Monthly Archives: February 2014

Recessions and Structural Change

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Ryan Avent writes,

Examining patterns of polarisation in America, Nir Jaimovich and Henry Siu find that displacement of routine work is not a gradual process but occurs almost entirely during recessions. Since the mid-1980s, roughly 92% of job loss in middle-skill, routine jobs has taken place during or within a year of recessions (as dated by the National Bureau of Economic Research). This pattern is linked to the phenomenon of “jobless recoveries”, which followed the recessions of 1990-1, 2001, and 2007-9 but not earlier downturns.

Pointer from Tyler Cowen. My first thought is that this makes it hard to sort out cyclical and structural change.

Avent’s hypothesis is that low inflation raises real wages and induces labor-saving substitution.

I think that there might be a number of hypotheses to explain the phenomenon. For example, what we call a recession could just be a bunching up of the process of shedding ZMP workers. In theory, ZMP workers should be let go at a steady rate, but it could be that firms come to a common realization that it is time to face reality.

But read Avent’s post. It is obvious that he would regard the UK in recent years as supporting his hypothesis more than mine.

The Macro Wars: Inside-out vs. Outside-in

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I remember reading once that it is still not understood how the giraffe manages to pump an adequate blood supply all the way up to its head; but it is hard to imagine that anyone would therefore conclude that giraffes do not have long necks. At least not anyone who had ever been to a zoo.

—Robert M. Solow

Solow wrote those words at the height of the macro wars. I was very much on his side at the time, and this post will explain the sense in which I am still on his side.

Think of the task of macroeconomics as completing a mineshaft between the “outside” (what we observe in the world) and the “inside” (a mathematical model that is “pure” in its microfoundations). The Old Keynesians, including Solow, took an outside-in approach: let’s work from what we observe, build a crude model to handle that, and maybe eventually we can dig deeper and find the microfoundations. Start from the fact that there is a giraffe, and try to figure out how it maintains its blood supply. Do not start from a model of blood supply that precludes the existence of giraffes.

For the Old Keynesians, macroeconometric models were a tool with which to observe the world. They provided the starting point for the outside-in approach. Then Robert Lucas came along with his “critique,” which said that if you took an inside-out approach that included rational expectations, macroeconometric models would break down. The Lucas Critique launched the macro wars.

Lo and behold, macroeconometric models did break down. However, I do not think that the Lucas Critique had much to do with it. You can get more on my perspective by reading this paper and by reading my macro book.

The New Keynesians took up Lucas’ challenge by adopting an inside-out approach. Stan Fischer’s course at MIT was 100 percent inside-out theory, and I viscerally hated it. At the start of one class, I stood up, proclaiming loudly and sarcastically to Fischer and my fellow students how much I enjoyed the topic of “monetary growth models,” which was the particularly pointless mathematical, er, self-abuse that he was teaching us that week.

I chose Solow as my dissertation adviser, and I wrote an outside-in thesis, working backwards from what we observe to a theory of price rigidity. Not having a thesis that focused on rational expectations and not having Fischer plugging for me were career-altering. I was doomed to failure if I tried academia, and so I wound up on a different track. I don’t think I was the one who lost out on that deal.

So if you are trying to follow the methodological discussions among Mark Thoma, Paul Krugman, Noah Smith, and others, you will find me still on the side of the Old Keynesians. I still despise inside-out macro, and I still prefer the outside-in approach.

What has happened to me since I left MIT is that I no longer think that macroeconometric models provide a valid lens into observing the real world, and I no longer think that Keynesianism is the One True Way. The real world is still out there, and I still think it should be our starting point for digging the mineshaft. I still respect the Old Keynesian approach of starting with observations about the world rather than starting at the bottom of the mine with a “pure” model. However, I am willing to entertain theories that differ considerably from the Old Keynesian one. Hence, PSST, which you can also read more about in my essays/papers.

Diane Coyle on GDP and Consumer Surplus

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I just received a review copy of her new book. I’ve enjoyed her work in the past, and I am optimistic about this one.

Given my recent interest, I looked in the index for “consumer surplus.” There is one entry, which leads to a discussion of consumer surplus in the context of the Internet, where we know that there is a lot of free (non-material) stuff available.

My point is that even without the Internet, there is a lot of consumer surplus. Think about anesthetic for surgery, antibiotics for infections, indoor plumbing, heating and air conditioning, automobile driving, washing machines, electric lighting, and so on.

Show Me the Model

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Mark Thoma writes,

There is no grand, unifying theoretical structure in economics. We do not have one model that rules them all. Instead, what we have are models that are good at answering some questions – the ones they were built to answer – and not so good at answering others…

But the New Keynesian model has its limits. It was built to capture “ordinary” business cycles driven by pricesluggishness of the sort that can be captured by the Calvo model model of price rigidity. The standard versions of this model do not explain how financial collapse of the type we just witnessed come about, hence they have little to say about what to do about them (which makes me suspicious of the results touted by people using multipliers derived from DSGE models based upon ordinary price rigidities). For these types of disturbances, we need some other type of model, but it is not clear what model is needed. There is no generally accepted model of financial catastrophe that captures the variety of financial market failures we have seen in the past.

I think that Mark is closer to being on track than are some folks like this fellow or this fellow. A model is not all-or-nothing, right-or-wrong. A model is like a pair of binoculars. It helps you see some things more clearly, at the expense of not seeing other things at all. If you do not have that understanding of the modeling process, then you are missing what I see as a fundamental methodological truth.

Some more comments:

1. In my estimate, the real-world usefulness of New Keynesian and DSGE models is close to zero. Even if it is a bit more positive than that, there is no way to justify the intensity with which those models were pursued. And as much as Paul Krugman wants to blame Minnesota, I keep coming back to the fact that it was Stan Fischer who turned out the grad students who captured probably 75 percent of the available top-tier academic macro posts available for a period of about 15 years, effectively over-running the entire ecosystem. To suggest instead that the profession caved into bullying from Prescott or Sargent or Lucas is to create a false narrative, offering what amounts to an intellectual bailout for MIT. Read my recent macro book to try to get a better sense of the history.

2. Mark Thoma may be optimistic in suggesting that there is a “right model” to use in every situation. It may be that there are important macroeconomic episodes that are beyond the scope of any model to truly capture.

3. If there is a “right model” for what I call the Financial Crisis Aftermath episode, then I think it will have to include a role for malinvestment. Not so much malinvestment because of the Fed’s misbehavior in 2004 (sorry, John Taylor), and even not so much malinvestment in housing. In the financial sector, I suspect that a lot of the malinvestment reflected poor judgment on the part of both private-sector executives and regulators. In the nonfinancial sector, I suspect that the malinvestment included poor choices on the part of people in terms of skill acquisition (a lot of college degrees in psychology and “____ studies” majors) and a lot of malinvestment on the part of firms that took too long to recognize that the Internet was blowing apart their business models.

4. The PSST story emphasizes the lengthy, trial-and-error process involved in finding new patterns of sustainable specialization and trade. It tends to defy the entire “model” genre, because modeling tends to involve solving for equilibrium, rather than describing what may be a laborious process of groping within a state of disequilibrium.

Austerity

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Chris Edwards dissects it.

Transfers are the largest and fastest-growing activity. Since 2000, transfers have grown at an annual average rate of 6.7 percent, which compares to purchases at 6.0 percent, compensation at 5.5 percent, and aid to the states at 5.0 percent. Total federal spending grew at 5.5 percent during this period, while the consumer price index grew at just 2.4 percent.

PSST Questions from a Reader

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First,

Suppose that for some reason, the marginal value of many former employees in sector A has gone down nearly to zero. My contention is that whenever this happens, the marginal cost of sector A’s products should be plummeting…The spiffy new technology can only dislocate traditional production if it is so productive that it can outbid firms with access to this cheap labor. Maybe this will happen, but either way we should be seeing a huge decline in marginal cost.

I have a somewhat different perspective on zero marginal product. Remember that nowadays very few workers produce widgets. As Garrett Jones pointed out, they produce organizational capital. In the sense of the neoclassical production function, they are always ZMP. The decision to retain them or unload them depends on management’s assessment of the future value of organizational capital.

Suppose we take the example from Ben Stiller’s mediocre remake of the Walter Mitty story, in which Walter’s job is threatened because the print magazine he works for is looking obsolete. It’s not the case that if you could just bring down the marginal cost of producing copies of the print magazine, everything would be fine. The magazine has a dim future, regardless. To make matters worse for Walter, his skill set involves working with negatives from old-fashioned film cameras.

Second,

we don’t see huge relative price declines in the sectors that are losing workers due to some structural change. The auto industry, one of the very most cyclical industries in terms of output and employment, shows virtually no cyclical pattern in relative prices

The pre-1990 business cycles generally involved accumulation of excess inventories of autos and other durable goods. In hindsight, these seem like timing errors on the part of businesses. An inventory recession is not a permanent disturbance to patterns of sustainable specialization and trade. When the excess inventory has been worked off, you can recall the men on the production line.

The secular change to the auto industry in Detroit and elsewhere in the Midwest, due to more automation and stiff competition from overseas as well as from the South, is quite different from an inventory correction. In theory, the effect could be gradual, with Detroit shedding a few workers each year. In practice, the adjustment tends to be “lumpy,” with an entire plan shutting its doors forever, then a few years of little change, then another plant shutting down forever, etc.

the postwar experience is even more problematic for PSST. Including the prewar arms buildup, at the end of the war in 1945 the economy had just spent 4 to 5 years on an extreme military-oriented path, a vastly distorted pattern of production and consumption. Before that, there was the Great Depression, not exactly a normal time either. The transition to a relatively normal postwar economy following 1945, therefore, was an extraordinary adjustment

I agree, except that I want to be clear that I do not think of it as a transition back to a normal economy by pre-war standards. 1949 was very different from 1929. The agricultural work force has plummeted. The proportion of the work force with only an 8th-grade education has shrunk. The urban factory worker is giving way to the suburban sales clerk.

In my view, the key to the transition was the uprooting that took place during the War. After you have been shipped all over the country (or all over the world) and met all sorts of people from other backgrounds, you are not as committed to returning to that obsolete farm or declining small town or stagnating city. You are much more willing and able to move to where the opportunities are. My guess is that we had a particularly mobile society in the late 1940s, and this contributed to the surprisingly rapid establishment of patterns of sustainable specialization and trade.

But I agree that one of the more interesting questions of economic history is how the U.S. economy managed to undertake the transition to peace time so quickly and smoothly.

John Cochrane’s Bank Reform

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He proposes,

For every dollar of short-term debt, pay the government (say) 10 cents. I don’t know the exact number either, but a wrong tax rate does a lot less damage than a wrong quanti[t]ative restriction.

Instead of telling banks what their ratio of debt to equity should be, let them choose that ratio, based on a tax that offsets the implicit subsidy to debt that comes from bailouts. Makes sense.

Are We Near Full Employment?

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Timothy Taylor writes,

We have now returned to an economy where those who leave their jobs are more likely to have done by quitting voluntarily than by being laid off or discharged involuntarily

Read the whole thing. One interpretation of the data is that the labor market has now divided. There are active workers, who are exhibiting fairly typical patterns of working, quitting, and being laid off. And there are inactive workers, who have either officially or unofficially left the labor force. If this interpretation is correct (and I am not confident that it is), then we may be close to full employment.

Signs of the Future

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From Technology Review.

Though genome editing with CRISPR is just a little over a year old, it is already reinventing genetic research. In particular, it gives scientists the ability to quickly and simultaneously make multiple genetic changes to a cell. Many human illnesses, including heart disease, diabetes, and assorted neurological conditions, are affected by numerous variants in both disease genes and normal genes. Teasing out this complexity with animal models has been a slow and tedious process. “For many questions in biology, we want to know how different genes interact, and for this we need to introduce mutations into multiple genes,” says Rudolf ­Jaenisch, a biologist at the Whitehead Institute in Cambridge Massachusetts. But, says ­Jaenisch, using conventional tools to create a mouse with a single mutation can take up to a year. If a scientist wants an animal with multiple mutations, the genetic changes must be made sequentially, and the timeline for one experiment can extend into years. In contrast, ­Jaenisch and his colleagues, including MIT researcher Feng Zhang (a 2013 member of our list of 35 innovators under 35), reported last spring that CRISPR had allowed them to create a strain of mice with multiple mutations in three weeks.

The IGM forum tried to ask economists to take sides in the end-of-innovation debate by asking if they agreed with

Future innovations worldwide will not be transformational enough to promote sustained per-capita economic growth rates in the U.S. and western Europe over the next century as high as those over the past 150 years.

The most popular answer was “uncertain,” and the next most popular answer was “disagree.” I would note that Tyler Cowen has consistently said that he is bullish on innovation longer term.