Matching on Noise: Finite Sample Bias in the Synthetic Control Estimator

We investigate the properties of a systematic bias that arises in the synthetic control estimator in panel data settings with finite pre-treatment periods, offering intuition and guidance to practitioners. The bias comes from matching to idiosyncratic error terms (noise) in the treated unit and the donor units’ pre-treatment outcome values. This in turn leads to a biased counterfactual for the post-treatment periods. We use Monte Carlo simulations to evaluate the determinants of the bias in terms of error term variance, sample characteristics and DGP complexity, providing guidance as to which situations are likely to yield more bias. We also offer a procedure to reduce the bias using a direct computational bias-correction procedure based on re-sampling from a pilot model that can reduce the bias in empirically feasible implementations. As a final potential solution, we compare the performance of our corrections to that of an Interactive Fixed Effects model. An empirical application focused on trade liberalization indicates that the magnitude of the bias may be economically meaningful in a real world setting.