The Failure of Macroeconomic Models and the Housing Bust

[Toro]

From Peter Orszag, the former director of the OMB.

The problem is that the macroeconometric models used by the Fed -- like those used by the Congressional Budget Office, the White House and others -- had at best a very rudimentary financial sector built into them. As a result, they took into account the macroeconomic impact from the housing bust -- but for the most part didn’t reflect the concentrated loss of wealth and degree of leverage in the financial industry.

In other words, the official models effectively ignored the very distinction that Bernanke highlighted as being crucial to distinguishing the housing collapse from the tech bust. And so the models completely missed the recession’s severity.

In late 2007, for example, the midpoint of the range that the Fed projected for real gross-domestic-product growth in 2008 was more than 2 percent. Instead, real GDP declined by more than 3 percent that year. In early 2008, the Fed projected the economy would expand 2.4 percent in 2009. Instead, real GDP fell 0.5 percent. Those are big forecast errors: The 70 percent confidence interval for one-year-ahead projections is plus or minus 1.2 percentage points. The 2007 projection for 2008 was off by more than five percentage points.

The Fed was far from alone in being overly optimistic; every formal macroeconometric model that I’m aware of made the same mistake. In early 2008, for example, forecasts for 2009 from both the Congressional Budget Office (which I ran at the time) and the Bush administration were roughly in line with, and therefore just as wrong, as the Fed’s.

A paper delivered at the same conference where Bernanke spoke last month suggests one way to address the problem. The economists Simon Gilchrist of Boston University and Egon Zakrajsek of the Fed staff augmented a traditional macroeconomic model with a measure of stress in the financial industry: credit spreads on bonds issued by financial institutions. Those spreads barely moved following the tech bust, but they widened substantially after the housing collapse.

Accounting for Stress

This model, the authors conclude, “can account for the broad movements in consumption, investment, hours worked and output observed during this period.” And since 2007, some progress has been made in incorporating metrics of financial stress into macroeconometric models. But the progress remains inadequate.

Bad Models Mistook Housing Bust for Dot-Com Bubble - Bloomberg

 

[Listening]

It would be great to actually see something from these models....even some sample tables that we could discuss.

I really struggle with the idea of a useful macroeconomic model, but would at least like to have some data in front of me.

 

[EdwardBaiamonte]

From Peter Orszag, the former director of the OMB.

The problem is that the macroeconometric models used by the Fed -- like those used by the Congressional Budget Office, the White House and others -- had at best a very rudimentary financial sector built into them. As a result, they took into account the macroeconomic impact from the housing bust -- but for the most part didn’t reflect the concentrated loss of wealth and degree of leverage in the financial industry.

In other words, the official models effectively ignored the very distinction that Bernanke highlighted as being crucial to distinguishing the housing collapse from the tech bust. And so the models completely missed the recession’s severity.

In late 2007, for example, the midpoint of the range that the Fed projected for real gross-domestic-product growth in 2008 was more than 2 percent. Instead, real GDP declined by more than 3 percent that year. In early 2008, the Fed projected the economy would expand 2.4 percent in 2009. Instead, real GDP fell 0.5 percent. Those are big forecast errors: The 70 percent confidence interval for one-year-ahead projections is plus or minus 1.2 percentage points. The 2007 projection for 2008 was off by more than five percentage points.

The Fed was far from alone in being overly optimistic; every formal macroeconometric model that I’m aware of made the same mistake. In early 2008, for example, forecasts for 2009 from both the Congressional Budget Office (which I ran at the time) and the Bush administration were roughly in line with, and therefore just as wrong, as the Fed’s.

A paper delivered at the same conference where Bernanke spoke last month suggests one way to address the problem. The economists Simon Gilchrist of Boston University and Egon Zakrajsek of the Fed staff augmented a traditional macroeconomic model with a measure of stress in the financial industry: credit spreads on bonds issued by financial institutions. Those spreads barely moved following the tech bust, but they widened substantially after the housing collapse.

Accounting for Stress

This model, the authors conclude, “can account for the broad movements in consumption, investment, hours worked and output observed during this period.” And since 2007, some progress has been made in incorporating metrics of financial stress into macroeconometric models. But the progress remains inadequate.

Bad Models Mistook Housing Bust for Dot-Com Bubble - Bloomberg

makes no sense to me:

1) what you read over and over is that no models anticipated a significant drop in housing prices as it had rarely happened over a protracted period. If that drop had been built into the models the broader ramifications of the liberal crash seemingly would have been built in too, if only speculatively.

2) the tech bust was tiny compared to the liberal housing bust so I don't see the comparison.

 

[Listening]

Is the point of this thread that predictive models are meaningless and that we can now shoot all the Keynesians like Krugman and Reich ?

 

[Oddball]

In other words, the official models effectively ignored the very distinction that Bernanke highlighted as being crucial to distinguishing the housing collapse from the tech bust. And so the models completely missed the recession’s severity.

In other words, the models were created from a standpoint of political considerations, rather than from sound economic theory.