The weak instrument problem of the system GMM estimator in dynamic panel data models

The system GMM estimator for dynamic panel data models combines moment
conditions for the model in first differences with moment conditions for the model in
levels. It has been shown to improve on the GMM estimator in the first differenced
model in terms of bias and root mean squared error. However, we show in this paper
that in the covariance stationary panel data AR(1) model the expected values of
the concentration parameters in the differenced and levels equations for the crosssection
at time t are the same when the variances of the individual heterogeneity
and idiosyncratic errors are the same. This indicates a weak instrument problem
also for the equation in levels. We show that the 2SLS biases relative to that of the
OLS biases are then similar for the equations in differences and levels, as are the
size distortions of the Wald tests. These results are shown to extend to the panel
data GMM estimators.

JEL Classification: C12, C13, C23
Keywords: Dynamic Panel Data, System GMM, Weak Instruments