Monthly Archives: July 2013

Rules vs. Discretion

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Scott Sumner writes,

I’m all for a rules-based approach to policy. But unfortunately Taylor fails to make his case. You’d think a fan of rules-based policy would provide a razor sharp critique of Fed policy, but Taylor’s critique is anything but clear

Scott Sumner’s rallying cry is “Target the Forecast!” (for nominal GDP) and John Taylor’s rallying cry is “Follow the Taylor Rule!”

Some remarks:

1. I think I saw the clash between Sumner and Taylor coming even before Sumner did.

2. “Target the Forecast!” is, in a generic sense, what the Fed has been doing since the 1960s. The FOMC discussions revolve around forecasts. Fed staff scrutinize data closely in order to divine what it means for the forecast. Alan Greenspan was an intense and promiscuous data-scrutinizer. Taylor would argue that, until late in his term, Greenspan’s target-the-forecast approach happened to line up with the Taylor rule.

3. What is the result? As Ed Leamer puts it in chapter 15 of Macroeconomic Patterns and Stories,

On the basis of circumstantial evidence, the Federal Reserve Board, by raising rates late in expansions, can take some blame for almost all our recessions.

Below is circumstantial evidence of the sort he describes. See how large moves in the Fed Funds rate tend to lead large moves in the unemployment rate.

4. Leamer also says,

With all these patterns, it is a mystery* whether monetary policy can be said to cause anything or merely reacts to things that would have occurred anyway. But if I felt the need, I could suppress the doubt and tell with confidence the following story.

[Expansions start out with mild inflation. Then price pressures build as the expansion matures] But the Fed fiddles as inflation smolders. The ever-so-gradual increase in inflation is not enough to get the Fed to respond, but like a small brush fire, inflation soon enough gets out of control…By the time the data are in, and the Fed rate-setting committee has deliberated enough to make absolutely sure that it is time to make a change in monetary policy, inflation is burning fiercely and it takes a heavy spray of higher interest rates to put the fire out. That creates an inverted yield curve, a credit crunch** for housing, and an unpleasant recession. Oh, Oh, we’re sorry, say the Fed Governors, who knock down interest rates to try to get housing and the rest of the economy back on their feet.

5. From this historical perspective “target the forecast” is what got us where we are today. Sure, it looks like a great idea now, when we think that the expansion is still not mature and price pressures are still nowhere to be seen. But eventually “target the forecast” will once again result in a failure to change policy in time. We will continue to experience needless, Fed-induced cyclical behavior unless the Fed is lashed to a rule.

6. You might characterize my beliefs as:

Probability that “target the forecast” (using some market prediction for nominal GDP) would stabilize the economy = .15

Probability that “stick to a rule” would stabilize the economy = .10

Probability that monetary policy “merely reacts to what would have occurred anyway” = .75

*The “mystery” arises in part because the Fed only controls the short-term nominal interest rate, and it is the long-term real interest rate that most plausibly drives spending. In chapter 5, Leamer writes,

the interest-rate on the 10-year has a life of its own, sometimes moving with the 3-month rate, but not always. That should make one wonder how much impact the Fed has on the longer-term rates and also wonder how much it matters.

In chapter 15 he says that

long-term interest rates were generally elevating at the ends [of economic expansions since 1960]. Maybe that is what killed off housing. Maybe that would have occurred even if the Fed had not taken action.

**Leamer was writing prior to 2008, when a different sort of credit crunch arose. I will discuss the Leamer credit-crunch model in a subsequent post.

My Last Zimmerman Post (I hope)

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Michelle Mayer writes about George Zimmerman’s phone calls to police.

Of the six incidents involving black males, one, recall, is the one in which GZ reports that he is concerned about the well being of a black male child who is wandering a busy street without adult supervision. So we’re talking about five incidents involving black males GZ found suspicious, and one involving a black male he wanted to help.

On the other hand, of the six incidents involving white males and Hispanic males, we may want to distinguish those incidents where GZ knew or at least had prior contact with the “suspect” (#11, the incident involving his ex-roommate, and #40, the one involving the food server he fired but had never met) from those where he reported total strangers (the remaining four). This leaves us with five reports involving black males GZ found suspicious and four reports involving white and/or Hispanic males.

I think it is possible to believe several somewhat paradoxical propositions.

1. George Zimmerman was not a harasser of blacks.

2. Martin would probably be alive today if he were not a black teenager. That is, I would guess that Zimmerman was less likely to be suspicious of a middle-aged black man or a white teenager. Also, someone other than a black teenager might have felt less threatened/insulted by Zimmerman.

3. The verdict in the case was correct, even if one believes (2).

4. President Obama gave a moving and heartfelt speech about the feeling of shopping while black or riding an elevator while black. He made a good case against a Washington-based response and for constructive thinking about race relations in this country.

5. The net result of the Zimmerman brouhaha will not be constructive for race relations in this country. People cannot handle paradox. They want simple, one-sided narratives, and these require falsehood and distortion.

Richard Epstein on Freddie, Fannie

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He writes,

There is no way that a statutory scheme that was intended to nurse Fannie and Freddie back to health as private corporations can be used unilaterally by the government to devour the interests of the very private shareholders that they were intended to protect. Government actions that don’t comply with the minimum standards of the APA should have no force and effect. Thus, even if the 2008 transaction stands, the 2012 transaction should be nullified, and the private and common shares restored.

I have no understanding of the legal mechanics. But in economic terms, I do not think that the point of conservatorship was to “nurse Fannie and Freddie back go health.” That would be like saying that you are going to nurse the parrot back to health in the famous Monty Python skit.

Fannie and Freddie were dead as private corporations, because investors would no longer lend to them at interest rates that were low relative to the rates that they could earn on assets. Fannie and Freddie have spent the last five years borrowing at rates that they only could have obtained with full taxpayer backing. The spreads that they enjoyed between the rates on their investments and the rates at which they have borrowed are in no way due to risk-bearing by shareholders. The taxpayers are the risk-takers, and the taxpayers deserve the rewards.

Epstein may have some points in terms of legal technicalities. But I think it’s a stretch to say that unless those technicalities are dealt with, the entire rule of law collapses and shareholders will never again have rights. You have plenty of rights if your management does not drive your highly-leveraged company into ruin, so that the only way it can stay out of bankruptcy is to get the government to put its full faith and credit behind your paper.

Falkenstein on Happiness Research

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He makes three interesting points. (Pointer from Jason Collins)

I note many writers I otherwise admire, usually libertarian leaning, are quite averse to the Easterlin conclusion, thinking it will lead us to adopt a luddite policies because growth would not matter in such a world

I am one of those libertarian writers who is averse to happiness research, but my aversion holds regardless of the conclusions reached. Happiness research embodies the claim that you, the researcher (I am not referring here to Falkenstein), can know more than me, the subject, about what gives me happiness. I believe that claim is false. Further, from a libertarian perspective, I believe that claim almost surely will lead you to devalue my liberty.

When an economist tells you a symmetric ovoid contains a highly significant trend via the power of statistics, don’t believe them: real effects pass the ocular test of statistical significance (ie, it should look like a pattern).

See his charts to understand his point. Putting Falkenstein’s point in more colloquial language, I would say that when the data consists of a blob of points, just because the computer can draw a line of best fit does not mean that you have demonstrated the existence of a meaningful linear relationship.

evolution favors a relative utility function as opposed to the standard absolute utility function, and the evidence for this is found in ethology, anthropology, and neurology. Economists from Adam Smith, Karl Marx, Thorstein Veblen, and even Keynes focused on status, the societal relative position, as a motivating force in individual lives

What Does Japan Exemplify?

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Noah Smith writes,

It seems to me that the standard New Keynesian sticky-price story just cannot explain Japan. The “short run” for Japan is over and done. We are not looking at a “short-run” fluctuation caused by sticky prices.

Pointer from Tyler Cowen.

In textbook terms, Smith is saying that the long-run aggregate supply curve is vertical, so aggregate demand does not matter.

Paul Krugman objects. In textbook terms, Krugman is saying (I am pretty sure) that in a liquidity trap the aggregate demand curve is vertical, so that the long-run aggregate supply curve does not matter.

So it gets back to whether one believes in a liquidity trap. Krugman writes,

the only reason deflation “works” in the standard model is that it increases the real money supply, which leads to lower interest rates; in effect, it acts like an expansionary monetary policy.

It depends what you mean by standard model. Some economists would put the Pigou Effect into the standard model. Krugman can argue–and has argued–that the Pigou Effect does not apply in Japan. Anyway, I personally don’t stake my case against the liquidity trap on the Pigou effect.

But the standard model actually has another channel by which lower prices raise demand, imparting a downward slope to the aggregate demand curve. It comes from the trade balance. If wages and prices go down in Japan, and this is not offset by an appreciation of the yen, then Japanese goods become cheaper in America and American goods become more expensive in Japan. As a result, the demand for Japanese output goes up. If Krugman has an argument that refutes this, I would like to see it.

Not surprisingly, Scott Sumner has a take.

The BOJ has produced 20 years worth of adverse AD shocks. In both 2000 and 2006 they raised interest rates despite the fact that Japan was experiencing deflation. In 2006 they cut the monetary base by 20%.

So, it’s a sequence of aggregate demand curve shifts. If the Bank of Japan would just hold still for a sec, the economy would find its way back to the long-run aggregate supply curve. As usual, Sumner is coherent, but I am not persuaded.

Smith continues,

But I don’t think Japan is living in an RBC world either. Because in an RBC world, keeping interest rates at zero for decades, and printing a bunch of money (as the Bank of Japan did in the mid-2000s), should cause inflation (without helping growth). Instead, we see persistent deflation. So an RBC model of the common type can’t be describing Japan’s world either.

RBC being “real business cycle,” in which slow productivity growth is the driver of a recession. For me personally, this is even less plausible than the Keynesian story. PSST is not RBC.

I think we need to get away from static thinking, including AS-AD and RBC. In static thinking, there is a full-employment equilibrium out there, if everyone would just adjust to it (match the right person with the right job, or cut wages by enough, or whatever). In the dynamic world of PSST, new opportunities to reconfigure production constantly arise. Some of these create ZMP situations, in which (some) workers’ value to the firm drops essentially to zero. These workers are released into the economy as free resources. Entrepreneurs can try to pick up these free resources and do something profitable with them. But it may take some time for entrepreneurs to figure out exactly what this “something profitable” might consist of.

I know nothing about Japan. But if I were looking for the source of its problems, I would examine the cultural, legal, and institutional factors that surround the formation of new businesses. If what you had during Japan’s post-war resurgence was an economy based on top-down industrial policy and cronyism, and what you need to fix the problem today is bottom-up entrepreneurial energy and creativity, then, as Noah suspects, the solution is not going to come from wiggling interest rates and deficits.

Shoot First, Negotiate Later

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No, this is not another post on the Zimmerman case. It is my reaction to an article by Mary C. Dalythese patterns are consistent with the reluctance of employers to adjust wages immediately in reaction to changing economic conditions. In particular, employers hesitate to reduce wages and workers are reluctant to accept wage cuts, even during recessions. This behavior, known as downward nominal wage rigidity, played a role in past recessions, but was especially apparent during the Great Recession. Wage rigidity kept nominal wage growth positive throughout the recession. This led to a significant buildup of pent-up wage cuts, that is, wage cuts that employers wanted, but were unable to make. As the economy recovers, pent-up wage cuts will probably continue to slow wage growth long after the unemployment rate has returned to more normal levels.

Pointer from Mark Thoma.

If no one told you what the data looked like, which would be more plausible?

a) Employers at first are reluctant to let go of employees, and they instead react to a drop in demand by immediately slowing wage growth. If the recession persists, they fire people.

b) Employers at first are reluctant to slow wage growth, so they fire people. If the recession persists, they slow wage growth.

I’m sorry, but (a) seems way more plausible to me than (b). We live in a world where there are a lot of fixed costs of hiring and firing. Yet the authors want to argue that in the short run, the easiest margin of adjustment is to fire people, and then in the long run you hire them back at lower wages.

Now this is a bit better:

As the recovery takes hold, businesses gradually reduce wage growth. At the same time, inflation typically erodes the real wages of workers, relieving some of the pent-up demand of employers for wage cuts. This gradual process can continue long after the unemployment gap begins to narrow. At the same time, slower wage growth also means businesses are able to hire more workers, which stimulates the demand for labor and pushes the unemployment rate down further.

Emphasis added. Still, I hate the phrase “pent-up demand for wage cuts.” It makes it sound as if “gee, if we could just get workers to accept a little lower wage, I could keep all of them.” That is a world in which there are an awful lot of $20 bills lying on the sidewalk.

Instead, I prefer to think of a dynamic economy and ask “what keeps entrepreneurs from finding ways to make use of available resources (unemployed workers)?” To me, that makes a recession more comprehensible, although less treatable.

Two Blog Posts on Servants

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Two years ago, I asked, Where are the Servants?

In an economy where some folks are very rich and many folks are unemployed, why are there not more personal servants? Why don’t Sergey Brin and Bill Gates have hundreds of people on personal retainer?

A few days ago, Alex Tabarrok wrote Inequality and the Servant Boom, in which he quotes an article from the Telegraph.

The number of domestic servants is booming across central London: wherever the multiple between the wages of the rich and the poor grows, so does the number of servants. Much of the time, the towering Georgian and Victorian terraced houses of Belgravia now have only servants living in them – their masters and mistresses are drifting around the world, from yacht to schloss to Park Avenue apartment, in search of pleasure or tax avoidance. Drive round the area at night, and it’s often only the lights in the attics and the basements – the servants’ quarters – that are on.

But it’s not just in the gilt-edged parts of Britain that the service industry is flourishing. According to the Work Foundation, there are now more than two million part-time or full-time domestic workers across the country. All told, 10 per cent of households now employ some sort of domestic help.

How to Interpret Asset Market Prices?

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Jeremy Stein says (in my words) “Don’t try.” His words are

fundamentals only explain a small part of the variation in the prices of assets such as equities, long-term Treasury securities, and corporate bonds. The bulk of the variation comes from what finance academics call “changes in discount rates,” which is a fancy way of saying the non-fundamental stuff that we don’t understand very well–and which can include changes in either investor sentiment or risk aversion, price movements due to forced selling by either levered investors or convexity hedgers, and a variety of other effects that fall under the broad heading of internal market dynamics.

If true (and I believe it is), this is a very important statement. It implies that events are in the saddle and ride the Fed. Not the other way around.

Pointer from “G.I.” of The Economist blog, via Mark Thoma.

Education, Status Goods, and Economics

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Rory Sutherland makes a valid point about education.

while we may want everyone else to be equally healthy (bee), we want our children to receive a better education than our neighbour’s children (chimp). If parents were more honest about their chimp heritage, they might also admit that, when choosing a school, they care less about the staff or the facilities (something government might solve) than about placing their children within an appropriate peer-group (something it can’t).

Pointer from Jason Collins. I agree that status-seeking plays a role in education, but I disagree that it plays no role in health care.

However, Sutherland goes overboard in his description of life as “Darwinist.” He focuses on status as a zero-sum game. The point that economists make is that while this game is going on, there is also a positive-sum game, involving trade, innovation, and growth.