Thinking About Using Instrumental Variables? Think Again

[From the paper “Consistency without Inference: Instrumental Variables in Practical Application” by Alwyn Young, posted on his university webpage at London School of Economics]
“I use Monte Carlo simulations, the jackknife and multiple forms of the bootstrap to study a comprehensive sample of 1359 instrumental variables regressions in 31 papers published in the journals of the American Economic Association.”
“I maintain, throughout, the exact specification used by authors and their identifying assumption that the excluded instruments are orthogonal to the second stage residuals. When bootstrapping, jackknifing or generating artificial residuals for Monte Carlos, I draw samples in a fashion consistent with the error dependence within groups of observations and independence across observations implied by authors’ standard error calculations.”
“Non-iid errors weaken 1st stage relations, raising the relative bias of 2SLS and generating mean squared error that is larger than biased OLS in almost all published papers.”
“Monte Carlo simulations based upon published regressions show that non-iid error processes adversely affect the size and power of IV estimates, while increasing the bias of IV relative to OLS, producing a very low ratio of power to size and mean squared error that is almost always larger than biased OLS.”
“In the top third most highly leveraged papers in my sample, the ratio of power to size approaches one, i.e. 2SLS is scarcely able to distinguish between a null of zero and the alternative of the mean effects found in published tables.”
“Monte Carlos show, however, that the jackknife and (particularly) the bootstrap allow for 2SLS and OLS inference with accurate size and a much higher ratio of power to size than achieved using clustered/robust covariance estimates. Thus, while the bootstrap does not undo the increased bias of 2SLS brought on by non-iid errors, it nevertheless allows for improved inference under these circumstances.”
“I find that avoiding the finite sample 2SLS standard estimate altogether and focusing on the bootstrap resampling of the coefficient distribution alone provides the best performance, with tail rejection probabilities on IV coefficients that are very close to nominal size in iid, non-iid, low and high leverage settings.”
“In sum, whatever the biases of OLS may be, in practical application with non-iid error processes and highly leveraged regression design, the performance of 2SLS methods deteriorates so much that it is rarely able to identify parameters of interest more accurately or substantively differently than is achieved by OLS.”
To read the paper, click here.



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