Transforming Structural Econometrics
Chapter 4: Variables, laws and induction I: are there laws of nature?
During the 1950s and 1960s, leading econometricians developed large-scale and detailed models of the economies of the USA and the UK; many smaller models were also developed. These models worked well enough that they became accepted as aids in policy-making, in particular, as guides to understanding the likely results of policy interventions. But in the 1970s they broke down almost everywhere when they were most needed – that is, when crises emerged, hitting the economies of the world with shocks. They failed to predict the onset of domestic and foreign exchange crises, nor did they accurately portray the effects of the oil shocks; in addition, they failed to forecast the consequences of policy responses. But worst of all, they failed to capture the essential feature of the decade: stagflation, the simultaneous emergence of serious recession and strong inflation. Indeed, since these models tended to be built around a well-established Phillips Curve, simultaneous inflation and recession was not a possibility in them. Yet the models rested on strong empirical work; by all reasonable standards, they were well confirmed. Apparently reliable relationships unexpectedly changed or simply gave wrong answers. It appeared that inductive methods had failed.
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