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The Nobel Series: Stalwart of macroeconometric modelling

Lawrence Klein's models laid the ground for quantitative analysis of economic policies — at the same time — defined the contours of econometrics

The Nobel Series: Stalwart of macroeconometric modelling
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The Nobel prize in Economics was awarded to Lawrence Klein for the application of econometric models to macroeconomics. His Nobel citation states that "few, if any, research workers in the empirical field of economic science have had so many successors and such a large impact as Lawrence Klein." As the Nobel website tells us, he was given the award for:

Analysis of the effects of macroeconomic policy by econometric model-building. He also made important contributions in developing forecasting techniques

Like many of the Nobel awardees and other economics stalwarts, Klein grew up during the Great Depression and this had an impact on his academics and career. He did his undergraduate studies in computer modelling and economics at the University of California at Berkeley and got his degree in 1942. Thereafter, he went on to do his PhD in economics from MIT as Paul Samuelson's first doctoral student. He then moved to the Cowles Commission, which was then at the University of Chicago and took up the challenge to carry forward Jan Tinbergen's work to build a macroeconomic model of the US economy. He moved to the University of Michigan thereafter and continued his work on econometric modelling. Here he developed the well-known Klein-Goldberger model in collaboration with Arthur Goldberger. He was denied a tenure in Michigan on account of his flirting with the US Communist Party in the 1940s, which is the reason for his moving to Oxford in the UK. He returned to the US in 1958 to join the University of Pennsylvania.

In this article, we will review the main works of Lawrence Klein and look at how they are relevant to public policy.

Main works of Klein

Lawrence Klein's early work which made him famous was his doctoral dissertation in 1947 titled 'The Keynesian Revolution'. Earlier in 1947 itself, he had published an article on theories of effective demand in the Journal of Political Economy. In that article, Klein compared the Keynesian theory of employment with the neoclassical theory and with an original formal interpretation of Marxian theory. The article was important for the interpretation of Keynes and is often grouped with other classical works of Hicks (1937), Lange (1938) and Modigliani (1944) as part of the "neoclassical synthesis" of Keynesian theory (this was appropriate since Samuelson, who was Klein's doctoral advisor, was the original proponent of the synthesis).

Klein produced many original and innovative econometric models. One of the earliest ones was the prediction of the economy after World War II. Bucking the trend, Klein suggested that there would be an uptick in consumption demand after the War to cater to the pent-up demand and because of the disposable income with the soldiers. He was proven right. After returning to the US in 1958, Klein continued from where he left off and began a project on an econometric model to predict the trajectory of the US economy in the short run.

To further strengthen his model, Klein began the Brookings-SSRC project with several other academics. This project was preceded by the Committee on Economic Stability set up at the SSRC (Social Science Research Council) in 1959. This committee consisted of Klein among others and was formed to collect data and take forward macroeconometric model-building. In the 1960s, Klein along with Duesenberry developed models of the US economy and this effort was handed over to the Brookings institution in 1963. This model had similarities with the model built by Jan Tinbergen in the 1930s, though the methodology was largely different. In fact, the model was built on Klein's earlier smaller models.

Continuing with his work, Klein proposed another model, 'The Wharton Econometric Forecasting Model', which is considerably smaller than the Brookings model but is better suited for the analysis of business conditions and forecasting of GNP, investment, consumption exports etc. In 1969, Klein set up the Wharton Economic Forecasting Associates (now called IHS Global Insight), which was an early start-up in the econometric forecasting industry in the US. He also began the LINK project, which was a collaboration of model builders from many countries, whose aim was to produce the world's first global economic model, linking models of many of the world's countries. LINK is now operated by the United Nations and still meets regularly.

Towards the end of his career, he was constructing short-range "current quarter models". Such a model is a high-frequency forecasting model and is purely technical with no subjective intervention of the economist in the determination of arbitrary assumptions or initial conditions. The methodology combines high-frequency information, times series equations, and regression analysis. The model was originally designed to anticipate the quarterly GDP for the US economy. The methodology estimates the GDP by three independent approaches — production, expenditure, and principal components.

In addition to his work on model-building, Klein also had a leading role in the development of econometrics. His textbooks include 'A Textbook of Econometrics' (published in 1953, but revised in 1974) and 'An Introduction to Econometrics' (1962). As regards to his specific contributions to econometric theory, he first wrote an article in1943 in the respected journal 'Econometrica' on the identification of an investment function. He continued his work on the development of econometric theory and its applications.

Klein's work and Public Policy

Klein's econometric model-building, which he began in the 1940s continued till the end of his career till as late as the 1990s. His objective was to improve the forecast ability of quantitative methods in economics and apply quantitative analysis to public policy.

In the US, his models found a wide application in public policy by the Department of Commerce, Federal Reserve and the Congressional Budget Office. While the Brookings model found success in many applications, other large-scale models were less successful. This was due to their size (they involved more than 400 estimated equations) and the dimensions of the project (with many scholars from across the world with varied interests). Nevertheless, the models found a ready market for the forecast of economic and financial variables. This gave rise to an early start-up for the forecasting business. Two companies that proved to be leaders in this business were — Data Resources Incorporation (DRI) whose chief economist and a major shareholder was the Harvard professor Otto Eckstein, and Klein's Wharton Econometric Forecasting Association (WEFA) owned by the University of Pennsylvania. As noted above, Klein used the WEFA model for examining the effects of fiscal and monetary policies, the use of subjective variables drawn from household and business surveys, the economic impact of demobilization as a result of the end of the Vietnam War etc.

In his later life, Klein had extended his models to other countries through the LINK programme as well as directly interacting with other governments. In 1960, he began work on a joint model-building project at Osaka University and jointly with Michio Morishima and Shinichi Ichimura, he started 'International Economic Review'. Other collaborations included projects in Israel (with Hebrew University) and Austria (with the Institute of Advanced Studies). In China, he worked on a project to examine whether the GDP figures were genuine or not. Contrary to the popular perception, he found that China's inflation rate was overstated by more than 1.0 per cent, thus implying that China's growth rate was higher than assumed people.

In 1990, Klein was the chairman of a new society called 'Economists Against the Arms Race' (ECAAR). It reflected his attachment to public issues. The society has been active in its opposition to arms races, support of conflict resolution, arms control, and the analysis of the effect of war on economic performance.

Klein was also involved in the US Presidential elections of 1976, where he coordinated Jimmy Carter's economic task force. His inclination to public service and application of his models to public policy is reflected in his Nobel speech. In his words:

From my student days, the concept of public service and the relationship of theoretical economics or econometrics to real-world problems has appealed to me, and I have tried to follow the footsteps of my teachers in practicing economics in this way.

Like most renowned economists, Klein's work was criticized by many. For example, Christopher Sims criticized the assumptions underlying his models. Others found faults with the suitability of the large-scale models and their application to economic systems of different countries.

Conclusion

Klein's greatest contribution was in applying econometric models to forecasting and economic policymaking. Today, econometric modelling has come a long way and has reached new heights with the availability of greater computing power and advances in information technology. Klein's other theoretical contribution was the Keynesian neoclassical synthesis, which was perhaps inspired by his doctoral advisor Paul Samuelson. He was convinced of the role of the Government in economic regulation. In his own words, written in an article in 1992:

Philosophically, I do not believe that the market system, in even its purest form, provides adequate self-regulatory responses. The economy definitely needs guidance – even leadership – and it is up to professional economists to provide public policy makers with the right information to deliver such leadership. As for the methods of doing this, I see no alternative to the quantitative approach of econometrics, but I do realize that all policy issues are not quantitative and measurable. At times, subjective decisions must also be made"

Whatever be the criticism of Klein's models and their applications, it is clear that without them, quantitative analysis of economic policy would not have been possible. Klein's lasting contribution was best captured by Robert Ball, his collaborator in many projects. Writing in 1981 about Klein's Nobel Prize, he wrote:

It is appropriate to describe his work as pioneering. . . . He has attempted what others would not undertake. It is no mean achievement to have lifted, almost single-handedly in the earlier years, the practice of large scale econometric model building to a position of great value and respectability in the profession. In this sense, his work has been as much entrepreneurial as intellectual. . . . As a by-product of this, he set an example and a style which cannot simply be represented by any book, and which played a major role in integrating economic theory and applied analysis and in liberating applied economics from its rather dull image to the more exciting and active investigation of many contemporary problems. In this respect, his practical influence has been enormous.

Views expressed are personal

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