The EconomicDynamics Newsletter
Volume 13, Issue 2, April 2012
A free electronic supplement to the Review of Economic Dynamics
distributed through the EconomicDynamics mailing list and
also available on the web at http://www.EconomicDynamics.org/
In this issue:
- The Research Agenda: Stijn Van Nieuwerburgh on Housing and the Macroeconomy
- EconomicDynamics interviews Frank Schorfheide on DSGE Model Estimation
- Book Review: Nosal and Rocheteau's "Money, Payments, and Liquidity"
- Impressum
- Subscribing/Unsubscribing/Address change
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The Research Agenda: Stijn Van Nieuwerburgh on Housing and the Macroeconomy
Stijn Van Nieuwerburgh is Professor of Finance at New York University's
Stern School of Business. His research interests lie in housing,
macroeconomics, and finance.
1. Introduction
An important part of my research focuses on the intersection of real
estate, the largest financial asset for most households, asset markets,
and the real economy. In the US, aggregate household residential real
estate wealth is currently about $18 trillion and residential mortgage
debt about $13 trillion. A common theme in my work is that housing plays a
key role as collateral against which households can borrow. In several
papers, I model the extent to which households use their house to insure
against income shocks and study how changes in the value of housing
affects interest rates and rates of return on risky assets. The main
message from this research agenda is that, through its effect on risk
sharing, fluctuations in housing collateral wealth can help explain
puzzling features of stock returns, house prices, interest rates, and the
cross-sectional dispersion in households' consumption. The research speaks
to the dramatic swings in real estate markets we observed in the last
fifteen years. In this overview I take the opportunity to report on some
of my ongoing work in this area and to review some of the main findings of
earlier research.
2. The Housing Boom and Bust: Time-Varying Risk Premia
An important challenge in the housing literature is to explain why house
prices are so volatile relative to fundamentals such as rent (rental cost)
and why price-to-rent ratios exhibit slow-moving boom-bust cycles all over
the world. The unprecedented amplitude of the boom-bust cycle between the
years 2000 and 2010 in particular begs for a coherent explanation.
In Favilukis, Ludvigson and Van Nieuwerburgh (2010), we generate booms and
busts in house price-to-rent ratios that quantitatively match those
observed in U.S. data in a model that accounts for the observed equity
risk premium and risk-free rate behavior. A large preceding literature
makes clear that this is a difficult task, especially in a model with
production and realistic business cycle properties like ours (e.g., Davis
and Heathcote 2005, Jermann 1998).
Specifically, we study a two-sector general equilibrium model of housing
and non-housing production where heterogeneous households face limited
risk-sharing opportunities as a result of incomplete financial markets. A
house in the model is a residential durable asset that provides utility to
the household, is illiquid (expensive to trade), and can be used as
collateral in debt obligations. The model economy is populated by a large
number of overlapping generations of households who receive utility from
both housing and non-housing consumption and who face a stochastic
life-cycle earnings profile. We introduce market incompleteness by
modeling heterogeneous agents who face idiosyncratic and aggregate risks
against which they cannot perfectly insure, and by imposing collateralized
borrowing constraints on households (standard down-payment constraints).
Within this context, we focus on the macroeconomic consequences of three
systemic changes in housing finance, with an emphasis on how these factors
affect risk premia in housing markets, and how risk premia in turn affect
home prices. First, we investigate the impact of changes in housing
collateral requirements. Second, we investigate the impact of changes in
housing transactions costs. Third, we investigate the impact of an influx
of foreign capital into the domestic bond market.
These changes are meant to capture important changes to the U.S. economy
over the last fifteen years. Taken together, the first two factors
represent the theoretical counterpart to the relaxation of credit
standards in mortgage lending that took place in the real world between
the late 1990s and the peak of the housing market in 2006, and the
subsequent tightening of credit standards after 2006. We refer to these
two changes as financial market liberalization (FML) and its reversal.
During the boom years, the U.S. mortgage market saw a massive increase in
the use of subprime mortgages, negative amortization and teaser rate
loans, and low or no-documentation loans. It also saw a massive increase
in the incidence and dollar volume of second mortgages and home equity
lines of credit, and with it a large rise in the fraction of borrowers
with combined loan-to-value ratios above 95 or even above 100%. Finally,
the transaction costs associated with mortgage borrowing, home equity
extraction, and mortgage refinancing fell rapidly while borrowers'
awareness of the opportunities to tap into one's home equity rose. During
the housing crisis and to this day, mortgage credit constraints tightened
substantially, costs of tapping into one's home equity rose and both
reverted to their pre-boom levels. Favilukis, Kohn, Ludvigson, and Van
Nieuwerburgh (2011) provide detailed evidence as well as references to
this literature.
The last 15 years were also marked by a sustained depression of long-term
interest rates that coincided with a vast inflow of capital into U.S. safe
bond markets. While in 1997 foreigners only held $1.6 trillion in U.S.
Treasury and Agency bonds, that number had grown to $5.2 trillion by June
2010, representing nearly half of the amounts outstanding. Interestingly,
foreign purchases of safe U.S. securities not only rose sharply during the
housing boom, but the inflows continued unabated during the housing bust.
The vast bulk of these foreign purchases over this period (80%) were made
by foreign official institutions, mostly Asian central banks. The increase
in foreign purchases of U.S. safe assets accounts for the entire rise in
the U.S. net foreign liability position in all securities, because the net
position in risky securities hovers around zero.
The main impetus for rising price-rent ratios in the model in the boom
period is the simultaneous occurrence of positive economic (TFP) shocks
and a relaxation of credit standards, phenomena that generate an
endogenous decline in risk premia on housing and equity assets. As risk
premia fall, the aggregate house price index relative to aggregate rent
rises. A FML reduces risk premia for two reasons, both of which are
related to the ability of heterogeneous households to insure against
aggregate and idiosyncratic risks. First, lower collateral requirements
directly increase access to credit, which acts as a buffer against
unexpected income declines. Second, lower transactions costs reduce the
expense of obtaining the collateral required to increase borrowing
capacity and provide insurance. These factors lead to an increase in
risk-sharing, or a decrease in the cross-sectional variance of marginal
utility. The housing bust is caused by a reversal of the FML, negative
economic shocks, and an endogenous decrease in borrowing capacity as
collateral values fall. These factors lead to an accompanying rise in
housing risk premia, driving the house price-rent ratio down. Thus, in
contrast with the literature, housing risk premia play a crucial role in
house price fluctuations.
It is important to note that the rise in price-rent ratios caused by a FML
in our study must be attributed to a decline in risk premia and not to a
fall in interest rates. Indeed, the very changes in housing finance that
accompany a FML drive the endogenous interest rate up, rather than down.
It follows that, if price-rent ratios rise after a FML, it must be because
the decline in risk premia more than offsets the rise in equilibrium
interest rates that is attributable to the FML. This aspect of a FML
underscores the importance of accounting properly for the role of foreign
capital over the housing cycle. Without an infusion of foreign capital,
any period of looser collateral requirements and lower housing
transactions costs (such as that which characterized the housing boom)
would be accompanied by an increase in equilibrium interest rates, as
households endogenously respond to the improved risk-sharing opportunities
afforded by a FML by reducing precautionary saving.
To model capital inflows, the third structural change in the model, we
introduce foreign demand for the domestic riskless bond into the market
clearing condition. We model foreign capital inflows as driven by foreign
governments who inelastically place all of their funds in U.S. riskless
bonds. Krishnamurty and Vissing-Jorgensen (2012) estimate that such
foreign governmental holders, such as central banks, have a zero price
elasticity for U.S. Treasuries, because they are motivated by reserve
currency or regulatory motives (Kohn, 2002).
Our model implies that a rise in foreign purchases of domestic bonds,
equal in magnitude to those observed in the data from 2000-2010, leads to
a quantitatively large decline in the equilibrium real interest rate. Were
this decline not accompanied by other, general equilibrium, effects, it
would lead to a significant housing boom in the model. But the general
equilibrium effects imply that a capital inflow is unlikely to have a
large effect on house prices even if it has a large effect on interest
rates. One reason for this involves the central role of time-varying
housing risk premia. In models with constant risk premia, a decline in the
interest rate of this magnitude would be sufficient by itself to explain
the rise in price-rent ratios observed from 2000-2006 under reasonable
calibrations. But with time-varying housing risk premia, the result can be
quite different. Foreign purchases of U.S. bonds crowd domestic savers out
of the safe bond market, exposing them to greater systematic risk in
equity and housing markets. In response, risk premia on housing and equity
assets rise, substantially offsetting the effect of lower interest rates
and limiting the impact of foreign capital inflows on home prices. There
is a second offsetting general equilibrium effect. Foreign capital inflows
also stimulate residential investment, raising the expected stock of
future housing and lowering the expected future rental growth rate. Like
risk premia, these expectations are reflected immediately in house prices
(pushing down the national house price-rent ratio), further limiting the
impact of foreign capital inflows on home prices. The net effect of all of
these factors is that a large capital inflow into safe securities has only
a small positive effect on house prices.
In summary, there are two opposing forces simultaneously acting on housing
risk. During the housing boom, there is both a FML and a capital inflow.
The FML lowers risk premia, while foreign purchases of domestic safe
assets raise risk premia. Under the calibration of the model, the decline
in risk premia resulting from the FML is far greater than the rise in risk
premia resulting from the capital inflow. The decline in risk premia on
housing assets is the most important contributing factor to the increase
in price-rent ratios during the boom. During the bust, modeled as a
reversal of the FML but not the capital inflows, risk premia unambiguously
rise while risk-free interest rates remain low. The rise in risk premia
drives the decline in house-price rent ratios. Time variation in risk
premia is the distinguishing feature that permits our model to explain not
just the housing boom, but also the housing bust. Moreover, the model
underscores the importance of distinguishing between interest rate changes
(which are endogenous) and exogenous changes to credit supply. In the
absence of a capital inflow, an expansion of credit supply in the form of
lower collateral requirements and lower transactions costs should lead, in
equilibrium, to higher interest rates, rather than lower, as households
respond to the improved risk-sharing/insurance opportunities by reducing
precautionary savings. Instead we observed low real interest rates,
generated in our model by foreign capital inflows, but the inflows
themselves are not the key factor behind the housing boom-bust.
Our model is silent on the origins of the relaxation of credit constraints
and its subsequent tightening, but it is worthwhile to briefly digress and
consider some possibilities. A first possibility is that mortgage lenders
were confronted with exogenous changes in technology that affected
mortgage finance. The boom period witnessed the birth of private-label
securitization, collateralized debt obligations, credit default swaps, as
well as automated underwriting and new credit scoring techniques employed
in that underwriting (Poon, 2009). These innovations have been linked to
the boom in mortgage credit and house price growth by Mian and Sufi (2009)
and Keys, Seru, Piskorski and Vig (2012). Second, there was substantial
legislative action that gave banks much more leeway to relax lending
standards: Mian, Sufi and Trebbi (2010) mention 700 housing-related
legislative initiatives that Congress voted on between 1993 and 2008 while
Boz and Mendoza (2010) highlight the 1999 Gramm-Leach-Bliley and the 2000
Commodity Futures Modernization Acts. Third, in this period, regulatory
oversight over investment banks and mortgage lenders weakened
substantially (Acharya and Richardson, 2009). For example, the regulatory
treatment of AA or better rated private label residential mortgage-backed
securities (MBS) was lowered in 2002 to the same low regulatory capital
level as that applied to MBS issued by the Agencies since 1988. Also,
since 2004 investment banks were allowed to use their internal models to
assess the risk of the MBS and capital requirements fell even further.
Regulatory capital rules were relaxed on guarantees that banks extended to
the special purpose vehicles they set up and that housed a good fraction
of mortgage credit (Acharya, Schnabel, and Suarez, 2012). These changes
took place in an environment where private sector mortgage lenders where
engaged in a race to the bottom with the government-sponsored enterprises,
who themselves were substantially affected by regulatory changes and
implicit government guarantees (Acharya, Richardson, Van Nieuwerburgh and
White, 2011). Faced with such changes in their economic environment,
mortgage lenders formed expectations of higher future house price growth,
justifying more and riskier mortgages as in the optimal contracting
framework of Piskorski and Tchystyi (2010). The bust saw a tightening of
regulatory oversight and the Dodd-Frank Act (Acharya, Cooley, Richardson
and Walter, 2011), to which lenders responded by cutting back on credit.
3. International Evidence and the Role of Capital Flows in the Housing
Boom and Bust
In follow-up empirical work, Favilukis, Kohn, Ludvigson and Van
Nieuwerburgh (2011) study the empirical relationship between house prices,
foreign capital flows, and a direct measure of credit standards for a
cross-section of countries. Across countries, we find a positive
correlation between house price growth and foreign capital inflows
(current account deficits) during the boom period, but a negative
correlation during the bust. For a smaller subset of countries we have a
direct measure of the tightness of credit constraints from senior loan
officers' surveys on banks' standards of supplying mortgage credit to
households. In a panel regression for 11 countries for a sample that spans
the boom and bust, we find a strong positive association between the
fraction of banks that eases credit standards and house price growth. Over
the same sample, such a relationship is absent between current account
deficits and house price growth. These results are robust to alternative
measures of capital flows. Longer time series evidence for the U.S.
suggests that more than 50% of variability in house price growth is
accounted for by changes in credit standards, and very little by the
dynamics of the current account. Our measure of credit standards is
positively related to the ratio of non-conforming to conforming mortgage
originations. In sum, the time series and cross-country data seem
supportive of the notion that changes in international capital flows
played, at most, a small role in driving house prices during this time,
both in the U.S. and around the world.
4. Foreign Holdings of U.S. Safe Assets: Welfare Effects for U.S.
Households
In Falukis, Ludvigson and Van Nieuwerburgh (2012), we use a similarly rich
framework to evaluate the implications of the dramatic rise on foreign
holdings of U.S. safe assets for the welfare of U.S. households. Despite a
vigorous academic debate on the question of whether global imbalances are
a fundamentally benign or detrimental phenomenon (see Gourinchas (2006)
Mendoza, Quadrini and Rios-Rull (2007), Caballero, Fahri, and Gourinchas
(2008a), Caballero, Fahri and Gourinchas (2008b), Obstfeld and Rogoff
(2009), and Caballero (2009)), little is known about the potential welfare
consequences of these changes in international capital flows, or of
foreign ownership of U.S. safe assets in particular. We argue in this
paper that a complete understanding of the welfare implications requires a
model with realistic heterogeneity, life-cycle dynamics, and plausible
financial markets. The model has a special role for housing as a
collateral asset.
The model economy implies that foreign purchases (or sales) of the safe
asset have quantitatively large distributional consequences, reflecting
sizable tradeoffs between generations, and between economic groups
distinguished by wealth and income. Indeed, the results suggest that a
sell-off of foreign government holdings of U.S. safe assets could be
tremendously costly for some individuals, while the possible benefits to
others are many times smaller in magnitude.
Welfare outcomes are influenced by the endogenous response of asset
markets to fluctuations in foreign holdings of the safe asset. Foreign
purchases of the safe asset act like a positive economic shock and have an
economically important downward impact on the risk-free interest rate,
consistent with empirical evidence. Although lower interest rates boost
output, equity and home prices relative to measures of fundamental value,
foreign purchases of the domestic riskless bond also reduce the effective
supply of the safe asset, thereby exposing domestic savers to greater
systematic risk in equity and housing markets. In response, risk premia on
housing and equity assets rise, substantially (but not fully) offsetting
the stimulatory impact of lower interest rates on home and equity prices.
These factors imply that the young and the old generations experience
welfare gains from a capital inflow, while middle-aged savers suffer. The
young benefit from higher wages and from lower interest rates, which
reduce the costs of home ownership and of borrowing in anticipation of
higher expected future income. On the other hand, middle-aged savers are
hurt because they are crowded out of the safe bond market and exposed to
greater systematic risk in equity and housing markets. Although they are
partially compensated for this in equilibrium by higher risk premia, they
still suffer from lower expected rates of return on their savings. By
contrast, retired individuals suffer less from lower expected rates of
return, since they are drawing down assets at the end of life. They also
receive social security income that is less sensitive to the current
aggregate state than is labor income, making them more insulated from
systematic risk. Taken together, these factors imply that the oldest
retirees experience a significant net gain even from modest increases in
asset values that may accompany a capital inflow.
The magnitude of these effects for some individuals is potentially quite
large. For example, in the highest quintile of the external leverage
distribution, the youngest working-age households would be willing to give
up over 2% of life time consumption in order to avoid just one year of a
typical annual decline in foreign holdings of the safe asset (which
amounts to about 2% of U.S. trend GDP). This effect could be several times
larger for a greater-than-typical decline, and many times larger for a
series of annual declines in succession or spaced over the remainder of
the household's lifetime. By contrast, the absolute value of the
equivalent variation welfare measure we study is often one-tenth of the
size (and in general of the opposite sign) for sixty year-olds than it is
for the youngest or oldest households. Thus, middle-aged households often
stand to gain from an outflow, but their gain is much smaller in magnitude
than are the losses for the youngest and oldest.
We also compute welfare consequences for groups that vary according to
total wealth, housing wealth, and income, as well as an ex-ante measure
for agents just being born. The latter provides one way of summarizing the
expected welfare effects over the life cycle, as experienced by a newborn
whose stochastic path of future earnings and foreign capital inflows is
unknown. Under the veil of ignorance, newborns benefit from foreign
purchases of the safe asset and would be willing to forgo up to 18% of
lifetime consumption in order to avoid a large capital outflow.
Our study focuses on the effect of a reserve-driven upward trend in the
U.S. net foreign debtor position over time on the macroeconomy and
welfare. Our model is silent on the economic implications of gross flows,
and we do not study cyclical fluctuations in the value of net foreign
holdings of other securities which, unlike net foreign holdings of U.S.
safe assets, show no upward trend (Favilukis, Kohn, Ludvigson and Van
Nieuwerburgh, 2011). By contrast, Gourinchas and Rey (2007) and Maggiori
(2011) investigate how the net foreign asset position of the U.S. invested
in risky securities varies cyclically across normal and crisis times, as
well as how gross flows are affected. On the other hand, these papers are
silent on the reasons for the large and growing net foreign debtor
position of the U.S. in good times, and on its upward trend over time. We
view these studies as complementary to our study. Integrating both aspects
of foreign flows in one model seems like a priority for future research.
5. Housing Collateral, Financial Market Puzzles, and Measures of Risk
Sharing
My earlier work explores the role of housing as a collateral asset in
models of limited commitment, along the lines of Krueger (1999), Alvarez
and Jermann (2000), and Chien and Lustig (2010). Lustig and Van
Nieuwerburgh (2005) predicts that households are less keen to take on
financial risks, and therefore demand a higher return for bearing these
risks, when housing collateral is scarce. In U.S. aggregate data, we show
that a decrease in housing collateral is followed by higher future stock
returns, in excess of the risk-free rate and that this relationship is
statistically significant. The cross-sectional prediction of the model is
that assets whose returns covary more positively with the value of housing
must offer their investors higher returns relative to other assets. In
contrast, assets whose value increases when housing collateral is scarce
are a valuable hedge against the risk of being borrowing-constrained. This
additional benefit induces the holders of these assets to accept lower
returns. In the data, this mechanism explains more than 80% of the
cross-sectional difference between average returns on value (high
book-to-market ratio) and growth stocks (low book-to-market ratio). Its
pricing errors compare favorably to those of competing asset pricing
models. The model upon which these empirical results are based, spelled
out in Lustig and Van Nieuwerburgh (2007), also provides an explanation
for why short-duration assets, whose risky cash flows accrue in the near
future, have higher risk premia than long-duration assets, an empirical
fact highlighted by Binsbergen, Brandt and Koijen (2011). The second piece
of evidence on the housing collateral and risk sharing mechanism comes
from quantity data for U.S. metropolitan areas. Lustig and Van
Nieuwerburgh (2010) measures the degree of risk sharing as the
cross-sectional variance of consumption relative to the cross-sectional
variance of income. The model aggregates heterogeneous,
borrowing-constrained households into regions characterized by a common
housing market and solves for the equilibrium consumption dynamics. It
generates a lower degree of risk sharing when housing collateral is scarce
to an extent similar to what we find in the data.
6. Regional Variation in Housing Prices
My interest in regional variations across housing markets led to a project
that explores why house prices differ across regions and over time. The
spatial location model in Van Nieuwerburgh and Weill (2010) is one of the
first dynamic versions of the seminal Rosen (1979) and Roback (1982) model
in urban economics. Regions differ in their productivity levels and
therefore the wages paid to their resident workers. Since workers are free
to move across regions, house prices must adjust to make them indifferent
between living in any region. Regions which experience fast wage growth
attract new households who bid up house prices. Housing supply regulation
constrains the number of new units that can be built per period in each
area; muting the response of quantities amplifies price changes. By
feeding realized regional wages into a calibrated version of the model, we
can explain the magnitude of the increase in average house prices and the
increase in the dispersion of house prices across regions over the
1975-2005 period. Interestingly, a tightening in housing supply regulation
by itself -an alternative candidate explanation for the observed changes
in the house price distribution- does not generate much of an increase in
the price level or its dispersion in the model because households can
relocate.
While the paper produces rich patterns for house prices across time and
space and matches important features of the data over the sample period of
study, it would fall short in accounting for house prices over the recent
boom and bust period described above. This is because the model does not
generate time variation in risk premia associated with relaxing and
tightening credit constraints. An important research challenge going
forward is to enrich the spatial housing models so that they imply richer
asset pricing dynamics. This would allow us to understand better the
heterogeneous house price experience of U.S. metropolitan areas over the
last decade.
7. Conclusion
In light of the recent events, there has never been a more relevant time
to work on housing and its implications for macroeconomics and asset
markets at large. There is a flurry of exciting research in progress by
established and young researchers alike, studying a range of interesting
questions. How can we account for the magnitude and dynamics of mortgage
foreclosures and how do they affect the macro-economy? How successful are
the government's mortgage modification programs in getting the U.S.
economy back on track? What are the macro-economic implications of the
credit crunch that is currently taking place in mortgage markets in the
U.S.? What should the future architecture of the U.S. housing finance
system look like and what can we learn from other countries? Finally,
commercial real estate remains a largely unexplored asset class in the
macro-finance literature despite its size and importance to the
macroeconomy. These are some of the questions I hope the profession will
continue to make progress on going forward.
Selected references to the papers mentioned are available in
the web version of this newsletter at
http://www.EconomicDynamics.org/newsletter.htm
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EconomicDynamics Interviews Frank Schorfheide on DSGE Model Estimation
Frank Schorfheide is Professor of Economics at the University of
Pennsylvania. He is interested in the estimation of DSGE models, Bayesian
methods, vector autoregressions.
EconomicDynamics: DSGE model used to be exclusively calibrated. Your work
was a major contributor in bringing estimation to this literature. Where
do you see the major advantages of estimating a DSGE model?
Frank Schorfheide: When I started my research as a PhD student in the
mid 1990s there seemed to be strong misconceptions among calibrators about
what econometrics can deliver and among econometricians about what it
means to calibrate. Both camps seemed to engage in some sort of trench
warfare launching grenades at what were poor incarnations of econometrics
and calibration analysis. The stereotype among calibrators was that
econometrics requires "true" models and the stereotype among
econometricians was that calibrators pick parameters in an arbitrary way,
disregarding empirical evidence. While this made for good pub
conversations, it didn't exactly facilitate progress in empirical
macroeconomics.
My personal interest, when I started to work on econometric methods
for the analysis of DSGE models, was to develop a formal statistical
framework (Schorfheide 2000) that captures some of the reservations of
calibrators: the framework should be able to account for misspecification
of DSGE models and it should recognize that objective functions for the
determination of parameters should be derived from loss functions that are
connected to the decision problems that the model is supposed to solve.
Once one recognizes that econometrics does not need to rely on the
"Axiom of Correct DSGE Model Specification" it offers a lot of tools that
are useful to summarize parameter uncertainty, uncertainty associated with
model implications, forecasts, and policy predictions, and it provides
coherent measures of fit for the comparison and weighting of competing
models. My favorite approach of dealing with DSGE model misspecification
is to use the models to construct priors for VARs or other flexible time
series models. Starting in 2004, I have explored this idea in several
co-authored papers with Marco Del Negro. We called the resulting hybrid
model DSGE-VAR.
In the past decade the time series fit of (representative agent) DSGE
models has improved considerably, an example is the celebrated
Smets-Wouters model, such that the initial concerns about inappropriate
probabilistic structures of the model became less relevant. In turn, the
use of formal econometric tools is much more attractive now than it was 20
years ago. I have discussed some of the progress and the challenges in the
area of DSGE model estimation in Schorfheide (2010).
ED: Can a case still be made for calibration?
FS: A few years ago my colleague Victor Rios-Rull and I engaged into
the following computational/educational experiment. At the time Victor was
teaching his quantitative macro class and I was teaching my time series
econometrics class. We both asked our students to use a stochastic growth
model to measure the importance of technology shocks for business cycle
fluctuations of hours and output. Victor's students were supposed to
calibrate the model and my students were supposed to estimate it with
Bayesian methods.
Together with some of our students we later turned the results into a
paper. While the two of us favor different empirical strategies, the paper
emphasizes the most important aspect of the empirical analysis is how the
key parameters of the model can be identified based on the available data.
Once there is some agreement on plausible sources of identification, these
sources can be incorporated into either an estimation objective function
or a calibration objective function.
In fact, Bayesian estimation and calibration are much closer than many
people think. The steps taken when prior distributions for DSGE model
parameters are elicited are often quite similar to the steps involved in
the calibration. Moreover, both calibration and estimation tend to
condition on the data and are not concerned about repeated sampling. The
main difference is that Bayesians tend to utilize the information in the
likelihood function, whereas in a calibration analysis the information in
the autocovariances of macroeconomic time series is often deliberately
ignored when it comes to the determination of parameters.
Coming back to the question, calibration is particularly attractive in
models that have a complicated structure, e.g. heterogeneous agent
economies, and are costly (in terms of computational time) to solve
repeatedly for different parameter values. However, it is important to
clearly communicate how the data are used to determine the model
parameters and to what extent the model is consistent or at odds with
salient features of the data.
ED: DSGE models and calibration were a response to the Lucas Critique.
Isn't the estimation of inherently abstract models a step backwards in
this respect?
FS: Not at all. Let me modify your statement as follows: DSGE models
were a response to the Lucas Critique and, at the early stage of
development, calibration was a way of parameterizing DSGE models in view
of their stylized structure.
The Lucas Critique was concerned with the lack of policy-invariance of
estimated decision rules, e.g. consumption equations, investment
equations, or labor supply equations. In turn, macroeconomists specified
their models in terms of agents' "preferences and technologies" and
derived the decision rules as solutions to intertemporal optimization
problems, imposing a dynamic equilibrium concept. Counterfactual policy
analyses could then be conducted by re-solving for the equilibrium under
alternative policy regimes and comparing the outcomes.
Arguably, the more stylized the DSGE model, the less convincing the
claim that the preference and technology parameters are indeed
policy-invariant, which undermines the credibility of the counterfactual
policy analysis. In Schorfheide, Chang and Kim (forthcoming) we provide
some simulation evidence that the aggregate labor supply elasticity and
the aggregate level of total factor productivity in a representative agent
model is sensitive to changes in the tax rate if the representative agent
model is an approximation of a heterogeneous agent economy. In turn,
policy predictions with the representative agent model tend to be
inaccurate.
ED: Forecasting has traditional been limited to purely statistical models.
You have started evaluating the forecasting performance of estimated DSGE
models. Can the limitations from theory still allow them to compete with
models fitted for forecasting?
FS: Marco Del Negro and I recently wrote a chapter for a forthcoming
second volume of the Elsevier Handbook of Economic Forecasting and we used
the following analogy: while a successful decathlete may not be the
fastest runner or the best hammer thrower, he certainly is a well-rounded
athlete. In this analogy the DSGE model is supposed to be the decathlete
that competes in various disciplines such as forecasting, policy analysis,
story telling, etc., and it has to compete on the one hand with purely
statistical forecast models that are optimized to predict a particular
series, e.g. inflation, and on the other hand with less quantitative and
more specialized applied theory models that highlight, say, particular
frictions in financial intermediation or in the housing market.
Our general reading of the literature and the finding in our own work
is that (i) DSGE models, in particular models that have been tailored to
fit the data well -- such as the Smets and Wouters (2007) model, are
competitive with statistical models in terms of forecast accuracy. But
when push comes to shove elaborate statistical models can certainly beat
DSGE models. (ii) The use of real-time information, e.g. treating nowcasts
of professional forecasters as current quarter observations, can
drastically improve short-run forecasting performance. (iii) Anchoring
long-run inflation dynamics in the DSGE model with observations on 10-year
inflation expectations improves inflation forecasts. (iv) Relaxing the
DSGE model restrictions a little bit by using the DSGE model to generate a
prior for the coefficients for a VAR also helps to boost forecast
performance.
ED: Recent economic history gives good reasons to believe non-linear
phenomena may be at play at business cycle frequencies. How should we
study this?
FS: Nonlinearities tend to be compelling ex post but are often elusive
ex ante. In the time series literature there exists an alphabet soup of
reduced-form nonlinear models. Many of these models have been developed to
explain certain historical time series pattern ex post, but most of them
do not perform better than linear models in a predictive sense (though
there are some success stories).
When I looked at real-time forecasts from linearized DSGE models and
vector autoregressions during the 2007-09 recession I was surprised how
well these models did -- in the following sense: of course they did not
predict the large drop in output in the second half of 2008, but neither
did, say, professional forecasters. However, in early 2009, the models
were back on track. So, for a nonlinear model to beat these models in a
predictive sense, it would have had to predict the 2008:Q4 downturn, say,
in July.
Of course, the ex-post story of a linear model for the recent
recession is that it was caused by large shocks with a magnitude of
multiple standard deviations. This may not be particularly compelling --
since the narrative for the financial crisis involves problems in the
Mortgage market that lead to a severe disruption of financial
intermediation and economic activity. A model that captures this mechanism
has to be inherently nonlinear and the development of models with
financial frictions is an important area of current research.
Our standard stochastic growth model as well as the typical New
Keynesian DSGE model are actually fairly linear (at least for
parameterizations that can replicate post-war U.S. business cycle
fluctuations). However, researchers have been adding mechanisms to these
models that can generate nonlinear dynamics, including stochastic
volatility, learning mechanisms, borrowing constraints, non-convex
adjustment costs, a zero-lower-bound on nominal interest rates, to name a
few. This is certainly an important direction for future research.
Aruoba, Bocola and Schorfheide (2012) started to work on the
development of a class of nonlinear time series models that can be used to
evaluate DSGE models with nonlinearities -- in the same way that we have
used VARs to evaluate linearized DSGE models. With a simple univariate
version of this nonlinear time series model one can pick up some
interesting empirical features, e.g. asymmetries across recessions and
expansions in GDP growth and zero-lower-bound dynamics of interest rates.
We are currently working on multivariate extensions.
ED: We tend to focus on deviations from a trend or steady state. But in
many ways trends matter more. Is there any work on estimating trends in
DSGE models, and if not, should there be?
FS: Most estimated DSGE model nowadays have the trend incorporated
into the model. For instance, in a stochastic growth model, a trend in the
endogenous variables can be generated by assuming that the technology
process has a deterministic trend or a stochastic trend (e.g., random walk
with drift). The advantage of this method is that one does not have to
detrend the macroeconomic time series prior to fitting the DSGE model. The
disadvantage is that the DSGE model imposes very strong co-trending
restrictions that are to some extent violated in the data.
For instance, the basic stochastic growth model implies that output,
consumption, investment, and real wages have a common trend, whereas hours
worked is stationary. However, in the data the "great ratios," e.g.
consumption-output or investment-output are not exactly stationary.
Moreover, hours worked are often very persistent and exhibit
unit-root-type dynamics. As a result, some of the estimated shock
processes tend to be overly persistent because they have to absorb the
trend misspecification. This might distort the subsequent analysis with
the model.
In general, this is an important topic but there is no single solution
that is completely satisfactory. Neither the old method of detrending each
series individually and then modeling deviations from trends with a model
that has clear implications about long-run equilibrium relationships, nor
the newer method of forcing misspecified trends on the data are entirely
satisfactory. More careful research on this topic would be very useful.
In my own (co-authored) work (Del Negro and Schorfheide forthcoming,
and Aruoba and Schorfheide 2011), one of the more successful attempts to
dealing with trends -- not in real series, but in nominal series -- was to
include time-varying target inflation rates into the model and to "anchor"
the inflation target by observations on long-run inflation expectations.
This really helps the fit and the forecast performance and has the
appealing implication that low-frequency movements in inflation and
interest rates are generated by changes in monetary policy.
ED: Is theory still ahead of measurement?
FS: The phrase "theory ahead of measurement" is connected to
Prescott's (1986) conjecture that (some of) the discrepancy between
macroeconomic theories and data could very well disappear "if the economic
variables were measured more in conformity with theory." The phrase
becomes problematic if it is used as an excuse not to subject
macroeconomic models to a careful empirical evaluation.
In general we are facing the problem that in order to keep or models
tractable we have to abstract from certain real phenomena. Take for
instance seasonality. We could either build models that can generate
fluctuations at seasonal frequencies or we could remove these fluctuations
from the data. Most people would probably agree that matching a model that
is not designed to generate seasonal fluctuations to seasonally-unadjusted
data is not a good idea. The profession has converged to an equilibrium in
which seasonality is removed from the data and not incorporated into DSGE
models.
However, in other dimensions there is more of a disagreement among
economists: what are the right measures of price inflation, wage
inflation, hours worked, and interest rate spreads that should be used in
conjunction with aggregate DSGE models? In general, a careful measurement
of key economic concepts is very important, but that does not mean that
theory is ahead of measurement.
I do agree with the following statement in Prescott's (1986)
conclusion: "Even with better measurement, there will likely be
significant deviations from theory which can direct subsequent theoretical
research. This feedback between theory and measurement is the way mature,
quantitative sciences advance."
Selected references to the papers mentioned are available in
the web version of this newsletter at
http://www.EconomicDynamics.org/newsletter.htm
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Book Review: Nosal and Rocheteau's "Money, Payments, and Liquidity"
Money, Payments, and Liquidity
by Ed Nosal and Guillaume Rocheteau
Monetary theory has made rapid progress with a new field opening up within
the past decade, money search. These new developments are somewhat
difficult to follow for the outsider as there is no work that would
summarize what it is about and what the main results are, except for a
very recent handbook chapter by Steve Williamson and Randall Wright.
Ed Nosal and Guillaume Rocheteau fill this void with a book that tries to
take the most modern approach to monetary theory. This is a book that is
also meant to be a textbook for graduate classes. It uses as a starting
point the Lagos-Wright model with alternating market structure. Each
subsequent chapter builds on it to study the impact of credit, credit
frictions, pricing mechanisms, and the properties of money. The books then
expands on monetary policy, the coexistence of money and credit, and
ultimately also other assets and how trading frictions impact asset
markets, prices and liquidity.
The strength of the book is the unified framework. The same basic model is
used to touch many issues, which also demonstrates the versatility of the
approach. This comes at the cost of alternative approaches, which may be
better suited for some questions, and which may prevail in this afterall
very young literature. The pedagogy, however, dominates and delivers a
very readable introduction into money search.
Money, Payments, and Liquidity is published by MIT Press.
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Impressum
The EconomicDynamics Newsletter is a free supplement to the Review of
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responsible editors are Christian Zimmermann (RED associate editor),
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The EconomicDynamics Newsletter is published twice a year in April and
November.
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