Monthly Archives: December 2013

The Flat Tire as Discontinuity

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From the current draft of my macro book:

The gas pedal is a metaphor for continuity. The flat tire is a metaphor for discontinuity. If the economy is characterized by continuity, then in the absence of a large shock, it cannot suddenly “jump” from one state to a very different state. Typically, macroeconomic models embody continuity, so that they do not allow for sudden jumps. To do so, a model must incorporate multiple equilibria, or what I would prefer to call discontinuity.

…With respect to perception and reality (or liquidity and solvency), a firm might be in one of three states:

1) insolvent under all circumstances. Investors with funds at risk with the firm are going to experience losses, whether they realize it or not.

2) solvent under all circumstances. Even if investors were to lose confidence in the firm, it would be able to meet its obligations to them.

3) solvency contingent on investor perceptions. If investors maintain confidence, so that the cost of short-term funding is low, the firm’s net worth is positive. However, if investors lose confidence and the cost of short-term funding rises, the firm’s net worth would become negative.

It may be the norm for financial institutions to be in state (3), meaning contingent solvency. They are solvent if their investors remain confident, but they are insolvent otherwise.

…If banks are normally in a state of contingent solvency, then there arises the possibility of discontinuity in the financial sector. A relatively modest adverse shift in perceptions, by causing a run, can lead to a large decline in both liquidity and solvency among affected banks. This can cause a sudden drop in financial intermediation.

Perspective on Fiscal Policy

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From Laurence Kotlikoff:

The US fiscal gap now stands at an estimated $205 trillion, or 10.3 percent of all future US GDP. Closing this gap is imperative, and requires a fiscal adjustment of an immediate and permanent 37 percent reduction in spending (apart from servicing official debt), an immediate and permanent 57 percent increase in all federal taxes, or some combination of the two. The necessary size of this adjustment increases the longer it is put off.

Meanwhile, all reasonable centrists can celebrate the Ryan-Murray budget compromise.

The bill will authorize $1.012 trillion worth of discretionary spending in 2014, more than the $967 billion scheduled under sequestration

Have a nice day.

Macroeconomic Changes

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From an article bySerena Ng and Jonathan H. Wright (gated)

There has been a secular increase in the share of services in consumption from an average of 50 percent before 1983 to 65 percent after 2007, at the expense of nondurables (from 35 percent to 22 percent). Labor share in the nonfarm sector has fallen, as has the share of manufacturing employment. The civilian labor force participation rate stands at 63.5 percent in 2013, much below the peak of 67.2 percent in 1999. This is in spite of the female participation rate rising from under 35 percent in 1945 to over 60 percent in 2001, as the male participation rate has been falling since 1945. The economy has experienced increase openness; international trade and financial linkages with the rest of the world have strengthened, with the volume of imports plus exports rising from 12 percent of GDP before 183 to 27 percent post-2007. Meanwhile, not only have households’ and firms’ indebtedness increased, so has foreign indebtedness. For example, the household debt-to-asset ratio rose from under 0.75 in the 1950s to over 1.5 in 2000 and has since increased further. Net external assets relative to GDP have also risen from 0.82 in the 1970s to 2.4 when the sample is extended to 2007.

Keep in mind that the conceit of macroeconometrics is that each quarter is an independent observation, and that by controlling for a few variables one can make, say, 1982 Q1, equivalent to 2009 Q3, except for key policy drivers. If you cannot buy that (and of course you cannot), then I believe that you have reasons to be skeptical of any purported estimates of multipliers.

Symposium on Hayek

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It appears in the forthcoming issue of Critical Review. for now, all the papers except Jeffrey Friedman’s are gated. In the symposium, Karen L. Vaughn writes,

While Hayek overtly focused on the price system as the means of achieving economic coordination, in fact, prices will only do their work if the complex of market institutions within which action takes place is relatively stable. The coordination problem is solved by both the price system and the complex of rules, practices, and routines that characterize the market order. Moreover, the market order evolves over time as people find better “solutions” to their problems.

This seems to me to anticipate George Gilder’s description of high-information entrepreneurial activity occurring within a low-information channel of rules and regular behavior.

Daniel Kuehn writes,

the relative lengthiness of the capital structure in growth years, and the relative shortness of the capital structure in recessions, does not mean that it is too long during growth years and just right during the recession (as Hayek theorized). It may be the case that it is just right during growth years and too short during the recession.

Michael Strong writes,

[Hayek] realized that, just as constraints on freedom of expression limit our search for the truth, constraints on freedom of action do so as well. In fact, limiting freedom of action can lead to long-term reductions in human well-being insofar as innovation is necessarily based on the cognitive rewiring that takes place from encountering specific new situations.

In short, people learn from experiences that contradict their preconceptions, and limiting their experiences means limiting their ability to learn.

Andrew Gamble writes,

The growth of public-sector employment and bureaucratic private corporations has meant that most individuals, including Hayek himself, have been security-seeking employees, rather than risk-taking market entrepreneurs. As Hayek noted, a nation of employees is likely to be averse to risk and prone to seek safety, valuing security more than enterprise

Peter J. Boettke and Kyle W. O’Donnell write,

Given the impenetrable shroud of time and ignorance, trial-and-error experimentation through the competitive market process is among the only established methods for assessing the value to society of alternative courses of action. The effectiveness of this trial-and-error method is analogous to the theory of biological evolution by natural selection

Jeffrey Friedman writes (not gated),

the adaptive aspect of Hayek’s approach to interpretation can explain erroneous interpretations without invoking irrationality (as is so often done by social scientists, especially economists). Hayek’s explanation for error juxtaposes the wider objective world against expectations that we form on the basis of local objective conditions (as reflected by the stimuli we notice)…Hayek’s account of learning describes the correction of our subjective interpretations by further experience with the objective environment.

…we can be sure that everyone has what they view as good reasons for their beliefs, even when these beliefs seem, to us, to be obviously mistaken.

Friedman goes on to say that Hayek mis-speaks when he talks about local “knowledge” rather than local opinion. Read the entire essay.

Is the Flat Tire an AD Shock?

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I recently suggested that if the economy is a car and monetary policy is the gas pedal, then perhaps the financial crisis was a flat tire. Keeping with the metaphor, we can ask.

1. Was the flat tire fixed by early 2009?

2. Was the flat tire an AD shock? Can monetary and fiscal expansion restore full employment?

I think that the mainstream view is “yes” to both questions. Of course, that depends on how one interprets the flat tire. If one interprets it as troubled banks and a high TED spread, then it was fixed. In that case, I am not sure how you would explain why the the macroeconomic problems lasted five years.

Perhaps it is more promising to say that the flat tire was not fixed by early 2009. Maybe the best one can say is that it was patched before even more was let out of it. Yes, the banks did not collapse, but financial confidence remained low, as reflected in tighter credit conditions for mortgage loans and business loans (can we really demonstrated the latter)?

I find it more promising still to suggest that the flat tire was a broader loss of confidence. Confidence in certain types of financial transactions fell. But it also fell in business in general. So older businesses rushed to let go of excess workers, and entrepreneurs did not rush to form new businesses.

So my inclination is to say “no” to both questions. Perhaps the air stopped running out of the tire, but it was not really fixed. Also, I do not think that it helps to view the economy as suffering from an AD shock. If the financial sector is not functioning properly, and the analogy is with having a nation-wide electrical power failure (as Larry Summers suggested in his “stagnation” talk), then that is more of supply-side issue. Moreover, if some businesses are shedding excess workers while other businesses are not hiring, then that is a PSST issue.

Possibly related, here is Timothy Taylor on Alvin Hansen. Taylor concludes,

I worry that the current U.S. economic policy agenda is all about fiscal and monetary policy, along with financial regulation and health insurance. I hear relatively little discussion focused directly on an agenda for creating a supportive environment for private domestic investment.

A Challenge for Francis Fukuyama

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He writes,

Many American political actors recognize that the political system isn’t working well, but nonetheless have very deep interests in keeping things as they are. Neither major party has an incentive to cut itself off from access to interest group money, and the interest groups fear a system where money can’t buy influence. As in the 1880s, a reform coalition has to emerge that unites groups without a stake in the current system. But achieving collective action among these out-groups is difficult; it requires skillful and patient leadership with a clear agenda, neither of which is automatically forthcoming. It may also require a major shock, or shocks, to the system. Such shocks were critical, after all, in crystallizing the Progressive movement—events like the Garfield assassination, the requirements of America’s rise as a global power, entry into the World War, and the crisis of the Great Depression.

Pointer from Tyler Cowen.

I did not care for this essay. He sounds to me like a Progressive, circa 1910. With sufficient moral authority, the government can be more effective and reflect the true Will of the People™.

My challenge for Fukuyama is to name a government with a large, diverse population that in his view works really well. The countries with populations larger than the U.S. are China and India, and I do not wish to trade governance with either country. In fact, of the top 10 most populous countries, the only one with a government that is not atrociously worse than ours is Japan. And they are the least diverse. Germany, with 1/4 of our population, is decently governed. So is the UK, with 1/5 of our population, and Canada, with 1/9 of our population.

When you think of a country with an effective central government, what comes to mind? I come up with Singapore, Switzerland, Finland, Sweden, and such, all with populations under 10 million. And Switzerland delegates a lot of political power to cantons and towns. What this says to me is that the most promising way to reform government in the U.S. is in the direction of Federalism, rather than betting on making the central government work better.

Medicaid = Nursing Homes

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Harold Pollack writes,

If we want to provide more cost-effective care to poor people, we should proceed in the same way that we should proceed in other parts of the medical economy. We must do the hard work of improving the quality and economy of care provided to the concentrated group of extremely costly patients. There is no short cut. Under any financing system, this requires the hard work of clinical-care coordination, quality improvement and social services to address life circumstances that undermine health.

Pointer from Tyler Cowen. His main statistical argument is that a small percentage of Medicaid patients account for much of the spending. It is likely that these are patients in nursing homes.

However, this does not answer the question of where there are opportunities to save money in medical care. Some possibilities.

1. Death panels. To the extent that late-stage treatments are wasteful, you have to change the decision-making process. Families and would-be heroic doctors need to have less influence.

2. Reducing procedures, such as back surgery, with high costs and low benefits. In Crisis of Abundance, I argued that there is in fact a large “gray area” of medicine, in which procedures are neither absolutely necessary nor absolutely unnecessary. This is counterintuitive, and if you do not believe it, then you end up siding with Pollack. If you do believe it, then having patients pay more of the cost of treatment could be a big deal.

3. Improving management in health care, particularly of patients with complex illnesses. My guess is that if there are big savings to be had here, they come from reducing the status of doctors relative to managers, social workers, and care-givers with lesser credentials. See Does the Doctor Need a Boss? I would not bet that government will be successful at re-engineering the system, and in fact regulation of medical practice is probably a major inhibitor.

4. Innovation in treatment. My concern would be with the Food and Drug Administration. They want to err on the side of keeping treatments off the market. We might be better off if their task was shifted to funding and publicizing research, not actually regulating.

Occupations of the Future

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David Brooks writes,

Millions of people begin online courses, but very few actually finish them. I suspect that’s because most students are not motivated to impress a computer the way they may be motivated to impress a human professor. Managers who can motivate supreme effort in a machine-dominated environment are going to be valuable.

Actually, I think that a big reason that people drop online courses is that those courses are a misfit for them. An advantage of a typical live course is that most of the students have been selected to have similar abilities and experiences. A lot of people sign up for online courses who otherwise would be discouraged from doing so. That is not necessarily a problem with online learning.

However, that is why MOOCs are not the answer, in my view. My line is that we need instruction that is many-to-one, not one-to-many. Indeed, Jonathan Haber suggests that MOOCs might be a step backward, and he links to something I wrote in 2002.

suppose that we had all of the highly-touted electronic technologies for distance learning, and then someone came along and invented the book. My guess is that the book would be greeted as a technological marvel–easy to hold, convenient to carry, outstanding resolution, and so forth. This thought experiment leads me to suspect that electronic distance learning is a fad.

On the subject of the future, my joke is that the ideal occupation will be a yoga instructor working in an old-age home. That lines up with the trends toward more spending on health care, education, and leisure, along with an older demographic.

Hal Varian on Big Data

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The self-recommending paper is here.

When confronted with a prediction problem of this sort an economist would think immediately of a linear or logistic regression. However, there may be better choices, particularly if a lot of data is available. These include nonlinear methods such as 1) neural nets, 2) support vector machines, 3) classifi cation and regression trees, 4) random forests, and 5) penalized regression such as lasso, lars, and elastic nets.

In one of his examples, he redoes the Boston Fed study that showed that race was a factor in mortgage declines, and using the classification tree method he finds that a tree that omits race as a variable fits the data just as well as a tree that includes race, which implies that race was not an important factor.

Thanks to Mark Thoma for the pointer.