirical Work

methodology. The Walrasian approach, which underlies the predominant dynamic
stochastic general equilibrium (DSGE) approach in macroeconomics, concentrates on
carefully developing the theoretical model first. Advocates argue that one must first
specify the theoretical model before one can even have a hope of adequately grasping the
complex empirical reality. If one doesn’t develop, and stay true to, such a carefully
specified theoretical model, one will likely be fooled by spurious empirical relationships.
This means that a DSGE researcher sees all macroeconomic issues through a DSGE lens.
To keep the formal model tractable, this DSGE approach generally requires the
researcher to disregard the institutional environment and complex dynamics as possible
explanations for why what we observe differs from what theory predicts.
The two approaches to macroeconometrics differ significantly in their underlying

be brought to the data. It is a “theory-first” methodology, where “theory first” means a
carefully specified and fully developed formal theory which may deviate significantly
from the characteristics of the economy that intuitively might be important. Only after
having fully developed the underlying microeconomic theory in a highly simplified
model do advocates of the DSGE approach bring their model to the data. When they do
bring it to the data, they generally use calibrated values for some parameters of the model
and Bayesian estimation methods to reconcile the information in the data with the theory
model. While this DSGE approach allows for some flexibility by representing part of the
empirical dynamics with a simple VAR it usually does so without using the VAR to
check for misspecification such as parameter non-constancy (parameters are assumed to
be constant).
The DSGE approach requires that only a fully pre-specified theoretical model can

methodology. Because it sees the outcomes of the economy as data points from a
complex system, where by complex I mean a system that involves so many interactions
and potential non-linearities that intuitively, one could not hope to fully specify a formal
model of the system, the European CVAR approach gives smaller weight to any specific
formal theory, and instead uses a broad heuristic theoretical understanding of the
economy, which is guided by, but not necessarily dominated by, a formal theory.2 Thus,
for example, the European CVAR approach would address the recent crisis within a
system of equations where economic behavior is allowed to persistently deviate from
long-run economic equilibrium states. It would provide information on which other
variables react on these persistent movements away and where in the system the
adjustment takes place. Rather than assuming one correct theory it would be open to
theoretical explanations that are consistent with agents who drive prices away from long-
run attractors for significant periods of time.
What I am calling the European CVAR approach uses a quite different

foundation of hard core theory; it simply questions the usefulness of an oversimplified
theoretical model that, to anyone other than a true believer, intuitively does not
The European CVAR approach does not deny rationality and equilibrium as the

2 I have discussed these issues further in Colander, (1996, 2006).
10/7/2009 3

Page 5

Economists, Incentives and Empirical Work
correspond to a model that would reasonably explain economic behavior as it manifests
itself in observed economic data.3

CVAR advocates have, it is not surprising that the CVAR approach gives more emphasis
to data analysis. Advocates of this approach use a carefully constructed econometric
methodology designed to extract as much information as one can from the data. (My
focus in this paper is the cointegrated vector autoregressive (CVAR) approach advocated
by Søren Johansen and Katarina Juselius (Johansen and Juselius, 2006, Juselius, 2006),
but the approach is also related to the related general-to-specific approach advocated by
David Hendry (Hendry, 2000, 2009).(I see both of these approaches are consistent with
the broad archeological approach methodologically advocated by Kevin Hoover (Hoover,
2006, Hoover, Johansen and Juselius, 2008)).
Given the concern about knowledge that can be deduced from formal theory that

dynamic system of forces that move equilibria (pushing forces, which give rise to
stochastic trends) and forces that move equilibria (pulling forces, which give rise to long-
run relations) (Hoover et al., 2008). Thus in this European CVAR approach the formal
theory of a static economy is adapted to a more heuristic theory that incorporates the
researcher’s judgment about the effects of institutions, and dynamics on the theoretical
results into one’s theoretical intuition of what the formal theory is telling one. The
European CVAR macroeconometric approach is designed to allow the complexity of the
economic reality to speak as freely as possible through the lens of the institutional
environment. The data analysis blends with the theoretical analysis to produce a vision of
reality that is not necessarily correct, but is the best that can be arrived at given such a
complex system as the macroeconomy.
These approaches all share the feature that they view economic reality as a
2.2. The Importance of Judgment in the European CVAR Approach

article is that it explicitly requires the researcher to use judgment about the applicability
of theoretical, institutional and empirical information to arrive at a conclusion from the
analysis. The analysis is as much art as it is science. It is an approach that has a long
history in economics and I would argue is consistent with the Marshallian/Keynesian
approach that J.M. Keynes summarized as follows:
The important aspect of the European CVAR approach for my argument in this
Economics is a science of thinking in terms of models joined to the art of
choosing models which are relevant to the contemporary world. It is
compelled to be this, because, unlike the typical natural science, the
material to which it is applied is, in too many respects, not homogeneous
through time. The object of a model is to segregate the semi-permanent or
relatively constant factors from those which are transitory or fluctuating so
as to develop a logical way of thinking about the latter, and of
understanding the time sequences to which they give rise in particular

3 When considering the simplicity of the underlying theory assumptions relative to the complexity of the
economy typical of many DSGE models, it may not come as a big surprise that they have been essentially
silent about explaining many observed events in particular the more recent ones.
10/7/2009 4