Monthly Archives: December 2013

Phillips Curve Specifications and the Microfoundations Debate

Posted on by

Scott Sumner writes,

As you may know I view inflation as an almost worthless concept… In contrast Krugman discusses the original version of the Phillips curve…which used wage inflation instead of price inflation. Whereas price inflation is a useless concept, wage inflation is a highly useful concept.

Fine. But Krugman also draws attention to how the level of the unemployment rate affects the level of the wage inflation rate. This takes us back to the original, pre-1970 Phillips Curve, from Act I in my terminology (Act I was the Forgotten Moderation, from 1960-1969, Act II was the Great Stagflation, from 1970-1985. Act III was the Great Moderation, from 1986-2007, and Act IV is whatever you want to call what we are in now.) The Act I Phillips Curve says flat-out that (wage) inflation will be high when unemployment is low, and vice-versa.

The Phillips Curve was revised in Act II, when the specification became that the rate of wage inflation increases when the unemployment rate is above below the NAIRU and decreases when it is belowabove the NAIRU. In other words, it relates the change in the rate of wage inflation to the unemployment rate. At the time, cognoscenti were saying that Friedman had moved the Phillips Curve one derivative.

Some comments.

1. The Act I Phillips Curve works better over the 27-year period (Acts III and IV) that Krugman covers. Within the sample period, in 9 out of the 10 years when unemployment is near the bottom of its range (less than 5 percent), wage inflation is near the top of its range (3.5 percent or higher). In all three high-unemployment years, wage inflation is less than 2.5 percent.

2. Although the rate-of-change in wage inflation is also correlated with the unemployment rate, the relationship is not as impressive. In the late 1990s, we had the lowest unemployment rate, but wage inflation actually declined (admittedly by only a small amount). More troubling is the fact that the very high rate of unemployment in recent years produced a decline in wage inflation hardly larger than that of the much milder previous recessions.

3. The overall variation in wage inflation over the 27 years is remarkably low. It ranges from 1.5 percent to 4 percent. When there is this little variation to explain, the actual magnitude of the effect of variations in unemployment on inflation is going to be pretty small. See the post by Menzie Chinn. If you do not have any data points that include high inflation, then you cannot use the Phillips Curve to explain high inflation. Chinn argues that the relationship is nonlinear. I would say that we do not know that there exists a nonlinear relationship. What we know is that we observe a relationship that, if linear, has a shallow slope. The most we can say is that if there is a steep slope somewhere, then there is a nonlinear relationship.

4. If you had given a macroeconomist only the information that wage inflation varied between 1.5 percent and 4 percent, that macroeconomist would never have believed that such a time period included the worst unemployment performance since the Great Depression. In terms of wage inflation, the last five years look like a continuation of the Great Moderation.

Some larger points concerning market monetarism, paleo-Keynesianism, and the microfoundations debate:

5. Concerning Scott’s view of things, I have said this before: Arithmetically, nominal GDP growth equals real GDP growth plus growth in unit labor costs plus the change in the price markup. If you keep the price markup constant and hold productivity growth constant, then nominal GDP growth equals real GDP growth plus wage growth. So it is nearly an arithmetic certainty that when nominal GDP grows more slowly than wages, then real GDP declines. But to me, this says nothing about a causal relationship. You could just as easily say that a decline in real GDP causes nominal GDP to grow more slowly than wages. What you have are three endogenous variables.

Scott insists on treating nominal GDP growth as the exogenous variable controlled by the central bank. To me, that is too much of a stretch. I am not even sure that the central bank can control any of the important interest rates in the economy, much less the growth rate of nominal GDP. Yes, if they print gobs and gobs of money, then inflation will be high and variable, and so will nominal GDP growth. But otherwise, I am skeptical.

6. I view paleo-Keynesianism as being hostile to Act III macro. I share this hostility. However, right now, you have saltwater economists saying, “Freshwater economists reduce macroeconomics to a single representative agent with flexible prices solving stochastic calculus problems. Hah-hah. That is really STOOpid.”

The way I look at it, the Act III New Keynesians reduced macroeconomics to a single representative agent with sticky prices solving stochastic calculus problems. They should not be so proud of themselves.

Paul Krugman calls Act III macro a wrong turn. (Pointer from Mark Thoma.) I would not be so kind. I also would not be as kind as he is to the MIT macroeconomists who emerged in that era.

You cannot just blame Lucas and Prescott for turning macro into a useless exercise in mathematical…er…self-abuse. You have to blame Fischer and Blanchard, too. Personally, I blame them even more.

Having said all that, I do not share Krugman’s paleo-Keynesianism. Just because the Lucas critique was overblown does not mean that other critiques are not valid. I have developed other doubts about the Act I model, and these lead me to believe that PSST is at least as plausible a starting point for thinking about macro.

Robots

Posted on by

The press is excited about Google’s purchase of robotics companies. For example, Popular Mechanics writes,

Car factories are stocked with powerful, precise robotic arms that assemble cars with uncanny speed and delicacy. Bringing that to our world—to our streets, nursing homes, warehouses—is the next big step in robotics. And Google bought its way into this future.

The interesting conflict in robotics is between those who want to build general-purpose, humanoid robots and those who want to build robots optimized for specific tasks. I lean more toward the latter. For example, I expect to wait a long time (perhaps forever) for a robot that can do all-purpose house cleaning. It is easier for me to picture a hotel using a toilet-cleaning robot, a shower-cleaning robot, a bed-making robot, etc., as such devices are invented.

Finance and Macro

Posted on by

Nick Rowe writes,

Here’s a very simple (and totally inadequate) theory of the rate of interest: it is set by the Bank of Canada. Add or subtract adjustments for risk, duration, liquidity, and earnings growth, and you get the equilibrium earnings yield on stocks. Take the reciprocal, and you get the P/E ratio. Done.

Why is that theory totally inadequate? Because the Bank of Canada does not set interest rates in a vacuum. It sets the rate of interest it thinks it needs to set to keep inflation at the 2% target. And that interest rate in turn depends on things like the demand for goods, and the Phillips Curve, and on the inflation target. And the demand for goods in turn depends on things like desired saving and investment, both in Canada and around the world. And those in turn depend on time-preference, and expectations of future income, and on the marginal rates of transformation of present goods into future goods, and whether there will be a demand for those future goods or a recession.

Read the whole thing.

This first paragraph reminds me that I have meant to write an imaginary Q&A with Scott Sumner.

Q: Why did the stock market go up about 2 percent the other day?

SS: Because the Fed announced an expansionary policy.

Q: But the Fed announced that it was tapering its purchases of assets, although they issued a “forward guidance” that interest rates would remain low. Given the somewhat contradictory announcement, how do we know that it was expansionary?

SS: Because the stock market went up about 2 percent.

Nick’s second paragraph reminds us that central bank policy is also endogenous. That is the way that I think of it.

So what’s my explanation for the rise in the market, which was obviously in response to the Fed announcement? A couple of possibilities.

1. Perhaps they read the taper announcement as an indication that the Fed has information that the economy is doing well. They took it as good news.

2. Perhaps a few key Wall Street gurus interpreted the announcement as good news, because of (1) or because they are devoted followers of Scott Sumner or because of the meds they were on or whatever. Then everyone else realized that if the gurus were optimistic then stocks would go up, so they pushed stocks up. It was collective irrationality. As Fischer Black famously said, the stock market is efficient only to a factor of 2.

The way I reconcile finance with macro is that I minimize the weight I give to macro. Markets are happy to let the Fed wiggle around an interest rate or two, as long as it does not wiggle too hard on an interest rate that really matters to the economy. If the Fed were to wiggle too hard on a rate that matters, the markets would find a way around that particular part of the money market in order to make that interest rate matter less. As an economist, your best bet is to treat interest rates and stock prices as determined by financial markets, rationally or otherwise (I vote otherwise), and not by the Fed.

Factor-Price Equalization, Illustrated

Posted on by

Timothy Taylor writes,

It used to be said back in the 1960s that the global distribution of income was bi-modal–that is, it had one hump representing the large number of people who were very low-income and then a smaller hump representing those in the high-income countries…But over time, the highest point in the income distribution is shifting to the right, and by 2008, the world has moved fairly close to having a unimodal or one-hump distribution of income.

Read the whole post, which discusses a paper by Christoph Lakner and Branko Milanovic. Globalization, and in particular the growth of China, has flattened out the rich-country “hump,” leaving only the global hump. Average is over for the rich countries, in part because average has started for China.

Perspective on Fiscal Policy, Revisited

Posted on by

From the comments on this post:

the entire discussion is about accounting for “money” which while very important is not the same as real output.

Let us assume, as a first approximation, that real output is the same, regardless of the path of the government budget. In that case, we are talking only about distribution issues. Kotlikoff tends to worry about the intergenerational distribution. We may be on a path in which Baby Boomers consume a lot, and their children and grandchildren are taxed heavily to pay of this.

My own concern is that the distribution issues cause damage to our social and political fabric. We set ourselves up for ever-increasing strife. Please re-read Lenders and Spenders.

Obama Repeals Obamacare

Posted on by

That was my first reaction to this morning’s story.

The Obama administration on Thursday night significantly relaxed the rules of the federal health-care law for millions of consumers whose individual insurance policies have been canceled, saying they can buy bare-bones plans or entirely avoid a requirement that most Americans have health coverage.

Some of my initial reactions, which I have to say are snarky and uncharitable.

1. This really amplifies “You have to pass the bill to see what’s in it.”

2. Until yesterday, this policy would have been impossible to enact legislatively (had the Republicans proposed it, the Senate would have killed it or Obama would have vetoed it). However, if I were a Republican, I would now introduce legislation that word-for-word enacts this proposal, just to rub the Democrats’ nose in it.

3. I am sure that many folks will say that the problems with the web site are what caused the change. However, my view is that had the web site been working well, people would have found out much sooner how unattractive the insurance policies were, and the self-repeal of Obamacare would have been just as imperative.

Ezra Klein notes,

A 45-year-old whose plan just got canceled can now purchase catastrophic coverage. A 45-year-old who didn’t have insurance at all can’t. Why don’t people who couldn’t afford a plan in the first place deserve the same kind of help as people whose plans were canceled?

Antonio Fatas Starts a Discussion

Posted on by

He wrote about what he sees as four missing ingredients in mainstream macroeconomics. Let me focus on his last two:

There is plenty of evidence that price rigidities are important and they help us understand some of the features of the business cycle. But there must be more than that. There are other frictions in the real economy that produce a slow adjustment and are responsible for the persistence of business cycles.

… The notion that co-ordination across economic agents matters to explain the dynamics of business cycles receives very limited attention in academic research.

Robert Waldmann adds,

I think the problem is that with coordination failures, multiple equilibria are possible. Not just two or two hundred either, but a large infinite number. There is no theory which tells us how likely different equilibria are. Worse, policy shifts can cause the economy to jump from one equilibrium to another in unpredictable ways.

This does not strike me as an argument against the validity of models of coordination failure. In fact recessions are hard to predict and, well, look like panics. The problem is that models which say that macroeconomists will not be able to predict well are not popular.

Pointer from Mark Thoma.

When I wrote one of my PSST papers, Peter Howitt’s response put it in the coordination failure literature. In fact, I think there is a (possibly slight) difference. “Coordination failure” sounds to me as if there is a great equilibrium sitting there, and people just cannot find it. I think that the patterns of sustainable specialization and trade need to be discovered, through trial and error.

I believe that even if there were no frictions impeding coordination, as long as entrepreneurs have to test business models without knowing whether they will work, there will be business models that fail and unemployment can result. However, this is a weird hypothetical, since there is obviously no such thing as an economy with frictionless coordination.

So my view of what macro needs would include coordination failure of a variety of types, as well as trial-and-error learning. In my opinion, the resistance to this comes from various sources:

1. As Waldmann says, you have multiple equilibria. In fact, you never get to any one equilibrium, so that the very notion of equilibrium as a core modeling element loses salience. That creates a ton of discomfort.

2. The system is no longer hydraulic, in which more X (fiscal stimulus, monetary growth) leads to proportional increases in Y (GDP, inflation, employment). For many macroeconomists, the whole point of modeling is to come up with implications for fiscal and monetary policy. The idea that your model may not lead to a cure for business cycle makes the effort seem pointless, at least in compared with Keynesian can-do thinking.

3, It is inconsistent with popular modeling simplifications, such as the “representative agent.” For the purpose of publishing papers in journals, economists like to gravitate toward standard models. It is much easier to get published if you do a variation on a standard model than if all the people working on an idea are just groping around in different ways. I think that the coordination-failure approach to macro involves this disparate groping, and thus it suffers from….a co-ordination failure, if you will. The DSGE folks can co-ordinate. The rest of us can’t. So even though the DSGE stuff is a blind alley we have better ideas, when it comes to the journal process, we lose.

Should Today’s Students Learn to Code?

Posted on by

In an interview, Tyler Cowen says,

If becoming a programmer is appealing to you, great. But seeking employment based on any one “hard skill” is an outdated way of thinking. The rapid evolution of technology forces us to constantly reconsider which hard skills are in demand. (And we should). Staying on top of the hard skills needed is a necessity in the short term, but one of the best ways to position yourself for success in the long term is to focus on the soft skills needed no matter what technology you are working with.

I think it is fair to say that one should not aspire to be on just one side of the suits/geeks divide. On the geek side, you end up as Dilbert, working for an idiot boss. On the suit side, you are the idiot boss. For years, I have been telling my high school students that the combination of technical skills and communication skills is important.

But I think that the most important career advice is to spend at least some time in a profit-seeking enterprise. The bias in our educational system against working business is intense, and I believe that this bias does considerable social harm. If you want to know where collective hostility toward business can lead you, look at healthcare.gov.

Normal AD vs. the Credit Channel

Posted on by

‘Uneasy Money’ writes,

try as they might, the finance guys have not provided a better explanation for that clustering of disappointed expectations than a sharp decline in aggregate demand. That’s what happened in the Great Depression, as Ralph Hawtrey and Gustav Cassel and Irving Fisher and Maynard Keynes understood, and that’s what happened in the Little Depression, as Market Monetarists, especially Scott Sumner, understand. Everything else is just commentary.

Pointer from Tyler Cowen. This argument broke out five years ago, and it is no closer to being settled. I might phrase it as the following multiple choice question:

a) the economic slump caused the financial crisis (the Sumnerian view, endorsed above)

b) the financial crisis caused the slump (the Reinhart-Rogoff view; also the mainstream consensus view).

c) both are symptoms of longer-term structural adjustment issues (I am willing to stand up for this view. Tyler Cowen also is sympathetic to it. Note that I do not wish in any way to be associated with Larry Summers’ view, which is that the structural issue is that we have too much saving relative to productive investments.)

d) both are symptoms of a dramatic loss of confidence. As people lose confidence in some forms of financial intermediation, intermediaries that are heavily weighted in those areas come to grief. Se see disruptions to patterns of trade that depend on those forms of intermediation. Moreover, as businesses lose confidence, particularly in their ability to access credit, they trim employment and hoard cash.

I want to emphasize that I see a reasonable case to be made for any of these views. There may be yet other points of view that I would find reasonable (although Summers’ “secular stagnation” is not one of them). In macroeconomics, if you think you have all the answers, then I cannot help you. I think that this is a field in which doubts are more defensible than certainties.