Brad DeLong on Piketty

Brad writes,

We have a world in which some eminent economists (Larry Summers) say r1 is too low, and other eminent economists (Thomas Piketty) say r2 is too high…

The difference between r1 and r2 is the risk premium. In a well-functioning market economy with well-functioning financial markets, there are powerful reasons to believe that this risk premium should be small: less than 1%-point per year. The fact the risk premium appears to me to be 7%-points per year today is a powerful evidence of the profound dysfunctionality of our financial markets, and of their failure to do their proper catallactic job. But that is a separate and largely independent discussion: that is a dysfunction of our modern market economy which is different from either the dysfunction feared by Summers or the dysfunction freaked by Piketty. For the moment, simply note that it is perfectly possible for all three of these major dysfunctions to occur together.

Pointer from Mark Thoma. Read the whole thing. The risk-premium solution was also suggested here in a comment by Matt Rognlie.

So far, the left-wing journalistic verdict on Piketty is rapture. Economists, even those inclined to agree with Piketty’s conclusions, seem somewhat unsatisfied with with his treatment of capital and interest.

Simon Wren-Lewis on the Phillips Curve

He writes,

So we choose a microfoundation because it gives us the aggregate answer suggested by the data, and not because of evidence that this microfoundation is appropriate. We then insist that everything in that model has to be consistent with this microfoundation, and that our model has been built from only thinking about what individual agents do. Have we just replaced ad hoc with post hoc?

Read the whole thing for context. Pointer from Mark Thoma. My comments:

1. My joke is that the Phillips Curve went from being an empirical finding in search of theory to a theory in search of empirical support.

2. Empirically, the only thing of which we can really be sure is that the best predictor of inflation is the lagged dependent variable (this is hardly the only macroeconomic variable to which this applies). After that, the magnitude (and even the sign) of the relationship between wage growth and employment varies quite a bit depending on how you do your specification searching.

3. Once again, let my plug my macro memoir.

Why I Want to Break Up the Big Banks

Matthew C. Klein writes,

Using the lowest estimates, the big banks can attribute almost a fourth of last year’s profits to taxpayer largess. Higher estimates suggest that almost all of the big banks’ earnings in 2013 were due to subsidies rather than productive activity. The IMF notes that even “these dollar values likely underestimate the true TITF subsidy values” because, among other things, the calculations are based on the assumption that shareholders in bailed-out banks would lose everything, which isn’t usually what happens.

Pointer from Patrick Brennan.

Of course, the NY Fed will tell you that there are terrific economies of scale in banking, and that explains the profits of large banks.

UPDATE: Actually, one economist at the NY Fed, Joao Santos, thinks it’s a too-big-to-fail subsidy.

Using information from bonds issued over the past twenty years, this study finds that the largest banks have a cost advantage vis-à-vis their smaller peers. This cost advantage may not be entirely due to investors’ belief that the largest banks are “too big to fail” because the study also finds that the largest nonbanks, as well as the largest nonfinancial corporations, have a cost advantage relative to their smaller peers. However, a comparison across the three groups reveals that the largest banks have a relatively larger cost advantage vis-à-vis their smaller peers. This difference is consistent with the hypothesis that investors believe the largest banks are “too big to fail.”

Pointer from David Dayen via Mark Thoma.

Mian-Sufi vs. Scott Sumner and John Taylor

They write,

What we are witnessing is the limit of what monetary policy alone can do. Sometimes there is a tendency to assume that the Fed can “target” any inflation rate it wishes, or that it can target the overall price level – the so-called nominal GDP targeting. The evidence suggests that the Fed may not be so omnipotent.

Pointer from Mark Thoma. A couple of comments.

1. This seems like an argument against Scott Sumner’s view that monetary policy was too tight in 2008. That is, I take them as saying that there was nothing that the Fed could have done. Scott Sumner would insist that the Fed lacked the will, not the way.

2. Mian and Sufi offer a chart showing that core inflation was below the Fed’s 2 percent target almost the entire period starting in 2000. This seems like an argument against John Taylor’s view that monetary policy was too loose in 2004-2006.

3. I believe that in 2007 the Fed folks thought that inflation was rising, in part because they looked at oil prices, not just core inflation.

4. Mian and Sufi entitle their post “Monetary Policy and Secular Stagnation.” I still want to see an economist reconcile a belief in secular stagnation with a belief in Piketty’s claim that the return on capital is going to exceed the growth rate of the economy on a secular basis. For the record, I believe neither.


Atif Mian and Amir Sufi write,

what we want to focus on today is the remarkable separation in productivity and median real income since 1980. While the United States is producing twice as much per hour of work today compared to 1980, a small part of the gain in real income has gone to the bottom half of the income distribution. The gap between productivity and median real income is at an historic all-time high today.

Pointer from Mark Thoma.

They are comparing average output per hour to real median income per family. Rhetorically, they attribute the divergence in the two ratios to the numerators. That is, average output has grown faster than median income. However, there are also two denominators at work. The first denominator is “hours of work.” The second denominator is “family.” I suspect that a fair amount of the divergence in the two series is due to divergence in the denominators. That is, I suspect that the ratio of “hours of work” to the number of family units fell markedly between 1980 and today. There is a downward trend in hours worked, particularly for men. In addition, there is an upward trend in the number of family units, due to divorce and lower propensity to marry.

It would seem that this would be an easy issue to check.

Labor Force Participation Chartfight

1. John Cochrane presents a chart showing that over the last 25 years, the employment-population ratio tracks the ratio of people aged 25-54 to the total population.

Pointer from Mark Thoma. The chart is from Torsten Slok of Deutsche Bank.

2. John Taylor has a chart showing that the labor force participation rate is several percentage points that which was projected several years ago based on demographics. The chart comes from a paper by Chris Erceg and Andy Levin.

The first chart suggests that most of the decline in the employment/population ratio in recent years is due to demographic changes. The second chart suggests the opposite. How to reconcile the two?

3. And then there is Binyamin Appelbaum:

In February 2008, 87.4 percent of men in that demographic had jobs.

Six years later, only 83.2 percent of men in that bracket are working.

Pointer from Tyler Cowen.

My verdict is that Slok’s chart, referred to by Cochrane, is misleading. Here is the chart:

The way that the two lines are superimposed makes it appear that 2007 was a glorious year of over-employment, and the plunge in the employment-population ratio looks like a reversion to trend. Suppose you were to slide the blue line up vertically so that it just touches the red line at the peak in 2007. That would make the chart look much more like Appelbaum’s, shown below:

Some other issues:

–I suspect that some of the drop-off in employment has occurred among youth, who are outside of the 25-54 bracket that Slok uses.

–Another issue is what you think should have happened outside Slok’s bracket at the other end, namely 55-64 year olds. These are baby boomers, so that their share of the labor market has been soaring. The most likely reconciliation of the two charts is that the baby boomers have been retiring early at rates higher than historical norms.

As far as labor force participation goes, is 55 the new 65? If so, then somebody should trace out what that means for Social Security. Fewer people paying in and more people collecting disability cannot be a good thing for solvency.

Update: Cochrane offers another take, more nuanced.

Made Me Think of Garrett Jones

Ellen R. McGrattan and Edward C. Prescott write,

In 2008, only a small part of all intangible investment was included in the measure of GDP from the Bureau of Economic Analysis (BEA). As a result, the fact that labor productivity rose between 2008 and 2009 is not inconsistent with theoretical predictions. The intuition is simple: during a downturn, measured labor productivity rises if we significantly underestimate the drop in total output. We underestimate the drop in total output if there are large unmeasured investments.

Pointer from Mark Thoma. Recall that Jones once tweeted that most workers do not make widgets. Instead they help to build organizational capital.

The authors, who were let go by the Minneapolis Fed several months ago in what was widely viewed as a “purge,” go on to point out that the Commerce Department recently decided to incorporate investment in intellectual property into its measure of investment, and that in recent decades this category accounts for about 1/3 of all investment. They point out that the government does not include other forms of intangible investment, including “advertising, marketing, and organizational capital.”

On the input side, we measure Garett Jones workers. However, on the output side, we tend not to count what they produce. This creates a mis-measured economy. When firms are undertaking a lot of intangible investment, measured productivity is understated. When they cut back in intangible investment, measured productivity growth is overstated.

I think, though, that in order to explain the reduction in intangible investment, you have to tell a PSST story. That is, I do not think that there was an economy-wide “shock” that reduced productivity. I think that there were firms that came to the realization that the outlook did not warrant continued intangible investment. Think of bookstores, newspapers, and other victims of creative destruction.

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

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.

The Qualifications for Fed Chair

Justin Fox writes,

So has an economics PhD basically become a prerequisite for running the Fed? “I think the answer is ‘probably yes’ these days,” former Fed vice chairman Alan Blinder — a Princeton economics professor — emailed when I asked him. “Otherwise, the Fed’s staff will run technical rings around you.”

Not if you have enough confidence in your own judgment. Paul Volcker could not have cared less about the macroeconomic models of the Fed staff. In fact, nowhere in academic economics do they teach how the central bank really operates on a day-to-day basis. For that, you have to read Marcia Stigum’s Money Market.

Pointer from Mark Thoma.

It does seem to be true that Ph.D economists are now in the saddle at the Fed. In fact, there is a non-trivial chance that Janet Yellen will be the last Fed Chair not to have Stan Fischer as part of her intellectual ancestry (she is roughly the same age as Fischer and did her dissertation under James Tobin).

A Problem with Modern Macro

David Glasner writes,

It is only after coordination failures have been excluded from the purview of macroeconomics that it became legitimate (for the sake of mathematical tractability) to deploy representative-agent models in macroeconomics, a coordination failure being tantamount, in the context of a representative agent model, to a form of irrationality on the part of the representative agent. Athreya characterizes choices about the level of aggregation as a trade-off between realism and tractability, but it seems to me that, rather than making a trade-off between realism and tractability, modern macroeconomics has simply made an a priori decision that coordination problems are not a relevant macroeconomic concern.

Pointer from Mark Thoma. In other words, the representative-agent approach in modern macro serves to eliminate what some of us think is the important reason that unemployment exists. In my book, I add

The first fundamental flaw is to to treat the production process as instantaneous. You have your capital and labor sitting there, and all you have to do is put them together to produce output. In my view, Fischer Black’s emphasis that production takes time is very important. It means that plans made months or years ago have to be reconciled with current conditions. As tastes and technologies evolve, some plans turn out to be brilliant, while others turn out to have been misguided…

The second flaw in mainstream macreoconomics is to ignore the time that it takes to discover successful production processes. There is a trial-and-error process at work as enterprises are launched. The fortunate few will expand, but most new firms will fail. Starting from a situation such as one that prevailed in 2009, with many previously-viable patterns of production no longer sustainable and consequently high unemployment, it takes a lot of time and effort to discover the new patterns of specialization and trade that will reveal everyone’s comparative advantage and restore full employment.

The importance of this laborious discovery process is what I think is missing from Fischer Black’s account of macroeconomics. He insists on using the term “general equilibrium,” while I believe that it is important to recognize that the economy is never in an equilibrium state. Moreover, the adjustment to changes in tastes, technology, and shocks (such as a surge in oil prices) can be long and painful.