The Role of the Econometrician in the Advancement of Economic Theory

Author(s): Trygve Haavelmo

Source: Econometrica, Vol. 26, No. 3 (Jul., 1958), pp. 351-357
Published by: The Econometric Society
Stable URL: http://www.jstor.org/stable/1907616
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 ECONOMET RICA
VOLUME 26 JULY, 1958 NUMBER 3

THE ROLE OF THE ECONOMETRICIAN IN THE ADVANCEMENT

OF ECONOMIC THEORY'

By TRYGVE HAAVELMO

THE REMARKS I HAVE to offer on this subject are going to be of a somewhat

general nature. In this respect I shall deviate a little from one of our good
rules, namely that econometrics is something that should be done, rather
than talked about. I find an excuse for my procedure in the fact that our
Society has passed some kind of milestone this year, with the completion of
the twenty-fifth volume of Econometrica. I do not know the extent to which
my fellow econometricians share the views I am going to express. I shall
not try to communicate any majority opinion. With your permission I shall
take this opportunity of expressing some personal thoughts on the perform-
ance of econometrics in striving to fulfill its promise: "The advancement
of economic theory in its relation to statistics and mathematics." I shall
offer some suggestions regarding objectives that perhaps ought to receive
more emphasis in our future work.

1. A SCIENCE OF MEASUREMENT

The most direct, and perhaps the most important, purpose of econometrics
has been the measurement of economic parameters that are only loosely
specified in general economic theory. Looking at the situation in the field
of economic models, the founders of our branch of economics met problems
like these: There were models "explaining" the determination of prices and
quantities in a market; but on closer inspection it was obvious that the answer
to the question of stability would depend on the numerical values of a mul-
titude of economic parameters. There were models of producers' behavior
in maximising profits, but little information on the facts concerning the
production functions involved, e.g., whether or not these functions were
homogeneous of degree one. There were models intended as a basis for spe-
cific recommendations on fiscal and monetary policies. Such models were,
however, often badly in need of factual information as to the quantitative
aspects of the various "effects" to be analysed. There were the "business
cycle theories" in the form of more or less complete dynamic models, but
without the quantitative information on the various lags and coefficients that
1 Presidential address, delivered before the Econometric Society at Philadelphia,
Pennsylvania, December 29, 1957.
351

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352 TRYGVE HAAVELMO

one would need, in order to decide whether or not the solutions would be
cyclical. And so on.
During the last twenty-five years a tremendous amount of effort has been
directed towards gathering such additional quantitative information, in order
to make the general ideas of the great thinkers in the field of economic theory
more specific and more applicable to the facts of economic life. Moreover,
these efforts at quantification have been extended not only to the measure-
ment of parameters in would-be "correct" models, but to the field of testing,
more generally, the acceptability of the form of a model, whether it has the
relevant variables, whether it should be linear, and many other similar prob-
lems.
A serious limitation on the possibility of solving these problems has been
the inadequacy of available statistical information. But we have witnessed
a good deal of improvement in this field in recent years. It is probably justi-
fied to say that the econometricians have had some part in this development.
It may even be claimed that they have helped, in some measure, to promote
the development of modern computation facilities, so essential to the large-
scale econometric research projects now on the programs of many research
institutions.
All these efforts have helped towards the fulfillment of one part of our
vow: To screen economic theories and to make them more specific by con-
fronting them with economic facts.

2. THE IMPACT ON ECONOMIC THEORY

Econometricians have influenced economic theory in various ways that

are, in a sense, byproducts of the efforts mentioned above.
One of these influences has been in the nature of general "repair work"
upon the logical consistency of theories as submitted to us in verbal or frag-
mentary mathematical form. I think we have learned that there is no better
way of finding logical flaws in a theoretical model than being forced to study
its adaptation to economic data. Contrary to what many people seem to
think, it is in the practical application of theories to facts, in attempts to
draw conclusions on the concrete level, that the need for stringent logic and
fancy mathematics really shows up.
Let me mention a few examples of what I called theoretical "repair work."
They will, I think, be familiar to all econometricians.
Consider first the fundamental question of "degrees of freedom" in an
economic model. The economists of older days were experts at counting vari-
ables and equations to see that their models of general equilibrium were
determinate. And their tradition has been well kept, both in advanced theory
and on the textbook level, as a method of explaining the determination of
prices and quantities traded in a market. But parallel with this kind of

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 PRESIDENTIAL ADDRESS 353

theory, and with it as the basis, we find a much larger volume of theoretical
literature studying effects of all kinds of hypothetical partial variations in
prices, interest rates etc. But these variations are often impossible because
they are contradictory to the general deterministic model within which the varia-
tions are supposed to take place. The problem shows up clearly when we
try do do quantitative work on the equations of such models. Then we are
forced to ask why the observed data show variations, or what freedom of
variation they can have if the model under consideration is true.
Connected with the general problem of the degrees of freedom is the prob-
lem of evaluating the effects of changes in policy parameters, e.g., tax rates.
Suppose that a model is determinate except for one free tax parameter.
For the purpose of studying the effects of changing this tax parameter it is
obviously quite inadequate to look only at the equations in which this
tax parameter appears explicitly. This problem the econometrician is bound
to discover as soon as he is asked to evaluate the quantitative effects of the
tax. This means that very often he has to reformulate the whole theoretical
framework in order to arrive at a clear definition of what he is supposed to
measure.
Consider another fundamental problem on which there has been much
confusion, the problem of autonomous vs. derived or "coflux" relations of
economic behavior. The so-called "paradox of a rising demand curve" is a
case in point. The apparent correlation between employment and taxes vs.
the effect of taxes on employment is another illustration. The confusion in
this field when economists first started to look for multiple regressions was
almost beyond description. Some people hailed regression technique as a
miracle tool for surprise discovery of economic laws. Others sensed the danger
of a mechanical approach and created the bogy of "spurious correlation."
Thus came the battle of "measurement without theory" versus "theory
without measurement." Here econometrics has helped to produce at least
an armistice.
Let me mention yet another field where there is in fact much clearing-up
work still to be done: The so-called "period analysis" in economic dynamics.
Here we find the dangerous device of putting all the lags equal to one in the basic
equations. The fact is, of course, that the lags usually are parameters to be
estimated, and that the length of the lags may have a profound effect upon
the character of the solutions, i.e. the time functions to which the lag model
leads.
Finally, let me mention a particular group of problems long neglected but
now being intensively studied: The problem of economic constraint in the
form of inequalities. While problems such as that of the rate of interest not
being capable of having negative values have troubled economists for a long
time, it is only recently, through the efforts at quantitative research in the

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354 TRYGVE HAAVELMO

field of resource allocation and programming, that we have become fully

aware of the need for extreme caution, minute reasoning, and powerful mathe-
matics in order to cope with these obvious and harmless-looking constraints.
In addition to this kind of logical repair work it has been our task to make
economic models more specific as to the form of the functions involved, to
derive appropriate aggregates and indices, and so on. And last but not least,
it has been the job of ecoiiometricians to add to "pure" theory a whole new
calculus, so to speak, a calculus of the deviations between pure theory and
facts. This has taken us deep into the theory of probability and statistical
inference. Sometimes the introduction of reasonable random elements into
an originally "exact" theory changes the observational implications of a model
very profoundly. This is one reason why one might well doubt whether the
kind of "division of labor" between pure theory and econometrics, which we
have been relying on, is practical and fruitful. It has become almost too easy
to start with hard-boiled and oversimplified "exact" theories, supply them
with a few random elements, and come out with models capable of producing
realistic-looking data. At the same time the introduction of random elements
in the theories has made it possible to account for seemingly rather puzzling
phenomena, such as the difference between the damped oscillations of exact
dynamic models and the maintained - though somewhat irregular - oscilla-
tions of actually observed series.
All this means that we have learned a lot about how to formulate a model
and make it logically valid, once we are given the general idea of it, or its
central hypotheses. We have gained considerable insight concerning the way
such models work - if they work. We have gained insight concerning the
kind of observations that would result if a given model actually were res-
ponsible for them. We have developed appropriate methods of testing
hypotheses and estimation.

3. POSITIVE RESULTS?

Now let us look briefly at the more concrete results of our efforts, the
explanatory value and the power of prediction of models that have gone
through the econometric work-shop. It is obviously somewhat problematic
to try to sum up these results with any broad and sweeping statement. We
have had quite a few encouraging results, for example in the field of con-
sumers' demand or in the study of production functions. Some of these results
may even have had a significant influence on economic policy both in the
private and in the public sector of the economy.
Nevertheless, it seems that there is one rather general feature of the many
econometric results produced which, to me at least, appears somewhat dis-
couraging or, let me say, disturbing. This feature is the following, if I may
state it somewhat bluntly and, therefore, perhaps somewhat uncritically: The

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 PRESIDENTIAL ADDRESS 355

concrete results of our efforts at quantitative measurements often seem to

get worse the more refinement of tools and logical stringency we call into
play! Now I want to hasten to explain this statement a little more before
anybody draws the wrong inference from it. What I have in mind is a phenom-
enon, which I am sure I have not been alone in observing, and which may
be described briefly as follows.
We have been striving to develop more efficient statistical methods of test-
ing hypotheses and estimation. In particular, we have been concerned about
general principles of consistent procedure in the important field of multiple
regression technique. We have found certain general principles which would
seem to make good sense. Essentially, these principles are based on the
reasonable idea that, if an economic model is in fact "correct" or "true,"
we can say something a priori about the way in which the data emerging
from it must behave. We can say something, a priori, about whether it is
theoretically possible to estimate the parameters involved. And we can decide,
a priori, what the proper estimation procedure should be. We have learned
to understand the futility of arguing that the data "in practice" may behave
differently, because such an argument would simply mean that we contradict
our own model. Now then, as I said, a very considerable amount of effort
has been spent in making econometric research more consistent along these
lines of thought. But the concrete results of these efforts have often been a
seemingly lower degree of accuracy of the would-be economic laws (i.e., larger
residuals), or coefficients that seem a priori less reasonable than those obtained
by using cruder or clearly inconsistent methods.
There is the possibility that the more stringent methods we have been
striving to develop have actually opened our eyes to recognize a plain fact:
viz., that the "laws" of economics are not very accurate in the sense of a
close fit, and that we have been living in a dream-world of large but somewhat
superficial or spurious correlations. We could of course also, as always, com-
plain about bad statistical data. However, I think we may well find part of
the explanation in a different direction, namely in the shortcomings of basic
economic theory, and in the somewhat passive attitude of many econome-
tricians when it comes to the choice of axioms and economic content of the
models we work on. I want to say a few words on the responsibility of the
econometrician in this matter.

4. THE NEED FOR MORE EMPHASIS ON ECONOMIC THEORY

It is probably fair to say that the interest of econometricians in the field

of pure economic theory has been more in the direction of the "repair work"
that I spoke of, rather than an interest in the fundamental economic ideas
themselves. In this way we have probably managed to have a somewhat
more comfortable scientific life than people who think of economics along

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356 TRYGVE HAAVELMO

philosophic and speculative lines. We have been able to lean back, looking
with satisfaction upon the many theorems that we have proved to be wrong,
and a few that we have proved to be right. Now, I do not want to claim, of
course, that econometricians necessarily would be so very much better think-
ers than others, and that the econometricians have neglected their oppor-
tunities on this account. What I believe to be true, however, is this: The
training in the technical skills of econometrics can represent a powerful tool
for imaginative speculation upon the basic phenomena of economic life; and,
furthermore, it would be fruitful to bring the requirements of an econometric
"shape" of the models to bear upon the formulation of fundamental economic
hypotheses from the very beginning. The ability and training in visualizing
the implications of axioms and assumptions is, I think, a powerful means of
discriminating between a priori alternatives concerning the structure of an
economic model.
In saying this I want to warn against one possible misinterpretation. The
idea of bringing econometric thinking into theory at an early stage is not
merely that of being able to throw out theoretical schemes which are unreal-
istic in a narrow sense. We must learn to think of facts to be explained in
a broader sense, as things that could be facts even if they are not at present.
After all, a very large part of the phenomena of economic life are man-made
and subject to alterations if we so desire. We have a very important task of
formulating and analysing alternative, feasible economic structures, in order
to give people the best possible basis for choice of the kind of economy they
want to live in. By formulating alternatives in the language of econometrics
we may also be in a position to judge the amount of quantitative information
concerning these alternatives that could conceivably be extracted from data
of past and current facts of our economy.
I have been speaking in general terms about the need for improvement of
economic theory. Let me mention a couple of more specific thoughts.
The economic relations that we have been trying to establish and confront
with facts are mostly of the following nature: Their starting point is some
notion of permanent preference schedules. Then there are the various con-
ditions and constraints upon choice, as visualized by the economic unit making
economic decisions, the actual knowledge or belief regarding the technological
possibilities, the expectations of prices, and so on. Then there are the links
between these subjective conditions or constraints and the objective facts
on which the decision makers presumably base their information. Finally,
there is the question of the relations between decisions taken and actions
actually carried out. From this veritable maze of interrelations our customary
economic theory extracts some would-be "net" relations between statistically
observable data of prices, quantities, etc., in the economy. The only trace left
of the whole "background structure" will then be the presumably constant

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 PRESIDENTIAL ADDRESS 357

parameters of the "net" relationships derived. At this final stage the thread
between the original, hypothetical invariants of the theory and the derived
relationships between market variables has indeed become long and thin.
I think most of us feel that if we could use explicitly such variables as,
e.g., what people think prices or incomes are going to be, or variables expres-
sing what people think the effects of their actions are going to be, we would
be able to establish relations that could be more accurate and have more
explanatory value. But because the statistics on such variables are not very
far developed, we do not take the formulation of theories in terms of these
variables seriously enough. It is my belief that if we can develop more explicit
and a priori convincing economic models in terms of these variables, which
are realities in the minds of people even if they are not in the current statis-
tical yearbooks, then ways and means can and will eventually be found to
obtain actual measurements of such data.
Another thought that I would like to mention is that we reconsider very
seriously the relevance of the standard scheme of permanent individual pref-
erences in a modern economy where almost everything that we do and think
depends on what our neighbors and fellow citizens do. This is certainly no
new idea, but I do not think that we have as yet really tackled this funda-
mental subject with the modern analytical tools that we now have available.
In fact, it seems that the great thinkers in the field of central economic theory
a hundred or two hundred years ago showed more imagination, more free-
dom of mind in looking for fruitful basic hypotheses of economic behavior
than is customary among most economists today. I believe the econometri-
cians have a mission in fostering a somewhat bolder attitude in the choice
of working hypotheses concerning economic goals and economic behavior in
a modern society.
There are already some econometricians who are engaged in work on the
fundamentals of economic theory along the lines I have indicated. To them
we should give all possible encouragement. We should also seek close contact
and cooperation with economists and others who have first-hand knowledge
of the facts of economic life and of the economic attitudes of our fellow
citizens.
I feel that we are now luckily beyond the stage where the arts of mathe-
matics and mathematical statistics had to fight for recognition as useful tools
in economic research. I think that the time has come for those who have the
good fortune of mastering these technical fields to share more in the respon-
sibility for choosing fruitful economic hypotheses which could widen the scope
and the usefulness of economic theory.

University of Oslo

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