Category Archives: PSST and Macro

What Should Austrian Macroeconomics Resemble?

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Noah Smith writes,

So it basically seems to me that the New Classicals captured and improved on the basic ideas of the Austrians in almost all of the ways that matter, while vastly improving on the presentation. New Classical concepts of rationality, distrust of empiricism, and distrust of government intervention are more moderate and nuanced than those of the Austrians, and their mathematical style is simply much more appealing to modern academics than the dense, turgid prose of von Mises or Hayek. Thus, if you were a smart young macroeconomist in 1980 who believed that people were both rational and smart, that government intervention was a bad idea, and that theory was the best way to investigate human behavior, you did not become an Austrian; you became a New Classical.

Not me!!

What I don’t like about Austrian macro is the focus on the central bank as the sole source of distortions. But I see New Classical as horrible along almost every dimension. I do not like the math. I do not like rational expectations (it is a very anti-Hayekian notion, that we all have the same information). I do not like the representative-agent formulation, because it rules out important co-ordination problems. I do not like the production function, which ignores the roundaboutness of production and what Fischer Black emphasizes, which is that people invest in all sorts of physical and human capital under conditions of uncertainty, and sometimes their capital ends up not so valuable.

I do not like AS and AD, which I think channel people’s thinking narrowly. AS and AD are like a pair of glasses that make you see the world only in black and white and in two dimensions. Sometimes, simplification is good, but not when you miss the color and the depth.

I do not like a priorism, but I see macro as only faux-empirical. As Noah pointed out in a previous post, the macro equations are not verified (or even verifiable) in the real world.

Moreover, the data with which macroeconomists work is very problematic. Who can be happy with how the money supply is measured? Or prices? Or even GDP–what is the GDP of Google? The measured economic activity consists of advertisements. Do we think that measures Google’s output?

Maybe the worst-measured variable of all is productivity. How many workers in the U.S. are in large organizations where they spend time reading email, producing reports, and going to meetings? I am going to go out on a limb here and say that these are, on average, productive activities. They produce some sort of organizational capital. But they do not produce output in the here and now. So if you divide this month’s output by this month’s hours spent on the job, that is inaccurate, because a lot of this month’s work is about output in later periods.

Finally, my first forays into macroeconomics (see my book) were when macroeconometricians tried to pay attention to special factors that messed with their data–steel strikes, tax-law changes, automobile sales-incentive programs, and so on. Now, it’s like “We don’t care. Stick everything into a vector-autoregression and accept whatever the computer spits out.”

The bottom line: Austrian economics ought to resemble PSST, not New Classical.

Inferring from an Identity

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Scott Sumner writes,

To my eyes it looks like “real wages” [(nominal average hourly earnings)/(NGDP/pop)] lead unemployment by about a month or two

Shock me, shock me. Let’s see:

NGDP = RGDP * P = N * (RGDP/N) * W*(P/W)

In words, nominal GDP = employment times output/worker times nominal wages times the price markup.

Solve this for the ratio of the nominal wage to nominal GDP:

W/NGDP = (W/P) * (RGDP/N)/N

In words, Sumner’s “real wage” (the nominal wage divided by nominal GDP) equals the inverse of the price markup times the inverse of productivity times 1/employment. If the price markup and productivity remain about unchanged, then by definition the “real wage” is inversely related to employment.

Scott is fond of saying, “Never reason from a price change.” I say, “Never draw a behavioral inference from an identity.”

A Problem with Modern Macro

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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.

The Medical Analogy

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Michael Huemer writes,

Voters, activists, and political leaders of the present day are in the position of medieval doctors. They hold simple, prescientific theories about the workings of society and the causes of social problems, from which they derive a variety of remedies–almost all of which prove either ineffectual or harmful. Society is a complex mechanism whose repair, if possible at all, would require a precise and detailed understanding of a kind that no one today possesses. Unsatisfying as it may seem, the wisest course for political agents is often simply to stop trying to solve society’s problems.

Pointer from Bryan Caplan. Similarly, in my almost-finished book on macro, I write,

From my perspective, the conventional structure of aggregate demand and aggregate supply offers nothing but a set of just-so stories. It is the equivalent of the ancient Greek theory of medicine which holds that health is governed by the four humors of black bile, yellow bile, phelgm, and blood.

My Macro Book

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IF you go here, you will find a link to a download page. I am not sure how many downloads my internet host will allow before siccing the bandwidth police on me. So please do not download it unless you are seriously planning to read it (it is about 120 pages, pdf).

Feel free to leave comments on the book on any blog post.

The Propagation Issue

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In the event featuring Tim Harford and Alex Tabarrok, this issue came up. The issue is how fluctuations in output and employment become broad and long-lasting. For advocates of real business cycles, the challenge is to explain the breadth of a recession. For example, if you want to say that the recession in 2009 came about because we overbuilt housing, you have to explain why so many other sectors declined. To standard macroeconomists, the breadth of the slowdown requires an aggregate-demand story.

On the other hand, as Alex points out, the many years over which the high unemployment has played out raises questions about the aggregate-demand story. In the AS-AD paradigm, sticky wages and/or prices play a crucial role. But five years on, are sticky wages such a plausible story, given all the churn that has taken place in the labor market? Alex also challenges the idea that “menu costs” could account for price stickiness lasting so long and with such devastating effects.

The Case Against Y = f(K,L)

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1. You want to use it to explain incomes. But you end up having to make up all sorts of alternative types of capital in order to do so.

2. It makes it seem as if you found a planet identical to earth and inhabited only by hunter-gatherers, that you could give them all the equipment that we use to make a brand-new Honda, combine this K with their L, and produce said Honda.

3. In general, it completely overlooks the path-dependency and context-dependency of the value of capital and of labor skills. Fischer Black’s theory of economic fluctuations is focused on the fact that people make investments in an uncertain environment, and sometimes a lot of those investments turn out sour. The way I would put it is that people start down paths expecting them to lead one way, and then the paths do not lead where they want.

In general, it might be better to think of production “paths” rather than production functions. The path enabling the hunter-gatherers to build a Honda would be long and complex. It would include general-purpose technologies, like language, writing, electric motors, the internal combustion engine, computer chips, and radio-frequency communication. It would include the accumulation of human skills, know-how, infrastructure of various kinds, business norms, and regulations.

Fischer Black on the ZLB

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On the topic of aggregate demand, he writes,

When people say that they see shifts in aggregate demand, they mean that they see changes in the match between wants and resources. Thus in a more specific sort of model, high aggregate demand can be a good match. If this is what “aggregate demand” means, we could also call it “aggregate supply.”

That is from p. 87 of the 2010 edition of Exploring General Equilibrium. Basically, he sees a cyclical slowdown as a reflection of capital investments that were made with good intention but turned out to be wrong. In my terminology, people bet on certain patterns of specialization and trade, and those turned out not to be sustainable patterns.

On the Great Depression, he writes,

Firms made investments during the 1920s based on their beliefs about what tastes and technology would be, along many dimensions, during the 1930s. These beliefs turned out to be very wrong, so the investments were not worth much and ability to produce what people wanted was low…

But monetary forces played a big role too…many countries experienced sharp deflation, which drove their nominal interest rates down. Normally, very low nominal interest rates mean a big demand for currency [but] some countries stopped supplying currency passively. This meant a serious breakdown in financial markets.

…the deflations forced short-term nominal interest rates to zero in some countries, and would have made these rates negative were it not for the effective floor at zero. This caused disequilibrium in real asset markets. The real interest rate was forced above its natural level. It was a kind of “currency trap.”

Longer-term nominal interest rates did not fall to zero, because they reflected the chance that the nominal short rate would bounce back to positive levels. But they were artificially high, so longer-term real rates were artificially high, even more so than short-term real rates.

Some notes:

1. He does not believe in AD, but he thinks that the ZLB mattered in the Great Depression. He thinks that the artificially high real interest rates accentuated the mismatches between previous investments and prevailing wants. He does not give any examples. But imagine that you are a farmer, and you invested in farm machinery, and now crop prices are falling. Are you going to throw more money at your investment by buying seeds and fertilizer? Will the bank lend you the money to do so? If growing crops is no longer profitable, then the value of your investment in farm machinery is looking bad.

2. He is saying that just because you observe positive long-term interest rates, that does not mean that the ZLB is unimportant.

3. What about the U.S. in the last five years? On the one hand, we have seen low short-term interest rates. On the other hand, we have not had deflation, so the short-term real interest rate has been low rather than high. Has the long-term real interest rate been artificially high because of the ZLB?

4. In explaining unemployment, I would be inclined to focus more on mismatches involving human capital. In the 1930s, men who had been farm laborers and tenant farmers were thrown out of work by tractors, trucking (which made it possible to shift production away from relatively poor farmland close to cities to better farmland farther away), refrigeration, and so on. Also, workers whose human capital was in cigar rolling or lightbulb glass-blowing found themselves obsolete. In hindsight, these guys should have stayed in school instead of dropping out without completing high school. But as it was, there were too many of them relative to the technology of the 1930s, which ultimately called for a work force with at least a high school education.

Today, I would say that, in hindsight, more people should either have acquired computer skills or prepared for life providing elder care or otherwise engaged in personal services.

Fischer Black: Seeing Capital Everywhere

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After Tyler Cowen told me that my macro book needs more on Fischer Black, I ordered the 2010 edition of Exploring General Equilibrium, which includes a posthumous essay. I will probably have a number of posts on the book.

One way I think of Black is that he sees capital everywhere. In an extreme (and Black does not take things this far), think of the economy as nothing but different forms of capital producing utility. Take the concept of human capital really seriously, to the point (again Black does not take things this far) of looking at a human worker as just another machine.

From the point of view of a firm, the human worker-machine has some capabilities. However, in order to make it productive, you have to set it up, tune it, program it, and coordinated it with other machines. It becomes obsolete when the cost of maintaining and using it exceeds the value of what it produces.

When I ate a piece of toast this morning, I was getting utility out of various forms of capital. These included the refrigerator out of which I took the bread and the toaster oven. However, the bread itself resulted from roundabout production. Seeds were planted, grain was harvested, other ingredients were added, loaves were baked, etc. In order to know how to obtain the bread and operate the toaster oven, I had acquired human capital.

In a world where utility is produced almost entirely by capital, most economic decisions are risky. Any decision today represents a bet on how the world will look tomorrow.

Some remarks on this capital-centric point of view.

1. Standard national income accounting assigns a 2/3 weight to labor’s share of output. But perhaps this is highly misleading. The value comes from the capital embodied in the workers, which includes general human capital (skill usable everywhere) and specific human capital (skills usable on a particular job).

2. Standard national income accounting says that consumption is over 2/3 of output. However, very little output is immediately consumed. When I buy a loaf of bread, I do not consume it immediately. Instead, the bread is an input to consumption that takes place over subsequent days. Although Black does not take things this far, you can think of the bread as capital that, when used, depreciates rapidly and proportionately. This is in contrast to the toaster oven, which depreciates slowly and not exactly proportionately to its use.

3. The value of capital changes as events unfold. A desktop computer from 1987 is not worth much today. Houses in Las Vegas were not worth as much in 2009 as they were in 2005. The ability to shoe a horse is not worth much today. Arguably, a plain vanilla college degree was not worth as much in 2013 as it was in 2006.

4. Black points out that because of adverse selection and moral hazard, human capital investments are harder to diversify than physical capital investments. That is, I cannot sell shares in my future earnings without creating adverse-selection and moral-hazard problems, so I have to retain a large interest in my own human capital.

5. One of Black’s central points is that as events play out, some investments earn good returns and some investments earn bad returns. You will not always see equal amounts of good luck and bad luck. A lot of good luck is a boom. A lot of bad luck is a bust.

6. Black says several times that worker compensation consists of training as well as pay and benefits. When a lot investments do not pan out as hoped/expected, compensation for some humans has to fall. Black points out that if the compensation still includes a lot of training, then the firm may not be able to afford much in terms of wages and benefits. It made me think of unpaid internships as a market response to these circumstances. Of course, dropping out of the labor force is another natural response.

7. In thinking about the current situation, ask yourself which sorts of investments are no longer panning out. At the margin, does it no longer pay to take on a manual worker and train that worker? Health insurance costs are rising, and machines are getting smarter and more dexterous. At the margin, does it no longer pay to hire an American worker with a plain vanilla college education? A web site and a call center in India may be more efficient than an American sales force. Maybe financial institutions have had to cancel a lot of plans to hire plain vanilla college graduates to work in what was once thought to be an ever-expanding lending-securitization industry. Maybe when you factor in health care costs and the time it takes for a worker to get up to speed, the present value of investing in a new college-grad worker is no longer positive.

DSGE and the Market Test

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Noah Smith writes,

In other words, DSGE models (not just “Freshwater” models, I mean the whole kit & caboodle) have failed a key test of usefulness. Their main selling point – satisfying the Lucas critique – should make them very valuable to industry. But industry shuns them.

Pointer from Mark Thoma.

A few years ago, I happened to run into Olivier Blanchard. I offered my complaint that folks like Stan Fischer and himself had made macroeconomics narrow and stilted. “We’ve passed the market test,” he replied. But the “market test” to which he referred is limited to academic macro. It is a supplier-controlled cartel, not a consumer market.