ECB research provides a withering critique of mainstream macroeconomics

Although this blog post considers some very technical material its message is simple. Mainstream macroeconomic models that are used to determine policy choices by governments are deeply flawed and the evidence strongly supports a central thrust of Modern Monetary Theory (MMT) – that fiscal policy is powerful and that austerity will kill growth. In that sense, it helps us understand why various nations and blocs (such as the Eurozone) struggled after the onset of the GFC. It also explains why the deliberate attack on Greek prosperity by the Troika was so successful in demolishing any prospect of growth – an outcome that the official dogma resolutely denied as they constructed one vicious bailout after another. It also explains why New Keynesian approaches to macroeconomics are flawed and should be ignored. I was reminded this week by a research paper I had read last year (thanks Adam for the reminder) which presents a devastating critique (though muted in central bank speak) of the mainstream approach to macroeconomic modelling. A research paper from the ECB (May 2017, No 2058) – On the sources of business cycles: implications for DSGE models – provides a categorical critique of DSGE models and a range of other stunts that mainstream economists have tried to introduce to get away from the obvious – economic cycles are demand driven.

The paper is highly technical and I will avoid discussing those aspects, even though they are very interesting in their own right.

The mainstream macroeconomics profession relies heavily on so-called Dynamic Stochastic General Equilibrium (DSGE) models.

Central banks and other forecasting agencies deploy to make statements about the effectiveness of fiscal and monetary policy.

I considered this type of model in several blog posts, including:

1. Mainstream macroeconomic fads – just a waste of time (September 18, 2009).

2. The myth of rational expectations (July 21, 2010).

3. Fiscal austerity damages real growth and prolongs the financial downturn (June 21, 2012).

4. Mainstream macroeconomics in a state of ‘intellectual regress’ (January 3, 2017).

5. Austerity is the problem for Britain not Brexit (January 9, 2017).

This is not meagre academic to-and-fro. The use of these models is prominent in current debates about Brexit.

For example, the National Institute of Economic and Social Research (NIESR) in the UK, which has been pumping out ridiculous forecasts of doom should Britain leave the EU uses as a core approach to its modelling a New Keynesian style, Dynamic Stochastic General Equilibrium (DSGE) model.

Its main model NIGEM has in their own words “has many of the characteristics of a … DSGE model” including the use of rational expectations, which means their long-run solution is supply-determined.

But you need to understand the ‘supply-determined’ bit means that there is a dichotomy between the real and nominal worlds or in simpler language – money doesn’t matter in a long-run general equilibrium.

That is standard nonsense and the ECB paper provides withering evidence to support my assessment.

This is one of the reasons the early forecasts of the impacts of Brexit have proven to be so wrong, a topic we considered in our recent Jacobin article (April 29, 2018) – Why the Left Should Embrace Brexit.

On March 9, 2009, the hardly radical economist Willem Buiter wrote in a Financial Times article (now deleted but available here) – The unfortunate uselessness of most ‘state of the art’ academic monetary economics – that:

Most mainstream macroeconomic theoretical innovations since the 1970s (the New Classical rational expectations revolution … and the New Keynesian theorizing) … have turned out to be self-referential, inward-looking distractions at best. Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes rather than by a powerful desire to understand how the economy works – let alone how the economy works during times of stress and financial instability. So the economics profession was caught unprepared when the crisis struck … the Dynamic Stochastic General Equilibrium approach which for a while was the staple of central banks’ internal modelling … excludes everything relevant to the pursuit of financial stability.

The ECB paper provides powerful support to that conclusion.

The question and conclusions

The ECB seek to:

… investigate sources of economic fluctuations … We consider real GDP, real consumption, real investment, real exports, real imports, the unemployment rate, and core inflation

They consider the US and other advanced countries.

The importance of this enquiry is that the mainstream models of the business cycle emphasise supply-side motivations and claim that demand shocks are temporary at best.

This is crucial because if that was true then the claim that fiscal policy cannot permanently alter the course of an economy would be valid.

The ECB paper though refutes the mainstream belief.

Their overall conclusions:

1. They find “great regularities in business cycle co-movements of key macroeconomic variables across multiple economies”.

They find “one dominant source of real co-movements … business cycle dynamics of key macroeconomic data can be largely, .. explained by a single source of variation”.
Which is?

2. The one dominance source of co-movement is a “demand factor” – that is, variations in aggregate demand (spending).

3. “any structural economic or econometric model of business cycles must be able to generate the principal component structure that we present” – that is the dominance of aggregate demand.

“We argue that the recent vintage of structural economic models fails this test-these models cannot explain business cycle dynamics.”

The authors find that:

… most prominent DSGE models today are not compatible with our empirical findings on the number of factors and the nature of co-movement in the macroeconomic data.

There it is!


The ECB authors deploy Dynamic principal component analysis, which is a relatively recent derivative of – Principal component analysis – (PCA). PCA was introduced as a statistical technique by Karl Pearson in 1901.

The statistical procedure manipulates data in such a way that principle component are generated which are ordered by the extent to which they account for the variability in the data (largest possible variance down). Once the first component is selected, the next component has the large variance subject to the constraint that it is “orthogonal” (totally uncorrelated) with the first component.

And so all the variance in the data is eventually accounted for by the set of orthogonal components.

PCA is limited by the assumption that the data set is time independent (that is, it is unsuitable for time series data where relationships are intrinsically correlated across time – so-called “serial correlation”).

Dynamic principal component analysis extends PCA to account for these lag structures within time series data. It adds lags to the data and then extracts the principle components once a specific lag structure is determined.

There are all sorts of options and techniques available to statisticians to determine these things and they are too complicated for me to deal with in this setting.

The point being that the technique is now well established, having been introduced in the early 1980s, and is an interesting way to examine dynamics in economic processes such as income and inflation generation.


The implications of the results can be summarised fairly simply.

The results point to only “a single dominant dynamic principal component” – aggregate demand.

The authors conclude that any model:

… for instance a DSGE model-that does not feature a structural shock that dominates the cyclical frequencies of consumption, investment, output, hours worked, and inflation is very likely to be misspecified.

They also say that “most DSGE models in the literature would struggle to explain the principal-component space of the data in a satisfactory manner”.

The authors find that:

… it simply does not happen that investment plummets while private consumption remains resilient or rallies during a recession. Again, it does not happen that the unemployment rate drops when output slumps. It just does not happen, except in many DSGE models.

This has implications for the ‘fiscal contraction expansion’ or the ‘growth friendly austerity’ that the IMF and other bodies were pushing during the GFC as they coerced governments to cut their deficits using fiscal austerity but claimed that the public spending cuts would spawn new private sector growth.

It was never going to happen because that is not the way economies work.

The ECB research confirms the remarkable stability of the co-movements between the aggregate variables.

If investment falls, or for that matter public spending falls, private consumption falls. Why?

Because the declining investment (or spending in general) creates an output gap and firms lay off workers. National income drops and household consumption and saving falls.

Standard observations that Marx, Keynes, Kalecki etc all understood intrinsically. And, a core component of what we now call MMT.

In simple terms, their results means that most of the macroeconomic models that are used by policy agencies, New Keynesian researchers etc ignore the dominance of aggregate demand in explaining growth and inflation dynamics and will therefore perform poorly and generate misleading policy inferences.

This “misspecification will cause remaining structural shocks or measurement errors to be correlated”, which means the models fail to say anything about what is going on in the real world.

The authors suggest that some of the mainstream models are more obviously flawed than others.

For example, they point to the Real Business Cycle theory literature (the so-called ‘new classical macroeconomics’) which emerged in the early to mid-1970s (mainly out of University of Chicago and Minnesota) to counter the Keynesian orthodoxy.

RBC theory thinks that economic cycles – boom and bust are driven by ‘productivity shocks’ (supply-side shocks), so that when new technologies arrive, raw material prices change, or new production methods are introduced – booms and busts occur depending on whether the shock is good or bad.

Adjusting aggregate demand has no impact – the so-called ‘policy ineffectiveness’ postulate that allows RBC theorists to eschew government attempts to manipulate the economy in any systematic way using fiscal policy.

So it challenged the keystone of Keynesian thinking.

The ECB authors show that in one recent RBC case (a 2010 paper they cite), the ‘supply shock’ “cannot explain more than 10% of the consumption dynamics”, which is due to them ignoring the key demand component.

Similar flaws can be found in most of the major mainstream approaches to explaining business cycle dynamics.

The ECB authors consider that “any structural economic model must at least be able to generate the principal component structure of the data it is supposed to represent”, which is why the mainstream macroeconomic models fail.

They argue that many mainstream models capture, say, the dynamics of perhaps one or two of the aggregate variables, but fail badly to capture the dynamics of other variables.

In other words, they have been unable to fully embrace what is going on in the economy in general.

The other important result is that:

… the analysis of both real variables and inflation reveals their tight co-movement – often doubted in the literature …

Thus real output and inflation move together as a result of demand dynamics.

In technical terms, this means that the vast majority of macroeconomic models (such as NIGEM, above) which exploit what is known as the ‘classical dichotomy’ – that money is neutral in the long-run, which is determined purely by supply-side forces – are misspecified and fail to appreciate these robust co-movements between real and monetary aggregates.

Which means that when a New Keynesian starts waxing lyrical about the ineffectiveness of fiscal policy in determining long run trajectories for the economy, you should turn the volume down or turn the page.


The authors are clear:

1. “We reach a conclusion that the business cycle dynamics of key macroeconomic data can be largely explained by a single source of variation. Since this dominant unobserved principal component behind the business cycle explains the positive co-movement of the output cycle and inflation, we label the principal component as a ‘demand factor.'”

2. The demand factor – the “dominant component” – captures the “positive co-movement of output and inflation”.

This is a very important finding and supports the core structure of Modern Monetary Theory (MMT) and its emphasis on the primacy of fiscal policy.

That is enough for today!

(c) Copyright 2018 William Mitchell. All Rights Reserved.

This Post Has 24 Comments

  1. “Which means that when a New Keynesian starts waxing lyrical…” You are very generous to attribute a musical talent to these guys. Although I guess everyone has something they are better at than other things…relatively speaking

  2. I notice that although the paper you cite comes with an ECB imprimatur, none of the authors works for the ECB. So we shouldn’t get our hopes up about the findings seeping into the collective understanding of that fine institution.

  3. dnm,
    that is a facsinating obseration. The truth gets partially told (once) in such a way that no one who works for the ECB has to get his/her fingers dirty and harm their carreer prospekts.

  4. “The funny thing is: they haven’t. In fact, among the more than 10,000 research articles produced by the major central banks in the two decades prior to the 2008 crisis, none explored the correlation or causation between nominal interest rates and nominal GDP growth. Fortunately, this task is not very demanding, and once we conduct such an examination, we conclude that, in actual fact, there is no evidence to back these assertions whatsoever. To the contrary, empirical evidence shows that the central banking narrative on interest rates is diametrically opposed to the observable facts in two dimensions: instead of the proclaimed negative correlation, interest rates and economic growth are positively correlated. Secondly, the timing shows that interest rates do not move ahead of growth, but instead are either coincidental or even follow it.”

    [Bill notes: quote is from Richard Werner]

  5. Another critic of mainstream macroeconomics is Lars P Syll. He has blog posts on this very topic, how useless and empirically irrelevant it is.

    The doom prediction is indeed irritating. And with no evidence being produced. However, they could provide prediction of severe disruption without having to provide any economic evidence. They would only need to take note of the incredible incompetence of the way in which Brexit is being managed, or mismanaged I should say, by the various players in this drama. Ministers and their staff do not seem to read the relevant documents — they certainly give every indication of not understanding some of the relevant treaties and other documents that have been produced. What kind of indication is this? What they say about documents they are commenting on do not gibe with what the given documents actually say. They also put forward solutions to problems that could not be implemented in the given time frame, and possibly never. Unless this is deliberate, though other hypotheses are available, there is no other reason in reality for such seeming incompetence. Brexit will be disruptive, but need not be ridiculously so. The most recent sighting of Davis has been at the Hay festival at Margaret Atwood’s talk on the TV adaptation of her novel, The Handmaid’s Tale.

  6. Werner’s paper is “Shifting from Central Planning to a Decentralised Economy: Do We need Central Banks?”.

  7. Thanks to Bill’s superlative, clinical, demolition of the basis of pretty-well the entirety of offialdom’s economic forecasting deriving from models which are faulty to the point of being crackpot (about on a level with astrology, or reading the tea-leaves), any reader of his blog is enabled to see clearly what lies at the root of the mess we are all in.

    How sad to reflect that the likelihood of such an unerring (and readily-understandable by any unbiased layperson) diagnosis having the slightest influence on the people and institutions which are in actual control of our lives is scarcely greater than zero despite its being freely available and tirelessly deployed, by others as well as by Bill himself. When I read that not only are DSGE models worse than useless for forecasting anything – something I had already impressionistically gathered to be the case – but in this article precisely *why* they are, and then reflect that the (erroneously so-called) “Nobel laureate” Paul Krugman continues to hold sway as some sort of guru whilst loudly proclaiming his undying faith in (guess what) DSGE models, I despair.

    How are we ever to be rescued from this surreal nightmare?

  8. It’s always sadly comical to watch rookies bring an economic argument to a raw power fight. “Orthodox” economics IS the academic kowtow to aristocratic or pure power politics.

  9. I’m no expert but even to a me this reads like groundbreaking stuff for the ECB and the mainstream macro community at large. Even if they’re very late at the party.

  10. Marriner Eccles et al, and to some extent FDR, summed up this whole discussion in a pragmatic way back ~1930 (as did Ben Franklin et al back in 1776). Then the latest backlash began, from diverse streams of blind, institutional momentum. We haven’t had a intelligent discussion of our bigger options since then, just squabbling over the meager spoils that pile up.

    You can tell how limited an intellect is by how distracted they are with the first golden egg the Scalable Goose lays.

    The deadly fault of “capitalism” (or any ideology) is that practitioners can never redefine Aggregate Missions fast enough to leverage accruing teamwork? How ironic is that?

    No wonder we misuse both our military and our wealth.

    The more excessively we tally, the more it hampers the quality (including tempo) of reinvestment. What’s the lesson about consolidating conquest? Don’t stop to despoil the vanquished? Use ’em as extended foundation instead?

    Political Economy features the same fog as War, just a slightly different hue & density. 🙂

  11. Roger G. Erickson:- “It’s always sadly comical to watch rookies bring an economic argument to a raw power fight. “Orthodox” economics IS the academic kowtow to aristocratic or pure power politics”.

    Your point being – what exactly? Would you care to elucidate?

  12. It is very disturbing to know that the downright evil consequences of mainstream economic theories has no consequences for the perpetrators. They have no legal liability at all, yet they produce policy after policy which is so destructive, so limiting to the welfare of many in the society that jail time should be mandatory.

    George Monbiot today takes to task the limited liability sham that allows company directors to keep their largesse while at the same time investors take a bath. No jail time there either.

    What a dysfunctional society we live in!

  13. To Larry, Roger Erickson,
    Larry: thanks for the source. I find Richard Werner has many very interesting things to say.
    Roger: Mainstream economics, despite its obvious absurdities, is indeed the veneer used to justify the status quo that benefits our elites and their servants. Nonetheless, it is important to understand the alternatives to mainstream, neoliberal/austerity economics. More and more people are being needlessly and cruelly tossed into a human scrap heap. Neoliberalism is breaking down and it has only more neoliberalism to offer. All we need is one major country to adopt MMT and mobilise the full potential of its economy for the whole neoliberal/austerity edifice to collapse worldwide. Will it be Corbyn in the UK? Will it happen in Italy? As an aside, in Canada, the debt/deficit/austerity discourse no longer has any traction (not that we’ve turned to MMT yet).

  14. @Willem

    As I mentioned above, this research doesn’t appear to come from an ECB unit. Two out of three authors work at the IMF, whose research side has a history of (sometimes) producing reality-based analysis. Unfortunately, this work is then promptly ignored by the policy side (as for the ECB…).

  15. @Keith Newman

    From where have you found that debt/deficits are no longer the rage in Canada?

  16. Keith said:
    “All we need is one major country to adopt MMT and mobilise the full potential of its economy for the whole neoliberal/austerity edifice to collapse worldwide.”

    No need to adopt it, we already have it. It’s just a shift in understanding we need.

    As L. Randall Wray said in a recent interview, there is no need to change anything in terms of processes. Just leave them as they are.

  17. RE William says:
    Wednesday, May 30, 2018 at 10:23
    Thanks for the link, great resource

  18. @Robert

    In Canada the spell of what I call the “deficit chicken-hawks” is not entirely broken as familiarity with the major national newspapers and talk radio will confirm. However, the Federal Liberals were elected on a platform promising to run serial deficits and recently declared an intention to continue running them longer than even their election platform claimed.

    Furthermore, the current Provincial election in Ontario (Canada’s largest province) features three major parties (Progressive Conservative, Liberal and New Democratic) ALL of which are running election platforms that feature several years of deficits. Weirdly the narrative has now shifted to slagging one another’s math in costing out their platforms and accusing each other of cooking the books, or accusing each other of making program promises with unrealistic funding assumptions. So the neoliberal notion of fiscal “responsibility” (read restraint) is still very much alive despite the official policy platforms committed to deficits; an “our deficits aren’t as bad as theirs are” version of what my bond-trading brother calls “least dirty shirt.”

    Setting aside for the moment that our provinces are sub-sovereigns and the potential hazards (as I imagine there may be for currency users as opposed to issuers) this may pose, it’s progress of a sort that all the neoliberal posturing is rendered functionally irrelevant by the actual fiscal behaviour of the players.

    My rich Toronto friends are apoplectic, of course. I never miss an opportunity to mock their pearl-clutching indignance and prognostications of doom by pointing out that the long term trend of deficit and debt in Canada has long been one of constant increases. As I’m fond of reminding them, “if the sky is always falling, why doesn’t it ever hit the ground?”

  19. And now Italy has Mr Scissors Cottarelli who wants spending cuts like removing subsidies from public transport to create expansionary fiscal contraction. The austerity narrative lives on in…or maybe not?

  20. “it simply does not happen that investment plummets while private consumption remains resilient or rallies during a recession. Again, it does not happen that the unemployment rate drops when output slumps. It just does not happen, except in many DSGE models.”

    There is no need whatsoever for a statistical procedure to draw these conclusions. Basic logic suffices. That so much “work” is put into “proving” the obvious is a reflection of just how deep the indoctrination is and how manipulable the human brain is. It’s also a sad commentary on humanity, of course, given the effort that has been put into the manipulation.

  21. William, thanks for the link to the podcast with Randall Wray. I thought it was very good.

  22. Roger E nail hit on head.
    With Canada in mind ,we have the government there bending over backwards to facilitate
    oil extraction even if they have to nationalize a pipeline or increase spending .There is
    no ideological restraint on government spending and taxation [think war,bailouts, trump tax cuts]
    neo liberal governments role is to give more to the wealthy and less to the poor that is it.
    Academic careerists are just useful idiots.

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