Monday, March 6, 2017

ML and Metrics VI: A Key Difference Between ML and TS Econometrics

[Click on "Machine Learning" at right for earlier "Machine Learning and Econometrics" posts.]

Continuing:

So then, statistical machine learning (ML) and 
time series econometrics (TS) have lots in common. But there's also an interesting difference: ML's emphasis on flexible nonparametric modeling of conditional-mean nonlinearity doesn't play a big role in TS. 

Of course there are the traditional TS conditional-mean nonlinearities: smooth non-linear trends, seasonal shifts, and so on. But there's very little evidence of important conditional-mean nonlinearity in the covariance-stationary (de-trended, de-seasonalized) dynamics of most economic time series. Not that people haven't tried hard -- really hard -- to find it, with nearest neighbors, neural nets, random forests, and lots more. 


So it's no accident that things like linear autoregressions remain overwhelmingly dominant in TS. Indeed I can think of only one type of conditional-mean nonlinearity that has emerged as repeatedly important for (at least some) economic time series: Hamilton-style Markov-switching dynamics.

[Of course there's a non-linear elephant in the room:  Engle-style GARCH-type dynamics. They're tremendously important in financial econometrics, and sometimes also in macro-econometrics, but they're about conditional variances, not conditional means.]

So there are basically only two important non-linear models in TS, and only one of them speaks to conditional-mean dynamics. And crucially, they're both very tightly parametric, closely tailored to specialized features of economic and financial data.

Now let's step back and assemble things:

ML emphasizes approximating non-linear conditional-mean functions in highly-flexible non-parametric fashion. That turns out to be doubly unnecessary in TS: There's just not much conditional-mean non-linearity to worry about, and when there occasionally is, it's typically of a highly-specialized nature best approximated in highly-specialized (tightly-parametric) fashion.