7 - Spurious Relations

Summary

In practice we do not always have clear guidance from economic theory about specifying an econometric model. At one extreme, it may be said that we should “let the data speak.” It is good to know that when they “speak” that what they say makes sense. We must be aware of a particularly important phenomenon in empirical econometrics: the spurious relationship. If you encounter a spurious relationship but do not recognize it as such, you may inadequately consider such a relationship for hypothesis testing or for the creation of forecasts. A spurious relationship appears when the model is not well specified. In this chapter, we see from a case study that people can draw strong but inappropriate conclusions if the econometric model is not well specified. We see that if you a priori hypothesize a structural break at a particular moment in time, and based on that very assumption analyze the data, then it is easy to draw inaccurate conclusions. As with influential observations, the lesson here is that one should first create an econometric model, and, given that model, investigate whether there could have been a structural break.