We conclude by pointing out the main lessons of this essay. First, we have tools, the Belsley, Kuh, and Welsch (1980) collinearity diagnostics, which allow us to determine the form and severity of collinearity in the linear regression model. Most importantly, we know which variables are involved in collinear relationships, and which variables are not involved in collinear relationships. If the least squares estimator is severely affected by collinearity, but the model’s variables of interest are not involved in the collinear relationships, then there is no call for remedial actions. Such a conclusion requires us to think clearly about our models, and to pinpoint key variables.
Since new and better data are rarely available, the only practical approach to mitigating harmful collinearity is the introduction of nonsample information about the parameters, based on prior empirical research or economic theory. However the information is introduced, whether it be via restricted least squares, the Bayesian approach, or maximum entropy estimation, we must endeavor to introduce "good" nonsample information. The difficulty with this statement is that we never truly know whether the information we introduce is good enough to reduce estimator mean square error, or not.
The analysis of collinearity in nonlinear models is difficult. Collinearity (ill – conditioning) in asymptotic covariance matrices may arise from collinearity in the matrix of explanatory variables X, and/or particular parameter values and function values. Identifying the cause of the ill-conditioning may, or may not, be possible, but again the use of good nonsample information would seem the only remedy. In nonlinear models the problem of collinearity spills over into the estimation process, because the iterative algorithms used for numerical optimization may be sensitive to it. When this occurs, consider alternative algorithms, because how we find the maximum or minimum of our objective function is not important. Estimator properties only depend upon the successful location of the global maximum.
* The authors wish to thank three anonymous referees for their helpful comments. All remaining errors are the authors’ own.
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