econometrics

On the remarkable success of the

Arellano-Bond estimator
by: Tom Wansbeek1

Research often begins with some kind of fascination. This is certainly true in the present case. The fascination is
generated by figure 1. It shows the pattern, over the years, of the citations to the paper by Arellano and Bond (1991).
This paper was published in one of the top journals in economics, the Review of Economic Studies. Whatever the
paper may be about, the pattern is certainly striking, justifying the “remarkable success” in the title. If you don’t
find this picture fascinating, don’t read on!

Figure 1: Citations to Arellano and Bond (1991)

The picture shows something like exponential growth.
The growth seems to taper off a little recently, but an
inspection of the citations data over the first half of 2012,
as taken from the endlessly captivating Web of Science,
shows that the citation frequency has in fact doubled, and
an update of the picture at the end of the year would need
stretching the vertical axis by a factor of two. By way of
benchmark, the number of citations to the paper will soon
overtake the number of citations to the classical paper by
Hansen (1982) that started the generalized method of
moments (GMM) revolution in econometrics.
This being said, it may not hurt to briefly summarize
Tom Wansbeek (1947)
Tom Wansbeek is Professor of Statistics and Econometrics and for-
mer Dean at the University of Groningen. He obtained his MSc in
Econometrics from the University of Amsterdam (1972). After his
PhD from the University of Leiden (1980) he has worked with the
Netherlands Central Bureau of Statistics, the University of Southern
California and the University of Amsterdam. He has published in
econometrics (panel data models, measurement error and latent vari-
ables), linear algebra and marketing.
what the paper by Arellano and Bond (1991), AB
hereafter for brevity, is in fact about. The issue is to
estimate a dynamic model for panel data,
(1)
where t = 1, ... ,T indexes time and i = 1, ... ,N indexes
individuals, for whom (people) or for which (e.g. firms)
a variable y is observed repeatedly over time, so we
have so-called “panel data”. As usual in panel data
models, there is an individual effect capturing the
unobservable, time-constant traits of i, and the model
is completed by an error term commonly assumed
uncorrelated over time. The parameter of interest is α, the
autocorrelation parameter, for which we want to have a
consistent estimator. We consider the case of large N and
small T, so the kind of consistency we have in mind is
one where T is fixed and N goes to infinity.
1 I would like to thank Manuel Arellano and Jan Kiviet for
their very useful comments, without of course implicating
any support for my points of view.

AENORM vol. 20 (77) December 2012 15

 econometrics

Figure 2: The AB estimator as from the original

AB in perspective
The problem with consistent estimation is that yit AB in perspective
depends on γi . As is clear from the model, this holds for
all t, so the variable at the right-hand side of the model, Another view at the remarkable success of AB is offered
yi,t-1 also depends on γi. Hence there is an endogeneity through a comparison with a number of other papers
problem that we need to tackle if we want to avoid dealing with the dynamic panel data model. Table 1 gives
the risk of ending up with an inconsistent estimator of citation numbers, now in pairs of two as I have added
α. The usual approach is through instrumental variables the numbers from Google Scholar. These numbers are
(IV), and that is also the approach here, as it appears to roughly four times those from the Web of Science, which
be possible to derive instruments from the model; we are is what you usually find; Google Scholar refers to any
in the fortunate situation that we don’t need instruments source that can be found on the internet, whereas the Web
from some external source. AB is one such approach and, of Science only considers citations from a rather select
in fact, by far the dominant one in terms of number of set of international journals; having a decent refereeing
empirical applications. system is a prerequisite for a journal to be included. The
The idea of AB is to transform the model into first success of AB is dramatically brought out by its hitting,
differences. This eliminates the individual effects from somewhere in the beginning of this year, the 10,000 mark
the model. Their presence caused the endogeneity on Google Scholar.
problem and, when gone, cannot cause problems
anymore. For the thus transformed model, the variables Google WoS
yi,t-2 and their predecessors are valid instruments. These
instruments can be used in a GMM approach to obtain an Arellano and Bond (1991) 10342 2349
asymptotically efficient estimator of α. The fame of AB
is based on this simple idea. For the fun of it, I reproduce Blundell and Bond (1998) 5465 1290
the relevant paragraph from their paper, see figure 2. Arellano and Bover (1995) 4588 1021
This short paragraph does it, and brought the authors
Holtz-Eakin, Newey and Rosen (1988) 1380 359
a number of citations of which I am a little jealous. In
fact there is not so much new here since, as was of Anderson and Hsiao (1982) 1384 320
course acknowledged by AB, the idea of using earlier Anderson and Hsiao (1981) 1257 294
observations on y as instruments in a first-differenced
model was already a decade old and was due to Anderson Balestra and Nerlove (1966) 852 319
and Hsiao (1981, 1982). They use only the most recent Ahn and Schmidt (1995) 637 153
preceding y as instrument. What AB added to this was to
use all preceding y’s. A more important contribution of AB, Hsiao, Pesaran and Tahmiscioglu (2002) 153 30
not contained in this paragraph but described at the end of Wansbeek and Bekker (1996) 32 10
the paper, was the presentation of test statistics to test for
autocorrelation in the residuals. This is a critical issue as Table 1: Number of references to selected papers.
the consistency of the AB estimator depends on the νit not
being correlated over time. Incidentally, the observation
made in the last sentence of the paragraph shown was later
on elaborated by Ahn and Schmidt (1995).

16 AENORM vol. 20 (77) December 2012


Apart from AB and the other papers that already have
been mentioned, the list contains a selection of other
papers on the dynamic panel data model. The papers by
Arellano and Bover (1995) and Blundell and Bond (1998)
were the basis of “System GMM”, with instruments
added to AB that in a sense are the mirror image of AB,
that is, instruments in difference form used to estimate
the model in its original form in levels. Holtz-Eakin et
al. (1988) elaborated vector autoregression in panel data
models, and Balestra and Nerlove (1966) were the first
to present an estimator of the dynamic panel data model
by maximum likelihood. A fairly recent and exhaustive
treatment of maximum likelihood estimation was given
by Hsiao et al. (2002).
I could not resist the temptation to include a paper that
I wrote with my Groningen colleague Paul Bekker in the
1990’s. This paper is mentioned as the last (and least-
cited) entry in the table. As is apparent from the number
of citations, it has more or less been neglected, although
ten citations (no self-citations) is not even that bad for a
paper published in Economics Letters, where it ended up
after being rejected by I forgot which journal.
The reason to mention it here is that an extended
version of it, taking additional regressors into account,
developed by Harris and Mátyás (2000) and called WB+
by them, in their words including the italics, “generally
outperformed all other estimators when T was moderate
in all of the situations that an applied researcher might
encounter.” The other estimators included AB. So we
had the best method on offer at the time, but nobody
noticed. Too bad, but such is academic life, sometimes.
We apparently sold our method poorly.
Apart from the sheer number of citations by itself, the
pattern of citations over time is also a striking feature
of figure 1. The fame of AB developed slowly until the
turn of the millennium, when the number of citations
started to grow going over into something resembling an
explosion over the most recent years. The sky is the limit.
At first sight this may not seem remarkable as this
pattern is a good proxy of panel data econometrics,
which has become a healthily growing subfield of
econometrics, theory and empirics equally. But what
holds at the aggregate need not hold at the level of a single
paper. If a paper is important and makes a contribution,
it inspires other researchers to build on it and to come
up with new and better results, which in due course will
outshine the paper that inspired it; the source fades away
as a paradoxical reflection of success. This is what you
often see but, by sharp contrast, such a development
did not occur in the case of AB. The sheer fact that it is
just a very good paper, fully deserving its place in a top
journal and inspirational for many others, leaves open the
question as to its persistent popularity.
The answer is of course speculative. But speculation
is fun. One reason may be is that it is easily available
in various packages like Stata. The threshold for its use
is agreeably low, and AB has become the standard; to
give a typical quote, “[in] an influential article, Arellano
econometrics
and Bond (1991) settled what later has become the
bible for estimating [the dynamic model]” (Soto, 2003).
Another reason may come from the teachers’ side. Many
people over the world (at least, me) teach a course in
microeconometric models. Often, the theory behind
GMM is taught somewhere in the beginning of the course.
Later on, panel data models are on the agenda. The AB
approach to the dynamic model yields instruments from
within the model, which is a rewarding moment for
the teacher, and the abundance of instruments nicely
motivates GMM, which is equally rewarding. Also,
AB’s popularity may be due to a “signaling” function.
Citing AB clarifies the positioning of a paper in a way
everybody understands: the paper is clearly about the
dynamic panel data model.
What kind of dynamics?
But there is a more fundamental issue. Behind the popu-
larity of AB looms another, more general phenomenon,
which is the popularity of the dynamic panel data model
in general. Why has this model become so popular?
Again speculating, there are various possible
answers. From a theorists’ point of view, one reason
for the popularity of the dynamic panel data model is
that it is just a very interesting model to work on. The
model looks deceivingly simple but yet contains all
kinds of complications that have invited research up
till the present day. Also, the dynamic panel data model
is a substantively important model as it allows for
disentangling “state dependence” (through the lagged y
in the model) and “heterogeneity” (as reflected by the
individual effect in the model). And, last but not least,
see above, the dynamic formulation may just be the
appropriate one, as justified from the underlying theory.
Yet the dynamic specification may not always be best,
and there may be a certain degree of overenthusiasm
for it. Let me explain what I mean, starting from the
following observations. In panel data, the dependent
variable, y, is always highly persistent. There is still a lot
of persistence left after projection on the (equally highly
persistent) regressors, x. This is fair enough as the factors
that you don’t observe, captured in the error term u, could
be (more or less) equally persistent as the things you do
observe, x. This suggests immediately that any panel data
model should allow for an unconstrained time structure
of u as there is usually no justification for the opposite.
The model is then a specific form of the so-called
“seemingly unrelated regression model” or SUR model.
This does of course not preclude the model from having
the lagged y among the regressors. Yet, as an econometric
modeler, you want to keep things simple if possible and
you are tempted not to do everything at the same time
but to consider either dynamics in y or correlation over
time in u.
The question then is where to start. Sometimes the
choice is simple. In quite a few cases the economic theory
AENORM vol. 20 (77) December 2012 17
 econometrics
underlying the case at hand implies a dynamic model.
Examples are growth models, habit-formation models,
and models based on dynamic optimization. Also, apart
from articulate economic theorizing, a dynamic model
follows, in any context, from partial adjustment in an
equilibrium-seeking context. To model this, we assume
that the static equilibrium value y*it is for an endogenous
variable yit, after a realization of the innovation uit has
been obtained, is given by
(2)
where xit is an exogenous variable and i is the individual
effect of cross-sectional unit i. The path to a static
equilibrium is described by a partial adjustment model,
(3)
Substitution gives
(4)
yielding the dynamic panel data model. Notice that
estimation of this model produces an estimate of the short-
run coefficient (1-α)β and not of the long-run coefficient
(or “structural parameter”) itself. So a trivial bit of extra
work is needed to get an estimate of the parameter of
interest, and a less trivial bit of extra work gives you its
asymptotic standard error.
Otherwise, if there is no compelling a priori reason
to choose between the two approaches, dynamics in y
or correlation over time in u, the choice might be left
to invoking a philosophical principle commonly called
Ockham’s razor. There are various formulations of this
principle but it comes down to the idea that, other things
being equal, simpler explanations are generally better
than more complex ones. When applying this principle
in the present context one can argue that starting with
correlation over time in u is simpler than starting from
dynamics in y since the econometric theory behind the
SUR model is quite a bit simpler than the theory behind
the dynamic panel data model.
Since econometricians like quantification, there is a
statistic that illustrates this point, and that is the amount of
research effort put in both. When scanning the literature
over the last ten years, it is hard to find developments
around the SUR model, whereas a fifteen-minutes
search for the literature about the dynamic panel data
model showed that at least 80 researchers have written
about the dynamic panel data model in these ten years.
The list is not just very long but is also impressive as
to its quality since it includes a number of the world’s
leading econometricians. Such a comparison by head
count of research effort may seem a little weird, and I
am happy to trade it in for a better way to show which
18 AENORM vol. 20 (77) December 2012
approach is the simplest one. But as yet I have no better
alternative.
The whole issue points a topic that, surprisingly, has
not received any research effort as far as I am aware of.
It is about the following. As was said already above, AB
presents tests for correlation over time of the residuals.
If no such correlation is found, starting with a dynamic
model is apparently justified. But one can also start
with a model with u freely correlated over time, and
next test whether the lagged dependent variable should
be added to the model. This is hardly if ever done. The
critical issue here is that both approaches may lead to
different conclusions. An estimator for the structural
parameter that is consistent under one specification will
be inconsistent under the other, and the difference can be
huge. Some kind of tie-breaking mechanism should be
introduced. My preference for simplicity would lead me
choose the static model with correlated u. Sorting these
very important issues out deserves a place high on the
research agenda. An excellent starting point would be to
extend the ideas of general-to-specific model selection
(e.g., Hendry, 2000) to the panel data context.
A brief look at the empirical reality
In order to get an idea about the reasons why empirical
researchers use the dynamic panel data model, I
consulted the Web of Science again, this time to check
the papers that actually cite AB. Given the huge amount
of citations, I had to make a selection. At the time I made
this selection, in October 2011, AB had 1925 citations,
which happens to be 25 × 77. Since you can set the Web
of Science at 25 entries on a page, it was logistically
easy to select the bottom entry on each page, leading to
a manageable 77 papers, equally spread over the citing
papers in order of time. Next I went after these papers
through my university’s electronic library.
It so happened that eight of these papers could not
be found there. Another seven papers had no empirical
content, and yet another eleven were empirical but the
model after all was not dynamic. This left me with 51
papers for inspection, dealing with a bewildering and
fascinating range of topics; the dynamic model is all over
the place.
The first thing to look at was the motivation behind
the specification of a dynamic model, and in particular
the strength of this motivation. In principle this is a well-
defined job but it clearly has a strong subjective element.
No (clear) argument 17
Partial adjustment 11
“Weakly” theory-based 16
“Strongly” theory-based 7
Table 2: Motivation for a dynamic specification.

Moreover, I did the job rather quickly, in a first round
that I intend to replicate later, so there will no doubt be
inaccuracies; scanning so many papers about so many
different topics is a very interesting job, but it is also
sometimes hard to stay concentrated and not to make a
run for the coffee machine when yet another dynamic
model pops up.
With these caveats, a first set of results of this look at
a sample from the AB-citing literature are summarized
in table 2. It is about the motivation for using a dynamic
specification. It appears that a third of the papers did not
motivate the dynamic element in a clearly visible way. Of
the remaining two-thirds of the papers, partial adjustment
was clearly the favorite, being mentioned, in some form
or another, in eleven papers.
Partial adjustment is a sound argument for a dynamic
model, yet something strange appeared. As is apparent
from the discussion of the partial adjustment model given
above, a paper that takes partial adjustment seriously
should report estimates of the long-run coefficients, β,
not the short-run ones, (1 - α)β, which come out of the
computer first; the long-run coefficients are the structural
parameters and should be the objects of interest. Yet only
two of the eleven papers invoking partial adjustment did
this, in a rather minimal way.
This left me with 23 out of the 51 papers having some
kind of substantive story behind the dynamics. In most
of these cases, though, the motivation is not very deep
or very strong, but at least it gets some attention. Only
seven out of the 51 papers take the dynamics more or
less seriously. Two of these papers deal with growth
models. I was left with the impression that the dynamic
element in the model is not a matter of great concern to
applied researchers. Many of the papers showed great
competence and loving attention in discussing the subject
matter at hand, with the dynamics playing a minor role.
The interest in the precise value of the coefficient of the
lagged dependent variable appeared meager. Yet this
is a topic to which still a huge research effort is being
dedicated. This was a somewhat melancholic-making
finding.
A next issue of interest from inspecting the literature
concerned the methods actually used by the researchers.
It appears that 29 out of the 51 papers use AB. This is
not surprising, of course. Somewhat more surprisingly,
System GMM, considered superior in a stationary model,
is used in only twelve papers. The result is no doubt
biased since the selection of papers is based on citing AB.
Ten papers used different methods. Two used plain, good
old OLS, another two applied methods that adjust AB for
small-sample bias, in yet another two cases I could not
easily find out what actually has been done, one paper
used the Anderson-Hsiao instrumental variable, and three
papers used lagged values of x as instruments. There is
a lot in favor of the latter, but this again is a issue in
panel data analysis that gets far too little attention,
unfortunately; there are situations where using lagged
values of x as instruments leads to superior results.
econometrics
Another issue is residual autocorrelation. This issue
is crucial as the presence of autocorrelation renders the
AB estimator inconsistent. Out of the 51 papers, 20
did not report test results in this important matter. The
other 31 did, and 24 of them obtained test results that
did not necessitate to reject the null-hypothesis of no
autocorrelation. The other seven had to reject the null-
hypothesis although that did not induce further action.
This suggests that correlation in the error term is not a
matter of great concern. To repeat the point made above,
however, we could have reached a different conclusion
about the model when we would have started from the
position that there is such correlation, and test for the
presence of the lagged dependent variable in the model.
This would lead to a different conclusion about the
structural parameters in the model.
Summing up
One of the great advantages of having panel data availa-
ble is they can provide insight into the dynamics under-
lying the relations that you want to analyze. This mes-
sage is not lost on the research community, given the
remarkable success of the Arellano-Bond estimator. Ho-
wever, the source of the dynamics is sought very much
one-sided in the dynamics in the dependent variable, at
the cost of attention for dynamics in the error term. Tes-
ting between the two (or rather, between a much larger
class of models encompassing them) is a neglected topic
in econometric theory, and the more so in econometric
practice, although the effects on the estimation of the
structural parameters of misspecification can be huge.
Also, the potential of using exogenous variables as
instruments is a matter deserving more attention that
it has received up till now. One reason for this relative
neglect may be that many papers start by investigating
the dynamic panel data model without further regressors,
adding them later on as an afterthought, that is, as a
(minor) problem that has to be tackled, too, instead as a
part of the solution.
So this short paper ends, like almost all papers in
econometrics, with the conclusion that further research
is needed. Together with my colleagues Laura Spierdijk,
also from Groningen, and Christoph Hanck, from the
Universität Duisburg-Essen, I am trying to elaborate
some of the issues raised. I can’t guess how far we
will ever come, but dreaming of thousands of citations
certainly motivates!
AENORM vol. 20 (77) December 2012 19
 econometrics

References

Ahn, S.C. and P. Schmidt (1995), “Efficient estimation Holtz-Eakin, D., W. Newey and H.S. Rosen (1988),
of models for dynamic panel data”, Journal of “Estimating vector autoregressions with panel data”,
Econometrics, 68, 5–27. Econometrica, 56, 1371–1395.

Anderson, T.W. and C. Hsiao (1981), “Estimation of
dynamic models with error components”, Journal of
the American Statistical Association, 77, 598–606.
Anderson, T.W. and C. Hsiao (1982), “Formulation and
estimation of dynamic models using panel data”,
Journal of Econometrics, 18, 47–82.
Arellano, M. and S. Bond (1991), “Some tests of
specification for panel data: Monte Carlo evidence
and an application to employment equations”, Review
of Economic Studies, 58, 277–297.
Hsiao, C., M.H. Pesaran and A.K. Tahmiscioglu (2002),
“Maximum likelihood estimation of fixed effects
dynamic panel data models covering short time
periods”, Journal of Econometrics, 109, 107–150.
Soto, M. (2003), “Taxing capital flows: an empirical
comparative analysis”, Journal of Development
Economics, 72, 203–221.
Wansbeek, T.J. and P.A. Bekker (1996), “On IV, GMM
and ML in a dynamic panel data model”, Economics
Letters, 51, 145–152.

Arellano, M. and O. Bover (1995), “Another look at the

instrumental variable estimation of error-components
models”, Journal of Econometrics, 68, 29–51.

Balestra, P. and M. Nerlove (1966), “Pooling cross-

section and time series data in the estimation of
a dynamic model: the demand for natural gas”,
Econometrica, 34, 585–612.

Blundell, R. and S. Bond (1998), “Initial conditions and

moment restrictions in dynamic panel data models”,
Journal of Econometrics, 87, 115–143.

Hansen, L.P. (1982), “Large sample properties of

generalized method of moments estimators”,
Econometrica, 50, 1029–1054.

Harris, M.N. and L. Mátyás (2000), “Performance of the

operational Wansbeek-Bekker estimator for dynamic
panel data models”, Applied Economics Letters, 7,
149–153.

Hendry, D.F. (2000), “Epilogue: the success of general-

to-specific model selection”, in D.F. Hendry, editor,
Econometrics: alchemy or science? Essays in
econometric methodology, Oxford University Press,
467–490.

20 AENORM vol. 20 (77) December 2012