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The Economic Journal
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The Economic Journal, 105 (November), I622-I636. ) Royal Economic Society I995. Published by Blackwell
Publishers, io8 Cowley Road, Oxford OX4 iJF, UK and 238 Main Street, Cambridge, MA 02I42, USA.
Business cycle empirics have long been a central arena for the debate about the
roles of economic theory and econometrics in modelling economic time-series
data: some famous historical examples are Moore (I9I4), Keynes (I939) and
Koopmans (I947). Sources for potential disagreements include that the entire
economic system is involved, and unobservable stochastic 'forces' seem more
than usually prominent in determining the outcome. Not only do these
constitute two aspects about which it is hard to theorise, they are equally
difficult to model empirically. There are both positive arguments for and
negative arguments against according a dominant role to either 'theory' or
'evidence', not least because it is unclear what constitutes admissible instances
of either in the absence of the other. We first review what precludes a purely
theoretical approach, what prevents a purely empirical approach, and hence
why an interactive approach is imperative. Even so, both the relative
importance of the two ingredients and their substantive contents are likely to
remain, at issue.
system is not easy. Such difficulties adversely afflict both theory and empirical
modelling.
system. A more direct critique of the empirical enterprise is that samples are
short and highly aggregated, economic magnitudes are inaccurately measured,
are subject to considerable revision, and important variables are not measured
or are unobservable, so inferences are both imprecise and tentative. Combined
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how an economic system might function, enhanced by the fact that we are also
agents. This should not be extrapolated to the belief that theory is 'correct'
since in practice, economic theories are seriously incomplete, highly aggregate,
multitude of ceteris paribus assumptions, change over time, and co-exist with
rival explanations. Thus, no firm theoretical basis exists either: that arm-chair
theoretical deduction could be claimed to tell us more about reality than
empirical study is a relic of a failed scholasticism. No matter how good
economic theory may be, it is manifestly inadequate to characterise many
salient aspects of real-world economies. An overemphasis on theory, which at
the extreme involves imposing the theory model on data, leads to the theory
dependence of results, where the very relevance of empirical evidence changes as
theory progresses.
All models - theory or empirical - are not born equal, and economics needs
those which are useful for understanding economic behaviour, for testing
economic theories, for forecasting, and for analysing economic policy. All four
objectives involve discovering sustainable empirical relationships between
This formulation and its related concepts are discussed in Hendry (I995). The
two main concepts used below are congruence and encompassing. The former
denotes that the empirical model matches the available evidence in all
measured attributes (e.g. is consistent with the theory from which it was
ostensibly derived, with unexplained components that are innovations against
available information, and parameters that are constant when assumed so,
etc.). The latter denotes that the model of interest can account for the results
of rival models of the same phenomena (see Mizon and Richard, I986).
Congruent, encompassing models need not be 'true' in any sense.
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The positive arguments for basing empirical research on economic analysis are
powerful. First, the principles of economic theory are nearly independent of the
being no quantitative laws (see Robbins, I932), although the absence of any
evidence may render the concept of 'explanation' empty. Even so, one could
imagine a world where price and quantity were never reliably related, yet
'laws' of supply and demand operated. However, this positive argument for
theory only becomes a negative one for econometrics with the unsubstantiated
claim that useful empirical regularities do not exist.
Thirdly, economic analysis has a perceived general success in explaining
economic behaviour, from why the postman delivers our mail, through why
health care is hard to deliver effectively, to why the 'Oil crisis' would not end
economic growth. However, some issues have not yielded, one of the most
salient being high levels of unemployment in OECD countries. Moreover, the
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partly on the quality of, and pre-eminence accorded to, theory: both orderings
occur in practice. Since new contributions can affect all existing knowledge in
an empirical science, neither can claim logical precedence. Substantive
as prompts for discovery, but the only available theory will almost never be
even degeneration, can result. In any case, the rejection of an empirical model
does not entail rejecting the theory from which it was derived, nor does
corroborating the model entail the validity of the theory (Section V considers
testing rival theories in econometrics).
worked. This did not stop aspirin from working (the initial use of aspirin acetylsalicylic acid - arose as a folklore remedy for hangovers, based on
brewing willow-tree bark, of which it is a natural constituent: see Weissmann,
I99I). Sufficiency falls on the example of a theory that is violently false, such
as that a huge dose of arsenic will cure a cold with no side effects.
Tinbergen, I940; and Koopmans, I947, versus Vining, I949). The outcomes
? Royal Economic Society I995
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III. STRUCTURE
Structure has many meanings in econometrics (see, inter alia, the different
notions in Frisch (I 934), Haavelmo (I 944), Wold and Jureen (I 953), Bardsen
and Fisher (I 993), and Juselius (I 993), as well as connoting 'being derived
from inter-temporal optimisation by economic agents'). Here, we define
structure as the set of invariant features of the economic mechanism. This
therefore no more or less valid than the initial theory; sample dependence is the
opposite extreme that the results are subject to important sampling vagaries.
A. Theory-driven Approaches
The RBC approach starts with a theoretical model and estimates (or
calibrates) its parameters; deliberately little testing is done on any one
occasion, and little is learnt from the data. Between occasions, however, the
theory is revised in the light of manifest failures, then reapplied to (essentially)
the same data, inducing a sophisticated data-mining problem. Such 'theory-
driven' approaches, where a model is derived from a priori theory and calibrated
from data evidence, suffer from theory dependence. Their credibility depends
on the credibility of the theory from which they arose, and when that theory
C Royal Economic Society I995
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is discarded, so is the associated evidence (see Kydland and Prescott, I 99 I). Since
economic theory is progressing rapidly, theory dependence is likely to induce
transient and non-structural evidence.
If an empirical implementation is discarded when it is inconsistent with the
theory, the theory loses credibility, whereas if the implementation is not
may not lack credibility. But postulating an endless sequence of theories that
get rejected in turn fails to incorporate learning from the evidence. My
proposed solution is to conduct research in a progressive framework of
isolation (e.g. an output growth rate of 2-5%, a savings rate of io%, a real
interest rate of 400, and an unemployment rate of 80%), yet jointly can be
inconsistent with the evidence in that there is a negligible probability of
observing the vector of claimed stylised facts, given the joint distribution of the
original data. There seem no good reasons for eschewing internally consistent
Watson (I 993) .
By ignoring the possibility that the claimed 'parameters' of RBC models
may reveal predictive failure. Restrictions are sometimes imposed to offset this
problem. These could be data-based as in Box and Jenkins (I976) modelling
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I628
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prejudiced search for corroborative evidence (see Leamer, I978), and may
even be believed to vitiate any substantive role for empirical evidence in
mining, whereby corroboration is sought for a prior belief, from strong data
mining, in which conflicting evidence is either camouflaged or not reported. A
model-search process which deliberately camouflages conflicting results is
unscientific, but is open to adversarial scrutiny by seeing how well the resulting
model accounts for the findings of rival studies. Thus, the resolution of potential
data-mining criticisms is to explain the Gestalt of empirical evidence: strong
data mining fails when there is already conflicting evidence; weak data mining
fails when other models cannot be emcompassed.
C. Data Modelling Using Economic Theory Guidelines
A further approach attempts to merge inference from data with guidelines from
economic theory, emphasising empirical models as reductions which can be
designed to be congruent. Cointegration analysis, seeking to establish robust
Simplification procedures are often used in data modelling, and these could
attenuate or exacerbate sample dependence: the former by eliminating
irrelevant factors, the latter if the influences of accidental aspects are captured
more 'significantly'. This last difficulty may be offset by reference to a theory
model, but is a transient problem since an extended data sample will reveal the
accidental nature of the earlier effects by their becoming less significant.
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level of the complete testing process is controlled and declines as the sample
grows.
Rejecting a null hypothesis against a specific hypothesis provides no
information about an appropriate alternative model. This is a minor variant of
the Duhem-Quine thesis (see Cross, I982), which also reveals that rejecting an
empirical model does not entail rejecting the theory from which it was derived,
nor does accepting .the model entail the validity of the theory: mutually
incompatible congruent empirical models can be designed to match in-
fads. There are obvious dangers in trying to learn more from a relatively short,
autocorrelated, non-homogeneous, non-stationary, imprecise and inaccurate
data sample than it can reasonably yield. The problem of sample dependence
of findings is especially acute in practice because all aspects of an empirical
model may be designed to satisfy pre-assigned criteria, even parameter
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The logic of our analysis is perhaps best seen by applying it to five aspects
of econometric modelling. Each of these either offers what I deem to be
achievable conditions for structure to be determined, or highlights the
drawbacks of approaches that seem unlikely to achieve structural knowledge.
empirical analysis yields oc*p*' instead of o4p', let the first vector be *' xt_ =
ft1 Xl + P2 xt-1. This has two consequences. First, by using PI* xt-, rather than
pj xt_, the unwanted I(o) combination Pjxt_ makes the resulting equation
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resulting characterisation of the long run matches that of the DGP and is
constant over prolonged periods of time. Then , would constitute structural
expansions of the information set. This follows because I'xt is I(o), so once J is
identifiable then that is not affected by the presence of additional variables,
whether these are I(o) or I(i) (cointegrated or not).
In a linear system, , is an invariant, and cointegration could be defined by
The adjustment coefficients are altered to Qx, whereas J'xt remain the
cointegrating vectors. This result extends to 1(2) processes, and to conditional
models of yt given zt when xt = (Yt: zt) (the transformation E12 21 only affects
a). As Ericsson et al. (I994) show, P is also invariant to seasonal adjustment
filters like XI I. We conclude that identified P represent one aspect of structure
that may be determinable without omniscience.
B. Orthogonal Parameters
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i632
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Perhaps the greatest worry from using 'inconsistent' estimators is that they
deliver different parameters in the empirical model from those which would
have been obtained by more appropriate methods. Consequently, structure
could be lost despite a clever prior analysis. For example, as Campos et al.
(I996) show, if the two-step method in Engle and Granger (I987) is used when
the imposed common factor restrictions are invalid (see Kremers et al., I992),
analysis, and what exists is rather critical (see Canova et al., I992, Kim and
Pagan, I993, and Hoover, I995), one must be concerned that implementations
of the resulting models could be non-structural even when the theory happened
to capture some structural aspects of reality. Worse still, present intertemporal
optimisation theory seems ineffective without arbitrary assumptions about
stochastic forcing functions (such as technical progress) which do not themselves
have a theory basis as yet.
D. Residual Analysis
involved (namely, feedback and feedforward models: see Hendry, I 988). When
no member of one class can encompass a congruent representative of the other,
? Royal Economic Society I995
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then that class is in grave doubt. If agents form expectations about zt when
planning Yt, then behavioural parameters +1 will depend on the expectations
parameters +2 of the zt process, and should alter when +2 changes. This is a
testable hypothesis, with the implication that the failure of +1 to change when
+2 changes is inconsistent with the critique.
Since both conditional and expectational models can be derived from the
sequential joint density of (Yt: zt), and all sensible forms of expectations should
be cointegrated with outcomes, aspects of the Lucas critique are testable in a
framework of cointegration where some of the expectations variables are
subject to regime shifts (see Hendry and Neale, I988). The constancy of a
conditional model in the face of a changing marginal process entails that agents
do not use expectations models to predict future values of relevant decision
variables. A possible explanation is that contingent planning dominates
forward-looking behaviour in practice. Another possibility is that agents form
expectations without using models, but use data-based predictors, perhaps
because of high costs of information collection and processing (especially the
VI. CONCLUSION
discover it in part without prior knowledge of the whole: Keynes's worry about
the prior necessity of a complete specification is misplaced. Tests for necessary
attributes of structure exist, especially its invariance to extensions of the
information over longer time periods (constancy), regime changes (parameter
but by itself, it cannot endow a parameter with structurality since the mapping
involved is between a theory and a model, whereas structure concerns a
mapping between a model and reality. The best is that theory delivers a model
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argued, in that best practice does not fall foul of them, even if there remain
potential problems due to moral hazard (selecting only a favourable subset of
results to report, etc.). The positive aspects of theory provide a much stronger
case without resolving what are the precise theories of relevance and how best
to use them. Finally, the two-way interaction between evidence and theory
would benefit from being strengthened in practice.
Nuffield College, Oxford
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