Monday, February 20, 2012

Put down your Sargent textbook and step away from the econometrics!

The confusion among mainstream economist is amazing. Mark Thoma in his recent post on our under-performing economy highlights this fact. While going through various models illustrating the GDP gap he makes this statement:

“One way to think of these models is that variation in the red line arises from supply shocks, and variation around the red line -- shown by the blue line -- represents demand shocks. Thus, under this interpretation, the first two models assume that all variation in the economy is due to demand shocks. This is clearly incorrect -- certainly supply shocks matter too -- and therefore these models may not give a very good measure of the gap.”

What is simple amazing about this post and statement is that it is wrong on so many levels. The red line (GDP trend) Thoma is referring to is his trend generated from a regression run on the blue line (actual GDP). If the blue line represents demand, the red line is an average of that demand over the whole data set, not supply! Yes! it is a lack of demand in the economy. What supply shock is Thoma so concerned with capturing in his models? Supply is fine; there are 12.8 million people currently unemployed (officially). This is from a guy who is supposed to be “Keynesian”.

His last model attempts a RBC trick of allowing the trend to be stochastic. So the blue line is still the variations in the actual demand in the economy, and the red line is just a more elaborate average of that demand and still not supply. It’s great to see that the mainstream of the profession has such a firm understanding of theory and basic statistics!


  1. Oh my god, this would be painful if weren't so funny. (Or would it be funny if it weren't so painful?) Good catch. In Thoma's defense, I think he explicitly denies identifying as a Keynsian, tho.

    We might also think like Thoma if we knew with absolute certainty that demand constraints cannot persist more than six quarters or so. Of course this is totally false, but he thinks he knows it, so...

  2. The whole literature on potential GDP (or the natural rate of unemployment) is like that. The basic way of calculating is an average of the actual variable, and then they suggest that the actual data fluctuates around the average, that is in their head not an average, but some attractor of the whole series.


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