On the Fixed-Effects Vector Decomposition

Trevor Breusch, Michael Ward, Hoa Nguyen, Thomas Kompas

    Research output: Contribution to journalArticle

    Abstract

    This paper analyzes the properties of the fixed-effects vector decomposition estimator, an emerging and popular technique for estimating time-invariant variables in panel data models with group effects. This estimator was initially motivated on heuristic grounds, and advocated on the strength of favorable Monte Carlo results, but with no formal analysis. We show that the three-stage procedure of this decomposition is equivalent to a standard instrumental variables approach, for a specific set of instruments. The instrumental variables representation facilitates the present formal analysis that finds: (1) The estimator reproduces exactly classical fixed-effects estimates for time-varying variables. (2) The standard errors recommended for this estimator are too small for both time-varying and time-invariant variables. (3) The estimator is inconsistent when the time-invariant variables are endogenous. (4) The reported sampling properties in the original Monte Carlo evidence do not account for presence of a group effect. (5) The decomposition estimator has higher risk than existing shrinkage approaches, unless the endogeneity problem is known to be small or no relevant instruments exist.
    Original languageEnglish
    Pages (from-to)123-134
    JournalPolitical Analysis
    Volume19
    Issue number2
    DOIs
    Publication statusPublished - 2011

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