Category Archives: PSST and Macro

What if Inflation is Lower than Reported?

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Martin Feldstein makes the case. John Cochrane draws out one implication.

It would mean that we really have 0% nominal interest rates, 1.5% deflation rather than 1.5% inflation; +1.5% real rates rather than -1.5% real rates.

I find it much more satisfying to believe that the real interest rate is positive than to buy into secular (demand) stagnation. But some caveats:

1. Tyler Cowen’s third law.

2. I think that talking about “the” rate of inflation is difficult when relative prices are changing by much more than the average of all prices. Prices in the New Commanding Heights sectors of education and health care still seem to be rising faster than other prices. Products that incorporate computer chips still seem to be getting better and/or cheaper. Housing costs are going up in some locations, not in others. Etc.

On Macro and Methods

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This may or may not relate to the issue of “mathiness” raised by Paul Romer, recently cited by by Joshua Gans and by Mark Thoma. It is from an essay I am working on:

Keynesianism treats the economy as a single business producing one output, called GDP. This modeling strategy focuses all attention on the problem of choosing how much to produce. It assumes away the problem of choosing among outputs or the problem of choosing from among many possible production methods or supply-chain configurations.

This single output, GDP, is produced by a single technique, called the aggregate production function. Thus, the Keynesian modeling strategy ignores the existence of multiple alternative patterns of specialization. Keynesians act as if there were exactly one pattern of specialization in the economy. There is no need to choose among alternative patterns, to discard outmoded patterns, or to discover new patterns.

In the Keynesian framework, jobs are only lost when there is a drop in demand. In the PSST framework, and in the real world, jobs are constantly being destroyed, for a variety of reasons.

Economic progress consists of re-arranging production of output to be more efficient. It is an always-ongoing process that necessarily destroys jobs. A new consumer product makes other products obsolete, or at least less desirable. A new invention or managerial innovation makes it possible to produce the same output with fewer workers. A new configuration of trade uses labor more efficiently…

In the Keynesian story, all unemployment looks like the temporary layoffs that used to occur in automobiles and steel when firms accumulated excess inventories. Once inventory balance was restored, workers were recalled to the same jobs.

In the PSST story, all unemployment looks like structural unemployment. That is, workers who lose jobs will not find that those jobs return in several months, or ever. Instead, displaced workers will have to be employed by different firms, often in different industries.

In the Keynesian story, the process of economic adjustment to a shock consists of arriving at the correct relationships between the money supply and the aggregate price level and between the price level and the aggregate wage. In the PSST story, the process of economic adjustment to a shock requires entrepreneurs to discover new arrangements of tasks that add sufficient value to generate sustainable profits. As with all entrepreneurial effort, this is a trial-and-error process. Some new businesses will fail, generating no sustainable employment. Only a few will be so successful that they create large numbers of new jobs. Sorting out this process will take time.

From the perspective of someone who finds that the PSST story fits well with economic thinking, the Keynesian modeling strategy seems contrived and misguided. By aggregating the economy into a single business, Keynesianism necessarily shoves the phenomenon of structural adjustment and the ferment of entrepreneurial trial and error into the background. Keynesians regard this as a useful simplification. Instead, Keynesianism is more like Hamlet without the Prince.

Acemoglu and others on Network Macro

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Noah Smith offers praise.

thanks to the hard work and insight of Acemoglu and others, the old dream of a network model of the economy is a little closer to reality. Someday we may draw maps of economic linkages the way we now draw circuit diagrams, and use supercomputers to simulate economic disturbances as they make their way through the web.

The paper is by Daron Acemoglu, Ufuk Akcigit, and William Kerr. Tyler Cowen was at the conference where the paper was presented, and he blogged some random comments.

My thoughts:

1. Because input-output tables do not incorporate prices or substitution, it is easy to get Keynesian multipliers out of them. To the extent that there is substitution and price adjustment, multipliers should vanish. The authors claim to find large multipliers, which suggests that that they have found some validity to the no-substitution, no-price-mechanism approach, at least in the context of their analysis.

2. While this is not treating the economy as a GDP factory, it is only slightly better. What they call demand shocks might be described as, respectively, a competing-with-Chinese-imports factory and a government purchases factory.

3. The task of coming up with new patterns of sustainable specialization and trade, which I think of as one of the central issues in the PSST story, is not captured in the input-output framework.

The Handle-Baumol Model of Stagnation

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Handle writes,

we have a savings glut – it’s on the demand side for capital, not the supply side. The savings rate in the US really hasn’t moved all that much, but there are fewer profitable places to invest the same amount of savings, so to clear the market, rates fall in the competition for yield.

Again, the point is that normal labor market forces gradually reallocate the labor force from higher-labor-productivity-growth industries to lower-labor-productivity growth sectors.

The NCH sectors are exactly those places, which for whatever reason, we can observe very low rates of labor productivity growth over time, and the reason is because they are dependent on human factors which cannot be easily sped up to any significant degree.

So, we have a lot of labor now working in sectors where the reduction in labor (or increase in output) that you get from an additional unit of capital is low. I can see where that would make the return on capital low. I think you still need to tell a story to explain why savers are willing to accept those low returns. And you have to explain why saving and investment does not gravitate toward India and other places where the opportunities to produce much more with less labor ought to still be there.

Finally, even if the story holds up, it is a story of supply-side stagnation, is it not? I suppose that you can say that with low investment you get a Keynesian demand-side shortfall, but that is just hand-waving, right? Or have I been into PSST so long that all Keynesian macro seems like hand-waving to me?

What is a Job?

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In a recession, we speak of jobs being “hard to find” and “the need to create jobs.” As intuitively reasonable as these phrases seem, they run counter to conventional economics.

The goal of an economy is not to create work. What we want is higher productivity, which means that more goods and services can be obtained with less work.

The traditional view of the economic problem is that we have unlimited wants and limited resources. The folk Keynesian view is the opposite: we have resources that are superfluous because of limited wants (low aggregate demand).

When we focus on trade as the central principle of economics, we can resolve this tension. That is, we can explain a shortage of “jobs” even though the economic problem is to try to produce more with less.

The most striking thing about a modern economy is specialization. Most of us produce goods or services that cannot be directly consumed. And all of us consume goods and services that we could not possibly produce.

As an individual, I earn a living by doing a few tasks that do not produce a single item that I consume. Instead, my few tasks allow me to exchange for goods and services that require many tasks. Think for a moment about all of the tasks required to produce a pencil or a toaster.

How many tasks go into the production of the goods and services that I consume in a single day? My guess is that the number is in the millions. And yet I only have to perform a few tasks myself in order to earn the means to obtain these goods and services. That is the miracle performed by complex patterns of specialization and trade.

So I arrive at this definition of a job:

A job is a context for performing a particular small set of tasks that can be exchanged for the means to obtain goods and services produced by a far larger set of tasks.

This definition of a job is consistent with the ordinary intuition that jobs must be “created.” You cannot just do any random set of small tasks to earn the means to obtain the goods and services of the market. That is why I do not define a job as the set of tasks. Instead, I define it as the context in which those tasks are undertaken. Without a context in which the set of tasks adds value, there is no basis for exchange. In order to have a job, you or an employer must discover a context in which sufficient value is created by a particular set of tasks that you are capable of performing.

This definition avoids the suggestion that jobs are lacking because of a scarcity of wants. It also avoids the suggestion that the labor market should be described as a “matching problem,” with employers and potential employees in search of one another. It is a definition of a job that reflects the importance of patterns of sustainable specialization and trade.

What’s Wrong with Keynesian Economics?

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It looks like I will be contributing to a set of essays on this topic. Here is what I am thinking of in terms of an outline.

1. What is Keynesian economics?

I think that there are two important versions. There is the folk Keynesianism of policy makers and journalists, and there is the academic Keynesianism of graduate school and peer-reviewed papers. When pressed to give a narrative interpretation and discuss policy, economists tend to fall back on folk Keynesianism. When other economist object to some basic flaws in folk Keynesian economics, macroeconomists fall back on academic economics. In Greg Mankiw’s terminology, the policy engineer does not make use of the scientific paper, but he can pull a copy out of his back pocket if somebody asks to see it.

What I call Folk Keynesianism is what is used in narrative interpretation and policy discussions. Spending creates jobs and jobs create spending. The Folk Keynesian economy is one in which the price mechanism for adjustment and clearing markets has disappeared. Instead, quantities determine other quantities.

The other version is what I call academic Keynesianism. Think of it as an attempt to introduce re-introduce prices into an otherwise Keynesian economy. You start with Hicks sneaking the interest rate back in as a determinant of investment. Then you have the Phelps volume sneaking the real wage back in as a determinant of employment. Then you have the Lucas critique, which is answered by bringing in intertemporal optimization. You end up with Blanchard’s “state of macro” paper.

2. What is the alternative?

PSST, of course, which interprets macroeconomic phenomena as the problem of coordinating in a world of very complex trading patterns. Compared with folk Keynesianism, PSST fails to offer as compelling a basis for a narrative interpretation and policy discussions. If you want a satisfying narrative that probably is false, then stick with Keynesianism.

3. What can we learn from the data?

There are at least two problems with macroeconomic data. One is the fact that it is non-experimental. We cannot test important hypotheses against one another. It is easy to impose competing narratives on the same data. I might also mention Leamer’s attempts to document patterns in the data.

The other problem is that the classification and aggregation of data is questionable. According to economic theory, education is an investment. But in the national income accounts, what consumers spend on education is called consumption. What government spends on education is government consumption. And even what businesses spend on training is not typically included in investment. If I buy a cell phone for my household, it is consumption. If my company buys me a cell phone, it counts as investment. Much of what is counted as labor income in the national income accounts is actually a return on investment. The concept of “the real wage rate” is ridiculous. Neither the numerator nor the denominator is the same across individuals. Aggregate productivity statistics are also ridiculous.

4. Where did Keynesian economics go wrong? I think it focused too much on (the lack of) price adjustment, and not enough on trial-and-error adjustment. And, more fundamentally, I think it errs by thinking in crude aggregate terms. The economy is not one giant GDP factory. It is a pattern of specialization and trade.

Ken Rogoff on the State of the Economy

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He writes,

The steady decline of real interest rates is certainly a puzzle, but there are a host of factors. First, we do not actually observe the true economic real interest rate; that would require a utility-based price index that is extremely difficult to construct in a world of rapid change in both the kinds of goods we consume and the way we consume them. My guess is that the true real interest rate is higher, and perhaps this bias is larger than usual. Correspondingly, true economic inflation is probably considerably lower than even the low measured values that central banks are struggling to raise.

Read the whole thing. It is part of an interesting symposium on secular stagnation. Pointer from Mark Thoma.

Rogoff also supports the hypothesis of financial crowding out.

Whether by accident or design, banking and financial market regulation has hugely favoured low-risk borrowers (governments and cash-heavy corporates), knocking out other potential borrowers who might have competed up rates. Many of those who can borrow face higher collateral requirements. The elevated credit surface is partly due to inherent riskiness and slow growth in the post-Crisis economy, but policy has also played a large role. Many governments, particularly in Europe, have rammed down the throats of pension funds, banks, and insurance companies. Financial repression of this type not only effectively taxes middle-income savers and pensioners (who receive low rates of return on their savings) but also potential borrowers (especially middle-class consumers and small businesses), which these institutions might have financed to a greater extent if they were not required to be so overweight in government debt.

Do Unit Roots Ruin the Concept of Potential GDP?

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Roger Farmer re-litigates an old controversy about macroeconomic data, concluding

What do we learn from this? Much the same as we learn from the fact that unemployment has a unit root. Just as unemployment can remain persistently high, so GDP can remain persistently below trend. There is no evidence that the economy is self-correcting.

Pointer from Mark Thoma. My comments:

1. Although unemployment has a unit root, Ed Leamer finds that there is some persistence to changes in payroll employment. See his textbook. You might also Google Kling-Leamer-momentum-employment.

2. Unit roots in macro data cause a huge problem. If you don’t correct for them, you get spurious correlation. If you do correct for them, you tend to get noise. That is one reason I call macroeconometrics The Science of Hubris.

3. In stock market returns, econometricians have been able to identify long-term mean reversion even though the short run is a random walk. Can something similar be done with GDP data?

4. If real GDP truly is nonstationary, then how can we rescue the concept of potential GDP? If you think of the economy as ultimately self-correcting, then what it corrects to is potential GDP. If the economy is not self-correcting, then the concept of potential GDP can have no objective basis.

I come to this issue with a desire not to praise the concept of potential GDP, but to bury it. From a PSST perspective, there is no such thing as potential GDP. The patterns of specialization and trade that are sustainable now are the patterns that are sustainable now. There were other patterns that were sustainable in the past, and entrepreneurs will discover still other patterns sustainable in the future, but right now we cannot describe those alternative patterns as potential. Right now those alternative patterns are either not sustainable or yet to be discovered.

What Isn’t Wrong with Macro?

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David Andolfatto is in a very different place than I am. He writes,

what part of the above manifesto do you not like? The idea that people respond to incentives? Fine, go ahead and toss that assumption away. What do you replace it with? People behave like robots? Fine, go ahead and build your theory. What else? Are you going to argue against having to describe the exact nature of government policy? Do you want to do away with consistency requirements, like the respect for resource feasibility. Sure, go ahead.

Pointer from Mark Thoma. Elsewhere, Mark points to interesting comments by Noah Smith.

Some of the parts of mainstream macro that I do not like:

1) that there is a single representative agent who is the consumer and owner of the one firm.

2) that this representative agent never has to use trial and error to figure out what might be a profitable business, much less what might be a profitable pattern of trade involving many businesses.

3) that this representative agent cannot hold more than one expectation about the future. Instead, there is the very anti-Hayekian notion of “rational expectations” which assumes away local information.

4) that “money” and “the price level” are objective, precisely determinate quantities, rather than part of a consensual hallucination.

5) that you can wave your hands and talk about “financial friction” in models in which financial intermediaries are redundant.

And those are just off the top of my head.

The Crowding-Out of Financial Intermediation

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Timothy Taylor points to an IMF report, which says,

The investment slump in the advanced economies has been broad based. Though the contraction has been sharpest in the private residential (housing) sector, nonresidential (business) investment—which is a much larger share of total investment—accounts for the bulk (more than two-thirds) of the slump

I have an argument that this represents crowding out, caused by increased government deficits. However, this is not textbook crowding out, in which the government increases the demand for savings, raising interest rates and reducing investments.

Instead, it is crowding out of financial intermediation. Recall that my view of financial intermediation is that the public wants to issue risky, long-term liabilities and hold safe, short-term assets. Financial intermediaries accommodate this by doing the opposite.

When the government incurs large deficits, it issues safe, short-term liabilities. This crowds out private financial intermediation, because much of the demand for safe, short-term liabilities is satisfied by government debt. Think of the public holding a $100 balance sheet. Without government deficits, financial intermediaries might hold $100 in risky, long-term investments and issue $100 in safe, short-term securities. Instead, with $100 in government bonds issued to financed deficits, the public’s demand for safe, short-term securities can be satisfied with zero investment. Financial intermediation goes away altogether, or just consists of intermediaries who issue safe securities backed by government bonds.