A Note on the Theme of Too Many Instruments*

Authors


  • *

    I thank Selvin Akkus for research assistance and Thorsten Beck, Decio Coviello, Kristin Forbes, Mead Over, Jonathan Temple (editor) and two anonymous reviewers for helpful comments. I take sole responsibility for all assertions and opinions expressed herein.

Abstract

The difference and system generalized method of moments (GMM) estimators are growing in popularity. As implemented in popular software, the estimators easily generate instruments that are numerous and, in system GMM, potentially suspect. A large instrument collection overfits endogenous variables even as it weakens the Hansen test of the instruments’ joint validity. This paper reviews the evidence on the effects of instrument proliferation, and describes and simulates simple ways to control it. It illustrates the dangers by replicating Forbes [American Economic Review (2000) Vol. 90, pp. 869–887] on income inequality and Levine et al. [Journal of Monetary Economics] (2000) Vol. 46, pp. 31–77] on financial sector development. Results in both papers appear driven by previously undetected endogeneity.

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