Janet Yellen raises some good questions

She said,

Prior to the financial crisis, these so-called representative-agent models were the dominant paradigm for analyzing many macroeconomic questions. However, a disaggregated approach seems needed to understand some key aspects of the Great Recession.. . .

More generally, studying the effects of household and firm heterogeneity might help us better account for the severity of the recession and the slow recovery.

Pointer from Mark Thoma.

You might have to go much farther than Yellen has in mind in thinking in terms of heterogeneity of firms, workers, and households. At some point, it ceases to be macro.

And there is this:

the influence of labor market conditions on inflation in recent years seems to be weaker than had been commonly thought prior to the financial crisis. Although inflation fell during the recession, the decline was quite modest given how high unemployment rose; likewise, wages and prices rose comparatively little as the labor market gradually recovered.

I disagree with the standard models of inflation, including the monetarist model. Specialization and Trade offers my answers to all of Ms. Yellen’s questions.

To the Aspiring Econ Grad Student

Paul Romer writes,

If I am right that in recent decades the equilibrium in post-real macro has discouraged good science (and remember, many economists do not agree with me, at least not yet) there is some risk that a rear-guard of post-real macroeconomists will continue to defend their notion of methodological purity. At this point it is hard to know whether this group will fracture or dig in for a fight to death. If they dig in, I suspect that it will be in a few departments and that the variation between departments will be larger. Watch to see how this plays out and choose where you go with this in mind.

Pointer from Mark Thoma.

My own advice is to look for opportunities other than graduate school in economics.

One way to think of my latest book, Specialization and Trade, is as a denunciation of the path that academic economics took since 1940. It is a Quixotic attempt to pull off what Paul Samuelson did in the 1940s, which is completely re-orient economics from undergraduate education on up. That is not going to happen. I think that academic economics (especially macro, but not just macro) is simply too far gone.

If you have a strong interest in studying economics and in joining in the intellectual conversation, you can do that on your own, without going to graduate school. This was less true forty years ago, when I was starting grad school, because we did not the Internet, with its blogs, online working papers, podcasts, and so on.

On your own, you can be selective about what you study and how intensively you delve into various areas. Studying on your own will be a lot less expensive than going to graduate school, particularly in terms of opportunity cost. Graduate programs will make you waste a lot of time studying things that are either uninteresting to you or uninformative, or both.

It could be that you really want the academic lifestyle, and suffering through an economics Ph.D program is the best way to get it. But be careful about assuming that the academic lifestyle is the only one for you. I think that bright college students tend to over-estimate the intellectual stimulation that they can get out of academia and they under-estimate the intellectual stimulation that they could get out of working in business.

James Tobin’s Presidential Address

Robert Waldmann brings it up. Tobin delivered it in 1971, and it was published in 1972.

Pointer from Mark Thoma.

As I remember it, Tobin suggested thinking of an economy with two industries and wages rigid downwards. Suppose that demand shifts away from industry X to industry Y. Because wages do not fall in industry X, you get unemployment there. Because wages do rise in industry Y, the overall rate of inflation goes up. Note, however, that with more inflation, the real wage in X falls, which means less unemployment there than otherwise.

This simple story gives you an explanation for both stagflation and the Phillips Curve. The point that Waldmann is making is that macroeconomists did not need to take the detour that they took in the 1970s. They could have stayed on the path that Tobin laid out for them. My thoughts:

1. It is amazing how much better you can do if you break up the GDP factory into two industries. I think you can do even better with more disaggregation, but the modeling would be much hairier.

2. I agree that macro would have done better to follow this path. However, macro still would not be very good. The problem of too many plausible causal factors chasing too little data is insurmountable. See my science of hubris paper, as well as the recent Paul Romer screed.

3. The sociology-of-economists question of how macro remained (and continues to be) stuck for so long is quite interesting. See Daniel Drezner’s piece (for which I also thank Thoma). As you know, my explanation is that Stan Fischer became the Genghis Khan of macro.

Cities that Attract College Graduates

Rebecca Diamond writes,

the additional benefits college graduates gained from having access to a variety of desirable local amenities actually outweighs the negative effects of high housing costs. The 50 percent increase in the wage gap between high school and college graduates from 1980 to 2000 actually understates the true increases in economic inequality due to changes in wages, housing costs, and local amenities by at least 30%.

Pointer from Mark Thoma.

I think that the story she tells is pretty close to my model of gentrification.

1. Some high-skill enterprises locate in a downtown area. Think of the New Commanding Heights industries of health care and education.

2. This attracts well-educated professionals.

3. This attracts amenities that well-educated professionals enjoy. Bicycle lanes. Sushi restaurants. Opportunities to meet other well-educated professionals.

4. Rents and house prices go up.

5. Former residents are driven away by declines in low-skill jobs, higher housing costs, and lower propensity to enjoy bike lanes, sushi, and opportunities to meet well-educated professionals.

Why You Don’t Have to Change Your Mind

James Surowiecke writes,

Obamacare is being hobbled by the political compromises made to get it passed. ..

Conservatives point to Obamacare’s marketplace woes as evidence that government should stop mucking around with health insurance. In fact, government hasn’t mucked around enough: if we want to make universal health insurance a reality, the government needs to do more, not less.

Pointer from Mark Thoma.

A while back on twitter, someone pointed me to a passage from David Deutsch.

The key defect of compromise policies is that when one of them is implemented and fails, no one learns anything because no one ever agreed to it.

So, one side says that the stimulus failed because stimulus does not work. The other side says that it worked, but there was not enough of it. One side says Obamacare has not achieved its objectives because it is a flawed concept. The other side says that “government hasn’t mucked around enough.”

If you wanted to create accountability in politics, you could say, “You can have your way, but if the results do not conform to your promises, you lose power.” But things are never that clean.

With markets profits and losses ensure accountability. When your firm loses enough money, you can insist that you were right all along and just ran into bad luck, but nonetheless you go out of business.

Who Needs Liquidity?

Lynn Stout writes,

Wall Street is providing far more liquidity (at a hefty price—remember that half-trillion-dollar payroll) than investors really need. Most of the money invested in stocks, bonds, and other securities comes from individuals who are saving for retirement, either by investing directly or through pension and mutual funds. These long-term investors don’t really need much liquidity, and they certainly don’t need a market where 165 percent of shares are bought and sold every year. They could get by with much less trading—and in fact, they did get by, quite happily. In 1976, when the transactions costs associated with buying and selling securities were much higher, fewer than 20 percent of equity shares changed hands every year. Yet no one was complaining in 1976 about any supposed lack of liquidity. Today we have nearly 10 times more trading, without any apparent benefit for anyone (other than Wall Street bankers and traders) from all that “liquidity.”

Pointer from Mark Thoma.

I was appalled by this paragraph (and by others in her essay), for a number of reasons.

1. It appears on a site calling itself “pro-market.” The conceit is that they are battling crony capitalism. However, the essay does not assert, much less establish, any connection between cronyism and trading volume.

2. Note that since 1976, some activities have been affected by the advent of a device known as the computer chip. The fact that we have nearly 10 times as much trading as then should be no shock. The cost of trading has likely fallen by way more than 10 times (feel free to compare brokerage charges adjusted for inflation). Who is Lynn Stout to suggest that the price elasticity of trading ought to be zero?

3. I would appreciate it if Lynn Stout could tell us how she thinks we should measure the benefit of liquidity. I believe that any thoughtful economist would say that this is a difficult issue. I have said that as individuals and nonfinancial firms we wish to hold liquid, riskless assets and issue risky, illiquid liabilities. Financial firms do the opposite. I am quite sure that this produces real benefits. But I would be hard pressed to arrive at even a conceptual approach to quantifying those benefits.

I believe that there is cronyism embedded in the relationship between Wall Street and Washington. But that does not justify pure demagogic bashing of investment bankers.

DSGE Models Are Not Micro-founded

Mark Thoma quotes George Evans,

First, because it is a carefully developed, micro-founded model incorporating price frictions, the NK model makes it possible to incorporate in a disciplined way the various additional sectors, distortions, adjustment costs, and parametric detail found in many NK/DSGE models.

No! There is no specialization and trade in these models. You can call such a model “micro-founded” all you want. It isn’t. These empty modeling exercises do not deserve to be called micro-founded. They do not even deserve to be called economics.

Is This Socialism?

Chris Dillow writes,

Markets, therefore, have a big place in socialism – not least because, as Adam Smith said, they are a means whereby people provide for others without caring. (The best counter-argument to this I’ve seen comes from Matthijs Krul).

This principle has another implication. Socialism should be achieved by evolution, by creating stepping stones – small institutional tweaks that create the potential for bigger ones. For example, small acts of empowering people – such as worker directors or patients’ groups – might create a demand for greater power.

Pointer from Mark Thoma. What Dillow appears to want strikes me as a form of capitalism that is tweaked to make competition less intense among low-skilled workers and more intense among employers. I can heartily endorse the thrust of what he is proposing as much better than what we have currently.

The Future of Mainstream Macro?

According to Olivier Blanchard,

I suspect that even DSGE modelers will agree that current DSGE models are flawed. But DSGE models can fulfill an important need in macroeconomics, that of offering a core structure around which to build and organize discussions. To do that, however, they have to build more on the rest of macroeconomics and agree to share the scene with other types of general equilibrium models.

Pointer from Mark Thoma.

Actually, he does not even mention what I believe is the main flaw with this approach to macroeconomics. As I point out in Specialization and Trade, that flaw is the failure to include specialization at all. Instead, there is one type of worker producing one type of good. This is obviously unwise once you consider it, but once you consider it you are no longer a respectable macroeconomist.

Expensive Cities and Labor Immobility

Peter Ganong and Daniel Shoag write,

Though lawyers still earn much more in the New York area in both nominal terms and net of housing costs, janitors now earn less in the New York area after housing costs than they do in the Deep South. This sharp difference arises because for lawyers in the New York area, housing costs are equal to 21 percent of their income, while housing costs are equal to 52 percent of income for New York area janitors. While it may still be “worth it” for skilled workers to move to productive places like New York, for unskilled workers New York’s high housing prices offset the nominal wage gains.

Once again, land-use regulation is accused of being a major culprit. And along those lines, discussing Tokyo, Alex Tabarrok writes,

Rising housing prices are not an inevitable consequence of growth and fixed land supply–high and rising housing prices are the result of policy choices to restrict land development.

However, note that in a post devoid of politics or vitriol, Paul Krugman writes,

In today’s world, core headquarters functions – the stuff done by top executives and highly paid experts – can be unbundled from the more mundane operations of a company. These high-end functions are also the ones that benefit most from the agglomeration economies of a big city; not to mention the amenities such a city offers to people whose salaries are enough to let them afford decent housing despite high prices.

Meanwhile, it’s no longer necessary to have all the back-office operations in the same place, requiring that a lot of less-well-paid workers deal with high rents even as they suffer on the long subway ride in from Queens.

Pointer from Mark Thoma.

The point is that with modern communications technology, the upper echelons no longer have to be close to all of their mid-level staff.

This particular form of unbundling may or may not be the major factor. However, I think that patterns of specialization have shifted in ways that allow the affluent to invade some major cities and drive out the less-affluent. My view is that, as with colleges, affluent residents are a powerful attraction to other affluent residents, so that you head toward an outcome in which there is competition for “admission” to the high-end cities. For a variety of reasons, including differences in tastes, many of the less-affluent do not enter this competition.