Thursday, July 20, 2006

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What are general equilibrium models good for?

The Economist has a long story on the relative value of Big Economic Models -- the kind of general equilibrium monsters that are used to calculate how much the world benefits from a completed Doha round,or how much the global economy suffers from high oil prices.

The story does a good job of highlighting the sensitivity of these models to first assumptions -- while also pointing out their signal virtue:

[Leon] Walras was adamant that one could not explain anything in an economy until one had explained everything. Each market—for goods, labour and capital—was connected to every other, however remotely. This interdependence is apparent whenever faster car sales in Texas result in an increase in grocery shopping in Detroit, the home of America's “big three” carmakers. Or when steep prices for oil lead, curiously enough, to lower American interest rates, because the money the Saudis and the Russians make from crude is spent on American Treasury bonds. This fundamental insight moved one economist to quote the poetry of Francis Thompson: “Thou canst not stir a flower/Without troubling of a star.”

Such thinking now comes naturally to economists. But it still escapes many politicians, who blindly uproot flowers, ignorant of the celestial commotion that may ensue. They slap tariffs on steel imports, for example, to save jobs in Pittsburgh, only to find this costs more jobs in the domestic industries that use the metal. Or they help to keep zombie companies alive—rolling over their loans, and preserving their employees on the payroll—only to discover they have starved new firms of manpower and credit. Big models, which span all the markets in an economy, can make policymakers think twice about the knock-on effects of their decisions.

The more surprising argument in the article is that these models are politically powerful:
These models were, for example, a weapon of choice in the battles over the 1994 North American Free-Trade Agreement (NAFTA). The pact's opponents had the best lines in the debate—Ross Perot, a presidential candidate in 1992, told Americans to listen out for the “giant sucking sound” as their jobs disappeared over the border. But the deal's supporters had the best numbers. More often than not, those with numbers prevail over those without. As Jean-Philippe Cotis, chief economist of the OECD, has put it, “orders of magnitude are useful tools of persuasion.”

But how plausible were the numbers? Twelve years on, economists have shown little inclination to go back and check. One exception is Timothy Kehoe, an economist at the University of Minnesota. In a paper published last year, he argued that the models “drastically underestimated” NAFTA's impact on trade flows (if not on jobs). The modellers assumed the trade pact would allow people to buy more of the goods for which they had already shown some appetite. In fact, the agreement set off an explosion in the exports of many products Mexico had scarcely traded before. Cars, for example, amounted to less than 1% of Mexico's exports to Canada before the agreement. By 1999, however, they accounted for more than 15%. The only comfort economists can draw from their efforts, Mr Kehoe writes, is that their predictions fared better than Mr Perot's. A low bar indeed.

Dubious computations also helped to usher the Uruguay round of global trade talks to a belated conclusion in 1994. Peter Sutherland, head of the General Agreement on Tariffs and Trade, the ancestor of the World Trade Organisation (WTO), urged negotiators to close the deal lest they miss out on gains as great as $500 billion a year for the world economy. This figure came, of course, from a big model.

Even staunch free-traders, such as Arvind Panagariya, an economist now at Columbia University, thought these claims “extravagant” and “overblown”. They escaped scrutiny, he argued in 1999, because they emanated from “gigantic” models, which were opaque even to other economists. Why then did these models thrive? Supply and demand. “Given the appetite of the press and politicians for numerical estimates and the publicity they readily offer researchers, these models are here to stay,” Mr Panagariya concluded.

[You do realize that the title of this post is worthy of an entry to Crooked Timber's contest for off-putting titles--ed. It's my special talent.]

posted by Dan on 07.20.06 at 09:17 AM


And indeed, the title proves a thread-killer.

posted by: Doug on 07.20.06 at 09:17 AM [permalink]

IMHO, econometric models are hokum. They arise from the same flawed economic assumptions used in central planning schemes. Why would we expect the econometrician’s predictions to be any more accurate than the socialist “central planner's.”

posted by: Jeff Younger on 07.20.06 at 09:17 AM [permalink]

I rather like the title. I just wish it bore more than a passing resemblance to the discussion that followed which was scant to an extreme degree. But perhaps the long quote sans commentary or analysis constituted the bulk of the equation and the Dreznerian adjoinder was simply in the error term?

posted by: Hemlock for Gadflies on 07.20.06 at 09:17 AM [permalink]

Jeff - These models depend on the welfare theorems.

If markets are complete and if production technology and consumer preferences are of certain forms, then the central plan will look like the competitive outcome. In other words, the outcome we see in the economy will look 'as-if' it was arranged by a central planner. So, the modeller solves the 'easy' central planning problem to see what the competitive outcome might be.

The 'ifs' are the assumptions that Dan mentions that the models are sensitive to. They are big, HUGE ifs.

posted by: Will on 07.20.06 at 09:17 AM [permalink]

Are these models linear as well as equilibrium? The point about the Mexican cars sounds like they don't model accelerations well.

posted by: Dick on 07.20.06 at 09:17 AM [permalink]

Isn't the question why these models are believed? Isn't it because the plums so planted are ever so sweet? Reassuring the emperor of his taste in finery is the fastest route to reward.

posted by: Lord on 07.20.06 at 09:17 AM [permalink]

Are these models similar to thermodynamic models in physics? It seems to me that modelling the economy is a bit harder than modeling the weather or nuclear explosions, both of which require massive supercomputers. Economics is harder because humans are so damn irrational.

posted by: Dude on 07.20.06 at 09:17 AM [permalink]

I would also point out that assessments of the cost of regulation may be gross underestimates because they ignore GE effects. Some years ago, Jorgensen and Wilcoxon looked at environmental regulation with a multi-sectoral GE model. They found that the total cost of these regulations on output had been vastly underestimated because partial-equilbrium methods ignore inter-sector distortions of investment and production.

posted by: srp on 07.20.06 at 09:17 AM [permalink]

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