Paul Romer on the identification crisis

LK Beland directed me to a paper by Paul Romer, which I’ve only had time to skim.  But the abstract is great:

For more than three decades, macroeconomics has gone backwards. The treatment of identification now is no more credible than in the early 1970s but escapes challenge because it is so much more opaque. Macroeconomic theorists dismiss mere facts by feigning an obtuse ignorance about such simple assertions as “tight monetary policy can cause a recession.” Their models attribute fluctuations in aggregate variables to imaginary causal forces that are not influenced by the action that any person takes. A parallel with string theory from physics hints at a general failure mode of science that is triggered when respect for highly regarded leaders evolves into a deference to authority that displaces objective fact from its position as the ultimate determinant of scientific truth.

He focuses on RBC theory, but the problems go far deeper.  New Keynesian models also fail at identification.  Nick Rowe has an excellent recent post on this problem:

Suppose we model monetary policy as M(t) = bX(t) + e(t), where M is the money supply, X is some vector of macroeconomic variables, and e is some random shock. Or, if you prefer, as i(t) = bX(t) + e(t), where i is a nominal interest rate. We estimate (somehow) that monetary policy reaction function, and call our estimate of e(t) the “monetary shock”.

Let us suppose, heroically, that our estimate of the monetary policy reaction function is correct. The econometrician, by sheer luck, gets it exactly right. Whatever that means. And then we use that estimate of monetary shocks to see what percentage of macroeconomic fluctuations (somehow defined) was caused by those “monetary shocks”, and what percentage was caused by other shocks. And suppose, again heroically, we get it right.

This is nonsense. We are making exactly the same mistake that the people were making in my Gold Standard examples above. If the central bank had been following the monetary policy reaction function exactly (or if the econometrician had a complete data set and correct model of the central bank’s behaviour so the estimated reaction function fitted exactly) then by definition there would have been no “monetary shocks”. And so “monetary shocks” would explain 0% of anything, because there weren’t any. 100% of macroeconomic fluctuations were caused by other, non-monetary shocks. Any deterministic monetary policy will have zero “monetary shocks”, by that definition, and any organisation’s behaviour is deterministic, if we understand it fully enough. That is not a useful definition of “monetary shocks”.

Monetary shocks are not the e(t). Monetary shocks mean the central bank chose the wrong monetary policy reaction function. It’s the choice of parameter b, and the choice of which variables belong in the vector X.

People get sick of me always talking about “the stance of monetary policy”.  But the misidentification of easy and tight money is THE central problem in macroeconomics.  Everything else is a footnote.

On a related topic, check out my new post at Econlog—I’m interested in feedback on my graph.



12 Responses to “Paul Romer on the identification crisis”

  1. Gravatar of Jason Smith Jason Smith
    18. September 2016 at 16:26

    Don’t leave off the piece where expectations make the identification problem worse!

    “4.3 Adding Expectations Makes the Identification Problem Twice
    as Bad”

    “So allowing for the possibility that expectations influence behavior makes the identification problem at least twice as bad. This may be part of what Sims (1980) had in mind when he wrote, ‘It is my view, however, that rational expectations is more deeply subversive of identification than has yet been recognized.'”

  2. Gravatar of ssumner ssumner
    18. September 2016 at 18:03

    Jason, It’s certainly subversive for simplistic sorts of identification, such as interest rates and the monetary base.

  3. Gravatar of Chuck Biscuits Chuck Biscuits
    18. September 2016 at 18:09

    Remember those old milk cartons that had pictures of missing children on them? Watching Nick Rowe and Scott Sumner discuss econometrics reminds me of that.

  4. Gravatar of E. Harding E. Harding
    18. September 2016 at 18:56

    The graph is good, but I wonder why in the world did it require printed labels and was drawn with pen? These things are easier to do with Paint or Excel. Are you using it for a class? Lorenzo is right that the concentric circles around the “Target (4%)” look a little weird and inexplicable without labels. As usual with these things, I would have loved it if you’d have used the actual NGDP growth and base/NGDP ratios of the various countries (presumably in Excel), so that everybody can see whether your hypothesis works for themselves.

    Interesting hypothesis. Switzerland should try it out.

  5. Gravatar of Ray Lopez Ray Lopez
    18. September 2016 at 22:35

    (Romer) “Macroeconomic theorists dismiss mere facts by feigning an obtuse ignorance about such simple assertions as “tight monetary policy can cause a recession.” –

    But this is absurd. If money is largely neutral, which that evidence shows it is (Bernanke, 2002, FAVAR paper), then this ‘simple assertion’ is just plain wrong. It’s like the Ptolemaic astronomers complaining after Copernicus that nobody talks about epicycles anymore…

  6. Gravatar of Postkey Postkey
    19. September 2016 at 00:25


    “Instead of high powered money, preferred by the monetarists, a more useful operating target would be the net quantity of credit creation, measured by the sum of all central bank transactions including those outside the money market operations.”

    Werner, Richard (2005), New Paradigm in Macroeconomics, Basingstoke: Palgrave Macmillan” P263.

    Evidence for the effectiveness of net quantity of credit creation is provided in New Paradigm in Macroeconomics.

  7. Gravatar of dtoh dtoh
    19. September 2016 at 02:17


    As I commented in an earlier post…

    “When he [Bernanke] retired I [Scott] did a post suggesting that he was better than average. Look at the ECB and BOJ, for example.”

    Scott, in this case, the difference between average and better than average is the difference between being an utter failure and a complete failure. Come on. Maybe there is a legitimate debate about targets, but when you completely and consistently miss your target, it’s just pure incompetence. Bernanke was a disaster as Fed Chair.

  8. Gravatar of Art Deco Art Deco
    19. September 2016 at 05:18

    Bernanke was a disaster as Fed Chair.

    No. The characters running the Fed during the period running from 1928 to 1932 and in 1937 and 1938 were disasters. Arthur Burns and William Miller were bad performers. No one else merits that kind of assessment.

  9. Gravatar of ssumner ssumner
    19. September 2016 at 06:17

    E. Harding, I don’t know how to draw graphs using a computer.

    There are about 10,000 studies of money demand, if you want double check my claim.

    dtoh, You are confusing Bernanke with the Fed. Bernanke’s performance was better than the Fed’s performance.

  10. Gravatar of dtoh dtoh
    19. September 2016 at 10:52

    Are you serious. How can you describe Bernanke’s performance as anything other than a complete failure?

  11. Gravatar of Ray Lopez Ray Lopez
    19. September 2016 at 12:08

    @Postkey- thanks, but “net credit creation” appears to be nothing more than endogenous ex post money creation, meaning, when customers demand more money from banks or shadow banks, these financial intermediaries respond. That proves my point, not Sumner’s. Sumner is claiming the Fed creates demand, ex ante, exogenously, meaning ‘build it and they will come’ (or, inject base money and they, the banks, will lend). We all know how badly this theory has worked out for poor old Sumner, but he clings to his old time religion.

  12. Gravatar of dtoh dtoh
    20. September 2016 at 07:38

    It’s yin and yang.

Leave a Reply